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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
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