Hedging
Hedging is a risk management technique used to protect against future
price or exchange rate changes.
It means taking an opposite position to reduce possible loss.
Hedging does not aim to earn profit; it aims to reduce risk.
It is commonly used in commodities, currency, and financial markets.
Types of Hedging
1. Forward Contract Hedging
Forward hedging is an agreement between two parties to buy or sell
an asset at a fixed price on a future date.
The price is decided today, but delivery happens later.
It protects businesses from price and exchange rate fluctuations.
Forward contracts are private and not traded on exchanges.
2. Futures Contract Hedging
Futures hedging uses standardized contracts traded on an organized
exchange.
These contracts fix the price of a commodity or financial asset for a
future date.
It reduces the risk of price movements in the market.
Futures contracts are liquid and regulated.
3. Options Hedging
Options hedging gives the right, but not the obligation, to buy or sell an
asset at a fixed price.
The buyer can choose whether to exercise the option or not.
It protects against unfavorable price changes while allowing profit
potential.
A premium is paid for this flexibility.
4. Money Market Hedging
Money market hedging uses borrowing and lending in domestic and
foreign markets.
It is mainly used to protect against foreign exchange risk.
Cash flows are adjusted today to avoid future uncertainty.
This method is common in international trade.
Merits of Hedging
Hedging reduces business risk.
Hedging gives price protection.
Hedging protects profit.
Hedging helps in planning.
Hedging avoids big losses.
Demerits of Hedging
Hedging involves extra cost.
Hedging limits high profit.
Hedging is difficult to use.
Hedging does not remove all risk.
Wrong hedging can cause loss
Dividend Discount Model (DDM)
The Dividend Discount Model is a method used to find the value of a
share.
It says that the value of a share is the present value of its future
dividends.
Investors buy shares to earn dividends, so dividends are the main
focus.
DDM assumes that dividends will grow at a constant rate in the future.
It is mostly used for companies that pay regular and stable dividends.
The Dividend Discount Model (DDM) is a way to calculate the intrinsic
value of a stock based on the present value of its expected future
dividends.
Formula
P° = D1 / r-g
Where:
� = Current share price
� = Dividend next year
� = Required rate of return
� = Dividend growth rate
assumptions of the Dividend Discount Model (DDM)
The stock’s value comes only from future dividends.
Dividends are expected to grow at a constant rate.
The investor’s required rate of return remains the same.
There are no taxes or trading costs.
The company is assumed to operate forever.
Explain Exchange risk and strategies to manage foreign currency
risk ??
Exchange risk is the risk of losing money when currency rates
change.
It happens when someone buys, sells, or owes money in another
currency.
If the currency value goes up or down, it can cause loss or extra cost.
It affects importers, exporters, investors, and companies with foreign
loans.
To avoid this risk, people use hedging like forward contracts, futures,
or options.
Example:
A company in Pakistan buys goods from the USA for $10,000.
Today 1 USD = 300 PKR → cost = 3,00,000 PKR
After 3 months 1 USD = 320 PKR → cost = 3,20,000 PKR
❌ Company loses 20,000 PKR because of currency change.
Strategies to manage foreign currency risk
Forward Contract
Forward hedging is an agreement between two parties to buy or sell
an asset at a fixed price on a future date.
The price is decided today, but delivery happens later.
It protects businesses from price and exchange rate fluctuations.
Forward contracts are private and not traded on exchanges.
2. Futures Contract
Futures hedging uses standardized contracts traded on an organized
exchange.
These contracts fix the price of a commodity or financial asset for a
future date.
It reduces the risk of price movements in the market.
Futures contracts are liquid and regulated.
3. Options Hedging
Options hedging gives the right, but not the obligation, to buy or sell an
asset at a fixed price.
The buyer can choose whether to exercise the option or not.
It protects against unfavorable price changes while allowing profit
potential.
A premium is paid for this flexibility.
4. Money Market hedging
Money market hedging uses borrowing and lending in domestic and
foreign markets.
It is mainly used to protect against foreign exchange risk.
Cash flows are adjusted today to avoid future uncertainty.
This method is common in international trade.
Explain maturity matching principal? And what risk are avoided
using this technique??
Maturity Matching Principle (Simple Concept):
It means a company should match the duration of its loans with the life
of the assets it buys.
Short-term needs → use short-term loans.
Long-term needs → use long-term loans or equity.
This helps the company avoid risk of not paying loans and manage
cash safely.
Short-Term Assets (Temporary Assets):
These are assets that can become cash within one year.
Examples: inventory (stock), accounts receivable (money to receive),
cash.
These are financed with short-term loans because they turn into cash
quickly.
Long-Term Assets (Permanent Assets):
These are assets that last more than one year and are used for a long
time.
Examples: buildings, machinery, land.
These are financed with long-term loans or equity because they last
for many years
Risks
Liquidity Risk: The chance that a company cannot pay its short-term
debts because it does not have enough cash.
Refinancing Risk: The chance that a company will have to take a new
loan in the future at higher interest or worse conditions.
Default Risk: The chance that a company fails to repay its loan or
debt on time.
Interest Rate Risk: The chance that borrowing costs increase
because interest rates rise.
Difference between future and forward contract ??
Forward Contract:
Definition: A private agreement between two people to buy or sell
something at a fixed price on a future date.
Example: Ali agrees to sell 100 kg wheat to Bilal at Rs. 500 per kg
after 3 months.
Futures Contract:
Definition: A standardized contract traded on an exchange to buy or
sell something at a fixed price on a future date.
Example: Zara buys a futures contract on the stock exchange to buy
100 shares of a company at Rs. 100 each after 1 month.
Differences:
*Forward contract is private between two people, futures contract is
traded on an exchange.
*Forward contract is flexible in price, quantity, and date, futures
contract has fixed rules and size.
*Forward contract settles only at the end, futures contract settles daily
(marked-to-market).
*Forward contract has higher risk of default, futures contract is safer
because the exchange guarantees it.
*Forward contract is customized, futures contract is standardized.
*Forward contract is not regulated, futures contract is regulated by the
exchange.
Question: Define interest rate risk vs commodity price risk.
Interest Rate Risk:
The risk of losing money because interest rates change.
It mainly affects borrowers and investors in bonds.
Example: If you hold a bond and interest rates rise, the bond’s value
falls.
Commodity Price Risk:
The risk of losing money because the price of a commodity changes.
It mainly affects producers, traders, and buyers of goods like oil,
wheat, or gold.
Example: If you buy oil at $100 and the price drops to $80, you lose
money.
Liquidity Risk vs credit risk
Liquidity Risk:
Definition: Liquidity risk is the risk that a company or person cannot
quickly convert assets into cash to meet short-term obligations.
Example: A company owns machinery worth $1 million but has a
$100,000 bill due tomorrow. If it cannot sell the machinery quickly, it
may fail to pay the bill.
Credit Risk:
Definition: Credit risk is the risk that a borrower will fail to repay a loan
or meet contractual obligations.
Example: A bank lends $50,000 to a person. If the person cannot pay
back, the bank faces a loss due to credit risk.
Define Operational Risk vs Systematic Risk with examples.
Operational Risk:
Operational risk is the chance that a company will lose money
because of problems inside the company.
These problems can be mistakes by employees, failure of computer
systems, fraud, or bad business processes.
Companies can often control or reduce this risk by improving systems,
training employees, or following rules carefully.
Example: A bank loses money because its software crashed during
online transactions.
Systematic Risk:
Systematic risk is the chance that the entire market or economy will
lose value, affecting almost all companies.
This risk cannot be avoided by just owning many different stocks
because it comes from outside the company.
Causes of systematic risk include recessions, changes in interest
rates, inflation, or political problems.
Example: Stock prices fall everywhere because of a country-wide
recession.
Define Market Value vs Book Value with examples.
Market Value:
Market value is the price at which a company’s stock or asset is
bought or sold in the market.
It changes every day according to demand, supply, and market
conditions.
Example: A company’s stock is trading at $50 per share on the stock
market – this is its market value.
Book Value:
Book value is the value of a company or asset according to its
accounting records.
It is calculated by subtracting liabilities from total assets.
Example: A company has assets worth $1,000,000 and liabilities of
$400,000. Its book value is $600,000.