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hedging-skw 10/15/2018
Outline
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hedging-skw 10/15/2018
Hedging & Price Volatility
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Hedging & Price Volatility (cont.)
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Hedging & Price Volatility (cont.)
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Hedging & Price Volatility (cont.)
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Interest Rate Volatility
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Interest Rate Volatility (cont.)
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Exchange Rate Volatility
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Exchange Rate Volatility (cont.)
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Commodity Price Volatility
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Commodity Price Volatility (cont.)
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Example:
- Oil is one of the most important commodities. Oil
prices have become increasingly uncertain since the
early 1970s (why?)
hedging-skw 10/15/2018
The Risk Management Process
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The Risk Management Process (cont.)
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Example
- An all-equity firm would not be concerned about
interest rate fluctuations as a highly leveraged firm.
- A firm with little or no international activity would
not be overly concerned about exchange rate
fluctuations.
hedging-skw 10/15/2018
Risk Profiles
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Risk Profile for a Wheat Grower
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Risk Profile for a Wheat Grower (cont.)
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Risk Profile for a Wheat Buyer
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Reducing Risk Exposure
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Reducing Risk Exposure (cont.)
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Example
- Consider a firm that uses rice to make a popular brand of
cereal. If the price of rice increases, the firm that raises and
processes the rice will benefit; the firm that uses the rice in
its cereal will lose.
- By signing a contract specifying that the rice producer will
deliver a certain quantity of rice at a certain price, the cereal
manufacturer has reduced (or eliminated) the uncertainty
about the cost of rice. At the same time, the rice producer
has eliminated uncertainty about the price they will receive
for the processed rice.
hedging-skw 10/15/2018
Reducing Risk Exposure (cont.)
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Timing
Short-run exposure (transactions exposure) – short-term
price fluctuations due to unexpected events or shocks are
referred to as transitory changes. These changes can be
managed in a variety of ways
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Reducing Risk Exposure (cont.)
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Timing
Long-run exposure (economic exposure) – some price
fluctuations may reflect permanent changes due to a
fundamental shift in the underlying economics of a business.
Almost impossible to hedge, requires the firm to be flexible
and adapt to permanent changes in the business climate
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Forward Contracts
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Forward Contracts (cont.)
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Payoff profiles for a forward contract
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Payoff profiles for a forward contract
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Hedging with Forwards
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Hedging with Forwards (cont.)
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Credit risk
- There is a credit risk involved because no money
changes hands until a forward contract is actually
completed
- The party on the losing end of the deal has an
incentive to default on the agreement
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Hedging with Forwards (cont.)
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Hedging with Forwards (cont.)
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Hedging with forward contracts
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Futures Contracts
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Trading in Futures
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Futures Exchanges
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Hedging with Futures
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Hedging with Futures (cont.)
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Hedging with Futures (cont.)
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Swaps
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Currency Swaps
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Interest Rate Swaps
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Commodity swaps
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The Swap Dealer
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Option Contracts
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Options versus Forwards
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Option Payoff Profiles
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The horizontal axis shows the difference between the asset’s value and
the strike price on the option
For a call option
- the owner begins to make a profit when the price of the underlying
asset rises above the strike price
- from the seller’s viewpoint, any gain to the owner of the option is a loss
to the seller of the option
For a put option
- the owner begins to make a profit when the price of the underlying
asset falls below the strike price
- a gain to the buyer of a put option is a loss to the seller of the option
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Payoff Profiles: Calls
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Payoff Profiles: Puts
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Option Hedging
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Hedging with Options
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Hedging Commodity Price Risk with Options
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Hedging Commodity Price Risk with
Options (cont.)
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Example
- When a futures call option on wheat is exercised, the owner
of the option receives two things
- The first is a futures contract on wheat at the current
futures price
- This contract can be immediately closed at no cost
- The second thing the owner of the option receives is the
difference between the strike price on the option and the
current futures price
- This difference is paid in cash
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Hedging Commodity Price Risk with
Options (cont.)
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Hedging Exchange Rate Risk with
Options
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Hedging Exchange Rate Risk with
Options (cont.)
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Hedging Interest Rate Risk with Options
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Hedging Interest Rate Risk with Options
(cont.)
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Summary
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