Question

1. What is the difference between hedging and speculation?

2. List one reason why risk management might increase the value of a firm.

3. List one difference between a futures contract and a forward contract.

4. What are you protecting against if you sell Treasury futures short?

5. Why would a company enter into a swap?

Answer 1

1) Speculators and hedgers are different terms that describe traders and investors.

a) The act of preventing an investment against unforeseen price changes is known as hedging. Speculation is a process in which the investor involves in a trading of financial asset of significant risk, in the hope of getting profits

b) Hedging is a means to control price risk. Speculation relies on the risk factor, in expectation of getting returns.

c) Hedging involves Protection against price changes. Speculation incurring risk to make profits from price changes.

d) In hedging operators are Risk averse while in speculation Risk Lovers

2) Risk management might increase the value of a firm because it allows corporations to

a) increase their use of debt; (b) maintain their optimal capital budget over time; (c) avoid costs associated with financial distress; (d) utilize their comparative advantages in hedging relative to the hedging ability of individual investors; (e) reduce both the risks and costs of borrowing by using swaps; (f) reduce the higher taxes that result from fluctuating earnings; and (g) initiate compensation systems that reward managers for achieving earnings stability.

3) Futures Contract and a Forward Contract

• Futures contracts are highly standardized whereas the terms of each forward contract can be privately negotiated.
• Futures are traded on an exchange whereas forwards are traded over-the-counter.

4) Going 'short' indicates that an investor believes that prices will drop and therefore will profit if they can buy back their position at a lower price. Many individual investors do not have the ability to go short an actual bond. To do so would require locating an existing holder of that bond and then borrowing it from them in order to sell it in the market. The borrowing involved may include the use of leverage, and if the price of the bond increases instead of falling, the investor has the potential for large losses.

A hedge is an investment made to reduce the risk of adverse price movements in another asset.

Leverage is the ability to margin investments with an investment of only a portion of their total value

5) Interest Rate Swaps

An interest rate swap is a contract in which two parties exchange streams of interest payments. The parties do not exchange the underlying principal amounts, only the streams of interest payments.

Advantages of Interest-Rate Swaps

There are several reasons why a company would want to enter into an interest-rate swap.

a) First is interest rate swap hedging. The interest rate swap is a technique for hedging risk of unfavorable interest rate fluctuations.

b) Also, an interest rate swap agreement can reduce uncertainty. If a company has a floating rate loan, they may not know what sort of interest rate payments they will be paying throughout the duration of that loan.

c) And finally, an interest rate swap can reduce the cost of a loan. Depending on the specifics of the transaction, a company may be able to enter into an interest rate swap that allows it to pay a lower fixed interest rate to a swap trader than it would have had to pay for a fixed interest rate with a lender.