Why do companies hedge to reduce risk?Fluctuations in commodity prices, interest rates, orexchange rates can make planning difficult and can throwcompanies badly off course. Financial managers thereforelook for opportunities to manage these risks, and a numberof specialized instruments have been invented to help them.These are collectively known as derivative instruments.
How can options, futures, and forward contracts beused to devise simple hedging strategies?In the last chapter we introduced you to put and calloptions. Options are often used by firms to limit theirdownside risk. For example, if you own an asset and havethe option to sell it at the current price, then you haveeffectively insured yourself against loss.Futures contracts are agreements made today to buyor sell an asset in the future. The price is fixed today, but thefinal payment does not occur until the delivery date. Futurescontracts are highly standardized and are traded on organizedexchanges. Commodity futures allow firms to fix thefuture price that they pay for a wide range of agriculturalcommodities, metals, and oil. Financial futures help firmsto protect themselves against unforeseen movements ininterest rates, exchange rates, and stock prices.Forward contracts are equivalent to tailor-madefutures contracts. For example, firms often enter into forwardagreements with a bank to buy or sell foreignexchange or to fix the interest rate on a loan to be madein the future.
How can companies use swaps to change the risk ofsecurities they have issued?Swaps allow firms to exchange one series of future paymentsfor another. For example, the firm might agree tomake a series of regular payments in one currency in returnfor receiving a series of payments in another currency.
