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Unit 6: Trading Strategies

Notes

Notes It is important to measure and to have on a daily basis some notion of the firm’s
potential liability from financial price risk.
There are three types of risk for every particular financial price to which the firm is
exposed.
Transactional risks reflect the pejorative impact of fluctuations in financial prices on the
cash flows that come from purchases or sales. This is the kind of risk we described in our
example of the pulp-and-paper company concerned about their US$10 million contract.
Or, we could describe the funding problem of the company as a transactional risk. How do
they borrow money? How do they hedge the value of a loan they have taken once it is on
the books?

Translation risks describe the changes in the value of a foreign asset due to changes in
financial prices, such as the foreign exchange rate.
Economic exposure refers to the impact of fluctuations in financial prices on the core
business of the firm. If developing market economies devalue sharply while retaining
their high technology manufacturing infrastructure, what effect will this have on an Ottawa-
based chip manufacturer that only has sales in Canada? If it means that these countries will
flood the market with cheap chips in a desperate effort to obtain hard currency, it could
mean that the domestic manufacturer is in serious jeopardy.
Third, what are the various hedging instruments available to the corporate Treasurer and
how do they behave in different pricing environments?
When it is best to use which instrument is a question the corporate Treasurer must answer.
The difference between a mediocre corporate Treasury and an excellent one is their ability
to operate within the context of their shareholder-delineated limits and choose the optimal
hedging structure for a particular exposure and economic environment. Not every structure
will work well in every environment. The corporate Treasury should be able to tailor the
exposure using derivatives so that it fits the preferences and the view of the senior
management and the board of directors.

6.2 Importance of Hedging

The single-most important point to take away from this material is that financial risk management
is critical to the survival of any non-financial corporation. Investors who have real money at
risk must understand the exposures facing the firms in which they invest, they must know the
extent of risk management at these companies and they must be able to distinguish between
good risk management programmes and bad ones. Without this knowledge, they may be in for
some ugly surprises.

Did u know? It may appear that companies in which individual investors place money do
not have exposures to financial prices.

6.3 Risk Management Strategies

Many corporate executives are faced with the challenge of managing the risks associated with
low cost basis and restricted-stock holdings (i.e., concentrated equity positions). There are many
strategies available, each with unique characteristics and requirements. In general, these strategies

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