Flashcards
TOPIC 11 - Derivatives and hedging risk
Cards in this deck (10)
- 1You are a business advisor to boutique food producers. At present one of your New Zealand clients is producing speciality berry products and has just begun to export to the Middle East, specifically Qatar. To undertake this business expansion your client has taken out a mortgage using the administration building as security. You have advised the CEO of your client company that it would be sensible to consider the use of derivatives in managing its financial situation. However the CEO has replied that he is not prepared to take on this advice as derivatives are speculative in nature and he is not prepared to gamble with the business. How would you respond to the CEO regarding the claim that use of derivatives is essentially gambling?derivatives can be considered a form of gambling. (1 mark). However for a business, derivatives are tools for changing a firm’s risk exposure. (1 mark). By using derivatives a firm can cut away unwanted portions of risk exposure.
derivatives are useful in her situation, as they can limit the firm’s exposure to risk. (2 marks) - 2Assuming you can convince the CEO that derivatives should be considered, name two derivative products that you would recommend. Explain why each of these derivatives would be appropriate for this client.There are many possible derivatives for an exporter with debt: e.g.
forward rate agreements – to mitigate against changes in price for the products
interest rate swaps – to mitigate against changes in interest rates
currency swaps - to mitigate against currency fluctuations
There are other suitable derivatives.
1 mark for naming a suitable derivative and 1 mark for explaining the risk mitigated - 3‘Futures contracts are traded on an exchange, whereas forward contracts are usually traded over the counter’. What does this statement mean?OTC – the contract is between the two parties and is privately negotiated and traded between the two parties directly. Therefor the contract can be tailor made to the two parties’ liking/
Exchange traded – trading is via an intermediary i.e. the exchange - 4Provide a short explanation of a derivative. Why are derivatives useful to a business?A derivative is a financial instrument whose payoffs and values are derived from, or depend on, something else. (2 marks)
Derivatives are useful to business as they allow a business to change its risk exposure. (1 mark) - 5For the following scenarios , describe a hedging strategy that might be considered: A wheat farmer fears that this year’s harvest will be at record high levels across the country.Sell wheat futures, since a record harvest implies low wheat prices.
- 6An Australian importer of Swiss army knives will pay for its order in six months time in Swiss francs.Buy Swiss franc futures, since the risk is that the dollar will weaken relative to the franc over the next six months, which implies a rise in the $/SFr exchange rate.
- 7A fine chocolates manufacturer is concerned about rising costs.Buy sugar and cocoa futures, since these are probably your primary commodity inputs.
- 8Ms. Steady was quoted as saying “The use of derivatives is pure speculation, and,as a risk averse business person, I will not be using such financial instruments” Do you agree with the comment made by Ms Steady? Give your reasonsDisagree
useful tools for changing a firm’s risk exposure.
An agricultural firm producing wheat uses a futures contract to lock in the price of wheat in 3 months time when the wheat will be delivered – here the risk of the wheat price collapsing is managed.
An Australian importer of machinery manufactured in Japan uses a forward currency rate agreement to lock in an exchange rate. Here the impact of the Australian dollar falling against the Japanese yen is mitigated. - 9Explain what a derivative is, including why a derivative is useful to a business and suggest a derivative that this company might consider using.-A financial instrument whose payoffs are dependent/ derived off something else.
- It is useful for allowing a firm to change its risk exposure.
- There are many possible derivatives for an exporter:
- Forward rate agreements
- interest rate swaps
- Currency Swaps
- forward contracts - 10Briefly set out 2 differences between a futures contract and a forward contract.Futures contract are market to market - Forward contracts are not.
Futures contracts traded ON an exchange - forward contracts are OFF an exchange
More flexibility re timing of delivery with a futures contract compared to a forward contract.
Higher chance of of default with forward contract compared to futures contract (market to market impact)
Information
- Description
- Managerial finance Flashcards on TOPIC 11 - Derivatives and hedging risk, created by Kerry Williams on 24/05/2019.
- Created by
- Kerry Williams
- Views
- 0
- Rating
More on Hedging with Derivatives