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We analyze risk in corporate finance and present alternative models for calculating risk and transforming those risks into "acceptable" hurdle rates.
One is said to hedge a risk if reducing a person's exposure to a loss requires giving up the potential of a gain. Thus, farmers who sell their future crops at a fixed price today in order to eliminate the possibility of a lower price at harvest time foregoes the possibility of profiting through higher prices at harvest time. They may be hedging their exposure to the price risk of their crops. Financial marketplaces offer a variety of systems for hedging from the risks of unstable commodity prices, stock prices, interest rates, as well as currency exchange rates. Such as forward, futures as well as swap contracts.
Option contracts are an additional means for insuring against losses. Standardized exchange-traded options currently permit one to insure against exposure to the risk of stocks, interest rates, exchange prices, and commodity prices. Customized options as well as contracts with option-like features offered off-the-exchanges greatly expand the range associated with risks one can insure against.
Using Forward and Futures Agreements to Hedge Risk
Any time two parties agree to exchange some item in the future at a prearranged price, they are entering into a forward contract. Often, people enter into forward agreements without knowing that is what they're actually called.
For example, you may be planning a trip through New York to Australia a year from today. You make your own flight reservations today, and the airline booking clerk tells you that you could either lock in a cost of $2,000 by committing right now or you can wait as well as pay whatever the cost may be on the day of the flight. In either case, payment will not take place till the day of your trip. If you decide to lock in the actual $2,000 cost, you have entered into the forward contract with the airline.
In agreeing with the forward contract terms today, you eliminate the risk of the cost of your air travel going above $2,000. If the price of a ticket happens to be $2,500 a year from now, you may be happy that you had the great sense to secure the $2,000 forward contract. However, if the price happens to be $1,500 on the day of the flight, you will nevertheless have to pay the $2,000 forward price you agreed to. If so, you will regret your choice.
A futures agreement is essentially a standard forward contract which is traded on an arranged exchange. The exchange interposes itself between buyer and the seller, so that each has a separate contract with the exchange. Standardization implies that the terms of the futures contract - e. g., amount and quality of the item to be shipped - are the same for all contracts.
Forward vs. Futures Contract
A forward contract can often reduce the risks faced through both the buyer and the seller. Let us demonstrate how with a comprehensive example.
Suppose a farmer has planted his fields with corn. It is now a month before harvest and the size of the farmer's crop is fairly certain. Because a substantial portion of the farmer's wealth is tied up in his whole corn crop, he might want to eliminate the risk related to uncertainty about future corn prices by selling his crop right now at a fixed cost for future delivery.
Let's also suppose that there is a feed company who knows that he will require corn a month from now to produce pig feed. The feed company has a large stake of his wealth tied up in his company. Like the farmer, the feed company is also confronted with uncertainty about the future price of corn; however the way for him to lessen the price risk would be to buy corn right now for future shipping. Thus the feed company is a natural match for the farmer, who wants to reduce his risk by selling corn now for future delivery.
The forward contract stipulates that this farmer will provide a specified amount of corn to the feed company at the forward price regardless of what the spot price turns out to be on the delivery date.
Let's place some actual amounts and prices in to our example to find out how forward agreements work. Suppose that the size of the farmer's corn crop is 200,000 bushels which the forward cost for delivery per month from now is $3 per bushel. The farmer agrees to sell his entire crop to the feed company along with delivery a month now at $3 per bushel. At that time, the farmer will deliver 200,000 bushels of corn to the feed company as well as $600,000 in return. With a contract like this, both parties get rid of the risk associated with the uncertainty about the spot price of corn at the delivery date.
Now let us to consider why it may be convenient to have standard futures contracts for corn that are traded on exchanges rather than forward contracts. The forward contract in our example calls for the farmer to deliver corn to the feed company within the contract delivery day. However, it can be hard for the feed company to locate a farmer who wants to market corn at the time and place that is most convenient to the feed company.
For example suppose that the farmer and also the feed company are divided by a great distance: The farmer might be located in Kansas and the feed company in New York. The feed company usually purchases corn from a nearby supplier in New York and the farmer generally sells his corn to a local supplier in Kansas. By utilizing corn futures contracts, the farmer and the feed company can retain the risk-reducing benefits of the forward contract (and save paying shipping cost to transport corn to New York) without needing to change their normal supplier and distributor relationships.
The futures exchange operates as an intermediary matching purchasers and sellers. Indeed, the buyer of corn futures contract in no way knows the identification of the seller since the contract is formally between the buyer and the futures exchange. Likewise, the seller never knows the identity of the buyer. Only a portion of the corn futures contracts traded within the exchange result in real delivery of corn. Most of them are settled in cash.
Allow us to illustrate how this works in the case of the farmer and the feed company. Instead of entering the forward contract calling for the farmer in Kansas to deliver his corn to the feed company in New York at a delivery date of $3 per bushel, there are two separate transactions.
The farmer and feed company enter a corn futures contract with the futures exchange at a futures price of $3 per bushel. The farmer takes a short position; the feed company takes a long position, and the exchange matches them. In a month's time, the farmer sells his corn to his regular distributor in Kansas, and the feed company purchases his corn through his normal provider in New York at the spot price (today's current price). They settle their future contract by paying to (or getting from) the futures exchange the differences between the $3-per-bushel futures cost and the spot price multiplied by the amount specified in the agreement (200,000 bushels). The futures exchange transfers the payment from one party to another.
Let's demonstrate how this all works step by step.
Consider first the farmer; to hedge his exposure to the price risk, he takes a short position in a one-month corn futures contract for 200,000 bushels at a futures price of $3 per bushel.
Let's point out what goes on if the spot price of corn turns out to be $2.50, $3.00 as well as $3.50 per bushel. If the spot price of corn happens to be $2.50 for each bushel a month from now, the farmer's proceeds from the sale of corn to the distributor in Kansas are $500,000. However, he gains $100,000 through his futures agreement. Thus his total receipts are $600,000.
If the spot price turns out to be $3.00 per bushel, the farmer's proceeds from the sale of his corn to the distributor in Kansas are $600,000, and there is no gain or loss on the futures contract. When the spot price happens to be $3.50 for each bushel, the farmer receives $700,000 from the sale of his corn to the distributor in Kansas but loses $100,000 on the futures contract. His total receipts are then $600,000.
Therefore, no matter what the spot price of corn turns out to be, the farmer winds up with total receipts of $600,000 through the combination of selling his corn to the supplier in Kansas as well as his short place in the corn futures contact.
Here is the scenario for the feed company. A month from now the feed company buys corn from his provider in New York at the spot price. If the spot price is actually $2.50 for each bushel, the feed company pays only $500,000 to the provider for his corn but he additionally loses $100,000 on his corn futures contract. His complete outlay is consequently $600,000. If the spot price is $3 per bushel, the feed company will pay the supplier $600,000, and there is absolutely no gain or loss on the futures contract. If the spot cost is $3.50 per bushel, the feed company pays the supplier $700,000 for corn but gains $100,000 on his futures agreement, thus making his total outlay $600,000.
Consider exactly what would happen without the futures contract. If the spot price of corn turns out to be $2.50 per bushel, then the farmer receives and the feed company pays $500,000. If the spot price turns out to be $3.50, then the farmer receives and the feed company pays $700,000. But with the futures contract, no matter what the spot price turns out to be, the farmer receives and the feed company pays a total of $600,000. Because both parties know for certain what they will get and what they will pay out, the futures contract has removed the risk posed through price uncertainty.
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