Topic 12: Risk Management (Hedging)

Question 1

What is risk management?

Answer 1

Risk management is the systematic process involved with accepting, mitigating, or eliminating risks that a business (or trader) faces.

Question 2

What are the five steps in the risk management system?

Answer 2

1. Planning: Determine risk tolerance level.
2. Identify Risks: Recognize potential risks.
3. Assess Risk: Evaluate the impact and likelihood of each risk.
4. Control Risk: Improve or mitigate risk to improve the Sharpe Ratio. If the risk is still too high, hedge or get insurance.
5. Monitor Controls: Ensure that controls are effectively decreasing risk, not increasing it.

Question 3

What are the types of risk?

Answer 3

Total Risk = Business (Independent) Risk + Non-Business (Common) Risk

Question 4

What is Business (Independent) Risk, Reputation Risk, and Strategic Risk?

Answer 4

Business (Independent) Risk: Risks specific to the business itself.

Reputation Risk: Risks that could damage the firm’s public image.

Strategic Risk: Risks related to the firm’s strategy and decision-making.

Question 5

What are the 7 Non-Business (Common) Risks?

Answer 5

Currency Risk

Economic Risk

Geopolitical Risk

Commodity Price Risk

Inflation Risk

Interest Rate Risk

Question 6

What are the types of Insurance?

Answer 6

Business Liability Insurance

Business Interruption Insurance

Key Personnel Insurance

Question 7

What is Business Liability Insurance?

Answer 7

A type of insurance that covers the cost that result if some aspect of a business causes harm to a third party or someone else’s property

Question 8

What is Business Interruption Insurance?

Answer 8

A type of insurance the protects a firm against the loss of earnings if the business is interrupted due to fire, accident, or some other insured peril

Question 9

What is Key Personnel Insurance?

Answer 9

A type of insurance that compensated a firm for the loss or unavoidable absence or crucial employees in the firm

Question 10

Why might a firm pay for insurance even if the cost equals the present value of the benefits?

Answer 10

1. Adjust to a Different Risk Tolerance: This answer is less effective since the risk is independent and investors can diversify to eliminate this risk.
2. Improve Cash Flow Management:

It is easier to manage regular smaller payments (e.g., $30,000 per year) than a large, unexpected one-time cost (e.g., $150 million).

Reduces expected market imperfection costs such as costs associated with raising new financing, inability to deduct large losses for tax purposes, or financial distress.

Reducing these costs improves the Sharpe ratio.

Question 11

What is a forward contract?

Answer 11

A forward contract is an obligatory agreement to buy or sell an asset at a specified future delivery date at a price set today called the forward price (also known as the delivery price).

Question 12

What does Ft,T represent in a forward contract?

Answer 12

Ft,T denotes the delivery date T and the forward price set at date t < T by Ft,T. It is the locked-in price you need to buy (sell) at on date T if you were to enter into a long (short) forward contract on date t.

Question 13

What are the two types of gains (losses) to consider in a hedging context with forward contracts?

Answer 13

Forward Gain (Loss): The gain or loss resulting from the forward contract itself.

Business Gain (Loss): The gain or loss resulting from the underlying business activities.

Question 14

What is the formula for Long Forward Gain (Loss) and what does it compare?

Answer 14

Long Forward Gain (Loss) =
𝐹𝑇−𝐹𝑡,𝑇

It compares the price at which you entered the forward contract with the price at which you exited the forward contract, i.e., the gain/loss if you were using the forward contract to speculate.

Question 15

What is the formula for Short Forward Gain (Loss)?

Answer 15

Short Forward Gain (Loss) =
𝐹𝑡,𝑇−𝐹𝑇

Question 16

What is the formula for Long Business Gain (Loss)?

Answer 16

Long Business Gain (Loss)
= 𝐹𝑡,𝑇−𝑆𝑇

Question 17

What is the formula for Short Business Gain (Loss)?

Answer 17

Short Business Gain (Loss)
= 𝑆𝑇−𝐹𝑡,𝑇

Question 18

What is the goal of using forward contracts in a risk management context?

Answer 18

The goal of using forward contracts in a risk management context is to set up a perfect hedge where the forward gain (loss) is perfectly offset by the business gain (loss) from commodity price fluctuations.

Question 19

Why are forward contracts considered a zero-sum game?

Answer 19

Forward contracts are a zero-sum game because the profits of one party are the losses of the other.

In a zero-sum game, the net change in wealth is zero, meaning the loss of one party is beneficial to another. Winners and losers cancel each other out in a zero-sum game.

Question 20

How do forward contracts differ from futures contracts in terms of trading?

Answer 20

Forward contracts do not trade on financial exchanges and are instead customized private arrangements between trading parties.

Question 21

If a firm intends to buy a commodity in the future and is concerned about a price increase, what are the hedging strategies to protect against an unfavorable price change?

Answer 21

Futures Strategy: Enter into a long futures contract. This locks in the purchase price of the commodity, protecting the firm from future price increases.

Option Strategy: Purchase a call option. This gives the firm the right, but not the obligation, to buy the commodity at a specified price, providing flexibility and protection against price increases.

Question 22

If a firm intends to sell a commodity in the future and is concerned about a price decrease, what are the hedging strategies to protect against an unfavorable price change?

Answer 22

Futures Strategy: Enter into a short futures contract. This locks in the selling price of the commodity, protecting the firm from future price decreases.

Option Strategy: Purchase a put option. This gives the firm the right, but not the obligation, to sell the commodity at a specified price, providing flexibility and protection against price decreases.

Question 23

What are the main methods for hedging foreign exchange (FX) risk?

Answer 23

Cash-and-Carry: Involves buying the underlying asset and selling it forward.

FX Futures: Entering into standardized contracts to buy or sell currency at a future date.

Forwards & FX Options:

Forwards: Customized contracts between two parties to exchange currency at a set date and rate in the future.

FX Options: Financial derivatives that give the right, but not the obligation, to exchange currency at a specified rate before a set date.

Question 24

What is the cash-and-carry trading strategy?

Answer 24

Cash-and-carry is a trading strategy where an investor buys an asset and simultaneously sells a corresponding forward contract on that asset. The investor profits by holding the asset and receiving the forward price difference over time.

Question 25

Why is there no uncertainty in the future amount received with futures or forward contracts?

Answer 25

Futures or forwards provide certainty in the future amount received because they lock in the exchange rate at the time the contract is made, eliminating exposure to future exchange rate fluctuations.

Question 26

What is the nature of exchange rate risk when using put options?

Answer 26

Put options involve some uncertainty but provide upside potential with no downside. This means that while the exact future value isn’t fixed, the option holder benefits from favorable market movements and is protected against adverse changes, with the cost limited to the option premium.

Question 27

What does it mean to use call options to hedge against exchange rate risk?

Answer 27

Some Uncertainty: Like with put options, the exact future value isn’t fixed, so there’s an element of uncertainty.

Downside Protection: Call options protect you from unfavorable market movements (if the exchange rate moves against you).

No Upside Potential: Unlike put options, call options don’t allow you to benefit from favorable market movements. The potential gain is limited to avoiding losses, with the cost being the option premium.

Question 28

What is the nature of exchange rate risk when there is no hedging?

Answer 28

When there is no hedging, there is uncertainty with both downside and upside potential. This means that the firm is fully exposed to any adverse changes in exchange rates, which could result in losses, but it can also benefit from favorable movements in exchange rates, leading to potential gains.

Question 29

What is the goal of risk management?

Answer 29

Not to eliminate all risk (as in doing so you would also eliminate all but a risk-free rate of return!) but instead to:

1. Mitigate or eliminate risks for which the business (or trader) would not be adequately compensated and in doing so improve the Sharpe ratio involved with the opportunity;

and then:

2. To manage the remaining risk according to the firm’s (or trader’s) risk tolerance level. Note that this could involve both increasing risk exposure as well as decreasing risk exposure

Question 30

What is Security Risk, Management Risk, and Operational Risk?

Answer 30

Security Risk: Risks involving the firm’s security, both physical and digital.

Management Risk: Risks related to the company’s management team and their decisions.

Operational Risk: Risks arising from the firm’s day-to-day operations.

Question 31

What is Human Risk, and how should these business risks be managed?

Answer 31

Human Risk: Risks associated with the firm’s employees and human resources.

Risk Management: Manage (accept or mitigate) but do not eliminate all these risks. Investors can diversify away this risk if they desire. Risks are generally within the firm’s control, although nothing is ever 100% controlled. Managing these risks can help improve the Sharpe ratio.

Question 32

What are all the 7 business risks?

Answer 32

Business (Independent) Risk

Reputation Risk

Strategic Risk

Security Risk

Management Risk

Operational Risk

Human Risk

Question 33

What is Currency Risk, Economic Risk, and Geopolitical Risk? (Non-Business Risks)

Answer 33

Currency Risk: The risk that changes in exchange rates will affect the value of investments. For example, if a company operates internationally, fluctuations in currency exchange rates can impact profits.

Economic Risk: The risk that economic conditions such as recessions, inflation, or changes in interest rates will affect the performance of a company.

Geopolitical Risk: The risk that political instability, conflicts, or changes in government policies will impact business operations and profitability.

Question 34

What is Commodity Price Risk, Inflation Risk, and Interest Rate Risk? (Non-Business Risks)

Answer 34

Commodity Price Risk: The risk that changes in the prices of commodities (like oil, gold, or agricultural products) will affect the cost and revenues of a business that relies on these materials.

Inflation Risk: The risk that rising prices will erode purchasing power and affect the cost of goods and services.

Interest Rate Risk: The risk that changes in interest rates will affect the cost of borrowing, the value of investments, and overall financial performance.

Question 35

How should non-business (common) risks be managed?

Answer 35

Eliminate if Possible: Use insurance or hedging strategies to eliminate these risks.

Focus on Controllable Factors: These risks are outside of the firm’s control, so management should focus on what they can control rather than being distracted by what they cannot.

Question 36

What positions can parties take in a forward contract?

Answer 36

The party committing to buy the asset is said to have a long forward position.

The party committing to sell the asset is said to have a short forward position.

Question 37

What are some key features of forward contracts?

Answer 37

There is no initial payment for entering into a forward contract.

Forward contracts allow firms to lock-in a future purchase price (by going long on a contract) or a future selling price (by going short on a contract).

Question 38

What does St represent in a forward contract?

Answer 38

St represents the spot price, which is the current market price to buy (sell) an asset today (i.e., on the spot).

Question 39

What does ST represent in a forward contract, and how is it related to FT?

Answer 39

ST represents the spot rate at delivery, which must equal FT (the forward price) on the delivery date.

Won’t enter into a forward contract with forward price > spot price, if were to buy

Won’t enter into a forward contract with a forward price < spot price, if were to sell

Question 40

What do 𝐹𝑇 and 𝐹𝑡,𝑇 represent in a forward contract?

Answer 40

𝐹𝑇: The actual spot price of the asset at the future time T (when the contract matures). This is the price you would pay or receive if you were to buy or sell the asset at that moment.

𝐹𝑡,𝑇: The forward price agreed upon at time t (when the forward contract is entered into) for a contract that will settle at time T. This is the price you promised to pay (for a long position) or receive (for a short position) at maturity.

Question 41

When does a gain occur in a short forward contract?

Answer 41

A gain occurs when the market price (𝐹𝑇) is lower than the forward price (𝐹𝑡,𝑇).

Question 42

When does a loss occur in a short forward contract?

Answer 42

A loss occurs when the market price (𝐹𝑇) is higher than the forward price (𝐹𝑡,𝑇).

Question 43

What do 𝐹𝑡,𝑇 and 𝑆𝑇
represent in a forward contract?

Answer 43

𝐹𝑡,𝑇: The forward price agreed upon at time t for a contract that settles at time T. It’s the price that the buyer (if in a long position) and the seller have agreed to exchange the asset for at the contract’s maturity.

𝑆𝑇: The spot price of the asset at time T, which is the actual market price of the asset at the time the contract matures.

Question 44

Why is it important to consider the spot price 𝑆𝑇 in a long forward contract?

Answer 44

Once you realize your gain on the forward contract, you still need to pay the spot price
𝑆𝑇.

If the spot price 𝑆𝑇 has increased, your business costs have gone up, resulting in a business loss despite any gains from the forward contract.

Question 45

When does a gain occur in a short business context with forward contracts?

Answer 45

A gain happens if the spot price
(𝑆𝑇) is greater than the forward price (𝐹𝑡,𝑇).

Question 46

When does a business loss occur in a short business context with forward contracts?

Answer 46

A business loss happens when the spot price (𝑆𝑇) is less than the forward price (𝐹𝑡,𝑇) at maturity.

Question 47

Why does a business gain occur in a long business context when the forward price (𝐹𝑡,𝑇) is greater than the spot price (𝑆𝑇)?

Answer 47

Even though you are buying the asset at a price higher than its spot price, in terms of the business context, you are gaining by avoiding potential higher market prices in the real world.

When you have a long forward loss, you also have a long business gain!

Question 48

What are the key characteristics of futures contracts?

Answer 48

A futures contract is very similar to a forward contract, except that it is exchange-traded and standardized in terms of delivery dates, delivery locations, contract size, etc.

Question 49

What positions can parties take in a futures contract?

Answer 49

The party agreeing to buy the asset for the futures price has a long futures position.

The party agreeing to sell the asset for the futures price has a short futures position.

Question 50

What is the futures price and how is it analogous to the forward price?

Answer 50

A futures price is analogous to a forward price; it is the price for the asset at the delivery date such that the contract value is zero at inception.

Question 51

How does the cash-and-carry strategy work?

Answer 51

Cash Part: You buy the asset today with your own money.

Carry Part: You hold onto the asset until the agreed-upon future date when you sell it at the higher forward price.

Question 52

What is the goal of the cash-and-carry strategy?

Answer 52

The goal of the cash-and-carry strategy is to make a profit from the difference between the price you paid today and the price you sell it for in the future. This strategy works best when the forward price is higher than the current market price (spot price).

Question 53

What does no-arbitrage imply about the relationship between futures/forwards and cash-and-carry strategies?

Answer 53

No-arbitrage ensures there are no risk-free profit opportunities due to price discrepancies.

It means that the price set in futures or forward contracts should be the same as the outcome from a cash-and-carry strategy. This ensures both methods yield the same financial result, preventing ‘free money’ from switching between them.