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CHAPTER23RISKMANAGEMENTANINTRODUCTIONTOFINANCIALENGINEERINGANSWERSTOCONCEPTSREVIEWANDCRITICALTHINKINGQUESTIONS1SINCETHEFIRMISSELLINGFUTURES,ITWANTSTOBEABLETODELIVERTHELUMBERTHEREFORE,ITISASUPPLIERSINCEADECLINEINLUMBERPRICESWOULDREDUCETHEINCOMEOFALUMBERSUPPLIER,ITHASHEDGEDITSPRICERISKBYSELLINGLUMBERFUTURESLOSSESINTHESPOTMARKETDUETOAFALLINLUMBERPRICESAREOFFSETBYGAINSONTHESHORTPOSITIONINLUMBERFUTURES2BUYINGCALLOPTIONSGIVESTHEFIRMTHERIGHTTOPURCHASEPORKBELLIESTHEREFORE,ITMUSTBEACONSUMEROFPORKBELLIESWHILEARISEINPORKBELLYPRICESISBADFORTHECONSUMER,THISRISKISOFFSETBYTHEGAINONTHECALLOPTIONSIFPORKBELLYPRICESACTUALLYDECLINE,THECONSUMERENJOYSLOWERCOSTS,WHILETHECALLOPTIONEXPIRESWORTHLESS3FORWARDCONTRACTSAREUSUALLYDESIGNEDBYTHEPARTIESINVOLVEDFORTHEIRSPECIFICNEEDSANDARERARELYSOLDINTHESECONDARYMARKETFORWARDSARESOMEWHATCUSTOMIZEDFINANCIALCONTRACTSALLGAINSANDLOSSESONTHEFORWARDPOSITIONARESETTLEDATTHEMATURITYDATEFUTURESCONTRACTSARESTANDARDIZEDTOFACILITATETHEIRLIQUIDITYANDTOALLOWTHEMTOBEEFFECTIVELYTRADEDONORGANIZEDFUTURESEXCHANGESGAINSANDLOSSESONFUTURESAREMARKEDTOMARKETDAILYTHEDEFAULTRISKISGREATLYREDUCEDWITHFUTURES,SINCETHEEXCHANGEACTSASANINTERMEDIARYBETWEENTHETWOPARTIES,GUARANTEEINGPERFORMANCEDEFAULTRISKISALSOREDUCEDBECAUSETHEDAILYSETTLEMENTPROCEDUREKEEPSLARGELOSSPOSITIONSFROMACCUMULATINGYOUMIGHTPREFERTOUSEFORWARDSINSTEADOFFUTURESIFYOURHEDGINGNEEDSWEREDIFFERENTFROMTHESTANDARDCONTRACTSIZEANDMATURITYDATESOFFEREDBYTHEFUTURESCONTRACT4THEFIRMISHURTBYDECLININGOILPRICES,SOITSHOULDSELLOILFUTURESCONTRACTSTHEFIRMMAYNOTBEABLETOCREATEAPERFECTHEDGEBECAUSETHEQUANTITYOFOILITNEEDSTOHEDGEDOESNTMATCHTHESTANDARDCONTRACTSIZEONCRUDEOILFUTURES,ORPERHAPSTHEEXACTSETTLEMENTDATETHECOMPANYREQUIRESISNTAVAILABLEONTHESEFUTURESEXPOSINGTHEFIRMTOBASISRISK,ORMAYBETHEFIRMPRODUCESADIFFERENTGRADEOFCRUDEOILTHANTHATSPECIFIEDFORDELIVERYINTHEFUTURESCONTRACT5THEFIRMISDIRECTLYEXPOSEDTOFLUCTUATIONSINTHEPRICEOFNATURALGAS,SINCEITISANATURALGASUSERINADDITION,THEFIRMISINDIRECTLYEXPOSEDTOFLUCTUATIONSINTHEPRICEOFOILIFOILBECOMESLESSEXPENSIVERELATIVETONATURALGAS,ITSCOMPETITORSWILLENJOYACOSTADVANTAGERELATIVETOTHEFIRM6BUYINGTHECALLOPTIONSISAFORMOFINSURANCEPOLICYFORTHEFIRMIFCOTTONPRICESRISE,THEFIRMISPROTECTEDBYTHECALL,WHILEIFPRICESACTUALLYDECLINE,THEYCANJUSTALLOWTHECALLTOEXPIREWORTHLESSHOWEVER,OPTIONSHEDGESARECOSTLYBECAUSEOFTHEINITIALPREMIUMTHATMUSTBEPAIDTHEFUTURESCONTRACTCANBEENTEREDINTOATNOINITIALCOST,WITHTHEDISADVANTAGETHATTHEFIRMISLOCKINGINONEPRICEFORCOTTONITCANTPROFITFROMCOTTONPRICEDECLINES7THEPUTOPTIONONTHEBONDGIVESTHEOWNERTHERIGHTTOSELLTHEBONDATTHEOPTIONSSTRIKEPRICEIFBONDPRICESDECLINE,THEOWNEROFTHEPUTOPTIONPROFITSHOWEVER,SINCEBONDPRICESANDINTERESTRATESMOVEINOPPOSITEDIRECTIONS,IFTHEPUTOWNERPROFITSFROMADECLINEINBONDPRICES,HEWOULDALSOPROFITFROMARISEININTERESTRATESHENCE,ACALLOPTIONONINTERESTRATESISCONCEPTUALLYTHESAMETHINGASAPUTOPTIONONBONDPRICES8THECOMPANYWOULDLIKETOLOCKINTHECURRENTLOWRATES,ORATLEASTBEPROTECTEDFROMARISEINRATES,ALLOWINGFORTHEPOSSIBILITYOFBENEFITIFRATESACTUALLYFALLTHEFORMERHEDGECOULDBEIMPLEMENTEDBYSELLINGBONDFUTURESTHELATTERCOULDBEIMPLEMENTEDBYBUYINGPUTOPTIONSONBONDPRICESORBUYINGCALLOPTIONSONINTERESTRATES9ASWAPCONTRACTISANAGREEMENTBETWEENPARTIESTOEXCHANGEASSETSOVERSEVERALTIMEINTERVALSINTHEFUTURETHESWAPCONTRACTISUSUALLYANEXCHANGEOFCASHFLOWS,BUTNOTNECESSARILYSOSINCEAFORWARDCONTRACTISALSOANAGREEMENTBETWEENPARTIESTOEXCHANGEASSETSINTHEFUTURE,BUTATASINGLEPOINTINTIME,ASWAPCANBEVIEWEDASASERIESOFFORWARDCONTRACTSWITHDIFFERENTSETTLEMENTDATESTHEFIRMPARTICIPATINGINTHESWAPAGREEMENTISEXPOSEDTOTHEDEFAULTRISKOFTHEDEALER,INTHATTHEDEALERMAYNOTMAKETHECASHFLOWPAYMENTSCALLEDFORINTHECONTRACTTHEDEALERFACESTHESAMERISKFROMTHECONTRACTINGPARTY,BUTCANMOREEASILYHEDGEITSDEFAULTRISKBYENTERINGINTOANOFFSETTINGSWAPAGREEMENTWITHANOTHERPARTY10THEFIRMWILLBORROWATAFIXEDRATEOFINTEREST,RECEIVEFIXEDRATEPAYMENTSFROMTHEDEALERASPARTOFTHESWAPAGREEMENT,ANDMAKEFLOATINGRATEPAYMENTSBACKTOTHEDEALERTHENETPOSITIONOFTHEFIRMISTHATITHASEFFECTIVELYBORROWEDATFLOATINGRATES11TRANSACTIONSEXPOSUREISTHESHORTTERMEXPOSUREDUETOUNCERTAINPRICESINTHENEARFUTUREECONOMICEXPOSUREISTHELONGTERMEXPOSUREDUETOCHANGESINOVERALLECONOMICCONDITIONSTHEREAREAVARIETYOFINSTRUMENTSAVAILABLETOHEDGETRANSACTIONEXPOSURE,BUTVERYFEWLONGTERMHEDGINGINSTRUMENTSEXISTITISMUCHMOREDIFFICULTTOHEDGEAGAINSTECONOMICEXPOSURE,SINCEFUNDAMENTALCHANGESINTHEBUSINESSGENERALLYMUSTBEMADETOOFFSETLONGRUNCHANGESINTHEECONOMICENVIRONMENT12THERISKISTHATTHEDOLLARWILLSTRENGTHENRELATIVETOTHEYEN,SINCETHEFIXEDYENPAYMENTSINTHEFUTUREWILLBEWORTHFEWERDOLLARSSINCETHISIMPLIESADECLINEINTHE/EXCHANGERATE,THEFIRMSHOULDSELLYENFUTURES13ABUYOILANDNATURALGASFUTURESCONTRACTS,SINCETHESEAREPROBABLYYOURPRIMARYRESOURCECOSTSIFITISACOALFIREDPLANT,ACROSSHEDGEMIGHTBEIMPLEMENTEDBYSELLINGNATURALGASFUTURES,SINCECOALANDNATURALGASPRICESARESOMEWHATNEGATIVELYRELATEDINTHEMARKETCOALANDNATURALGASARESOMEWHATSUBSTITUTABLEBBUYSUGARANDCOCOAFUTURES,SINCETHESEAREPROBABLYYOURPRIMARYCOMMODITYINPUTSCSELLCORNFUTURES,SINCEARECORDHARVESTIMPLIESLOWCORNPRICESDBUYSILVERANDPLATINUMFUTURES,SINCETHESEAREPRIMARYCOMMODITYINPUTSREQUIREDINTHEMANUFACTUREOFPHOTOGRAPHICEQUIPMENTESELLNATURALGASFUTURES,SINCEEXCESSSUPPLYINTHEMARKETIMPLIESLOWPRICESFASSUMINGTHEBANKDOESNTRESELLITSMORTGAGEPORTFOLIOINTHESECONDARYMARKET,BUYBONDFUTURESGSELLSTOCKINDEXFUTURES,USINGANINDEXMOSTCLOSELYASSOCIATEDWITHTHESTOCKSINYOURFUND,SUCHASTHESINANACTUALSWAPDEAL,THEDIVISIONSWOULDPROBABLYBENEGOTIATEDBYTHEDEALERONEPOSSIBLECOMBINATIONIS1FORABCAND1FORXYZABCDEALRLIBOR195XYZLIBOR25258DEBTMARKETLIBOR1DEBTMARKET8CHALLENGE7THEFINANCIALENGINEERCANREPLICATETHEPAYOFFSOFOWNINGAPUTOPTIO
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