Page 32 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 3: Forward Contracts

Second, what is the firm's exposure to financial price risk? 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. Financial institutions whose core business is the management
and acceptance of financial price risk have whole departments devoted to the independent
measurement and quantification of their exposures. It is no less critical for a company with
billions of dollars of internationally driven revenue to do so.
There are three types of risk for every particular financial price to which the firm is exposed.
1. 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?
2. Translation risks describe the changes in the value of a foreign asset due to changes in
financial prices, such as the foreign exchange rate.
3. 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.
3.1.2 Hedge Fund Strategies

The predictability of future results shows a strong correlation with the volatility of each strategy.
Future performance of strategies with high volatility is far less predictable than future
performance from strategies experiencing low or moderate volatility.
1. Aggressive Growth: Hedge fund investors invest in equities expected to experience
acceleration in growth of earnings per share. These are generally high P/E ratios, low or
no dividends; often smaller and micro cap stocks, which are expected to experience rapid
growth. These include sector specialist funds such as technology, banking, or biotechnology.
Hedges by shorting equities where earnings disappointment is expected or by shorting
stock indexes tends to be "long-biased." Expected Volatility: High.

2. Distressed Securities: Investors buy equity, debt, or trade claims at deep discounts of
companies in or facing bankruptcy or reorganization. Profits from the market's lack of
understanding of the true value of the deeply discounted securities and because the majority
of institutional investors cannot own below investment grade securities. (This selling
pressure creates the deep discount.) Results generally not dependent on the direction of
the markets. Expected Volatility: Low - Moderate.

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