Use of derivatives as essential risk management tools (II)
This write-up is a continuation of an earlier publication on how risk managers could employ derivatives such as options, swaps, futures, and forwards to effectively mitigate risk in their respective organisations. Discussions in the previous publication ended on some examples of swap contracts.
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Credit spread swap
In a credit spread swap, the emphasis is on the credit spread, which measures the difference between a risky bond’s yield and the yield of a Treasury bond which compares to the risky bond.
Here, quality of the risky bond and Treasury bond may differ; the Treasury bond may have a strong quality than the risky bond. For instance, a 15-year corporate bond may be issued at 12% and a 15-year Treasury bond issued at 10%. Due to the risky nature of the corporate bond, one observes it has a higher yield than the Treasury bond.
The former is said to offer a 200-basis-point spread over the latter. Some analysts refer to credit spread swap as the relative performance total return swap. A credit spread swap involves three parties: Party A; Party B; and Party C, commonly referred to as a third party. Under this contract, Party A agrees to make fixed payments to Party B against a floating spread with a value equivalent to the actual credit spread underlying the contract, and held by a third party.
Stated differently, it is where Party A agrees to make a payment based on the yield-to-maturity of a predetermined debt of Party B. In return, Party B agrees to pay party A, based on an equivalent yield used as a benchmark in the agreement.
In this case, the benchmark could be the yield of a Government’s (third party’s) Treasury bond. On one hand, a lower basis-point is indicative of corporate and other private borrowers’ creditworthiness; it symbolises their ability to repay their debts within time or at the due date.
On the other hand, a higher basis-point raises concern about corporate and other private borrowers’ ability to service or honour their debt obligations as they become due.
Commodity swap
There is a thin line, if any, between fixed-floating interest rate swap and commodity swap. A contractual agreement under the commodity swap is underpinned by a spot, market or floating price which is often determined based on an underlying commodity.
Price of the underlying commodity serves as the basis for exchange of cash flows between the two parties involved in the contract over a considerable or specified period of time.
Parties involved in the contract use commodity swap to hedge against the price of a trading commodity of interest.
Legs of a commodity swap
Generally, a commodity swap has two components namely, fixed-leg component and floating-leg component. A fixed-leg component is often specified in the contractual agreement; and held by the producer who assents to making floating rate payments, determined on the basis of the spot or market price of the underlying commodity.
The floating-leg component of the commodity swap contract is tied to a commodity index agreed upon by parties to the contract or the market price of the underlying commodity; and often held by the consumer of the commodity, or the party willing to pay a fixed price for the commodity.
Although different commodities such as livestock, grains, precious metals, and natural gas, to name a few, could be used in this contract, it is often entered into, with oil as the underlying commodity.
The magnitude and size of commodity swap contracts limit such transactions to corporate bodies, notably large financial institutions, and not individual investors.
A commodity swap allows consumers to access goods, products or commodities in the market at a fairly stable price over a given period of time.
Similarly, it provides producers the necessary hedge against market price fluctuations throughout the duration of the contract. Physical delivery of commodities is usually outlined in a commodity swap contract.
However, it is often characterised by cash settlements; parties involved in a commodity swap normally exchange cash, not a commodity or commodities.
To illustrate, suppose RASEAN Corporation needs to purchase 400,000 barrels of oil each year to meet its production targets for the next two years. The determined forward prices for oil deliveries in years one and year two are US$45 per barrel and US$48 per barrel respectively.
The contract includes one-year and two-year zero-coupon bond yields of four per cent and 4.5 per cent. RASEAN Corporation has two options. That is, decide to make an upfront payment for the entire two years or make annual payments contingent on oil delivery by the supplier or seller.
Should RASEAN Corporation decide to make one-time payment for the two-year contract, the cost of oil per barrel would be US$87.2242 [($45 ÷ (1.04)) + ($48 ÷ (1.045)²) = US$43.2692 + US$43.9550 = US$87.2242].
To receive 400,000 barrels of oil each year for the next two years, RASEAN Corporation would have to pay $34,889,680 today ($87.2242 x 400,000 barrels = $34,889,680).
Counterparts risk under commodity swap
In some cases, the supplier or seller may not be able to deliver the oil as agreed upon. This is often called a counterparts risk. In such a situation, RASEAN Corporation, the buyer or consumer, may agree to make two payments: a payment for each year the 400,000 barrels of oil are delivered.
For annual payments, RASEAN Corporation would pay about $46.4910 per barrel [(X ÷ (1+ 0.04)) + (X ÷ (1 + 0.045)²) = $87.2242 = (X ÷ (1.04) + (X ÷ (1.0920) = $87.2242 = (2X = $87.2242 x 2.1320) = ((2X÷2) = $185.9642 ÷ 2) = (X = 92.9821 ÷ 2) = X = $46.4911]. The total cost of oil delivered yearly to RASEAN Corporation would be US$18,596,440 ($46.4911 x 400,000 barrels).
The total cost of oil delivered in two years when avoiding counterparts risk would be US$37,192,800 ($18,596,400 x 2 = $37,192,880). Settling for option two would result in excess payments of US$2,303,200 ($37,192,800 - $34,889,680), representing 6.60% [($37,192,800 - $34,889,680) ÷ $34,889,680) x 100% = ($2,303,200 ÷ $34,889,680) x 100% = 6.60%] increase.
If RASEAN Corporation is certain of the oil delivery by the supplier, it would be cost-effective for it to adapt the first payment option, that is, the one-time payment for the two-year contract.
The writer is the Dean/Senior Lecturer at the Regent University College of Science and Technology.Email: [email protected]; [email protected] Website: www.ebenezerashley.com