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Natural hedging Hedging A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies. Hedging employs various techniques but, basically, involves taking equal and opposite positions in two different markets (such as cash and futures markets). Hedging is used also in protecting one's capital against effects of inflation through investing in high-yield financial instruments (bonds, notes, shares), real estate, or precious metals. Types of hedging Hedging can be used in many different ways including foreign exchange trading The stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly. Hedging strategies Examples of hedging include: Forward exchange contract for currencies Currency future contracts Money Market Operations for currencies Forward Exchange Contract for interest Money Market Operations for interest Future contracts for interest
This is a list of hedging strategies, grouped by category. Financial derivatives such as call and put options
Risk reversal: Simultaneously buying a call option and selling a put option. This has the effect of simulating being long on a stock or commodity position. Delta neutral: This is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. This is also a type of market neutral strategy. Natural hedges Many hedges do not involve exotic financial instruments or derivatives such as the married put. A natural hedge is an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses). For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars. One common means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life. Categories of hedge able risk There are varying types of risk that can be protected against with a hedge. Those types of risks include:
Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products. Credit risk: the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate. Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure. Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps. Equity risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency. Volumetric risk: the risk that a customer demands more or less of a product than expected. Hedging equity and equity futures Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, futures are shorted when equity is purchased or long futures when stock are shorted.
One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures – for example, by buying 10,000 GBP worth of Vodafone and shorting 10,000 worth of FTSE futures (the index in which Vodafone trades). Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures. Futures contracts and forward contracts are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk. Futures hedging Investors who primarily trade in futures may hedge their futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. To hedge against a long futures trade a short position in synthetics can be established, and vice versa. Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time. Forwards: A contract specifying future delivery of an amount of an item, at a price decided now. The delivery is obligatory, not optional. Forward rate agreement (FRA): A contract specifying an interest rate amount to be settled at a pre-determined interest rate on the date of the contract. Option (finance): similar to a forward contract, but optional.
Call option: A contract that gives the owner the right, but not the obligation, to buy an item in the future, at a price decided now. Put option: A contract that gives the owner the right, but not the obligation, to sell an item in the future, at a price decided now.
2. Risk-free portfolio
3. Assumptions of Black Scholes Formula for estimating the value of European (exercisable only on the expiration date) call options, primarily for equities. It incorporatesfactors such as underlying stock's price volatility, the relationship of its current price to the option's exercise price, expected dividends, expected interest rates, and option's time to expiration. The assumptions it is based on include: (1) No dividend is paid during the option's life, (2) Trading in the option and in its underlying stock occurs simultaneously, (3) No brokerage commissions are charged, (4) Borrowing and lending takes place at the same interest rate, (5) Market is efficient (information about stock prices is available instantly and to all participants), (6) Price of the underlying stock smoothly increases or decreases, without any discontinuous jumps, (7) Transaction costs are zero or negligible. The complex algorithm of this model was developed by the US mathematicians Fischer Black and Myron Scholes in 1973, and later modified by Robert Martin. After the death of Black in 1995, this model earned Scholes and Martin the 1997 Nobel Prize in economics. The algorithm has continuously been improved upon by researchers such as Barone Adesi & Whaley, Garman Kohlhagen, and Cox, Ross, & Rubinstein. Also called Black-Scholes-Martin model.
4. Importance of risk management Risk management ensures that an organization identifies and understands the risks to which it is exposed. Risk management also guarantees that the organization creates and implements an effective plan to prevent losses or reduce the impact if a loss occurs. A risk management plan includes strategies and techniques for recognizing and confronting these threats. Good risk management doesn’t have to be expensive or time consuming; it may be as uncomplicated as answering these three questions: 1. What can go wrong? 2. What will we do, both to prevent the harm from occurring and in response to the harm or loss? 3. If something happens, how will we pay for it? Risk management provides a clear and structured approach to identifying risks. Having a clear understanding of all risks allows an organization to measure and prioritize them and take the appropriate actions to reduce losses. Risk management has other benefits for an organization, including:
Saving resources: Time, assets, income, property and people are all valuable resources that can be saved if fewer claims occur.
Protecting the reputation and public image of the organization. Preventing or reducing legal liability and increasing the stability of operations. Protecting people from harm. Protecting the environment. Enhancing the ability to prepare for various circumstances. Reducing liabilities. Assisting in clearly defining insurance needs.
An effective risk management practice does not eliminate risks. However, having an effective and operational risk management practice shows an insurer that your
organization is committed to loss reduction or prevention. It makes your organization a better risk to insure. 5. Purpose of Black Scholes OPM Assist investors in decision making Assist the investor to hedge against risk Assist investors with an optimum risk free price.
6. Types of risks in business 7. Reasons for derivative growth
Factors contributing to the growth of derivatives
Factors contributing to the explosive growth of derivatives are price volatility, globalization of the markets, technological developments and advances in the financial theories. 1. Price Volatility A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another person’s money is called interest rate. And the price one pays in one’s own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have ‘demand’ and producers or suppliers have ‘supply’, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as ‘price volatility’. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The breakdown of the BRETTON WOODS agreement brought an end to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization of the markets and rapid industrialization of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990’s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. This price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds. 2. Globalization of the Markets Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent. 3. Technological Advances
A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in
communications allow for instantaneous worldwide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmed without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important. 4. Advances in Financial Theories Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970’s, work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets.
8. Futures contracts 9. Forward contracts
A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. However, this also means it is more difficult to reverse a position, as the counterparty must agree to canceling the contract, or you must find a third party to take an offsetting position in. This also increases credit risk for both parties. Uses of forward contracts Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of a scarce resources. Speculators also use forward contracts to make bets on price movements of the underlying asset. Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty about prices. For instance, coffee growers may enter into a forward contract with Starbucks (SBUX) to lock in their sale price of coffee, reducing uncertainty about how much they will be able to make. Starbucks benefits from contract because it is able to lock in their cost of purchasing coffee. Knowing what price it will have to pay for its supply of coffee ahead of time helps Starbucks avoid price fluctuations and assists in planning.
10. Swaps 11. Options
Contract to keep an offer open for a fixed period during which the offeror cannot withdraw the offer. 2. Formal contract between a seller (the optioner) and a buyer (the optionee) the right (but not the obligation) to buy-and-sell (or to buy-or-sell) a specific property or a fixedquantity of a commodity, currency, or security, at a fixed price (called exercise price) on or up to a fixed date (called expiration date). Optionee pays down only a fraction (called premium or option money) of the full value of the contract, thus obtaining an investment leverage. An option to buy (called call option) is purchased when prices are expected to rise, an option to sell (called put option) when prices are expected to fall, and an option to buy-or-sell (called double option) when prices may go either way. The most popular types of options are named American option (exercisable any day up to the expiration date) and European option (exercisable only on the expiration date). Any option that is not exercised is automatically cancelled and the optionee loses the premium. In practice, only a few options are exercised and most are bought from or sold to other optioners or optionees before the expiration date. Since options are legally binding contracts, they have intrinsic value and are freely traded on the futures exchanges. Futures contracts, in contrast, cannot lapse and their holder have to sell them before their expiration date or take delivery of the underlying item. Called also option contract. Employeestock option where key employees are given a chance to buy the firm's stock at a special price. Agreement through which a firm takes a tentative stake in a project and, while it has the right to continue its participation, does not make any commitment. Alternative term for an alternative. 12.
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