10 Business Snapshot 1.1 Hedge Funds
Hedge funds have become major users of derivatives for hedging, speculation, and arbitrage. A hedge fund is similar to a mutual fund in that it invests funds on behalf of clients. However, unlike mutual funds hedge funds are not required to register under U.S. federal securities law. This is because they accept funds only from ®nancially sophisticated individuals and do not publicly oer their securities. Mutual funds are subject to regulations requiring that shares in the funds be fairly priced, that the shares be redeemable at any time, that investment policies be disclosed, that the use of leverage be limited, that no short positions be ...view middle of the document...
Emerging Markets: Invest in debt and equity of companies in developing or emerging countries and in the debt of the countries themselves. Growth Fund: Invest in growth stocks, hedging with the sales of options. Macro or Global: Use derivatives to speculate on interest rate and foreign exchange rate moves. Market Neutral: Purchase securities considered to be undervalued and sell securities considered to be overvalued in such a way that the exposure to the overall direction of the market is zero.
Hedging Using Forward Contracts
Suppose that it is July 14, 2006, and ImportCo, a company based in the United States, knows that it will have to pay £10 million on October 14, 2006, for goods it has purchased from a British supplier. The USD/GBP exchange rate quotes made by a ®nancial institution are shown in Table 1.1. ImportCo could hedge its foreign exchange risk by buying pounds (GBP) from the ®nancial institution in the three-month forward
Introduction Example 1.1 Hedging with forward contracts
It is July 14, 2006. ImportCo must pay £10 million on October 3, 2006, for goods purchased from Britain. Using the quotes in Table 1.1, it buys £10 million in the three-month forward market to lock in an exchange rate of 1.8405 for the sterling it will pay. ExportCo will receive £30 million on October 14, 2006, from a customer in Britain. Using quotes in Table 1.1 it sells £30 million in the three-month forward market to lock in an exchange rate of 1.8400 for the sterling it will receive. market at 1.8405. This would have the eect of ®xing the price to be paid to the British exporter at $18,405,000. Consider next another U.S. company, which we will refer to as ExportCo, that is exporting goods to the United Kingdom and on July 14, 2006, knows that it will receive £30 million three months later. ExportCo can hedge its foreign exchange risk by selling £30 million in the three-month forward market at an exchange rate of 1.8400. This would have the eect of locking in the U.S. dollars to be realized for the sterling at $55,200,000. Example 1.1 summarizes the hedging strategies open to ImportCo and ExportCo. Note that a company might do better if it chooses not to hedge than if it chooses to hedge. Alternatively, it might do worse. Consider ImportCo. If the exchange rate is 1.7000 on October 14 and the company has not hedged, the £10 million that it has to pay will cost $17,000,000, which is less than $18,405,000. On the other hand, if the exchange rate is 1.9000, the £10 million will cost $19,000,000Ðand the company will wish it had hedged! The position of ExportCo if it does not hedge is the reverse. If the exchange rate in September proves to be less than 1.8400, the company will wish it had hedged; if the rate is greater than 1.8400, it will be pleased it has not done so. This example illustrates a key aspect of hedging. Hedging reduces the risk, but it is not necessarily the case that the outcome with hedging will be better than the outcome...