Financial Management of Risks 453into U.S. dollars would become more expensive. If the Canadian dollar falls,
the expenses in terms of U.S. dollars decline. Thus, the exposure is symmetric.
If the firm wishes to completely eliminate the exposure, a symmetric instru-
ment is called for, ruling out options. The firm should go long in Canadian dol-
lar futures or for wards, since either of these instruments will provide positive
cash f lows when the Canadian dollar is rising. An exchange-traded Canadian
dollar futures contract is available. The commission on the for ward is greater
than the commission on the futures, but the futures contract covers slightly
more Canadian dollars than the firm wishes to hedge, and the timing does not
exactly correspond to the timing of wage and rent payments. An over-the-
counter forward contract could be constructed so that cash f lows are synchro-
nized with wage and rent payments. After weighing the two alternatives, the
managers decide that the benefit from lower commissions on the futures con-
tract outweighs the disadvantage of the futures’ slight mismatch in the hedge.
They go long in Canadian dollar futures.
The same manufacturing firm has many customers in Venezuela. If the
Venezuelan currency (the bolivar) falls in value, the U.S. dollar value of the
revenue will fall. If the Venezuelan currency rises in value, the dollar revenue
will rise. Thus, the risk is symmetric, and so the list of hedging candidates is
narrowed to futures and for wards. The firm benefits from a rise in the bolivar,
and loses when the bolivar falls. Thus, the firm should go short in bolivar fu-
tures or for wards, so that a cash f low will be received when the bolivar falls.
No bolivar futures contracts are available on exchanges, so the firm must go
short in over-the-counter Venezuelan bolivar for wards.
A producer of copper wire purchases large amounts of copper as a raw
material. When copper prices rise, the firm must either absorb the higher ex-
penses, or raise the price of copper wire. Raising the price of wire, however,
causes customers to cut back on purchases, and so the firm is stuck with unsold
inventory. When copper prices fall, alternatively, competitors lower their
prices and so the firm must also lower its price in order to sell its output. Con-
sequently, the firm’s profits suffer when copper prices rise, but profits do not
increase when copper prices fall. Management would like to increase produc-
tion capacity, but it is difficult to forecast how much the firm can sell, given re-
cent copper price f luctuations. With current levels of raw copper inventory,
management believes that raw copper prices can rise as much as 10% without
significantly impacting the firm’s bottom line. What is the appropriate hedge?
Clearly, the firm faces an asymmetric risk. The firm is hurt when cop-
per prices rise, but does not benefit when the price falls. An option will best
mitigate the risk. Since the firm is hurt when copper prices rise, a call option
that pays off when copper prices rise is the best choice. Since the firm can
tolerate a 10% rise in copper prices without suffering significant losses, an
out-of-the-money copper call option that begins to pay off only when copper
prices rise more than 10% is ideal. Exchange-traded copper call options exist,
and so due to their greater liquidity and lower transaction costs, they would
be the best choice.