P1.T1.305. When a firm should hedge (per IFC)

[Fran]

AIMs: Define hedging, explain the tradeoff between the costs and benefits of hedging, and assess whether it is appropriate for a firm to hedge in particular cases. Identify financial products a firm can use to reduce or eliminate exposure to specific risks.

Questions:

305.1. Acme Industries manufactures widgets that are highly dependent on silver as an input cost; e.g., if the price of silver goes up, Acme's product cost increases and, for a given retail price to consumers, operating profit drops. Each of the following is a plausible tactic to hedge this exposure to silver EXCEPT which is not?

a. Long a forward contract on the price of silver
b. Write a collar on the price of silver: short a put plus (helps fund) long a call
c. Write (short) a call option on the price of silver
d. Vertical acquisition of a silver manufacturing company which increases in value as the price of silver increases

305.2. Downstream Energy has significant exposure to the price of oil: when the price of oil drops, corporate profits drop. In evaluating options, forwards and futures, Analyst Robert makes three arguments to his boss Sally:

I. A key advantage of short forward (or short futures) contracts, in contrast to put options, is they have neither explicit nor implicit costs (i.e., no costs)
II. A key advantage of short futures contracts, in contrast to forwards, is lower cost and virtual lack of credit risk
III. A put option is similar to a short forward (or futures) contract with respect to downside protection (in this case, oil price drops), but there are two key differences: the option preserves the upside potential by incurring an upfront premium
Which of Robert's arguments are true?

a. None
b. I. only
c. II. and III.
d. All are true

305.3. An international company is exposed to foreign exchange rate risk. The incremental BENEFIT of a hedging program will be realized by a lower discount rate and are given in incremental net present value dollar (iNPV) terms, denoted by $iNPV[benefit]. If the company hedges this risk itself, the incremental net present value dollar COST of hedging, incurred by lower cash flows, are denoted by $iNPV[cost]. If the company "passes through" the risk to its investors, management estimates the COST to investors will be $iNPV[investors], after they have eliminated some risk by diversifying. Which of the following most nearly summarizes the IFC's framework for when the firm should hedge this risk?

a. Firm should never hedge this risk
b. Firm should hedge only if iNPV[benefit] > iNPV[cost] and iNPV[investors] > iNPV[company]
c. Firm should hedge only if iNPV[cost] > iNPV[benefit] > iNPV[investors]
d. Firm should always hedge this risk

Answers:

• Here in Forum

 

[Dmitriy]

305.1. - c
305.2. - d
305.3 - b

 

[David Harper CFA FRM]

Dmitriy I am biased (having written the question) but i disagree with 305.2.d

 

[Dmitriy]

Dmitriy I am biased (having written the question) but i disagree with 305.2.d

David, thank you for the correction.
Then my answer for 305.2 would be c

 

[Tabriz]

1c
2c - seems tricky, point is on implicit costs, but could anyone tell what kind of implicit cost there could be ?
3b

 

[David Harper CFA FRM]

Hi Tabriz,

I agree 2 can be perceived as tricky, and i try hard to avoid "trick questions," but I think Malz (the source) is compelling and plain on this point:

When buying or selling futures or forward contracts, there is no upfront explicit cost. However, there is an implicit cost. This process means forfeiting upside for downside protection. Thus, a gold mining company that buys futures contracts to lock in the price of gold might not face explicit costs at the time it enters into these agreements. In the future, though, the company could report sharply lower earnings in future periods, if gold prices exceed the futures price.

in practice, this seems very true: the cost of forfeiting upside has been experienced as very real for some companies (e.g., airlines on occasion, when they did put on a hedge.)

Malz's point is even more plain that than the theoretically implicit cost of a short forward: under the theory (of normal backwardation), if the asset has non-zero beta, the short forward actually expects a loss (corresponding with the expected gain to the long position). Albeit this is an implicit cost that depends on a particular model of futures pricing. Thanks,

 

[ceddie]

thanx for the explanation