Financial hedging

The call option in a supply chain works as follows. At the beginning of the period, the retailer places an order of quantity Q, paying a price W for each unit. She also purchases q (call) option contracts from the supplier (at a price c per contract). She now has the right to purchase up to q additional units at the end of the period after demand is realized, at a cost w per unit (exercise price of the option). Under this arrangement, the supplier is committed to produce Q + q units, but can salvage any unexercised options at the end of the period. Thus, the call option transfers some risk from the buyer to the supplier. In scenarios where production lead time is high the buyer must place her order early, so that some uncertainty still remains when the call option is exercised. In this situation, a combination of call and put options can be employed (Erkoc and Wu 2005) that incorporates a put option when the call option is exercised the buyer has the right to return excess orders to the supplier after all demand uncertainty is resolved. 

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Commodity companies have to take a conscious view of feedstock price developments, and consider a wide range of options from financial hedging and optimizing flexibility to taking stakes in Middle Eastern companies to benefit from their stranded gas assets (see Chapters 7 and 16)... 

In a volatile market, contracts must reflect the uncertainties in the marketplace. This can be included in a contract in multiple ways. For example, the buyer can incorporate a delivery window instead of a fixed delivery time permit a small variation in the quantity delivered permit the wholesale price to vary within some botmds and buy insurance or financial hedges to insulate against market volatility. Examples of creative risk sharing contracts would be, capacity reservation, build-operate-transfer, forming supplier consortium, and forecast revision. 

Weather derivatives are another kind of financial instrument used by companies to hedge against the risk of weather-related losses. Weather derivatives pay out on a specified trigger, for example, temperature over a specified period rather than proof of loss. The investor providing a weather derivative charges the buyer a premium for access to capital. If nothing happens, then the investor makes a profit. 

Erb, Harvey and Viscanta Expected Returns and Volatility in 135 Countries. The Journal of Portfolio Management, Spring 1996. Cf also by the same authors Political Risk. Economic Risk, and Financial Risk. Financial Analysts Journal, November/December 1995, and Do World Markets Still Serve as a Hedge The Journal of Investing, Fall 1995. 

In the short term, producers should adapt their contract arrangements to the unstable environment, and consider financial and physical hedges. 

Barbaro A.F. and Bagajewicz M. 2004b. Use of inventory and option contracts to hedge financial risk in planning under uncertainty, AIChE J., 50(5), 990-998. 

Unfortunately, market risks have increased as the array of available investment instruments has broadened. For example, the Mexican peso crisis in 1994, the Asian currency debacle and recession beginning in 1997, the Russian debt default and the unprecedented hedge fund bail-out coordinated by the Federal Reserve Bank in 1998, and a 30% drop in the price of technology shares early in 2000 all had major repercussions for financial markets. Where is an investor to find solace in such an unfriendly and disturbing environment ... 

Fung, W., and Hseih, D. A. (1997), Empirical Characteristics of Dynamic Trading Strategies The Case of Hedge Funds, Review of Financial Studies, Vol. 10, No. 2, pp. 275-302. 

Goldman Sachs Co. and Financial Risk Management, Ltd. (1999), The Hedge Fund Industry and Absolute Return Funds, Journal of Alternative Investments, Vol. 1, No. 4, pp. 11-27. 

Remember of course that the forward rate is derived from the current spot rate term stracture, and therefore although it is an expectation based on all currently known information, it is not a prediction of the term structure in the future. Nevertheless the fra-ward rate is important because it enables market makers to price and hedge financial instruments, most especially contracts with a forward starting date. 

A fixed-rate bond pays fixed coupons during the bond s life known with certainty. Conversely, a floating-rate note ox floater pays variable coupons linked to a reference rate. This makes the coupon payments uncertain. The main pim-pose of this debt instrument is to hedge the risk of rising interest rates. Although the financial crisis and liquidity provided by central banks have decreased the level of interest rates, they will at some point of course rise in future years. 

In this chapter we have seen how interest rate options provide banks, investors, companies, and other users of the financial markets, with an immensely flexible set of tools for hedging against or taking advantage of European interest rate movements. 

It is not surprising that the net present value is zero. The zero-coupon curve is used to derive the discount factors that are then used to derive the forward rates that are used to determine the swap rate. As with any financial instrument, the fair value is its break-even price or hedge cost. The bank that is pricing this swap could hedge it with a series of FRAs transacted at the forward rates shown. This method is used to price any interest rate swap, even exotic ones. 

In the OTC market, a large variety of instruments are traded. As with other OTC products, such as swaps, the great advantage of OTC options is that they can be tailored to meet each buyers requirements. Because of this flexibility, corporations and financial institutions can use them to structure hedges that perfectly match their risk exposures. 

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