Finance School of Management Chapter 11: Hedging and Insuring Obiective Explain market mechanisms for Implementing hedges and insurance uesTc
1 Finance School of Management Chapter 11: Hedging and Insuring Objective Explain market mechanisms for implementing hedges and insurance
Finance School of Management Chapter 11 Contents 11. 1 Using Forward Futures 11.6 Basic Features of Contracts to Hedge risks Insurance Contracts 11.2 Hedging Foreign 1.7 Financial Guarantees Exchange Risk with Swap Contracts 1. 8 Caps floors on 11.3 Hedging Shortfall-Risk by Interest rates Matching Assets to 11.9 Options as Insurance Liabilities 11.10 The Diversification 11. 4 Minimizing the Cost of Principle Hedging 1111 Insuring a diversified 11.5 Insuring versus Hedging Portfolio uesTc
2 Finance School of Management Chapter 11 Contents 11.1 Using Forward & Futures Contracts to Hedge Risks 11.2 Hedging Foreign- Exchange Risk with Swap Contracts 11.3 Hedging Shortfall-Risk by Matching Assets to Liabilities 11.4 Minimizing the Cost of Hedging 11.5 Insuring versus Hedging 11.6 Basic Features of Insurance Contracts 11.7 Financial Guarantees 11.8 Caps & Floors on Interest Rates 11.9 Options as Insurance 11.10 The Diversification Principle 11.11 Insuring a Diversified Portfolio
Finance School of Management Example of a Forward Contracts Planning a trip from In either case, payment Boston to Tokyo a will not take place until year from now the day of flight You make your flight In entering the forward reservation now contract you eliminate You can either lock in the risk of the airfare a price of$1,000 by going above $1,000 committing now or But wait to do nothing uesTc
3 Finance School of Management Example of a Forward Contracts v Planning a trip from Boston to Tokyo a year from now v You make your flight reservation now v You can either lock in a price of $1,000 by committing now or wait to do nothing v In either case, payment will not take place until the day of flight v In entering the forward contract you eliminate the risk of the airfare going above $1,000 v But …
Finance School of Management Forward Contracts Any time two parties agree to exchange some item in the future at a prearranged price, they are entering into a forward contract 6 No money is paid in the present by either party to the other uesTc 4
4 Finance School of Management Forward Contracts v No money is paid in the present by either party to the other
Finance School of Management Terminology Forward price e Spot price Face value The party that has agreed to buy has what is termed a long position The party that has agreed to sell has what is termed a short position uesTc
5 Finance School of Management Terminology v The party that has agreed to buy has what is termed a v The party that has agreed to sell has what is termed a
Finance School of Management Forward Contract vs Spot Contract Price Delivery selfix To enter To exchange the into the asset(delivery) contract (quantit y, price and Tie future T dateypot contract is an agreement to buy or sel uesTc an asset immediately 6
6 Finance School of Management To enter into the contract (quantit y, price and future date) Delivery price(fixed) T To exchange the asset (delivery) A spot contract is an agreement to buy or sell an asset immediately Time Price 0
Finance School of Management Illustration a farmer a baker A farmer has planted her fields a baker will need wheat a with wheat and the size of her month from now to produce crop is reasonably certain bread It is now a month before A large fraction of his wealth is harvest tied up in his bakery business a large fraction of her wealth is The way for him to reduce the tied up in her wheat crop price risk is to buy wheat She want to eliminate the risk wheat now for future delivery associated with uncertainty The baker is a natural match about its future price by selling for the farmer to enter into a it now at a fixed price for forward contract future delivery uesTc
7 Finance School of Management Illustration: a Farmer & a Baker v A farmer has planted her fields with wheat, and the size of her crop is reasonably certain v It is now a month before harvest v A large fraction of her wealth is tied up in her wheat crop v She want to eliminate the risk associated with uncertainty about its future price by selling it now at a fixed price for future delivery v A baker will need wheat a month from now to produce bread v A large fraction of his wealth is tied up in his bakery business v The way for him to reduce the price risk is to buy wheat wheat now for future delivery v The baker is a natural match for the farmer to enter into a forward contract
Finance School of Management Illustration a farmer a baker Suppose the size of thethe farmers wheat crop is 100.000 bushels The forward price is $2 per bushel at the end of the month the farmer will deliver 100.000 bushels wheat to the baker and receive S200.000 from the baker in return Both parties eliminate the risk associated with the uncertainty about the spot price of wheat at the delivery date uesTc 8
8 Finance School of Management Illustration: a Farmer & a Baker v Suppose the size of the the farmer’s wheat crop is 100,000 bushels v The forward price is $2 per bushel v At the end of the month, the farmer will deliver 100,000 bushels wheat to the baker and receive $200,000 from the baker in return v Both parties eliminate the risk associated with the uncertainty about the spot price of wheat at the delivery date
Finance School of Management The difficulties to match a farmer and a baker The farmer and the baker may be separated by a great distant The farmer is located in Kansas and usually sells her wheat to a local distributor in Kansas The baker is located in New York, and usually buys wheat from a local supplier in New York e The exactly matched quantity The credit risk uesTc
9 Finance School of Management The Difficulties to Match a Farmer and a Baker v The farmer and the baker may be separated by a great distant – The farmer is located in Kansas, and usually sells her wheat to a local distributor in Kansas – The baker is located in New York, and usually buys wheat from a local supplier in New York v The exactly matched quantity v The credit risk
Finance School of Management Futures Contracts a standardized forward contract that is traded on an organized exchange Standardization of the terms of the future contracts (e.g. quantity, quality and delivery date The exchange interposes itself between the buyer and le seller as an intermediary The margin requirement and the mechanism of mark- to-market uesTc
10 Finance School of Management Futures Contracts v A standardized forward contract that is traded on an organized exchange – Standardization of the terms of the future contracts (e.g., quantity, quality and delivery date ) – The exchange interposes itself between the buyer and the seller as an intermediary – The margin requirement and the mechanism of ‘markto-market’