Risk
Management
and
Hedging
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
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–
–
–
–
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Tax effects
Financial distress (e.g., bankruptcy)
Financing
Debt capacity
Risk aversion
Non-financial factors
• Reasons for not hedging
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–
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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)