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Unformatted text preview: e worthless. However, options hedges are costly because of the initial premium that must be paid. The futures contract can be entered into at no initial cost, with the disadvantage that the firm is locking in one price for cotton; it can’t profit from cotton price declines. 2. 3. 4. 5. 6. 7. The put option on the bond gives the owner the right to sell the bond at the option’s strike price. If bond prices decline, the owner of the put option profits. However, since bond prices and interest rates move in opposite directions, if the put owner profits from a decline in bond prices, he would also profit from a rise in interest rates. Hence, a call option on interest rates is conceptually the same thing as a put option on bond prices. The company would like to lock in the current low rates, or at least be protected from a rise in rates, allowing for the possibility of benefit if rates actually fall. The former hedge could be implemented by selling bond futures; the latter could be implemented by buying put options on bond prices or buying call options on interest rates. A swap contract is an agreement between parties to exchange assets over several time intervals in the future. The swap contract is usually an exchange of cash flows, but not necessarily so. Since a forward contract is also an agreement between parties to exchange assets in the future, but at a single point in time, a swap can be viewed as a series of forward contracts with different settlement dates. The firm participating in the swap agreement is exposed to the default risk of the dealer, in that the dealer may not make the cash flow payments called for in the contract. The dealer faces the same risk from the contracting party, but can more easily hedge its default risk by entering into an offsetting swap agreement with another party. 8. 9. 10. The firm will borrow at a fixed rate of interest, receive fixed rate payments from the dealer as part of the swap agreement, and make floating rate payments back to the dealer; the net position of the firm is that it has effectively borrowed at floating rates. 11. Transaction exposure is the short-term exposure due to uncertain prices in the near future. Economic exposure is the long-term exposure due to changes in overall economic conditions. There are a variety of instruments available to hedge transaction exposure, but very few long-term hedging instruments exist. It is much more difficult to hedge against economic exposure, since fundamental changes in the business generally must be made to offset long-run changes in the economic environment. 12. The risk is that the dollar will strengthen relative to the yen, since the fixed yen payments in the future will be worth fewer dollars. Since this implies a decline in the $/¥ exchange rate, the firm should sell yen futures. The way the interest rate is quoted will affect the calculation of which currency is strengthening. 13. a. Buy oil and natural gas futures contracts, since these are probably your primary resource costs. If it is a coal-fired plant, a cross-hedge might be implemented by selling natural gas futures, since coal and natural gas prices are somewhat negatively related in the market; coal and natural gas are somewhat substitutable. Buy sugar and cocoa futures, since these are probably your primary commodity inputs. Sell corn futures, since a record harvest implies low corn prices. Buy silver and platinum futures, since these are primary commodity inputs required in the manufacture of photographic film. Sell natural gas futures, since excess supply in the market implies low prices. Assuming the bank doesn’t resell its mortgage portfolio in the secondary market, buy bond futures. Sell stock index futures, using an index most closely associated with the stocks in your fund, such as the S&P 100 or the Major Market Index for large blue-chip stocks. b. c. d. e. f. g. 488 h. i. Buy Swiss franc futures, since the risk is that the dollar will weaken relative to the franc over the next six months, which implies a rise in the $/SFr exchange rate. Sell euro futures, since the risk is that the dollar will strengthen relative to the Euro over the next three months, which implies a decline in the $/€ exchange rate. 14. Sysco must have felt that the combination of fixed plus swap would result in an overall better rate. In other words, the variable rate available via a swap may have been more attractive than the rate available from issuing a floating-rate bond. 15. He is a little naïve about the capabilities of hedging. While hedging can significantly reduce the risk of changes in foreign exchange markets, it cannot completely eliminate it. Basis risk is the primary reason that hedging cannot reduce 100% of any firm’s exposure to price fluctuations. Basis risk arises when the price movements of the hedging instrument do not perfectly match the price movements of the asset being hedged. 16. Kevin will be hurt if the yen loses value relative to the dollar over the next eight months. Depreciation in the yen relative to the dollar results in a decrease in the ¥/$ exchange rate. Since K...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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