Hedging Against Pure Risks

1
Hedging Against Pure Risks

• Recall that a pure risk is one that presents the
  opportunity for loss or status quo, not gain.
  Only a speculative risk includes the potential
  for gain.
• But it is important to note that a situation that
  would be perceived as a pure risk by one party
  may be speculative to another party.

2
Pure versus Speculative Risk in the Eye of the
Beholder

• Barney is looking forward to purchasing a home
  six months from now. He has been saving for the
  down payment, and expects to have enough by then.
  Further, he knows he can afford up to a 200,000
  mortgage loan so long as interest rates hold at
  the current 6.875 APR. He is nervous that rates
  will rise between now and May, thus making a
  200,000 loan too expensive.

3
Pure versus Speculative Risk in the Eye of the
Beholder (Contd)

• Barney would like to lock in his mortgage rate
  now, but the bank is unwilling (a sign that maybe
  they think rates will rise too?)
• Barney approaches his rich friend, Doug, for
  help. They strike a deal that works as follows
• Barney pays Doug 500.
• If mortgage rates dont change over the next six
  months, Barney is out the 500 he paid to Doug,
  and Barney continues with his plan to purchase a
  200,000 loan at 6.875.
• If mortgage rates rise over the next six months,
  Doug promises to provide enough cash at closing
  for Barney to buy down the mortgage to a
  present value amount that will result in a
  monthly payment equal to 200,000 at 6.875 over
  the next 30 years.

4
Pure versus Speculative Risk in the Eye of the
Beholder (Contd)

• The Barney-Doug Deal (Contd)
• If mortgage rates fall over the next six months,
  Barney is out the 500, but enjoys a
  cheaper-than-expected mortgage loan.
• So both Barney and Doug are parties to the
  contract, but they have different motives
• Barney is hedging against mortgage rates rising.
• Doug is speculating that mortgage rates will stay
  the same, or fall.
• Barney is engaging in a form of pure risk
  management (using a call option).

5
Hedging Methods

• Most pure-risk hedging is done using
• options
• forward (or futures) contracts or
• swap contracts.
• We will concentrate our discussion on the use of
  options and forwards (futures).

6
Options

• An option is the right to buy or sell something
  in the future (usually within a specified period
  of time) at a specific, agreed-upon price.
• A call option is the right to buy.
• A put option is the right to sell.
• The party that purchases an option to buy (a call
  option), will only exercise that option if the
  market price of the underlying asset rises above
  the call price (thus making the call price
  attractive to the owner of the option).
• The party that purchases an option to sell (a put
  option), will only exercise that option if the
  market price of the of the underlying asset falls
  below the put price (thus making the put price
  attractive to the owner of the option).

7
Illustration of a Call Option

• NeedOil must purchase 250,00 barrels of oil in
  six months for its production process.
• A rise in the market price of oil raises
  NeedOils costs.
• Since demand for NeedOils product is elastic,
  NeedOil cannot pass on all of its additional
  costs to its customers.
• Suppose NeedOil wants to avoid paying more than
  15 per barrel. NeedOil can accomplish this by
  contracting with OPTCO who will give NeedOil
  money when the price of oil rises above 15.

8
Illustration of a Call Option (Contd)

• The agreement is this In the event that the
  market price of oil rises above 15 per barrel in
  six months, OPTCO agrees to pay NeedOil 250,000
  times the difference between 15 and the actual
  market price.
• OPTCO will require compensation for taking on
  NeedOils price risk. Suppose OPTCO requires a
  100,000 premium for agreeing to this contract.
• What is NeedOilss net payoff if the market price
  of oil in six months is 14?
• What is NeedOilss net payoff if the market price
  of oil in six months is 15?
• What is NeedOilss net payoff if the market price
  of oil in six months is 16?

9
Is the Opposite Side of the Contract Always
Speculating?

• No. The other party to a derivatives contract may
  either be a hedger or a speculator. Although Doug
  appeared to be speculating in our first example,
  OPTCO may either be hedging or speculating
• OPTCO may attempt to make a living by gambling on
  contracts such as the one with NeedOil (and thus
  is a speculator) or
• OPTCO may be a business that makes more money
  when the price of oil rises. If OPTCO, for
  instance, is in the business of distributing
  natural gas, rising oil prices increase OPTCOs
  profits by increasing the demand for natural gas
  (thus giving OPTCO a hedging motive to engage in
  the NeedOil contract).

10
Illustration of a Forward (Futures) Contract

• There is another way that NeedOil can hedge its
  oil price risk.
• Suppose that instead of contracting with OPTCO,
  NeedOil contracts with F-CO who will provide
  protection against increases in the market price
  of oil. As with the earlier call option
• If the price of oil rises to 16, F-CO must pay
  NeedOil 250,000
• If the price of oil rises to 17, F-CO must pay
  NeedOil 500,000 and
• so on and so forth.

11
Illustration of a Forward Contract (Contd)

• NeedOil does not pay a premium in this case
  rather it must pay F-CO only if the price of oil
  falls below 15 in six months. And the more the
  price falls below 15, the more NeedOil must pay
  F-CO
• If the price of oil falls to 14, NeedOil must
  pay F-CO 250,000
• If the price of oil falls to 13, NeedOil must
  pay F-CO 500,000
• and so on and so forth.
• The possible payoffs of this contract are more
  directly calculated than within the earlier
  option contract because no premium is involved.

12
Comparison of Derivatives and Insurance

• Type of risk hedged
• Number of firms potentially interested in a
  particular contract
• Basis risk
• Contracting costs
• moral hazard
• adverse selection
• bonding contractual performance
• Liquidity