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# 5 sl - THE UNIVERSITY OF HONG KONG FACULTY OF BUSINESS AND...

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1 T HE U NIVERSITY OF H ONG K ONG F ACULTY OF B USINESS AND E CONOMICS FINA0301 CDE - D ERIVATIVES First Semester, 2009-2010 Tutorial 3 Slide Chapter 4 – Introduction to Risk Management checkbld Basic Risk Management What is Risk Management? A firm that actively uses derivatives and other techniques to alter its risk and protect its profitability is engaging in risk management. Producer’s Perspective square4 Short Forward A gold mining firm (a Long position in gold) enters into a short forward contract, agreeing to sell gold at a price of \$420/oz in a year. Fixed Cost: \$330 Variable Cost: \$50

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FINA0301 – Tutorial 3 Slide Mr. Clive Man Chung HO 2 Gold price in 1 year Fixed Cost Variable Cost Unhedged Net Income Profit on Short Forward ( F-S T ) Net Income on Hedged Position \$350 -330 -\$50 -\$30 \$70 \$40 \$400 -330 -\$50 \$20 \$20 \$40 \$450 -330 -\$50 \$70 -\$30 \$40 \$500 -330 -\$50 \$120 -\$80 \$40
FINA0301 – Tutorial 3 Slide Mr. Clive Man Chung HO 3 square4 Long Put Option Buying a put option allows a producer to have higher profits at high output prices, while providing a floor on the price. A gold mining firm purchases a 420-strike put, at a premium of \$8.77/oz. Fixed Cost: \$330 Variable Cost: \$50 Effective Interest Rate: 5% Future Value of the option Premium: \$8.77 × 1.05 = \$9.21 K = \$420 Gold price in 1 year Fixed Cost Variable Cost Unhedged Net Income Profit on Put Option Net Income on Hedged Position \$350 -330 -\$50 -\$30 \$60.79 \$30.79 \$400 -330 -\$50 \$20 \$10.79 \$30.79 \$450 -330 -\$50 \$70 -\$9.21 \$60.79 \$500 -330 -\$50 \$120 -\$9.21 \$110.79

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FINA0301 – Tutorial 3 Slide Mr. Clive Man Chung HO 4 square4 Written Call A written call reduces losses through a premium, but limits possible profits by providing
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