Hedging and Derivatives

Question 1

Define “hedging.”

Answer 1

A risk management strategy which involves using offsetting (or counter) transactions so that a loss on one transaction would be offset (at least in part) by a gain on another (or vice versa).

Question 2

Identify four major types of items that are hedged (i.e., hedged items).

Answer 2

1. Inventory/commodity prices
2. Foreign currency exchange rates
3. Interest rates
4. Default (Credit) risk

Question 3

Define “derivative.”

Answer 3

A derivative:

1. Has one or more underlying (s) and notional amount(s),
2. Has no or only a small initial net investment, and
3. Requires or permits net settlements in cash.

Question 4

Identify and describe the basic elements of a hedge.

Answer 4

1. Hedged item - the asset, liability, or other item that is at risk of possible loss and is being hedged
2. Hedging instrument - the contract or other arrangement entered into to mitigate the possible loss on the hedged item.

Derivatives are the primary hedging instrument.

Question 5

Identify common underlyings.

Answer 5

1. Stock price
2. Commodity price
3. Interest rate
4. Foreign currency exchange rate

Question 6

Identify common notional amounts.

Answer 6

1. Number of shares
2. Pounds or bushels of a commodity
3. Dollars principal amount
4. Number of currency units

Question 7

As a guideline, to hedge against an increase in the hedged item, what kind of action would one take?

Answer 7

As a general guideline, to hedge an increase in the hedged item, one would buy a forward/futures contract or call option.

Question 8

As a guideline, to hedge against a decrease in the hedged item, what kind of action would one take?

Answer 8

As a general guideline, to hedge a decrease in the hedged item one would sell a forward/futures contract or put option.