05: Risk handling I Proactive (3 - risk transfer) Flashcards
What is hedgin?
Hedging is a mean to reduce the variance of the spend at a certain cost
What is the “business award decisions”?
affect the supply profile of the commodity
- Contract duration
- Suppliers in different monetary areas
- Price escalation clauses
What is the “hedging decisions”?
The hedging decisions transfer the risk stemming from volatile markets to partners who are able and/ or willing to deal with the risk
- Put and call options
- Futures
- Swaps
Which two decisions inflence the spend on the commodity?
1.Business award decisions
2.Hedging decisions
–>all decisions are interdependently linked and influence the spend on the commodity
What are “unconditional derivatives”?
Unconditional derivatives secure a fixed price for a futurepoint in time now
Two forms:
- forward and future contracts
- swaps
What are “Forward and future contracts”?
Contracts where two parties agree on the price of an asset today to be delivered and paid for at some future date.
–>Legally binding on both parties
Differences between Forwards and futures?
- Forwards are customized and traded “over the counter” (OTC), while
- futures are standardized and traded publicly on organized securities exchanges
What is the evaluation of unconditional derivatives? (Pros and cons)
Pros:
- safeguarding material price
- high availability (Broker and Banker)
Cons:
- Financial transaction with additional risks resulting from high complexity
- no safeguarding of material availability in the future
What are “conditional derivatives”?
provide the right, but not the obligation to purchase (sell) at an agreed price
What are options?
In their most simple form, the right, but not the obligation, to buy (or sell) an asset for a set price on or before a specified date
What is a call and a put option?
-
Call option:
Right to buy; if exercised, obligation to sell -
Put option:
Right to sell; if exercised, obligation to buy
Who pays and who receive the option premium?
Party buying the option (option long) pays option premium,
party selling the option (option short) receives the premium
What is the evaluation of conditional derivatives? (pros and cons)
Pros:
- Safeguarding material price and benefiting from, e.g. declining prices
Cons:
- Additional cost for option premium (may be prohibitively high, but can be mitigated by the combination of options)
- No safeguarding of material availability inthe future
What are the direct and indirect additional expenses of hedging?
- Brokers and financial intermediaries will extract a fee for taking the other side of a derivative (analogous to insurance premiums)
- A reduction in risk means a reduction in potential downside and upside uncertainty
–>Gains from price reductions are offset by losses from financial instrument
Indirect costs are incurred to develop and maintain the ability of financial hedging
- Knowledge development
- Acquisition of needed data
- Relationships with brokers
What are the three additional risks to a compnay created by financial hedging?
1.Funding risk: Even unlikely events can occur that lead to a worst case scenario, leading to the maximum payment (to settle margin calls)
2.Credit risk: The counterparty may become bankrupt and consequently cannot fulfill its obligations to cover the position (especially in OTC market)
3.Rollover risk: Options are usually short-dated, in order to hedge a long-term price risk, the hedging position must be renewed on a regular basis
