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McMaster University
Kevin Brewer

Commerce 2FA3 Chapter 24: Risk Management: An introduction to Financial Engineering Hedging and Price Volatility Hedging: Reducing a firm’s exposure to price or rate fluctuations. Also, immunization Derivative security: A financial asset that represents a claim to another financial asset Managing Financial Risk - Financial managers need to identify the types of price fluctuations that have the greatest impact on the value of the firm The Risk Profile - A plot showing how the value of the firm is affected by changes in prices or rates - Increase in prices, increases value Reducing Risk Exposure - Price fluctuations have 2 components: 1) Short-run: essentially temporary changes 2) Long run: essentially permanent changes Hedging Short Run Exposure -Transitory changes are short-run temporary changes in prices that result from unforeseen events or shocks Transactions exposure: Short-run financial risk arising from the need to buy or sell at uncertain prices or rates in the near future Hedging Long Term Exposure Economic exposure: Long-term financial risk arising from permanent changes in prices or other economic fundamentals Hedging with Forward Contracts Forward Contracts: The Basics - A legally binding agreement between 2 parties calling for the sale of an asset or product in the future at a price agreed upon today - The terms of the settlement call for one party to deliver the goods to the other on a certain date in the future, called the settlement date - The other party pays the previously agreed-upon forward price ad take the goods - Can be bought and sold - The buyer of the forward contract has the obligation to take delivery and pay for the goods; the seller has the obligation to make delivery and accept payment - They buyer benefits if prices increase because the buyer will have locked in a lower price The Payoff Profile - A plot showing the gains and losses that will occur on a contract as the result of unexpected price changes Hedging with Future Contracts Futures contract: A forward contract with the feature that gains and losses are realized each day rather than only on the settlement date - The daily resettlement feature found in futures contracts in called marking-to-market Cross-hedging: Hedging an asset with contracts written on a closely related, but not identical, asset Hedging with Swap Contracts Swap contract: An agreement by 2 parties to exchange, or swap, specified cash flows at specified intervals in the future. - Just a portfolio or a series of forward contracts Currency Swaps - Two companies agree to exchange a specific amount of one currency for a specific amount of another at specific dates in the future Interest Rate Swaps -- Might involve exchanging one floating-rate loan for another as way of changing the underlying index - The 2 firms’ make each other’s loan payments Commodity Swaps - An agreement to exchange a fixed quantity of a commodity at fixed times in the future The Swap Dealer - Key role in the swaps market - A firm wishing to enter into a swap agreement contacts a swap dealer, and the swap dealer tales the other side of the agreement - They will then try to find an offsetting transaction with some other party or parties Credit Default Swaps (CDS) - A contract that pays off when a credit event occurs, default by a particular company termed the reference entity, giving the buyer the right to sell corporate bonds issued by the reference entity at their face value Hedging with Option Contracts Option contract: An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specific price for a set period of time. Option Terminology Call Option: An option that gives the owner the right, but not the obligation, to buy an asset. Put Option: An option that gives the owner the right, but not the obligation, to sell an asset. - The act of buying or selling the underlying asset using the option contract is called exercising the option Options versus Forwards - 2 key differences: 1) With a forward contract, both parties are obligation to transact; one party delivers the asset, and the other party pays for it. With an option, the transition occurs only if the owner of the option chooses to exercise it. 2) Whereas no money changes hand when a forward contract is created, the buyer of an option contract gains a valuable right and must pay the seller for that right.  Often called the option premium - An interest rate cap is a call option on an interest rate Commerce 2FA3 Chapter 25: Options and Corporate Securities Options: the basics - Are a unique type of financial contract because they give the buyer the right, but no the obligation, to do something - The buyer uses the option only if it profitable to do so, otherwise the option can be thrown away Exercising the option: The acting of buying or selling the underlying asset via the option contract Striking price: The fixed price in the option contract at which the holder can buy or sell the underlying asset. Also, the
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