Financial Management of Risks 451duration gap. The swap will grow in value as rates rise, offsetting the equity
losses. Again, the size, timing, and other terms of the interest rate swap can be
tailored to meet the particular needs of Kayman Savings.
HOW TO CHOOSE THE APPROPRIATE HEDGE
We have now examined for wards, futures, call options, put options, and swaps.
We have observed how these instruments can be used to hedge in a wide vari-
ety of risky scenarios. How does one choose which of these instruments to use
in a particular situation? When is a future better than a for ward? When should
an option be used instead of a future? Should interest rate exposure be hedged
with bond futures or swaps? The following steps will provide some guidance.
The first task in implementing a hedge strategy is to identify the natural
exposures that the firm faces. Does the firm gain or lose when interest rates
rise? Does it gain or lose as the dollar appreciates? Is a falling wheat price good
news or bad news for the company? What about oil prices and stock prices?
How about foreign stock and bond prices? Is the company exposed, and if so,
which direction causes a loss?
Clearly the answers to these questions vary from firm to firm. The bak-
ers benefited from falling wheat prices while the farmers suffered. Rising in-
terest rates might hurt a firm that has variable rate debt, but might help a
pension fund that is about to invest in bonds. A rising dollar benefits U.S. im-
porters but hurts U.S. exporters. The first step in risk management is to iden-
tify the exposures.
Once the exposures are identified, one should narrow the search for an
appropriate hedge to the set of derivatives that compensate the firm when the
adverse scenario is realized. For example, an airline that purchases jet fuel will
see higher costs when the price of oil rises. The airline should look for deriva-
tives that pay off when oil prices rise. Thus, the airline should consider a long
position in an oil future, or a long oil for ward, or an oil call option. A bank that
suffers losses when interest rates rise should consider a short position in a bond
future or for ward, bond put options, or the fixed-payer side of an interest rate
swap. An exporter that expects to receive Mexican pesos, might wish to go
short in peso futures or for wards, or buy peso puts.
The next step is to choose from among futures, for wards, options, and
swaps. This is perhaps the trickiest part of the analysis. To guide the selection,
it is helpful to categorize the risks and the instruments as either symmetric or
asymmetric. Futures, forwards, and swaps are symmetric hedging instru-
ments, in that they pay off money if prices move in one direction, but incur
losses if prices move in the opposite direction. Options, on the other hand, are
asymmetric hedging instruments. They pay off money if prices move in one di-
rection, yet result in no cash outf lows if prices should move the other way. A
symmetric risk is one in which the firm is hurt if underlying prices move one
way but benefits if prices move in the opposite direction. An asymmetric risk