Firms hedge to reduce risk. This chapter showed a number of hedging strategies.
A forward contract is an agreement by two parties to sell an item for cash at a later date. The price is set at the time the agreement is signed. However, cash changes hands on the date of delivery. Forward contracts are generally not traded on organized exchanges.
Futures contracts are also agreements for future delivery. They have certain advantages, such as liquidity, that forward contracts do not. An unusual feature of futures contracts is the mark-to-themarket convention. If the price of a futures contract falls on a particular day, every buyer of the contract must pay money to the clearinghouse. Every seller of the contract receives money from the clearinghouse. Everything is reversed if the price rises. The mark-to-the-market convention prevents defaults on futures contracts.
We divided hedges into two types: short hedges and long hedges. An individual or firm that sells a futures contract to reduce risk is instituting a short hedge. Short hedges are generally appropriate for holders of inventory. An individual or firm that buys a futures contract to reduce risk is instituting a long hedge. Long hedges are typically used by firms with contracts to sell finished goods at a fixed price.
An interest rate futures contract employs a bond as the deliverable instrument. Because of their popularity, we worked with Treasury bond futures contracts. We showed that Treasury bond futures contracts can be priced using the same type of net present value analysis that is used to price Treasury bonds themselves.
Many firms face interest rate risk. They can reduce this risk by hedging with interest rate futures contracts. As with other commodities, a short hedge involves the sale of a futures contract. Firms that are committed to buying mortgages or other bonds are likely to institute short hedges. A long hedge involves the purchase of a futures contract. Firms that have agreed to sell mortgages or other bonds at a fixed price are likely to institute long hedges.
Duration measures the average maturity of all the cash flows in a bond. Bonds with high duration have high price variability. Firms frequently try to match the duration of their assets with the duration of their liabilities.
Swaps are agreements to exchange cash flows over time. The first major type is an interest rate swap in which one pattern of coupon payments, say, fixed payments, is exchanged for another, say, coupons that float with LIBOR. The second major type is a currency swap, in which an agreement is struck to swap payments denominated in one currency for payments in another currency over time.
