FINM3405 Tutorial 1
Philip Gray 2009
Derivatives & Risk Management
When we have an exposure to a particular security (be it stocks, bonds, exchange rates,
commodities, …), movement in prices can be favourable or unfavourable. For most
securities, it is extremely difficult to predict future movements. Exchange rate movements,
for example, are pretty much a 50:50 chance of going up or down. The random walk
hypothesis for stock prices implies a similar thing.
In business, there are two main ways of approaching this exposure:
: take the attitude that I am not prepared to gamble on correctly predicting price
movements … not prepared to risk making a loss. Therefore, prefer to remove all
uncertainty by ‘locking-in’ a certain value (be it an exchange rate at which you transact,
an interest rate at which you borrow, a price at which you buy or sell, …).
: is the exact opposite to hedging. You don't lock-in; you basically take a
gamble that you correctly predict price movements. In doing so, you are fully exposed to
price movements. If you guess right, you gain; if you guess wrong, you lose.
Most of the lecture examples are based around hedging various risk exposures using
derivatives. If, however, you understand how derivatives work, you can easily use them to
speculate. A few tutorial questions will do this (including Q2).
Obviously, Qantas buys a lot of jet fuel and is exposed to the risk of fuel prices rising. A
long forward contract is a commitment to buy oil at the pre-specified price. This allows
Qantas to know exactly how much fuel will cost by locking in a purchase price.
Cattle farmers worry about falling auction prices for live cattle, and often enter short
futures contracts to lock in the sale price. However, this farmer has decided against doing
this – effectively, s/he will take his/her chances that prices won’t fall. It might sound odd,
but to do nothing in this case is in fact speculation – speculation that prices at sale time
will be higher than they are now.
Fifteen to twenty years ago, there were a number of high-profile cases where company
directors were found to be negligent for ‘doing nothing’ about risk management. They
refused to enter derivative positions to manage significant exchange-rate and interest-rate
Entering long futures positions to buy electricity is obviously a hedging activity.
Electricity prices can change very quickly due to weather, generator outages etc.