429week10f07 - Week 10: Oct 29 Derivatives Hedging Forwards...

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Week 10: Oct 29 Derivatives Hedging Forwards and Futures
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Derivatives Hedging What? Interest rate risk, exchange risk, idiosyncratic risk, credit and default risk, etc. Why? For risk averse investors, diversification moves the Efficient Frontier NW. However, the market only compensates for systematic risk. How can we reduce more? Hedging lowers bankruptcy but so what? (MM) Better credit = better borrowing rates which decreases WACC and increases firm value but at what cost? How can we hedge cheaply? Leveraged positions?
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Derivatives Wasting time on what consumers can do themselves What should managers be doing? Important to hedge correctly or your hedge could turn into speculation Metal. .., Daiwa, Sumitomo, Barings Managers have human capital invested Cannot diversify risk coming from effort so hedging makes managers better off, reduces moral hazard Tax law may favor constant but lower cashflows Tax brackets are higher for high flows and carry-forward (-back) may not be for full value of loss.
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Derivatives Futures and Forwards Contract set today for delivery of a good at a set date in the future at a set price. Priced to have zero value today: No money changes hands until maturity when delivery is taken Super-high leveraging (cost-free exposure_. Risks are multiplied. Forwards Strictly between two parties. Not exchange traded. Either side may default. Both sides have risk. Contracted between two entities so very flexible very specific and illiquid
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Derivatives Pricing by Arbitrage Since prices are set so that no cash changes hands: Delivery (forward) price F equals the price of the spot today, times the time value, divided by the dividend yield. » This must hold by no arbitrage. We can replicate the future, which will delivery stock and cost F, by saving money now and then buying the stock at time T. In order for F to be consistent, it must equal S*(r/d)^t. Intuition:
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This note was uploaded on 04/06/2008 for the course H ADM 429 taught by Professor Cchang during the Fall '03 term at Cornell University (Engineering School).

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429week10f07 - Week 10: Oct 29 Derivatives Hedging Forwards...

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