Hedging and Derivatives Flashcards
Define hedging?
A management strategy for mitigating (reducing) the risk of loss associated with certain transactions and positions
- Typically offsetting transactions
- Purpose: Is not to make a profit, but to minimize losses
What is hedged item?
The recognized asset, liability
Items include:
- A/R
- Investments
- Inventory
Recognized liabilities:
- A/P
- Interest Payable
What is firm commitment?
Executive contract to buy or sell in the future but not recorded (commitment to buy inventory in the future)
What is a hedging instrument?
The contract or instrument used to mitigate the risk of loss
Most common circumstances for hedging?
- Inventory or commodity price changes: Price will change an negatively impact profit margins. Price is difficult to pass onto customers. Decrease in market price which would require a LCM loss.
- FX changes: Risk that rate will change and impact revenues, expenses, asset, liabilities. Example: Receivables will convert to lower $, or liabilities will be more $.
- Interest rate changes: Market rate of interest will change which will negatively impact investment value.
- Default risk: The risk that issuer of debt will fail to make interest payments when due which results in loss to investor.
What is a derivative?
The most common contract that have three elements
- Underlying and notional amount
- Require no initial net investment
- Settled with net cash payment
What is the underlying and notional amount?
Specified price, rate, or variable.
National amount: Specified unit of measure (shares of stock, pounds or bushels, etc)
These two elements, determine the value of a derivative contract.
(Underlying * Notional amount) = Contract Price
Derivatives normally don’t require a net investment?
True, or it is going to be very small
Derivative require a net cash payment?
True- it can be settled for cash or an asset readily convertible to cash. Most are settled with cash for the net difference between the contract price and the market price.
What are the four kinds of derivative contracts?
- Futures contract
- Forward contract
- Option contracts
- SWAP contracts
What is a futures contract?
Contract to deliver or receive a commodity, foreign currency, security instrument, or other asset in the future at a price set now .
Executed through organized exchange or clearing house
Have margin-requirements, marked-to-market and settled daily.
What is forward contract?
Like a futures contract, except there is not third party.
Can be customized to any item, quantity
Settled only a the end.
What is an option contract?
Contract to buy (Call) and sell (put option) at a future date at a price set now (strike price).
RIGHT TO BUY OR SELL BUT DOES NOT HAVE THE OBLIGATION TO DO. ONLY IF IT IS FAVORABLE TO DO SO.
What is SWAP contract?
Contract between a buyer and seller by which they agree to exchange cash flows, currencies, commodities, etc.
Can be customized for any item, length of time.
When it is of SWAP is cash flows, it is normally only those associated with interest not just principle amount.
