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HEDGING, INSURING AND DIVERSIFYING Chapter 11

MAIN CONTENTS

• Forward and future contracts

• Hedging foreign-exchange risk with swap contract
• Hedging shortfall risk by matching assets to liabilities
• Insuring versus hedging
• Option as insurance
• Principles of diversification
 FORWARD AND FUTURE CONTRACTS
FORWARD CONTRACT
• Forward contract occurs when there are two parties who agree to exchange some item in the
future at a prearranged price.
• Main features of forward contract

• A price is specified at the time of signing a contract: the forward price

• The price for immediate delivery of the item is called the spot price
• No money is paid at the time of signing contract
• The face value is the quantity of the item specified in the contract times the forward price
• The party buys the specified item (long position) and the party sells the specified item (short
position)
FORWARD AND FUTURE CONTRACTS
FORWARD CONTRACT
Example about forward contract
You want to buy 10kg of wheat in 3 months. You worry about that the price of wheat will
increase at that time, so you enter a forward contract with a long position to fix the price
you will pay in 3 months (the forward price) (20 USD)

In 3 months:
If the price of wheat is above 20 USD, you are happy
If the price of wheat is below 20 USD, you regret your decision
 FORWARD AND FUTURE CONTRACTS
FUTURE CONTRACT
• A future contract is a standardized forward contract that is traded on some organized
exchange. Standardization means the quantity and the quality of the items are the same
for all contract
• The only difference between forward and future contract is that in reality, it is sometimes
difficult for the buyer and the seller can trade at the time and place that they want and
suitable for them. In this case, the future contract allow them to do that by operating an
intermediary matching buyers and sellers. In deed, the buyer never knows the identity of
the seller because the contract is officially between the buyer and the futures exchange
and similarly for the seller
 FORWARD AND FUTURE CONTRACTS
EXAMPLE
• Consider a trade between a textile company (in Hanoi) and a fashion company (in
HCMC). In a forward contract, a textile company in Hanoi will be called to deliver textile to
a fashion company in HCMC at a predetermined price of $2/1 metre. However, in a future
contract, there are two separate transactions.
• A textile and a fashion company each enter a textile futures contract with the futures
exchange at a futures price of $2/1 metre. A textile company takes a short position, a
fashion company takes a long position, and the exchange matches them. In a specified
day in the future, a textile company sells textile to her normal distributor in Hanoi and a
fashion company buys a textile from a normal supplier in HCMC at the spot price.
• A textile and a fashion company settle futures contract by paying to (or receiving from)
the futures exchange the difference between the $2 for 1 metre and the spot price
multiplied by the quantity specified in the contract
 FUTURE CONTRACT
THE SCENARIOS FOR THE DIFFERENCE BETWEEN SPOT PRICE AND THE
FUTURE PRICE
• Scenario 1: If the spot price is $2: no gain or loss on the futures contract
• Scenario 2: If the spot price is $2.50: a textile company receives $2,500 from the sale of textile to the
distributor in Hanoi (suppose they trade with a volume of 1 ton of textile), but loses $500 on the futures
contract. Total receipts are then still $2,000. And similarity, a fashion company pays $2,500 the supplier
$2,500 for a textile but gains $500 from his futures contract, total outlay are then still $2,000
• Scenario 3: If the spot price is $1.80: a fashion company pays only $1,800 to the supplier but also loses
$200 on the futures contract. Total outlay are then still $2,000. And similarity, a textile company receives
$1,800 but gains $200 from his futures contract, total outlay are still $2,000
 FUTURE CONTRACT

From the above example

• With the futures contract, no matter what the spot price turns out to be, a textile
company receives and a fashion company pays a TOTAL of $2000
• Because both parties know for certain what they will get and what they will pay out, the
futures contract has eliminated the risk posed by price uncertainty. Specifically, a textile
company is able to eliminate the price risk from owning the textile by taking the short
position in a futures contract. Meanwhile, a fashion company is able to eliminate the
price risk by taking a long position
• Futures contract make it possible for both a textile and fashion company to hedge their
exposure to price risk while continuing their normal relationships with distributors and
suppliers
 HEDGING FOREIGN-EXCHANGE RISK WITH SWAP CONTRACT

• A swap contract consists of two parties exchanging (or”swapping”) a series of cash

flows at specified intervals over a specified period of time.
• The swap payments are based on an agreed principal amount (the notional amount)
• No immediate payment of money and hence, the swap agreement provides no new
funds to either party
• Most swap contracts involve the exchange of returns on commodities, currencies, or
securities. In this part, we will look at a currency swap
 HEDGING FOREIGN-EXCHANGE RISK WITH SWAP CONTRACT

• You are a CEO of a houseware export company that is located in US. In one year, you
will sell an order of houseware to shop that is located in EU and this shop pays you
€100,000
• You want to hedge the risk of fluctuations in the dollar value of your expected revenues
(due to the fluctuations in the dollar/euro exchange rate), hence, you enter a currency
swap now to exchange your future earnings of euros for a future dollar at a set of forward
exchange rates specified now
 HEDGING FOREIGN-EXCHANGE RISK WITH SWAP CONTRACT

• Suppose that the dollar/euro exchange rate is currently $1.35 per euro. The notional
amount of this swap contract is €100,000.
• By entering this swap contract, you lock in the dollar value of $135,000 on the
settlement date.
• On the settlement date, assume that the spot rate of exchange is $1.30 per euro. In
this case, EU shop is obliged to pay you €100,000 x (1.35-1.30) = $5.000.
• If you do not enter the swap contract, you only receives $130,000
HEDGING SHORTFALL RISK BY MATCHING ASSETS TO LIABILITIES
• Customers are insured against the risk by an insurance company. They need to be
assured that the product they are buying is free of default risk. To do this, an insurance
company will invest in assets that match the characteristics of their liabilities
• The nature of the hedging instrument varies with the type of customer liability
For example:
• The appropriate hedging instrument of short-term deposits that earns floating interest
rate is a floating-rate bond, or just “rolling over” short-term bonds
• Banks can use the floating-rate deposit liabilities to invest in long-term fixed-rate bonds
 MINIMIZING THE COST OF HEDGING

• There has more than one way for hedging risk

• A rational manager or decision maker will choose the one that costs the least
For example
Your family intend to travel in Japan in 1 year. The travelling cost will be ¥300,000 and it
need to be paid at the time of travelling (that means, in 1 year). You have just received an
income of 45 million VND from your job and want to use this amount of money to cover
that cost. You immediately deposit in into a bank that gives you 6.67% per year. This
means that in 1 year, you will withdraw with approximately 48 million VND. In this case,
you worry about the Yen/VND exchange rate in one year. Currently, the exchange rate is
E(VND/JPY)=160
 MINIMIZING THE COST OF HEDGING

In one year, if the exchange rate turns out to be higher than 160¥ = 1 VND, you will get
lower than ¥300,000 ad can not have enough money to cover the travel cost
You will have 2 ways to eliminate exposure to the exchange rate risk
•Way 1: Entering a forward contract for Yen with a bank to fix the exchange rate at 160 ¥
= 1 VND
•Way 2: Require a travel agency to offer you for a price fixed in VND (may be less than
or more than 48 million VND). If a travel company charges you less than 48 million, this
deal will be better off than entering a forward contract and inversely
 INSURING VERSUS HEDGING

• When you hedge, you eliminate the risk of loss by giving up the potential for gain.
• When you insure, you pay a premium to eliminate the risk of loss and retain the potential
for gain
For example
You are a bakery shop owner. You want to buy 100 kilogram of sugar for order in next
month. You worry about the price of sugar. You will have two options
• Option 1: Lock in one specific price of sugar now for the delivery in next month (suppose
25,000 VND/1kg) (This means that in next month, whatever the price of sugar turns out
to be, you still pay 25,000 VND for 1 kg). By doing that, you will give up the gain if the
price of sugar less than 25,000 per 1 kg in next month. This is called hedging
 INSURING VERSUS HEDGING

• Option 2: Your supplier may offer you to pay 500,000 VND for the right of not buying
sugar with the price higher than 25,000 VND. If in next month, the price of 1 kg of sugar
will be less than 25,000 VND (for example 24,000, you need only to pay 2.4 million for
100 kilogram). This means that, you are retained the gain of a decline in the price of
sugar. However, if the price of sugar will be higher than 25,000 VND, you still pay 2.5
million.
 OPTIONS AS INSURANCE

• An option is the right to either purchase or sell something at a fixed price in the future
• An option contract is to be distinguished from a forward contract, which is obligation to
buy or sell something at a fixed price in the future
• There have some kinds of option: commodity options, stock options, interest rate
options, foreign- exchange options,...
 OPTIONS AS INSURANCE

Some fundamental characteristics of options:

• An option to buy (call option), option to sell (put option)
• The fixed price specified in an option contract is called the option’s strike price or
exercise price
• The date after which an option can no longer be exercised is called its expiration
date (or maturity date)
• An option can be exercised on the expiration date only which is called European-
type option whereas option can be exercised at any time up to and including the
expiration date which called an American- type option
 OPTIONS AS INSURANCE- PUT OPTIONS ON STOCKS

• Put options on stock is the way of being insured in the case of decline in the stock
price
Example
• Harry now owns 1000 shares of company X. The current price of this stock is $50
per share
• To be insured for the price decline of stock X, Harry buys an put option
• A X put option gives Harry the right to sell a share of X stock at a fixed exercised
price ($50). In other words, regardless of what the stock price will be in the future,
Harry will receive at least the exercise price at the option’s expiration date
 OPTIONS AS INSURANCE- PUT OPTIONS ON STOCKS

• Assumes that Harry buys an European put option and currently, this put option for a
single share with exercise of $50 is sold $10
• The premium Harry must pay to be insured is $10x1000=$10,000
• Buying put options on a stock portfolio is similar to buying term insurance on an any
particular asset. For the case of asset, you cannot buy a put option, however, you can
buy an insurance against the losses
• Suppose the current market value of stock you possess is $100,000 (you possess 1000
shares) and you are also owning a house for $100,000
• For a put option: You pay a premium $10,000=$10x1000 shares (the price for one put option for one share is
$10)
• For an insurance: You pay a premium $500
 OPTIONS AS INSURANCE- PUT OPTIONS ON BONDS

• Put options on bonds provide insurance losses from risks

• There are two types of risks for bond: If the bond is free of default risk, the risk only
coming from the fluctuations in the interest rates. While, with bonds subject to default
risk, their prices can change due to either the change in risk-free interest rate or possible
losses to bondholders from default
For example:
• Consider 10 year zero-coupon bonds issued by X corporation with the face value of 10
million. The bonds are insured by an real estate which is currently $15 million
• The market value of the bonds reflects both the current level of risk-free interest rates
and the market value of real estate
 OPTIONS AS INSURANCE- PUT OPTIONS ON BONDS

• Suppose the yield to maturity on the bonds is 15% per year. Then the current market
price of the bonds is $10 million/(1.15)A10= $247,524
• Suppose you buy a one-year put option on the bonds with an exercise price of $247
• If the bond’s price falls, either because of an increase in the risk-free interest rate of a
decline of market value of the real estate, you are still guaranteed a minimum price of
$247 for the bonds
 PRINCIPLES OF DIVERSIFICATION
DIVERSIFICATION WITH UNCORRELATED RISKS
For example
• You intend to invest in transport industries (company A and company B). You have 3
options: all money invested in A, all money invested in B, part money invested in A and
the remaining is for B
• Assume there is a 0.5 probability of success for each company and 0.5 probability of
failure. You have initially $100
• If you invest all $100 in only one company (A or B) (the return is you wind up with
$400 or nothing), hence the expected payoff will be = 0.5x0 + 0.5x400,000=200,000,
but the standard deviation is
O' = 7 0.5(0 - 200,000)2 + 0.5(400,000 - 200,000)2 = $200,000
PRINCIPLES OF DIVERSIFICATION
DIVERSIFICATION WITH UNCORRELATED RISKS

• If you invest $50 in company A, $50 in company B, there will have 4scenarios
- Both companies succeed, and you receive $400,000 (probability 0.25)
- Company 1 succeeds and company 2 fails, you receive $200,000 (probability 0.25)
- Company 2 succeeds and company 1 fails, you receive $200,000 (probability 0.25)
- Both companies fail, and you receive nothing (probability 0.25)
The expected payoff: E(X) = 0.25(0) + 0.5(200,000) + 0.25(400,000) - $200,000
The standard deviation a = V0.25(0 - 200,000)2 + 0.5(200,000 - 200,000)2 + 0.25(400,000 - 200,000)2
_ 200,000
V2
= $141,421
 PRINCIPLES OF DIVERSIFICATION
NONDIVERSIFIABLE RISK
• In the previous section, we assumed that the risks were uncorrelated with each other.
However, in practice, due to the underlying economic factors, many important risks are
positively correlated with each other

The risks which can be eliminated by just increasing the number of stocks are called
diversifiable risks, while the risks are still remain regardless of the number of stocks are
called nondiversifiable risks