- In most situations, risk exposure can be dealt with by one or more of the
following techniques: (i) transfer the risk to an insurance company, (ii)
transfer the function that produces the risk to a third party, (iii) purchase
derivative contracts, (iv) reduce the probability of occurrence of an
adverse event, (v) reduce the magnitude of the loss associated with an
adverse event, and (vi) totally avoid the activity that gives rise to the risk. - Financial futures markets permit firms to create hedge positions to protect
themselves against fluctuating interest rates, stock prices, and exchange
rates. - Commodity futures can be used to hedge against input price increases.
- Long hedges involve buying futures contracts to guard against price
increases. - Short hedges involve selling futures contracts to guard against price
declines. - A perfect hedge occurs when the gain or loss on the hedged transaction
exactly off-sets the loss or gain on the unhedged position.
Questions:
- Explain why finance theory, combined with well-diversified investors and “home-
made hedging” might suggest that risk management should not add much value to
a company. - What is a “natural hedge”? Give some examples of natural hedges.
- What is an option? A call option? A put option?
- What are some factors which affect a call option’s value?
- Describe how a risk-free portfolio can be created using stocks and options. How
can such a portfolio be used to help estimate a call option’s value? - What is the purpose of the Black-Scholes option Pricing Model? Explain what a
“riskless hedge” is and how the riskless hedge concept is used in the Black-
Scholes OPM. - Describe the effect of a change in each of the following factors on the value of a
call option:
(i) Stock price.