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David Dubofsky
Hedging Fundamentals
A Short (or selling) Hedge: Occurs when a firm holds a long cash
position and then sells futures/forward contracts for protection against
downward price exposure in the cash market.
A Long (or buying) Hedge: Occurs when a firm holds a short cash
position and then buys futures/forward contracts for protection against
upward price exposure in the cash market. Also known as an
anticipatory hedge.
Firms can hold long and short hedges simultaneously (but for different
price risks).
David Dubofsky
Liabilities
Owners Equity (stock value)
David Dubofsky
A Diagrammatic View
Change in
firm value
Change in
firm value
Change in
input price
Long
forwards
or futures
Inherent
risk
exposure
Change in
output price
Inherent
risk
exposure
Short
forwards
or futures
David Dubofsky
r
Short FRAs
Long FRAs
David Dubofsky
David Dubofsky
50,000,000(0.0545 - 0.0500)(365/365)
[1+0.05(365/365)]
David Dubofsky
Liabilities
Owners Equity (stock value)
Does the firm fear that the yen will rise or fall in value
($/ or $/)?
To hedge, will it want to buy or sell yen forward?
David Dubofsky
David Dubofsky
Liabilities
Owners Equity (stock value)
Does the firm fear that the yen will rise or fall in value
(/ or /)?
To hedge, will it want to buy or sell yen forward?
David Dubofsky
David Dubofsky
David Dubofsky
What interest rate risk does it face? How can it use a FRA
to manage this risk?
What exchange rate risk does it face? How can it use a
forward exchange contract to manage its risk exposure?
David Dubofsky
David Dubofsky
David Dubofsky
Futures Market:
Today:
Later:
David Dubofsky
Futures Market:
Today:
Later:
David Dubofsky
Futures Market:
Today:
Later:
David Dubofsky
Futures Market:
Today:
Later:
David Dubofsky
A Numerical Example.
A Gold Mining Hedger: Base Case
Revenue:
$37,000,000
Variable Costs:
$20,000,000
Fixed Costs:
$10,000,000
Pre-Tax Profit:
$7,000,000
Taxes (40%)
$2,800,000
Profit
$4,200,000
Return on Equity:
16.8%
Oz. Mined:
100,000 Avg. Selling Price: 370
100,000
Cost: 200
Equity:
25,000,000
David Dubofsky
Revenue:
$40,000,000
Oz. Mined:
100,000
Variable Costs:
$20,000,000
100,000
Fixed Costs:
$10,000,000
Pre-Tax Profit:
$10,000,000
Taxes (40%)
$4,000,000
Profit
$6,000,000
Return on Equity:
24.0%
Equity:
25,000,000
David Dubofsky
Revenue:
$34,000,000
Oz. Mined:
100,000
Variable Costs:
$20,000,000
100,000
Cost: 200
Fixed Costs:
$10,000,000
Pre-Tax Profit:
$4,000,000
Taxes (40%)
$1,600,000
Profit
$2,400,000
Return on Equity:
9.6%
Equity:
25,000,000
David Dubofsky
Profit ($)
8,000,000
6,000,000
4,000,000
2,000,000
0
320
340
360
380
400
420
David Dubofsky
David Dubofsky