Hedging and Derivatives

Question 1

Define hedging?

Answer 1

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

Question 2

What is hedged item?

Answer 2

The recognized asset, liability

Items include:

• A/R
• Investments
• Inventory

Recognized liabilities:

• A/P
• Interest Payable

Question 3

What is firm commitment?

Answer 3

Executive contract to buy or sell in the future but not recorded (commitment to buy inventory in the future)

Question 4

What is a hedging instrument?

Answer 4

The contract or instrument used to mitigate the risk of loss

Question 5

Most common circumstances for hedging?

Answer 5

• 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.

Question 6

What is a derivative?

Answer 6

The most common contract that have three elements

• Underlying and notional amount
• Require no initial net investment
• Settled with net cash payment

Question 7

What is the underlying and notional amount?

Answer 7

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

Question 8

Derivatives normally don’t require a net investment?

Answer 8

True, or it is going to be very small

Question 9

Derivative require a net cash payment?

Answer 9

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.

Question 10

What are the four kinds of derivative contracts?

Answer 10

• Futures contract
• Forward contract
• Option contracts
• SWAP contracts

Question 11

What is a futures contract?

Answer 11

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.

Question 12

What is forward contract?

Answer 12

Like a futures contract, except there is not third party.

Can be customized to any item, quantity

Settled only a the end.

Question 13

What is an option contract?

Answer 13

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.

Question 14

What is SWAP contract?

Answer 14

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.