1. 1 Chapter 11 Hedging, Insuring, Diversifying

2. 2 Contents 1. Forward and Futures to Hedge Risk 2. Swap Contracts 3. Hedging, Matching Assets to Liabilities 4. Minimizing the Cost of Hedging 5. Insuring v. Hedging 6. Insurance Contracts 7. Financial Guarantees 8. Caps and Floors on Interest Rates 9. Options as Insurance 10. The Diversification Principle 11. Diversification and the Cost of Insurance

3. 3 Forward Contracts Two Parties agree to exchange some item in the future at a prearranged price

4. 4 Forward Contracts,Terminology  Forward price: The specified price of the item  Spot price: The price for immediate delivery of the item  Face value: quantity of item times the forward price  Long/Short position: The position of the party who agrees to buy/sell the item

5. 5 Forward Contract, Example Farmer, Baker Uncertain about the future price of wheat one month from now Natural match Forward contract: One month from now, the farmer will deliver 100,000 bushels of wheat to the baker and receive the face value $200,000 in return

6. 6 Futures Contracts A standardized forward contract that is traded on some organized exchange

7. 7 Futures Contract, Example The farmer in Kansas, the baker in New York They enter a wheat futures contract with the future exchange at a price of $2 per bushel farmer: short position baker: long position The exchange matches them Futures Contract: Paying to (receiving from) the exchange ($2-spot price) 100,000

8. 8 Futures Contract, Example cont. At due date Wheat $1.5 per bu. $2 per bu. $2.5 per bu. Farmer from distributor $150,000 $200,000 $250,000 Farmer from\to exchange $50,000 0 ($50,000) Total $200,000 $200,000 $200,000

9. 9 Swap Contracts Consists of two parties exchanging (swapping) a series of cash flows at specified intervals over a specified period of time

10. 10 Swap Contracts, Example Computer software business in US, German company pays DM100,000 each year for a period of 10 years for the right to produce and market the software The dollar/mark exchange rate risk Currency swap: on an exchange rate of $0.5 per mark. Each year the US party receives from\pays to the counterparty DM100,000($0.5-spot rate)

11. 11 Hedging by Matching Asset to Liabilities Insurance company: sells a contract which insures a 5% interest rate for 5 years, premium $783.53, amount $1000 To hedge this liability, company buys a 5 year government bond with a face value of $1000

12. 12 Insuring versus Hedging  Hedging: Eliminating the risk of loss by giving up the potential for gain  Insuring: Paying a premium to eliminate the risk of loss and retain the potential for gain

13. 13 Insuring v. Hedging, Example The farmer: 1. Takes no measures to reduce risk 2. Hedges with a forward contract, 100,000 bushels, $2 per bushel 3. Buys an Insurance for a premium of $20,000, which guarantees a minimum price of $2 per bushel for her 100,000 bushels

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15. 15 Basic Features of Insurance Contracts 1. Exclusions: Losses that might seem to match the insurance but are specifically excluded, like suicide from life insurance 2. Caps: Upper limits on particular losses covered under insurance, like health policy with a cap of $1million

16. 16 Basic Features of Insurance Contracts 3. Deductibles: The amount of money the insured party should pay before receiving any compensation from the insurer, like a deductible of $1000 for an automobile insurance 4. Copayments: A copayment for an insurance means that the insured party must cover a fraction of the loss, health insurance, 80%-20%

17. 17 Financial Guarantees Insurances against credit risk, the risk that the other party of the entered contract will default

18. 18 Caps and Floors on Interest Rates  Interest rate floor: A guarantee of a minimum interest rate (for depositor)  Interest rate cap: A guarantee of a maximum interest rate (for borrower)

19. 19 Options The right to either purchase or sell something at a fixed price in the future

20. 20 Options, Terminology  Call/Put: An option to buy/sell a specified item at a fixed price  Strike price or Exercise price: The fixed price specified in the option  Expiration date or Maturity date: The date after which an option can no longer be exercised

21. 21 Options  European Option: Can only be exercised on the expiration date  American Option: Can be exercised at any time up to and including the expiration date

22. 22 Diversifying Splitting an investment among many risky assets instead of concentrating it all in only one

23. 23 The Diversification Principle By diversifying across risky assets sometimes it is possible to reduce the overall risk with no reduction in expected return

24. 24 Review

25. 25 Review

26. 26 Review

27. 27 Uncorrelated Risks

28. 28 Nondiversifiable Risk  In a randomly selected equally weighted portfolio, with possible positive correlation between stocks, by adding more stocks the standard deviation reduces just to a point  Diversifiable risk: The part of the volatility that can be eliminated  Nondiversifiable risk: The part that remains

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32. 32 Diversifiable Security Risk Nondiversifiable Security Risk

33. 33 All risk is diversifiable

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35. 35 Diversifying & Cost of Insurance  The cost of insuring a diversified portfolio of risks against a loss is less than the cost of insuring each risk separately  The more diversified are the risks in a portfolio of a given size, the less the cost of insurance of the portfolio’s total value against a loss