-
Looking for HSC notes and resources? Check out our Notes & Resources page
Hedging (1 Viewer)
- Thread starter tweakin
- Start date
B
Bambul
Guest
I didn't do BS, so don't quote me. But from my understanding, hedging is done to eliminate any risks incurred through future price movements (eg. currencies, commodity prices, etc). So you can do it with currency, but also with say a farmer who wants to fix a price for the wool that he/she will be selling in 3 months time. So in order to be certain of the price he/she will enter into a futures contract today.
Hope that made sense.
Hope that made sense.
p00_p00
Member
Good explaination
u really from AMP????
u really from AMP????
p00_p00
Member
if so, u mind giving me a nice explaination (in which a yr 12 student can understand) of derivatives????
i know the theory: fin instruments whos value is derived from other assets and commodities..... but wat does it mean???
cheers!
i know the theory: fin instruments whos value is derived from other assets and commodities..... but wat does it mean???
cheers!
B
Bambul
Guest
The Economics and Business Studies aren't run by AMP, they are sponsored by AMP (actually, they aren't sponsoring the competition next, year, we are in the process of finding new sponsors at the moment). It's actually run by student volunteers from the Commerce and Economics Society at UNSW.
For a non-textbook explination of drivatives (ie. don't write this in an exam): it is gambling on the price of things. eg. You walk up to a friend and bet them that the price of BHP shares will go up within the next 6 months. If it does, you make a profit.
This is derivatives trading. It is very risky and a less than zero sum game due to transaction costs (ie. if you add the profit and loss of traders you will get a net loss).
Alternatevely (sp?) you can use them for hedging. I'll give you an example using options (I'm going to assume you understand what options are/how they work). You buy some shares in Telstra, but you want to avoid any downward risk on the share price. So you sell some put options (the option, but not obligation, to sell your shares at a predetermined price within the next X months). Now if your Telstra shares fall below that price you are guaranteed a floor price for your shares.
If you're still confused, or more likely even more confused than before, then tell me and I'll try another explanation. I should point out that I wouldn't know a "textbook answer", most of what I have learned in this area is first hand/practical knowledge, which is not always good exam material.
---------
Edit: I should also have talked about how derivatives derive their value. They are things like futures or options. Imagine you enter into a futures contract to buy 1000kg of wool at 900c/kg in 3 months, which is also the going rate for wool today. If the price of wool goes up to 1100c/kg in 2 months time, then the value of your futures contract should also go up to 1100c/kg. So you could either hold on to your contract and buy wool cheaply in one month, buy the wool and sell it for a $2000 profit (if the price remains stable), or sell it now. Either way, can you see how the price of the derivative (in this case, a futures contract) is derived from the price of a commodity (in this case wool)?
For a non-textbook explination of drivatives (ie. don't write this in an exam): it is gambling on the price of things. eg. You walk up to a friend and bet them that the price of BHP shares will go up within the next 6 months. If it does, you make a profit.
This is derivatives trading. It is very risky and a less than zero sum game due to transaction costs (ie. if you add the profit and loss of traders you will get a net loss).
Alternatevely (sp?) you can use them for hedging. I'll give you an example using options (I'm going to assume you understand what options are/how they work). You buy some shares in Telstra, but you want to avoid any downward risk on the share price. So you sell some put options (the option, but not obligation, to sell your shares at a predetermined price within the next X months). Now if your Telstra shares fall below that price you are guaranteed a floor price for your shares.
If you're still confused, or more likely even more confused than before, then tell me and I'll try another explanation. I should point out that I wouldn't know a "textbook answer", most of what I have learned in this area is first hand/practical knowledge, which is not always good exam material.
---------
Edit: I should also have talked about how derivatives derive their value. They are things like futures or options. Imagine you enter into a futures contract to buy 1000kg of wool at 900c/kg in 3 months, which is also the going rate for wool today. If the price of wool goes up to 1100c/kg in 2 months time, then the value of your futures contract should also go up to 1100c/kg. So you could either hold on to your contract and buy wool cheaply in one month, buy the wool and sell it for a $2000 profit (if the price remains stable), or sell it now. Either way, can you see how the price of the derivative (in this case, a futures contract) is derived from the price of a commodity (in this case wool)?
Last edited by a moderator:
p00_p00
Member
HAHAHAH thanx! I watched somethin on derivivative trading on News Hour on SBS (yes i know its American propaganda but it helped cause they explained weather derivative trading)
And also about options, why would any1 want 2 purchase an option OFF u if the share prices have plummeted? Wouldnt they b better off buyying the cheap shares rather than ur mre expensive option? So this leads to my other question about who u sell the option 2? Is there a special market like a derivative market where speculators buy and sell options? Like i cant see how specs can make a profit over these options?
Also about the future contracts, i thought they remained stagnent and the prices wouldnt fluctuate??? BUt if u say they do, im beggining 2 get a mre solid understanding in derivatives, hedging and options etc. So generally speaking options, futures and derivatives are really the same thing as most options and futures involve commodities such as Gold and oil, but in some cases as u sed, they can involve shares! So generally derivatives (as a non-text book answer) is when the value of the instrument (may it b futures, options etc) is from the value of the commodity (such as wool, gold and oil).
And 1 final questions, can derivatives be from any form of commodities??? (does it always have 2 be say gold, oil, timber etc ..... )or can it b consumer goods as well, or will that make it more of a forward contract?
Porphyria_J
Member
Omg ...people are really getting into the detail with this hedging and derivatives thing, but remember, the stuff is only for global business and only revolves around currency fluctuations so dont worry too much i think abotu shares and commodities etc
Hedging is the description as you say, and the best way to hedge is through natural hedging when you have the payment contract denominated in your currecy so if you are the Xporter, basically you wouldnt give a CRAP about what happens on the forex market. but derivatives is a special form of hedging (i hope...thats in my notes) and is a financial instruement and thus can be traded in the financial market
Examples of derivatives are forward exchange contracts and options - which i think as above already defined
hey i could be wrong..hope not as these are what ive learnt
goodluck tommorrow!
Hedging is the description as you say, and the best way to hedge is through natural hedging when you have the payment contract denominated in your currecy so if you are the Xporter, basically you wouldnt give a CRAP about what happens on the forex market. but derivatives is a special form of hedging (i hope...thats in my notes) and is a financial instruement and thus can be traded in the financial market
Examples of derivatives are forward exchange contracts and options - which i think as above already defined
hey i could be wrong..hope not as these are what ive learnt
goodluck tommorrow!
B
Bambul
Guest
I was horrified by your spelling and punctuation, so I went ahead and corrected it. Now, as for your questions (and I'm a bit sketchy on the facts so bear with me):
Question 1. Why would anyone want to purchase an option OFF you if the share prices have plummeted? Wouldn't they be better off buying the cheap shares rather than your more expensive option?
ok, let's say you buy a call option (ie. the option to buy) for BHP. Let's assume that the share price for BHP is $10 and the exercise price for the option is $8 (the price at which you can buy the shares). Using a simple model (which ignores the time value of money) the price you would have to pay for the option is $2, so that $2+$8=$10=BHP share price.
Now say the BHP share price goes down to $9. If you wanted to sell that option you would have to sell it at a price of $1. No-one would be willing to pay more (as you infered to in your post) since it would effectively be cheaper to just buy some BHP shares.
[Note: this next paragraph may confuse you, so feel free to just skip it, I doubt you would need to know this anyway.]
In fact with options, there are 3 fixed characteristics (exercise price, number of shares and maturity date) so that leaves only 1 variable - the price. That makes it much easier to value individual options and improves their liquidity through higher trading volumes.
Question 2. Who do you sell the option to? Is there a special market like a derivative market where speculators buy and sell options? Like, I can't see how speculators can make a profit over these options?
I know there's a futures market (the Sydney Ftures Exchange - SFE). As for options, I think they are traded on the ASX, but I'm not actually sure. Originally options were used as insurance or for hedging, but now they are used more for speculative trading in the hope that price fluctuations in share prices will provide you with a profit. Like I said before (I think), it's like gambling.
Question 3. Also about the futures contracts, I thought they remained stagnant and the prices wouldnt fluctuate?? But if u say they do, I'm beggining to get a more solid understanding in derivatives, hedging and options etc. So generally speaking options, futures and derivatives are really the same thing as most options and futures involve commodities such as Gold and oil, but in some cases as u sed, they can involve shares! So generally derivatives (as a non-text book answer) is when the value of the instrument (may it be futures, options etc) is from the value of the commodity (such as wool, gold and oil).
Was that a question? Though I do feel I should point out the difference between options and futures, just in case. Futures are an obligation to trade a certain commodity or security at a future date, whereas options give you the right, but not the obligation.
Also, there are two prices you need to take into account, the exercise price (the price at which the contract specifies you will trade the commodity/security) and the price of the option/future (it's intrinsic value). The exercise price does not change. But as the price of the commodity/security changes, so does the price of the option/future because it's value changes (ie. it is worth more/less).
As for your last comment, that sounds like a reworded textbook answer to me. ie. derivatives derive their value from the prices of other commodities.
Question 4. Can derivatives be from any form of commodities? Does it always have to be say gold, oil, timber etc or can it be consumer goods as well, or will that make it more of a forward contract?
In general most options are for shares or share indices and futures are for commodities (boring ones like wool, copper, timber or oranges). But you can trade derivatives in whatever you like, as long as you can find a buyer.
Just remember, I didn't so Business Studies, so I may not be focusing on things you need to know.
Question 1. Why would anyone want to purchase an option OFF you if the share prices have plummeted? Wouldn't they be better off buying the cheap shares rather than your more expensive option?
ok, let's say you buy a call option (ie. the option to buy) for BHP. Let's assume that the share price for BHP is $10 and the exercise price for the option is $8 (the price at which you can buy the shares). Using a simple model (which ignores the time value of money) the price you would have to pay for the option is $2, so that $2+$8=$10=BHP share price.
Now say the BHP share price goes down to $9. If you wanted to sell that option you would have to sell it at a price of $1. No-one would be willing to pay more (as you infered to in your post) since it would effectively be cheaper to just buy some BHP shares.
[Note: this next paragraph may confuse you, so feel free to just skip it, I doubt you would need to know this anyway.]
In fact with options, there are 3 fixed characteristics (exercise price, number of shares and maturity date) so that leaves only 1 variable - the price. That makes it much easier to value individual options and improves their liquidity through higher trading volumes.
Question 2. Who do you sell the option to? Is there a special market like a derivative market where speculators buy and sell options? Like, I can't see how speculators can make a profit over these options?
I know there's a futures market (the Sydney Ftures Exchange - SFE). As for options, I think they are traded on the ASX, but I'm not actually sure. Originally options were used as insurance or for hedging, but now they are used more for speculative trading in the hope that price fluctuations in share prices will provide you with a profit. Like I said before (I think), it's like gambling.
Question 3. Also about the futures contracts, I thought they remained stagnant and the prices wouldnt fluctuate?? But if u say they do, I'm beggining to get a more solid understanding in derivatives, hedging and options etc. So generally speaking options, futures and derivatives are really the same thing as most options and futures involve commodities such as Gold and oil, but in some cases as u sed, they can involve shares! So generally derivatives (as a non-text book answer) is when the value of the instrument (may it be futures, options etc) is from the value of the commodity (such as wool, gold and oil).
Was that a question? Though I do feel I should point out the difference between options and futures, just in case. Futures are an obligation to trade a certain commodity or security at a future date, whereas options give you the right, but not the obligation.
Also, there are two prices you need to take into account, the exercise price (the price at which the contract specifies you will trade the commodity/security) and the price of the option/future (it's intrinsic value). The exercise price does not change. But as the price of the commodity/security changes, so does the price of the option/future because it's value changes (ie. it is worth more/less).
As for your last comment, that sounds like a reworded textbook answer to me. ie. derivatives derive their value from the prices of other commodities.
Question 4. Can derivatives be from any form of commodities? Does it always have to be say gold, oil, timber etc or can it be consumer goods as well, or will that make it more of a forward contract?
In general most options are for shares or share indices and futures are for commodities (boring ones like wool, copper, timber or oranges). But you can trade derivatives in whatever you like, as long as you can find a buyer.
Just remember, I didn't so Business Studies, so I may not be focusing on things you need to know.
eeeee! u know, u don't really need to know that much lol.
u would just have to be able to use hedging as a financial product and if the business should use it or not in the question, or something like that. and then explain what hedging is in 1 sentence.
u would just have to be able to use hedging as a financial product and if the business should use it or not in the question, or something like that. and then explain what hedging is in 1 sentence.
B
Bambul
Guest
Funny that, I want to work for the government.
I used to think as you do when I was in your position. Then I realised that public servants started at 10:00AM, finished at 3:00PM and took a 2 hour lunch break.