A plot showing how firm value is affected by changes in prices or rates.
Reducing Risk Exposure
Although perfect hedging may be impossible, the normal goal is to reduce financial risk to bearable levels and thereby flatten out the risk profile.
Forward Contracts: The Basics
Forward contract—contract between buyer, who will take future delivery of the goods, and seller, who will make future delivery, for sale of asset in the future (settlement date) at a price agreed upon today (forward price).
The Payoff Profile
Plot of gains and losses on a contract as the result of unexpected price changes.
Hedging with Forward Contracts
The basic concept in managing financial risk is that once we establish the firm's exposure to financial risk, we try to find a financial arrangement (such as a forward contract) with an offsetting payoff profile.
Futures contract—identical to a forward contract except gains and losses are realized (marked-to-market) on a daily basis rather than only on the settlement date.
Trading in Futures
Typically, futures contracts are divided into two groups: -commodity futures contracts
-financial futures contracts
Swap contract—an agreement by two parties to exchange or swap specified cash flows at specified intervals in the future.
Two firms agree to exchange a specific amount of one currency for a specific amount of another at specific dates in the future.
Interest Rate Swaps
Just as two companies can agree to exchange currencies at specific future dates, they can also agree to exchange the cash flows associated with respective loan agreements. Hence the interest rate swap.
Commodity swaps involve the exchange of a fixed...