1. Risk Management and Hedging

2. 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

3. 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

4. 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

5. 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

6. 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

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

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

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