Hedging Futures.pptVIP

Hedging Futures Today We will return to Capital Budgeting Financing. We will discuss how to reduce risk. Topics How to eliminate risk in capital budgeting. (i.e. variable costs) How to eliminate risk in financing (i.e. interest rate fluctuations) HOW? By Hedging Futures Contracts Ex - Cereal Production Ex - Kellogg produces cereal. A major component and cost factor is sugar. Forecasted income sales volume is set by using a fixed selling price. Changes in cost can impact these forecasts. To fix your sugar costs, you would ideally like to purchase all your sugar today, since you like today’s price, and made your forecasts based on it. But, you can not. You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today. This contract is called a “Forward Contract.” This technique of managing your sugar costs is called “Hedging.” Type of Contracts 1- Spot Contract - A K for immediate sale delivery of an asset. 2- Forward Contract - A K between two people for the delivery of an asset at a negotiated price on a set date in the future. 3- Futures Contract - A K similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract. The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades “provides” a secondary market for the speculation of Futures. Types of Futures Commodity Futures -Sugar -Corn -OJ -Wheat -Soy beans -Pork bellies Financial Futures -Tbills -Yen -GNMA -Stocks -Eurodollars Index Futures -SP 500 -Value Line Index -Vanguard Index Futures Contract Concepts Not an actual sale Always a winner a loser (unlike stocks) K are “settled” every day. (Marked to Market) Hedge - K used to eliminate risk by locking in prices Speculation - K used to gamble Margin - not a sale - post partial amount Hog K = 30,000 lbs Tbill K = $1.0 mil Value line Index K = $index x 500 Ex -