1. 1 Chapter 11: Hedging and Insuring Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc. Objective Explain market mechanisms for implementing hedges and insurance

2. 2 Chapter 11 Contents 11.1 Using Forward & Futures Contracts to Hedge Risks 11.2 Hedging Foreign- Exchange Risk with Swap Contracts 11.3 Hedging Shortfall-Risk by Matching Assets to Liabilities 11.4 Minimizing the Cost of Hedging 11.5 Insuring versus Hedging 11.6 Basic Features of Insurance Contracts 11.7 Financial Guarantees 11.8 Caps & Floors on Interest Rates 11.9 Options as Insurance 11.10 The Diversification Principle 11.11 Insuring a Diversified Portfolio

3. 3 Market Value of Mortgages Book Value of Mortgages

4. 4 CD Interest Payments Mortgage Interest Payments

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7. 7 Standard deviation, 1 firm The Standard Deviation is $200,000

8. 8 Standard deviation, 2 firms The Standard Deviation is about $141,000 (c.f. $200,000)

9. 9 Standard deviation, equal investment in “n” firms Generalizing the argument, it is easy to prove that the standard deviation in this case is just $200,000/SqrareRoot(n)Generalizing the argument, it is easy to prove that the standard deviation in this case is just $200,000/SqrareRoot(n) Conclusion: Given the facts of this example, the risk may be made as close to zero as we wish if there are sufficient securities! In reality, however …Conclusion: Given the facts of this example, the risk may be made as close to zero as we wish if there are sufficient securities! In reality, however … n is must be finite, and pharmaceutical projects have a non-zero correlations

10. 10 Correlated Homogeneous Securities Pharmaceutical projects do have positive correlation (Why?)Pharmaceutical projects do have positive correlation (Why?) Loosen the assumptions made about the correlation, and set it to ρ, and use the generalization ofLoosen the assumptions made about the correlation, and set it to ρ, and use the generalization of

11. 11 Correlated Homogeneous Securities We obtain the relationshipWe obtain the relationship σ port = σ sec *QSRT(ρ + 1/n) In the case of n -> Infinity, there remains the termIn the case of n -> Infinity, there remains the term σ port = σ sec *QSRT(ρ) This risk is not diversifiableThis risk is not diversifiable

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15. 15 Diversifiable Security Risk Nondiversifiable Security Risk

16. 16 All risk is diversifiable

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