Two marks question

1. WHAT IS HEDGING?

Making an investment to reduce the risk of adverse price movements in an asset.

The best way to understand hedging is to think of it as insurance. When people decide to
hedge, they are insuring themselves against a negative event. This doesn't prevent a
negative event from happening, but if it does happen and you're properly hedged, the
impact of the event is reduced. So, hedging occurs almost everywhere, and we see it
everyday.
– Take advantage of temporary dips in the market

• Ex:. You hold a stock portfolio and expect the market will drop.
• Selling index futures will offset any temporary losses that you
make in your stock portfolio.

2. What does hedge fund mean?

An aggressively managed portfolio of investments that uses advanced investment
strategies such as leveraged, long, short and derivative positions in both domestic and
international markets with the goal of generating high returns

Legally, hedge funds are most often set up as private investment partnerships that
are open to a limited number of investors and require a very large initial minimum
investment. Investments in hedge funds are illiquid as they often require investors keep
their money in the fund for at least one year.

For the most part, hedge funds are unregulated because they cater to sophisticated
investors. In the U.S., laws require that the majority of investors in the fund
be accredited. That is, they must earn a minimum amount of money annually and have a
net worth of more than $1 million, along with a significant amount of investment
knowledge. You can think of hedge funds as mutual funds for the super rich. They are
similar to mutual funds in that investments are pooled and professionally managed, but
differ in that the fund has far more flexibility in its investment strategies.

It is important to note that hedging is actually the practice of attempting to reduce risk,
but the goal of most hedge funds is to maximize return on investment. The name is
mostly historical, as the first hedge funds tried to hedge against the downside risk of a
bear market by shorting the market (mutual funds generally can't enter into short
positions as one of their primary goals). Nowadays, hedge funds use dozens of different
strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact,
because hedge fund managers make speculative investments, these funds can carry more
risk than the overall market.
 2. What are the objective and benefits of hedging?

Objectives of Hedging
 Goal is to prevent market fluctuations from interfering with the Business.
 Hedging is only possible if you know your exposure – so the first step is to define
and measure exposure.
 Hedging is also only possible if the institution understands how
Effective are the instruments of hedging – forwards, futures, swaps and options.
 Hedging should not be based on predictions
 Selective hedging is not really hedging – since you have to decide when to hedge,
you are basing your hedge on currency predictions. This is not true hedging.
 Partial hedging is also speculative, although less so.

Benefits of hedging
 Hedging is thus a primarily a device to achieve a greater certainty about cash
flows
 Ex: cost ,revenues, investments
 Hedging is essential when the risk are potential
 Hedging also makes easier to evaluate the performance of different divisions
 For ex: a division that imports a lot of raw material or export a lot of its output,
will have large swings in profitability because of exchange rate if the division
hedge all its import and export the problem goes away because the profit of the
division are no longer affected by the currency movement

Five mark question

Why do companies hedge?

One reason why companies attempt to hedge these price changes is because they are
risks that are peripheral to the central business in which they operate. For example, an
investor buys the stock of a pulp-and-paper company in order to gain from its
management of a pulp-and-paper business. She does not buy the stock in order to take
advantage of a falling Canadian dollar, knowing that the company exports over 75% of its
product to overseas markets. This is the insurance argument in favor of hedging.
Similarly, companies are expected to take out insurance against their exposure to the
effects of theft or fire.

By hedging, in the general sense, we can imagine the company entering into a
transaction whose sensitivity to movements in financial prices offsets the sensitivity of
their core business to such changes. As we shall see in this article and the ones that
follow, hedging is not a simple exercise nor is it a concept that is easy to pin down.
Hedging objectives vary widely from firm to firm, even though it appears to be a fairly
standard problem, the face of it. And the spectrum of hedging instruments available to the
corporate Treasurer is becoming more complex every day.

Another reason for hedging the exposure of the firm to its financial price risk is to
improve or maintain the competitiveness of the firm. Companies do not exist in isolation.
They compete with other domestic companies in their sector and with companies located
in other countries that produce similar goods for sale in the global marketplace. Again, a
pulp-and-paper company based in Canada has competitors located across the country and
in any other country with significant pulp-and-paper industries, such as the Scandinavian
countries.

Companies that are the most sophisticated in this field recognize that the financial risks
that are produced by their businesses present a powerful opportunity to add to their
bottom line while prudently positioning the firm so that it is not pejoratively affected by
movements in these prices. This level of sophistication depends on the firm's experience,
personnel and management approach. It will also depend on their competitors. If there are
five companies in a particular sector and three of them engage in a comprehensive
financial risk management program, then that places substantial pressure on the more
passive companies to become more advanced in risk management or face the possibility
of being priced out of some important markets. Firms that have good risk management
programs can use this stability to reduce their cost of funding or to lower their prices in
markets that are deemed to be strategic and essential to the future progress of their
companies.

Most importantly, hedging is contingent on the preferences of the firm's shareholders.

There are companies whose shareholders refuse to take anything that appears to be
financial price risk while there are other companies whose shareholders have a more
worldly view of such things. It is easy to imagine two companies operating in the same
sector with the same exposure to fluctuations in financial prices that conduct completely
different policy, purely by virtue of the differences in their shareholders' attitude towards
risk.

Who are Hedgers, Speculators and Arbitrageurs?

Hedgers wish to eliminate or reduce the price risk to which they are already exposed. s

Speculators are those classes of investors who willingly take price risks to profit from
price changes in the underlying.

Arbitrageurs profit from price differential existing in two markets by simultaneously

operating in two different markets.

Hedgers, Speculators and Arbitrageurs are required for a healthy functioning of the
market. Hedgers and investors provide the economic substance to any financial market.
Without them the markets would lose their purpose and become mere tools of gambling.
Speculators provide liquidity and depth to the market. Arbitrageurs bring price uniformity
and help price discovery.

The market provides a mechanism by which diverse and scattered opinions are reflected
in one single price of the underlying. Markets help in efficient transfer of risk from
Hedgers to speculators. Hedging only makes an outcome more certain. It does not
necessarily lead to a better outcome.

Ten mark question?

What are the instruments of hedging?

 Insurance
 Forward contract
 Futures
 Swaps
 Options

 Insurance: insurance is perhaps the best method of protecting against risk,

issuance simply transfers risk to a specialized intermediary in exchange for an
insurance premium this intermediary must then find some way of managing the
risk that it has taken on
 Forward contract: a forward contract is among the oldest and simples hedging
devices .it is simply a purchase or sale transaction in which the price and other
terms have been agreed upon ,but the delivery and payments are postponed to a
later date

 They are bilateral contracts and hence exposed to counter-party risk.

 Each contract is custom designed, and hence is unique in terms of contract
size, expiration date and the asset type and quality.
 On the expiration date, the contract has to be settled by delivery of the asset
 If the party wishes to reverse the contract, it has to compulsorily go to the
same counterparty, which often results in high prices being charged

Limitation of forward contract

 They are bilateral contracts and hence exposed to counter-party risk.

 Each contract is custom designed, and hence is unique in terms of contract
size, expiration date and the asset type and quality.
 On the expiration date, the contract has to be settled by delivery of the asset
 If the party wishes to reverse the contract, it has to compulsorily go to the
same counterparty, which often results in high prices being charged
  Future market: similar to forward contract but are standardized ,exchange
traded and subject to initial and mark to mark margins

Positions in futures
 Long
 Short

 If you hold a view that the underlying asset will rise you could buy futures -
known as a LONG futures position - which commits you to take delivery of the
underlying shares, or equivalent cash value, at a pre-arranged price and by a
certain date.

 If your view is that the share prices for the underlying asset will fall, you could
sell futures - known as a SHORT futures position - which commits you to deliver
the underlying shares, or equivalent cash value, at a prearranged price and by a
certain date
Standardization in Futures
 Size - the amount of the underlying commodity which is represented by
the contract. For instance, 1 corn futures represents 5,000 bushels, while 1
crude oil futures contract usually represents 1,000 barrels.
Price Fluctuation - this is the maximum and minimum fluctuations that
the contract can take. To prevent massive volatility many futures contracts
are limited in the amount their price can fluctuate in one trading day, if the
price reaches the upper or lower limit then the contract will be halted until
the next trading day.
 Trading Months - this is the specified months for which the particular
futures contract can be traded, this varies.
 Expiration Date - the date by which the futures trading month ceases to
exist at which all obligations are terminated.

Characteristics of futures

 They are traded on an exchange

 Standardized
 liquidity problem, which persists in the forward market, does not exist in
the futures market
 credit risk of the transactions is eliminated by the exchange through the
clearing corporation/house.

 Help to determine the future prices

 Help transfer risk
  Higher trading volumes in underlying securities
 Increase saving and investment.

Functions of futures

 Swaps: are essential bundles of forward contract that are used to hedge interest
rate risk and exchange rate risk

 Options: options are the contract that allow the hedger to transact the pre
committed price or at the running market price which ever is more advantages
Options are deferred delivery contracts that give the buyers the right, but not the
obligation, to buy or sell a specified underlying at a set price on or before a specified
date

 Call option – right to buy

 Put option – right to sell