Corporate finance chapter 011 hedzging and insuring

Chapter 11: Hedging and Insuring Objective Explain market mechanisms for implementing hedges and insurance... Chapter 11 Contents11.1 Using Forward & Futures Contracts to Hedge Risks 11

Chapter 11: Hedging and

Insuring

Objective

Explain market mechanisms for implementing hedges and insurance

Chapter 11 Contents

11.1 Using Forward & Futures

Contracts to Hedge Risks

11.2 Hedging

Foreign-Exchange Risk with Swap

Contracts

11.3 Hedging Shortfall-Risk by

Matching Assets to

Liabilities

11.4 Minimizing the Cost of

Hedging

11.5 Insuring versus Hedging

11.6 Basic Features of Insurance Contracts 11.7 Financial Guarantees

11.8 Caps & Floors on Interest Rates

11.9 Options as Insurance

11.10 The Diversification Principle

11.11 Insuring a Diversified Portfolio

Value of 30-Year Mortgage 5-Years Out (6%)

0 2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

Market Interest Rate

Market Value of Mortgages

Book Value of Mortgages

Cash from Mortgages and Cash Needed for CDs

0 200,000

400,000

600,000

800,000

1,000,000

1,200,000

Current Interest Rate

CD Interest Payments

Mortgage Interest Payments

Hedging v Insuring

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

Price of Wheat

Hedging with a Put

-2000

0

2000

4000

6000

8000

10000

12000

14000

16000

Share Price

Share Holding Value Puts

FV Premium Total Wealth

Standard deviation, 1 firm

State of the World Probability Payoff Mean Deviation Dev SQR <- * Prob

One Failure 0.5 0 200000 -200000 4E+10 2E+10

One Success 0.5 400000 200000 200000 4E+10 2E+10

Sum = 4E+10 Sqrt ^| 200000

•The Standard Deviation is $200,000

Standard deviation, 2 firms

State of the World Probability Payoff Mean Deviation Dev SQR <- * Prob

One Failure 0.25 0 200000 -200000 4E+10 1E+10

One Success 0.5 200000 200000 0 0 0

Two Successes 0.25 400000 200000 200000 4E+10 1E+10

Sum = 2E+10 Sqrt ^| 141421.356

•The Standard Deviation is

about $141,000 (c.f $200,000)

•The Standard Deviation is

about $141,000 (c.f $200,000)

Standard deviation, equal

investment in “n” firms

prove that the standard deviation in this case is just $200,000/SqrareRoot(n)

example, the risk may be made as close

to zero as we wish if there are sufficient securities! In reality, however …

n is must be finite, and pharmaceutical projects have a non-zero correlations

Correlated Homogeneous

Securities

correlation (Why?)

correlation, and set it to ρ, and use the generalization of

2 , 1 2

1 2

1

2 2

2 2

2 1

2 1

σ p = w + w + w w

Correlated Homogeneous Securities

remains the term

Standard Deviations of Portfolios,

rho = 0.2, sig = 0.2

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

Portfolio Size

Standard Deviations of Portfolios,

rho = 0.8, sig = 0.2

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

Portfolio Size

Standard Deviations of Portfolios,

rho = 0.5, sig = 0.2

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

Portfolio Size

Standard Deviations of Portfolios,

rho = 0.2, sig = 0.2

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

Portfolio Size

Diversifiable Security Risk

Nondiversifiable Security Risk

Standard Deviations of Portfolios,

rho = 0.0, sig = 0.2

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

Portfolio Size

All risk is diversifiable

Standard Deviations of Portfolios, rho = 1/(1-50) = -0.0204, sig = 0.2

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20