RiskManagement

andHedging

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

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

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

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

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

Q: Reasons for Hedging(From Exam FM Fin Econ Sample Questions)

Q: Insurance and Risk Sharing(From Exam FM Fin Econ Sample Questions)

Q: Hedging and Profit(From Exam FM Fin Econ Sample Questions)