Week 3 - Chapter 4

Week 3 - Chapter 4 - Chapter4:Introductionto RiskManagement

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1 FINA0301  Derivatives Faculty of Business and Economics  University of Hong Kong Dr. Tao Lin Chapter 4: Introduction to  Risk Management
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2 Chapter Outline Basic risk management: the producer’s  perspective Basic risk management: the buyer’s perspective Why do firms manage risk?  Reasons to hedge or not to hedge Empirical evidence on hedging Section  4.4  and  4.5  will not be covered or tested!!
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3 Basic Risk Management Firms convert inputs into goods and services                  output                 input                               commodity          producer                        buyer A firm is  profitable  if the cost of what it produces  exceeds the cost of its inputs A firm that actively uses derivatives and other  techniques to  alter its risk  and  protect its  profitability  is engaging in  risk management
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4 The Producer’s Perspective A producer selling a risky commodity has an  inherent  long  position in this commodity When the price of the commodity  , the firm’s  profit   (assuming costs are fixed) Some strategies to  hedge profit Selling forward Buying puts Selling a call Buying collars
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5 Producer: Hedging With Forwards A short forward contract allows a producer to  lock in   a price for his output Example:  a gold- mining firm enters  into a short forward  contract, agreeing  to sell gold at a price  of $420/oz. in 1 year.  Suppose the cost  is $380/oz. What is current gold price?
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6 Producer: Hedging With a Put Option Buying a put option  allows a producer to have  higher profits  at high output prices, while providing a  floor  on the price Example:  a gold- mining firm  purchases a 420- strike put at the  premium of $8.77/oz
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7 Producer: Insuring by Selling a Call written  call reduces losses through a premium, but 
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Week 3 - Chapter 4 - Chapter4:Introductionto RiskManagement

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