Contract Investment Strategies Essay Example | Topics and Well Written Essays - 1500 words

Contract Investment Strategies - Essay Example Hedging can be considered a source of financing for post-loss investment opportunities. Hedging has other dimensions besides financing the post-loss investment; it addresses the asset substitution and under investment problems, reduces the probability of insolvency, permits more effective managerial compensation contracts, and may help reduce tax liabilities when tax functions are convex. In nutshell hedging, is 1 - Taking a position in a futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change. 2 - A purchase or sale of futures as a temporary substitute for a cash transaction which will occur later. (http://www.cme.com/edu/ai/trdwthr/weatherbackground11784.html) For example, let us take the example of a hedger. A soybean grower must plan production based on some idea of a market price. There are, however, no guarantee against the decline of soybean prices once planting has begun. If prices drops once production is under way, future sale proceeds of soybeans may not be enough to cover the production cost, thus putting in jeopardy the financial health of the grower. Hedging can protect the farmer against this type of price uncertainty. Very similar is the case of weather derivatives. Weather derivatives cover low-risk, high probability events, while weather, insurance typically covers high-risk, low-probability events, as defined in highly tailored or customized policies. For example, a company might use a weather derivative to hedge against a winter that forecasters thought would be 5 Fahrenheit warmer than the historical average (a low risk, high probability event) since the company knows its revenues would be affected by that kind of weath er. However, the same company would most likely purchase an insurance policy for protection against damages caused by a flood or hurricane (high-risk, low-probability events.) (http://www.cme.com/edu/ai/trdwthr/weatherbackground11784.html) In the example of the soybean grower, by locking in a floor price through the purchase of a soybean put option, the grower would for example, at least know that no matter where the future market price of Soybeans is at harvest time, He/she will be able to sell the soybeans at the strike price. Of course, to establish this future price floor, the grower must pay a premium to purchase the put options, but this cost can be priced into production at the outset like any other cost of production. An owner of an asset will loose mosey when the price of the asset falls. Value of a put option rises when the asset price falls. What happens to the value of a portfolio containing both the asset and the put when the asset price falls Clearly, the answer depends on the ratio of assets to options in the portfolio. If the ratio is equal to zero, the value rises, whereas if the ratio is infinity, the value falls. Somewhere between these two extremes is a ratio at which a small movement in the asset does not results in any movement in the value of the portfolio. Such a portfolio is risk free. The reduction of risk by taking advantage of such correlations between the asset and the option price movements is called hedging. This is the one example how options are used in hedging. Call options can also be used for hedging. When using put options to hedge, various strike prices exist for an option on a specific stock index and for a specific expiration date. For example, put options on the