This document discusses various strategies that companies can use to manage and hedge risks, such as market risk, interest rate risk, and currency risk. It provides examples of how companies can use options, futures contracts, forwards contracts, and swaps to hedge against risks from fluctuations in prices, interest rates, and exchange rates. The key strategies discussed are increasing flexibility, purchasing insurance policies, and making investments in derivatives like options, futures, forwards and swaps to offset risks from changes in underlying prices, rates or currencies.

1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 24-2
Risk Management
Political Risk
The Financial Manager
Faces Multiple Sources
of Risk
Exchange Rate Risk
Environmental Risk
Market Risk
Interest Rate Risk
Competition
Industry Changes

3. Why Hedge: To Add Value?
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 Reason 1: Hedging is a zero-sum game.
 Reason 2: Investors’ do-it-yourself alternative.
How should a financial manager approach hedging?

4. A Sensible Approach to Hedging
Note: Any sensible risk strategy must answer the same five questions.
1) What are the major risks that the company faces and what are the
possible consequences?
2) Is the company being paid for taking these risks?
3) Can the company take any measures to reduce the probability of a
bad outcome or to limit its impact?
4) Can fairly priced insurance to offset any losses?
5) Can derivatives, such as options or futures, hedge the risk?
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5. 24-5
Why Hedge?
What is a cereal company in the business of
doing?
A. Producing a product efficiently and selling it for
a profit.
B. Speculating on the price of sugar, wheat, and other
inputs for its product.
Answer: Both. The company does A by choice and B
because it has no choice.

6. Risk Management Strategies
There are three principal ways to manage risk.
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Increasing Flexibility
Insurance Policies
Investments in Derivatives

7. Reducing Risk With Options:
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Example
Abramovic, Inc. sells crude oil. Since its costs are
relatively fixed, fluctuations in the sale price of
crude oil can cause unexpected profits or losses.
How might Abramovic, Inc. hedge this risk?

8. Reducing Risk With Options
Abramovic, Inc. sells crude oil. How does the price of oil
influence revenues?
Price per barrel
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Abramovic, Inc.
loses money when
prices drop.
Revenues

9. Reducing Risk With Options:
Example (continued)
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How might it hedge this risk?
Price per barrel
A put option
makes money
when prices drop.
Revenues

10. Reducing Risk With Options:
Example (continued)
What are the results of this strategy?
Price per barrel
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Abramovic, Inc.’s
natural risk, plus a put
option, provides a
HEDGE against price
declines.
Revenues
Revenues

11. Futures Contracts
In order to account for price fluctuations, investors
sometimes manage risk by investing in futures contracts.
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Profit to seller
= initial futures price - ultimate market price
Profit to buyer
= ultimate market price - initial futures price

12. Future Contracts: Example
Farmer Tom owns a wheat farm and wishes to hedge
against a drop in the future price of wheat.
What are the positions involved in this hedge?
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13. Farmer Tom owns a wheat farm. How does the price of wheat
influence revenues?
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Future Contracts:
Price of Wheat
The farmer loses
money when the
price drops
Price per bushel
Value of wheat

14. Future Contracts: Example
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(Continued)
How might Farmer Tom hedge against this risk?
The futures
contract profits
when prices drop.
Price per bushel
Value of wheat

15. Future Contracts: Example
What are the results of this strategy?
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(continued)
With a futures
contract, the
farmer locks in a
price.
Price per bushel
Value of wheat
Value of Wheat

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Financial Futures
Financial futures can be used to hedge against interest rate
risk, exchange rate risk, and price fluctuations.
 Commodity Futures
 Financial Futures

17. Forward Contracts
If the terms of a generic futures contract do not fit the investor’s
needs, he can instead buy or sell a forward contract.
Forward contracts are “custom-designed” futures
contracts. They have specific amounts and expiration
dates to meet the buyers’ needs.
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18. Forward Contracts: Example
You enter into a forward contract to take delivery of one million
Euros three months from now. What happens to the price you
will pay at expiration if Euros depreciate during the contract?
The price for the Euros will not change; it was fixed at
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the onset of the contract.

19. Example: Funding a variable-rate obligation with a fixed-rate payment.
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Swaps
One common way for firms to hedge against risk is to
enter into a swap.
Swap: Arrangement by two counterparties to exchange one
stream of cash flows for another.
Fixed rate payment
Company Swap Dealer
LIBOR payment
LIBOR obligation

20. Interest Rate Swaps: Floating
Rate to Synthetic Fixed Rate
In the previous example, the swapped rates cancel out any changes
in LIBOR and the total payment from the company is fixed.
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Currency Swaps
Currency swaps are a subset of interest rate swaps; the
loans are priced in different currencies.
Why would a firm engage in a currency swap?

22. Currency Swaps: Example
Suppose you have invested in a project in Japan that is
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financed with US bonds.
How would a currency swap be useful?
You might enter into a currency swap so that you can
emulate holding Japanese bonds.

23. Currency Swaps: Example
Coca-Cola wishes to borrow yen (¥) to finance its Japanese operations. Coca-Cola
believes the terms of the loan will be more favorable in the United States. It
borrows $50,000,000 for 4 years at 3%. It arranges, through a swap dealer, to
trade its future dollar liability for yen (the rate of the loan for yen is 4%).
Suppose the spot exchange rate is $1 = ¥80. Below are the cash flows (in
000,000s) which occur as a result of the swap.
Year 0 Years 1-3 Year 4
$ ¥ $ ¥ $ ¥
Coca-Cola Dollar Loan + 50 - 1.5 - 51.5
Arrange Currency Swap
a. Coca-Cola receives $ - 50 + 1.5 + 51.5
b. Coca-Cola pays ¥ + 400 - 16 - 416
Net Cash Flow (000,000s) $0 + ¥400 $0 - ¥16 $0 - ¥416
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24. Hedging vs. Speculating
Hedgers reduce risk; speculators do little more than
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gamble.
Uninformed investors should use derivatives for
hedging, not speculation.

25. Derivative Innovations
Derivatives can be created to hedge against any risk
a firm faces. The potential varieties are infinite.
Example: A TV network may want to hedge the risk of a World
Series game being rained out, foregoing advertising income.
Who might the counterparty be to such a contract?
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26. Appendix A: Worldwide
Turnover in Futures Contracts
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27. Contract Exchange
US Treasury notes CBT
US Treasury bonds CBT
Eurodollar deposits IMM
Standard and Poor's Index IMM
Euro IMM
Yen IMM
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Appendix B:
Financial Futures / Forwards
German Govt. Bond Eurex