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tolerate a 10% rise in copper prices without suffering significant losses, an out-of-the-money copper
call option that begins to pay off only when copper prices rise more than 10% is ideal. Exchangetraded
copper call options exist, so, due to their greater liquidity and low transaction costs, they would
be the best choice.
A cellular communications firm has sold a six-year variable-rate bond whose interest payments are
tied to the London Interbank Offered Rate (LIBOR). When LIBOR rises, so too do the company‟s
interest payments. When LIBOR falls, the firm‟s interest payments fall. The company‟s interest
payments are due twice a year, on the last days of February and August. The firm raised $160 million
this way. With competition holding cellular telephone rates down, the executives worry that an
increase in interest rates can wipe out all profits. What is the appropriate hedge instrument?
The interest rate exposure is symmetric, ruling out options. The firm needs an instrument that will
pay it money when interest rates rise. Thus, the firm should go short in either bond futures or
forwards, or the firm should be the fixed-rate payer in an interest rate swap. Since the cash flows that
the firm is trying to hedge do not conform to those of any exchange-traded futures contract, the correct
choice is narrowed to the over-the-counter instruments—a forward or a swap. The firm must hedge 12
interest rate payments, two per year for six years. Forwards are generally constructed to provide one
payment only. Swaps are designed to hedge multiple payments over longer terms. Thus, entering a
six-year interest rate swap as the fixed payer is the ideal hedge in this situation.
Summary and Final Recommendations
This chapter has presented the basics of risk management using derivatives. By separating an asset‟s
value from its exposure, derivatives allow firms to exchange exposures without exchanging the
underlying assets. It is much more economical to transfer exposures rather than assets, and thus
derivatives have greatly facilitated risk management. Derivatives are indeed powerful risk
management tools, but in the wrong hands they can be dangerous and destructive. It is essential that
managers fully understand how much and under what conditions derivatives will provide positive cash
flows or require cash outflows. If it is not absolutely clear when and how much the cash flows will be,
do not enter the contract. Managers should strive to identify the nature, magnitude, and size of their
risk exposures. They can then match those exposures with countervailing positions in derivatives.
Managers should never forget that their job is to preserve value by reducing risk. The temptation to
speculate should be avoided. Don‟t be greedy.
Notes
1 Zvi Bodie and Robert C. Merton, Financial Economics, 2nd ed. (Upper Saddle River, NJ: Prentice
Hall, 2009) deserve credit for this perspective on risk management techniques.
2 Time, April 11, 1994.