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HEDGING

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Outline
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 Hedging and Price Volatility


 Managing Financial Risk
 Hedging with Forward Contracts
 Hedging with Futures Contracts
 Hedging with Swap Contracts
 Hedging with Option Contracts

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Hedging & Price Volatility
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 Recall that volatility in returns is a classic measure of


risk
 Volatility in day-to-day business factors often leads
to volatility in cash flows and returns
 If a firm can reduce that volatility, it can reduce its
business risk
 Hedging (immunization) – Reducing a firm’s
exposure to price or rate fluctuations

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Hedging & Price Volatility (cont.)
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 Instruments have been developed to hedge the


following types of volatility
 Interest Rate
 Exchange Rate
 Commodity Price
 Financial Engineering - is the use of existing
financial instruments to create new ones that allow
firms to hedge against specific risks.

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Hedging & Price Volatility (cont.)
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 Derivative – A financial asset that represents a claim


to another financial asset. It derives its value from
that other asset
Example
A stock option gives the owner the right to buy or sell
stock, a financial asset, so stock options are
derivative securities.

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Hedging & Price Volatility (cont.)
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 The process of financial engineering often involves


creating new derivative securities or combining
existing derivatives to accomplish the firm’s hedging
goals.

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Interest Rate Volatility
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 Debt is a key component of a firm’s capital structure


 Interest rates are a key component of a firm’s cost of
capital
 Interest rates can fluctuate dramatically in short
periods of time
 Companies that hedge against changes in interest
rates can stabilize borrowing costs
 This can reduce the overall risk of the firm

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Interest Rate Volatility (cont.)
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 Available tools: forwards, futures, swaps, futures


options, and options
 In March 1980, the Bank of Canada dropped its
discretionary interest rate policy for a system that
allows floating interest rates. This led to an increase
in the volatility of interest rates.

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Exchange Rate Volatility
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 Companies that do business internationally are


exposed to exchange rate risk
 The more volatile the exchange rates, the more
difficult it is to predict the firm’s cash flows in its
domestic currency
 If a firm can manage its exchange rate risk, it can
reduce the volatility of its foreign earnings and do
a better analysis of future projects
 Available tools: forwards, futures, swaps, futures
options, and options

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Exchange Rate Volatility (cont.)
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 The exchange rate volatility for the U.S. dollar and


Canadian dollar has increased enormously since the
early 1970s.
 The reason for that was the breakdown of the
Bretton Woods accord that guaranteed that exchange
rates were fixed for the most part and significant
changes rarely occurred.

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Commodity Price Volatility
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 Most firms face volatility in the costs of basic goods and


materials and in the price that will be received when
products are sold (sale price)
 Depending on the commodity, the company may be able to
hedge price risk using a variety of tools
 This allows companies to make better production decisions
and reduce the volatility in cash flows
 Available tools (depends on type of commodity): forwards,
futures, swaps, futures options, and options

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Commodity Price Volatility (cont.)
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 Example:
- Oil is one of the most important commodities. Oil
prices have become increasingly uncertain since the
early 1970s (why?)

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The Risk Management Process
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 Identify the types of price fluctuations that will


impact the firm
 Some risks are obvious, others are not
 Some risks may offset each other, so it is important
to look at the firm as a portfolio of risks and not
just look at each risk separately
 You must also look at the cost of managing the risk
relative to the benefit derived
 Risk profiles are a useful tool for determining the
relative impact of different types of risk

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The Risk Management Process (cont.)
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 Example
- An all-equity firm would not be concerned about
interest rate fluctuations as a highly leveraged firm.
- A firm with little or no international activity would
not be overly concerned about exchange rate
fluctuations.

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Risk Profiles
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 Basic tool for identifying and measuring exposure to


risk
 A firm’s risk profile shows the relationship between
changes in the price of a particular good, service, or
rate and changes in the firm’s value
 The steeper the slope of the risk profile, the greater
the exposure and the more a firm needs to manage
that risk

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Risk Profile for a Wheat Grower
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Risk Profile for a Wheat Grower (cont.)
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 Because the risk profile slopes up, increases in wheat


prices will increase the value of the firm.
 Because the risk profile has a steep slope, the wheat
grower has a significant exposure to wheat price
fluctuations and they should take steps to reduce
that exposure.

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Risk Profile for a Wheat Buyer
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Reducing Risk Exposure
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 The goal of hedging is to lessen the slope of the risk


profile
 Hedging will not normally reduce risk completely
 Only price risk can be hedged, not quantity risk
 You may not want to reduce risk completely because you miss
out on the potential upside as well

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Reducing Risk Exposure (cont.)
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 Example
- Consider a firm that uses rice to make a popular brand of
cereal. If the price of rice increases, the firm that raises and
processes the rice will benefit; the firm that uses the rice in
its cereal will lose.
- By signing a contract specifying that the rice producer will
deliver a certain quantity of rice at a certain price, the cereal
manufacturer has reduced (or eliminated) the uncertainty
about the cost of rice. At the same time, the rice producer
has eliminated uncertainty about the price they will receive
for the processed rice.

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Reducing Risk Exposure (cont.)
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 Timing
 Short-run exposure (transactions exposure) – short-term
price fluctuations due to unexpected events or shocks are
referred to as transitory changes. These changes can be
managed in a variety of ways

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Reducing Risk Exposure (cont.)
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 Timing
 Long-run exposure (economic exposure) – some price
fluctuations may reflect permanent changes due to a
fundamental shift in the underlying economics of a business.
Almost impossible to hedge, requires the firm to be flexible
and adapt to permanent changes in the business climate

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Forward Contracts
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 Forward contracts are among the oldest tools for


risk management
 A contract where two parties agree on the price of
an asset today to be delivered and paid for at some
future date
 The delivery date of the goods is called the
settlement date
 The agreed-upon price is called the forward price
 If prices increase before the delivery date, the
buyer benefits
 If prices decrease before the delivery date, the
seller benefits

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Forward Contracts (cont.)
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 Forward contracts are legally binding on both parties


 They can be tailored to meet the needs of both parties and
can be quite large in size
 Positions
 Long – agrees to buy the asset at the future date

 Short – agrees to sell the asset at the future date

 Because they are negotiated contracts and there is no


exchange of cash initially, they are usually limited to large,
creditworthy corporations

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Payoff profiles for a forward contract
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 The payoff profile – is a plot that depicts the gains


and losses on a forward contract that result from
unexpected price changes

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Payoff profiles for a forward contract
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Hedging with Forwards
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 The basic idea is to use a risk profile to identify the


firm’s exposure to a given type of financial risk.
 Financial managers try to find a financial
arrangement (e.g., forward contract) that that has
a offsetting payoff profile.
 Entering into a forward contract can virtually
eliminate the price risk a firm faces
 It does not completely eliminate risk because both parties still
face credit risk

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Hedging with Forwards (cont.)
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 Credit risk
- There is a credit risk involved because no money
changes hands until a forward contract is actually
completed
- The party on the losing end of the deal has an
incentive to default on the agreement

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Hedging with Forwards (cont.)
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 Since it eliminates the price risk , it prevents the


firm from benefiting if prices move in the company’s
favor (i.e., favorable price adjustments)
 The firm also has to spend some time and/or money
evaluating the credit risk of the counterparty

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Hedging with Forwards (cont.)
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 Forward contracts are primarily used to hedge


exchange rate risk
 Example
Jaguar, the U.K. auto manufacturer, historically
hedged the U.S. dollar-British pound exchange rate
for six months into the future.

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Hedging with forward contracts
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Futures Contracts
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 Future contracts are identical to forward contract with one


exception
 With a forward contract, gains and losses are recognized
only on the settlement date
 With futures contracts, gains and losses to the buyer or
seller are recognized on a daily basis. This daily settlement
feature is referred to as marking-to-market
 This daily settlement greatly reduces the default risk
associated with forward contracts
 Because of this, organized trading in futures contracts is
much more common than in forwards contracts

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Trading in Futures
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 Future contracts for many items are routinely


bought and sold around the world
 There are two main types of futures contracts:
commodity futures and financial futures
 The underlying asset in a commodity future is
essentially anything except a financial asset
 The underlying asset in a financial future is any
type of financial asset (e.g., stock, bond, etc.)

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Futures Exchanges
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 The largest futures exchange is the Chicago Board


of Trade (CBOT)
 Other major exchanges include:
- The Chicago Mercantile Exchange (COMEX)
- The London International Financial Futures
Exchange (LIFFE)
- The New York Futures Exchange (NYFE)
- The Winnipeg Commodity Exchange (WPG)

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Hedging with Futures
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 A hedge created with futures contracts is conceptually the


same as a hedge created with forward contracts.
 The payoff profiles are drawn in the same way.
 The only difference is that a firm hedging with futures must
maintain an account with an investment dealer.
 The account will be debited or credited every day.
 Although there is a large variety of futures contracts
available, many firms may not be able to hedge the exact
quantity, quality, and/or delivery date they desire

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Hedging with Futures (cont.)
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 Example – a firm may produce a certain grade of


oil and find that no contract exists for exactly that
grade. However, all oil prices tend to move
together, so the firm can hedge its output using
future contracts on other grades of oil.
 This process is called cross-hedging. The firms buy
contracts on a related, but not identical asset, to
establish their hedge.
 Credit risk is virtually nonexistent
 Futures contracts are available on a wide range of
physical assets, debt contracts, currencies and
equities

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Hedging with Futures (cont.)
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 In practice, future contracts are very rarely held to


maturity.
 Firms usually sell and buy contracts, reversing
their financial position before the contracts
mature.

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Swaps
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 A swap contract is an agreement between two


parties to exchange specified cash flows at
specified intervals based on specified relationships
 The swap contract can be viewed as a series of
forward contracts
 The major difference is that there are multiple
exchanges, whereas forward contracts involve only
one exchange
 Generally limited to large creditworthy institutions
or companies

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Currency Swaps
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 The two parties agree to exchange a specific


amount of one currency for a specific amount of
another currency at a specified future date

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Interest Rate Swaps
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 In an interest rate swap, firms typically exchange


fixed-rate loans for floating rate loans (and vice-
versa).
 Frequently, interest rate swaps are combined with
currency swaps.
 In this case, one firm will obtain fixed-rate
financing in one currency and then swap it for
floating rate financing in another currency.

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Commodity swaps
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 A commodity swap is an agreement to exchange a


specified quantity of some commodity at a
specified future date
 This is the newest type of swap and, to date, the
market for commodity swaps is relatively small
compared to the other swap markets

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The Swap Dealer
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 Unlike futures contracts, swap contracts are not traded on


organized exchanges
 When a firm enters into a swap contract, the dealer takes
the opposite side of the agreement
 The swap dealer will then try to find an offsetting
transaction with some other party
 If this is not possible, dealers hedge their positions with
futures contracts
 A dealer’s contracts are detailed in a swap book.
 In general, dealers try to keep a balanced book (called a
matched book) to limit their net exposure

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Option Contracts
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 An option contract differs from forward, futures, and


swap contracts in that the owner of the contract has
the right, but not the obligation, to buy (sell) an asset
for a set price on or before a specified date
 Call option – right to buy the asset
 Put option – right to sell the asset
 Exercise or strike price –specified price at which the asset is bought or
sold
 Expiration date – last date at which the option may be exercised
 Unlike forwards and futures, options allow a firm to
hedge downside risk, but still participate in upside
potential

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Options versus Forwards
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 There are two main differences between option


contracts and forward contracts:
1- The transaction associated with an option contract
is only completed if the owner of the option
chooses to exercise it
2- The buyer of the option obtains the right to
purchase the underlying asset, that right is
valuable. Therefore, the buyer of an option must
pay an option premium for that right. In a forward
contract, no money exchanges hands until the
transaction is completed.

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Option Payoff Profiles
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 The horizontal axis shows the difference between the asset’s value and
the strike price on the option
 For a call option
- the owner begins to make a profit when the price of the underlying
asset rises above the strike price
- from the seller’s viewpoint, any gain to the owner of the option is a loss
to the seller of the option
For a put option
- the owner begins to make a profit when the price of the underlying
asset falls below the strike price
- a gain to the buyer of a put option is a loss to the seller of the option

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Payoff Profiles: Calls
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Payoff Profiles: Puts
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Option Hedging
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 It works in the same way as hedging with a forward


or futures contract
 Use options to create a payoff profile exactly the
opposite of the cash flow expected
 Because of the nature of options, firms can use
option contracts to hedge against the downside
risk caused by adverse price movements
 At the same time, they can retain the potential for
upside benefits if prices move in the desired
direction

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Hedging with Options
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Hedging Commodity Price Risk with Options
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 In addition to futures contracts on commodities, there are


now options available on the same commodities
 The options traded on commodities are really options on
futures contracts; they are referred to as futures options
 The owner of a futures call option receives a futures
contract on the underlying commodity; in addition the
owner receives the difference between the strike price on
the option and the current futures price
 This difference is paid in cash

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Hedging Commodity Price Risk with
Options (cont.)
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 Example
- When a futures call option on wheat is exercised, the owner
of the option receives two things
- The first is a futures contract on wheat at the current
futures price
- This contract can be immediately closed at no cost
- The second thing the owner of the option receives is the
difference between the strike price on the option and the
current futures price
- This difference is paid in cash

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Hedging Commodity Price Risk with
Options (cont.)
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 “Commodity” options are generally futures options


 Exercising a call
- Owner of a call option receives a long position in the futures contract
plus cash equal to the difference between the exercise price and the
futures price
- Seller of a call option receives a short position in the futures contract
and pays cash equal to the difference between the exercise price and the
futures price
 Exercising a put
- Owner of a put option receives a short position in the futures contract
plus cash equal to the difference between the futures price and the
exercise price
- Seller of a put option receives a long position in the futures contract
and pays cash equal to the difference between the futures price and the
exercise price

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Hedging Exchange Rate Risk with
Options
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 Future options are also available on foreign


currencies
 Future options allow firms to create additional
hedges against exchange rate risk
 May use either futures options on currency or
straight currency options
 Used primarily by corporations that do business
overseas
 Canadian companies want to hedge against a
strengthening dollar (receive fewer dollars when
you convert foreign currency back to dollars)

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Hedging Exchange Rate Risk with
Options (cont.)
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 Buy puts (sell calls) on foreign currency


 Protected if the value of the foreign currency falls relative to
the dollar
 Still benefit if the value of the foreign currency increases
relative to the dollar
 Buying puts is less risky

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Hedging Interest Rate Risk with Options
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 Can use futures options


 Large OTC market for interest rate options
 Caps, Floors, and Collars
 Interest rate cap prevents a floating rate from going
above a certain level (buy a call on interest rates)
 Interest rate floor prevents a floating rate from going
below a certain level (sell a put on interest rates)
 Collar – buy a call and sell a put
 The premium received from selling the put will help offset the cost
of buying a call
 If set up properly, the firm will not have either a cash inflow or
outflow associated with this position

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Hedging Interest Rate Risk with Options
(cont.)
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 Interest Rate Caps – if interest rate rise above an


agreed upon ceiling, the bank pays the cash
difference between the actual payment and the
interest rate ceiling
 Interest Rate Floor – the firm’s rate will never
drop below the floor price
 Collar – the firm knows its interest rate will always
be between the floor and ceiling rates

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Summary
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 The motivation for risk management stems from


the fact that firms face exposure to undesirable risk
 Firm’s risk profile is altered through the use of
derivatives – forwards, futures, swaps, options and
futures options
 Hedging can help enhance the value of a firm by
stabilizing short-term cash flows, giving the firm
time to react and adapt to changing market
conditions, and allowing the firm to take on new
projects that would otherwise be considered too
risky

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