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RiskManagement
andHedging
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Risk Management - Hedging
• “Hedge”: Take a position that offsets a risk
• “Risk”: Uncertainty regarding the value of the underlying asset
• By hedging, one changes the risk inherent in owning the underlying asset
• The return distribution of the underlying asset is not changed
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Using Options to Hedge
• Combine the underlying asset with an option or options
• Can reduce or eliminate downside risk while retaining upside potential
• Can protect against falls in held asset values, or against increases in input prices
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Risk Management Strategies
• Forward– Long: lock in purchase price– Short: lock in sale price
• Call– Long: buy insurance against high price– Short: sell insurance against high price
• Put– Long: buy insurance against low price– Short: sell insurance against low price
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Hedging
• Reasons for hedging– Tax effects– Financial distress (e.g., bankruptcy)– Financing– Debt capacity– Risk aversion– Non-financial factors
• Reasons for not hedging– Transaction costs– Costly expertise– Monitoring and control– Financial reporting, tax, accounting issues
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Cost of Hedging / Insurance
• Protection versus profit– May be able to reduce cost of hedge by trading away
potential profit associated with the strategy
• Zero-cost collar– Earn enough on the short position to pay the cost of
the long position
• Paylater– Form of contingent premium: pay premium only
when the insurance is needed
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Q: Reasons for Hedging(From Exam FM Fin Econ Sample Questions)
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Q: Insurance and Risk Sharing(From Exam FM Fin Econ Sample Questions)
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Q: Hedging and Profit(From Exam FM Fin Econ Sample Questions)