Note2 - Management 249 Derivatives Professor Fan Yu Lecture...

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Management 249 Derivatives Professor Fan Yu Lecture 2 Hedging with Forwards and Futures This Version: January 15, 2008 c 2008 Fan Yu. All Rights Reserved. 1
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Why Would Companies Hedge? In a perfect capital market, hedging makes no di/erence. Due to Modigliani and Miller. no transaction costs, and unlimited access to capital. Shareholders can hedge themselves. So, why do ²rms hedge? Managers are risk-averse and ²nancial distress is costly. Higher leverage is associated with more hedging. Hedging allows the ²rm to invest more e¢ ciently. Higher R³D is associated with more hedging. Firms may know the risk they are taking on better than shareholders. Hedging adds value in the case of multinationals whose risk expo- sure is complex and opaque. Hedging does not add value for ²rms with clearly de²ned risk (e.g. oil and gas producers). 2
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Example 1 Hedging with Futures and Forwards A Swiss institutional investor is holding a portfolio of long term U.S. Trea- sury bonds. The current date is June 1 and it is planned that the investment will be terminated in 6 months, on December 1. At that time, the bonds will be sold in the U.S. market and the proceeds will be converted into Swiss francs for repatriation to Switzerland. The portfolio contains $20 million face value of bonds, and at current market prices, it is worth $24.0 million. The spot exchange rate is 0.6700 (dollars per franc). If the transaction were done today, the proceeds would be: $24 : 0 = 0 : 6700 = SF 35 : 821 million : position is exposed to risk. During the next 6 months, the investor would like to minimize this risk exposure. What are the major risks facing the investor? How would you manage to eliminate these risks? 3
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Hedging with Futures under Ideal Circumstances In general, a long futures hedge is appropriate when you know you will an asset in the future and want to lock in the price. A short futures hedge is appropriate when you know you want to an asset in the future and want to lock in the price now. Example 2 A farmer wants to sell 10,000 bushels of corn after harvest. Spot price per bushel is $2.90. The farmer can short two corn futures contracts. Suppose the futures price is $3.00 per bushel. Suppose that there are only three possible spot prices for corn at harvest time: $2.90, $3.00 and $3.10. Spot Price $2.90 $3.00 $3.10 Value of Corn $29,000 $30,000 $31,000 Short Futures $1,000 $0 $-1,000 Overall $30,000 $30,000 $30,000 No matter what happens, the farmer is guaranteed to get $30,000 for his corn. This hedging strategy works perfectly because there exists a corn futures this situation occurs only by coincidence. What if the farmer expects harvest to occur in August or does not even
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This note was uploaded on 03/19/2008 for the course FI 478 taught by Professor Yu during the Spring '08 term at Michigan State University.

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Note2 - Management 249 Derivatives Professor Fan Yu Lecture...

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