QUESTION FIVE (5) Financial risks can be mitigated by several responses. Please
ID: 2658641 • Letter: Q
Question
QUESTION FIVE (5) Financial risks can be mitigated by several responses. Please explain what the following derivatives are and give a brief description of how they operate as hedging instruments. a) Futures contracts b) Forward contracts c) Options d) Swaps Operational risks can be mitigated by several responses. Please explain what the following responses are and give a brief description of how they operate as mitigating instruments. a) Long term supply contracts b) Take-or-pay contracts c) Take-and-pay contract d) Throughput agreements 5 Marks Each; Total: 20 MarksExplanation / Answer
a) Futures Contract
A futures contract is an agreement to either buy or sell an asset on a publicly-traded exchange. The asset is a commodity, stock, bond, or currency. The contract specifies when the seller will deliver the asset. It also sets the price. Some contacts allow a cash settlement instead of delivery.
Companies use futures contracts to lock in a guaranteed price for raw materials such as oil. Farmers use them to lock in a sales price for their livestock or grain. Futures contracts guarantee they can buy or sell the good at a fixed price. They plan to transfer possession of the good under contract. The agreement also allows them to know the revenue or costs involved. For them, the contracts reduce a significant amount of risk.
Hedge funds use futures contracts to gain more leverage in the commodities market. They have no intention of transferring any commodity. Instead, they plan to buy an offsetting contract at a price that will make them money. In a way, they are betting on the future price of that commodity. Price assessment and price forecasts for raw materials are how commodities futures affect the economy. Traders and analysts determine these values.
b) Forward Contracts
A forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time.
The assets often traded in forward contracts include commodities like grain, precious metals, electricity, oil, beef, orange juice, and natural gas, but foreign currencies and financial instruments are also part of today's forward markets
Example :
If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to sell 500 bushels of wheat to, say, Kellogg after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if prices rise later, you willget only what your contract entitles you to.
If you are Kellogg, you might want to purchase a forward contract to lock in prices and control your costs. However, you might end up overpaying or (hopefully) underpaying for the wheat depending on the market price when you take delivery of the wheat.
There are two kinds of forward-contract participants: hedgers and speculators. Hedgers do not usually seek a profit but rather seek to stabilize the revenues or costs of their business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in the marketfor the underlying asset. Speculators are usually not interested in taking possession of the underlying assets. They essentially place bets on which way prices will go. Forward contracts tend to attract more hedgers than speculators.
c) Options
Options are a financial derivative sold by an option writer to an option buyer. The contract offers the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at an agreed-upon price during a certain period of time or on a specific date. The agreed upon price is called the strike price. American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date (exercise date). Exercising means utilizing the right to buy or the sell the underlying security.
Using options for hedging is, relatively speaking, fairly straightforward; although it can also be part of some complex trading strategies. Many investors that don’t usually trade options will use them to hedge against existing investment portfolios of other financial instruments such as stock. There a number of options trading strategies that can specifically be used for this purpose, such as covered calls and protective puts.
The principle of using options to hedge against an existing portfolio is really quite simple, because it basically just involves buying or writing options to protect a position. For example, if you own stock in Company X, then buying puts based on Company X stock would be an effective hedge.
Most options trading strategies involve the use of spreads, either to reduce the initial cost of taking a position, or to reduce the risk of taking a position. In practice most of these options spreads are a form of hedging in one way or another, even this wasn't its specific purpose.
For active options traders, hedging isn't so much a strategy in itself, but rather a technique that can be used as part of an overall strategy or in specific strategies. You will find that most successful options traders use it to some degree, but your use of it should ultimately depend on your attitude towards risk.
d) Swaps
A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Usually, the principal does not change hands. Each cash flow comprises of one leg of the swap. One cash flow is generally fixed, while the other is variable, that is, based on a a benchmark interest rate, floating currency exchange rate, or index price.
In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate. For example, say ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate(LIBOR) plus 1.3% (or 130 basis points). LIBOR is at 1.7%, low for its historical range, so ABC management is anxious about an interest rate rise.
They find another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR? plus 1.3% on a notional principal of $1 million for 5 years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 6% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.