Chapter 11 Hedging Insuring Diversifying 1 Contents

Chapter 11 Hedging, Insuring, Diversifying 1

Contents 1. 2. 3. 4. 5. 6. Forward and Futures to Hedge Risk Swap Contracts Hedging, Matching Assets to Liabilities Minimizing the Cost of Hedging Insuring v. Hedging Insurance Contracts 7. 8. 9. 10. 11. Financial Guarantees Caps and Floors on Interest Rates Options as Insurance The Diversification Principle Diversification and the Cost of Insurance 2

Forward Contracts Two Parties agree to exchange some item in the future at a prearranged price 3

Forward Contracts, Terminology Forward price: The specified price of the item ¡ Spot price: The price for immediate delivery of the item ¡ Face value: quantity of item times the forward price ¡ Long/Short position: The position of the party who agrees to buy/sell the item ¡ 4

Forward Contract, Example Farmer, Baker Uncertain about the future price of wheat one month from now Natural match Forward contract: One month from now, the farmer will deliver 100, 000 bushels of wheat to the baker and receive the face value $200, 000 in return 5

Futures Contracts A standardized forward contract that is traded on some organized exchange 6

Futures Contract, Example The farmer in Kansas, the baker in New York They enter a wheat futures contract with the future exchange at a price of $2 per bushel farmer: short position baker: long position The exchange matches them Futures Contract: Paying to (receiving from) the exchange ($2 -spot price) 100, 000 7

Futures Contract, Example cont. At due date Wheat $1. 5 per bu. $2. 5 per bu. Farmer from distributor $150, 000 $200, 000 $250, 000 Farmer fromto exchange $50, 000 0 ($50, 000) Total $200, 000 8

Swap Contracts Consists of two parties exchanging (swapping) a series of cash flows at specified intervals over a specified period of time 9

Swap Contracts, Example Computer software business in US, German company pays DM 100, 000 each year for a period of 10 years for the right to produce and market the software The dollar/mark exchange rate risk Currency swap: on an exchange rate of $0. 5 per mark. Each year the US party receives frompays to the counterparty DM 100, 000($0. 5 -spot rate) 10

Insuring versus Hedging ¡ ¡ Hedging: Eliminating the risk of loss by giving up the potential for gain Insuring: Paying a premium to eliminate the risk of loss and retain the potential for gain 12

Insuring v. Hedging, Example The farmer: 1. Takes no measures to reduce risk 2. Hedges with a forward contract, 100, 000 bushels, $2 per bushel 3. Buys an Insurance for a premium of $20, 000, which guarantees a minimum price of $2 per bushel for her 100, 000 bushels 13

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Options The right to either purchase or sell something at a fixed price in the future 19

Options, Terminology ¡ ¡ ¡ Call/Put: An option to buy/sell a specified item at a fixed price Strike price or Exercise price: The fixed price specified in the option Expiration date or Maturity date: The date after which an option can no longer be exercised 20

Options ¡ ¡ European Option: Can only be exercised on the expiration date American Option: Can be exercised at any time up to and including the expiration date 21

Diversifying Splitting an investment among many risky assets instead of concentrating it all in only one 22

The Diversification Principle By diversifying across risky assets sometimes it is possible to reduce the overall risk with no reduction in expected return 23

Review 24

Review 25

Review 26

Uncorrelated Risks 27

Nondiversifiable Risk In a randomly selected equally weighted portfolio, with possible positive correlation between stocks, by adding more stocks the standard deviation reduces just to a point ¡ Diversifiable risk: The part of the volatility that can be eliminated ¡ Nondiversifiable risk: The part that remains ¡ 28

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Diversifiable Security Risk Nondiversifiable Security Risk 32

All risk is diversifiable 33

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