Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
© The McGraw−Hill^819
Companies, 2002point before maturity. This simply means that if the firm sells a futures contract to hedge
something, it will buy the same contract at a later date, thereby eliminating its futures
position. In fact, futures contracts are very rarely held to maturity by anyone (despite
horror stories of individuals waking up to find mountains of soybeans in their front
yards), and, as a result, actual physical delivery very rarely takes place.
A related issue has to do with contract maturity. A firm might wish to hedge over a
relatively long period of time, but the available contracts might have shorter maturities.
A firm could therefore decide to roll over short-term contracts, but this entails some
risks. For example, Metallgesellschaft AG, a German firm, nearly went bankrupt in
1993 after losing more than $1 billion in the oil markets, mainly through derivatives.
The trouble began in 1992 when MG Corp., a U.S. subsidiary, began marketing gaso-
line, heating oil, and diesel fuel. It entered into contracts to supply products for fixed
prices for up to 10 years. Thus, if the price of oil rose, the firm stood to lose money. MG
protected itself by, among other things, buying short-term oil futures that fluctuated with
near-term energy prices. Under these contracts, if the price of oil rose, the derivatives
gained in value. Unfortunately for MG, oil prices dropped, and the firm incurred huge
losses on its short-term derivatives positions without an immediate, offsetting benefit on
its long-term contracts. Thus, its primary problem was that it was hedging a long-term
contract with short-term contracts, a less-than-ideal approach.
HEDGING WITH SWAP CONTRACTS
As the name suggests, a swap contractis an agreement by two parties to exchange, or
swap, specified cash flows at specified intervals. Swaps are a recent innovation; they
were first introduced to the public in 1981 when IBM and the World Bank entered into
a swap agreement. The market for swaps has grown tremendously since that time.
A swap contract is really just a portfolio, or series, of forward contracts. Recall that
with a forward contract, one party promises to exchange an asset (e.g., bushels of wheat)
for another asset (cash) on a specific future date. With a swap, the only difference is that
there are multiple exchanges instead of just one. In principle, a swap contract could be
tailored to exchange just about anything. In practice, most swap contracts fall into one
of three basic categories: currency swaps, interest rate swaps, and commodity swaps.
Other types will surely develop, but we will concentrate on just these three.
Currency Swaps
With a currency swap,two companies agree to exchange a specific amount of one cur-
rency for a specific amount of another at specific dates in the future. For example, sup-
pose a U.S. firm has a German subsidiary and wishes to obtain debt financing for an
expansion of the subsidiary’s operations. Because most of the subsidiary’s cash flows
are in euros, the company would like the subsidiary to borrow and make payments
in euros, thereby hedging against changes in the euro-dollar exchange rate. Unfor-
tunately, the company has good access to U.S. debt markets, but not to German debt
markets.
CONCEPT QUESTIONS
23.4a What is a futures contract? How does it differ from a forward contract?
23.4bWhat is cross-hedging? Why is it important?CHAPTER 23 Risk Management: An Introduction to Financial Engineering 793For information on the
regulation of futures
contracts, go to the
Commodity Futures
Trading Commission at
http://www.cftc.gov.swap contract
An agreement by two
parties to exchange, or
swap, specified cash
flows at specified
intervals in the future.