Chapter 11: Hedging and Insuring Objective Explain market mechanisms for implementing hedges and insurance Chapter 11 Contents 11.1 Using Forward & Futures Contracts to Hedge Risks 11.6 Basic Features of Insurance Contracts 11.2 Hedging ForeignExchange Risk with Swap Contracts 11.7 Financial Guarantees 11.3 Hedging Shortfall-Risk by Matching Assets to Liabilities 11.4 Minimizing the Cost of Hedging 11.5 Insuring versus Hedging 11.8 Caps & Floors on Interest Rates 11.9 Options as Insurance 11.10 The Diversification Principle 11.11 Insuring a Diversified Portfolio Value of 30-Year Mortgage 5-Years Out (6%) 16,000,000 Market Value of Mortgages Market Value of Mortgage 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 Book Value of Mortgages 2,000,000 1% 3% 5% 7% Market Interest Rate 9% 11% Cash from Mortgages and Cash Needed for CDs Cash Flows From Mortgages and to CDs 1,200,000 CD Interest Payments 1,000,000 800,000 600,000 400,000 Mortgage Interest Payments 200,000 1% 2% 3% 4% 5% 6% 7% 8% Current Interest Rate 9% 10% 11% 12% Hedging v Insuring 450000 400000 Revenue from Wheat 350000 Hedged Insured 300000 250000 200000 150000 100000 50000 0 0.5 1.5 2.5 Price of Wheat 3.5 Hedging with a Put 16000 14000 12000 10000 Share Holding Value Puts FV Premium Total Wealth 8000 6000 4000 2000 50 60 70 80 90 100 110 -2000 Share Price 120 130 140 150 Standard deviation, firm State of the World Probability One Failure One Success 0.5 0.5 Payoff 400000 Mean 200000 200000 Deviation Dev SQR -200000 200000 4E+10 4E+10 [...]... diversifiable 11 Standare Deviation Standard Deviations of Portfolios, rho = 0.2, sig = 0.2 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 0 5 10 15 20 25 30 Portfolio Size 12 35 40 45 50 Standare Deviation Standard Deviations of Portfolios, rho = 0.8, sig = 0.2 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 0 5 10 15 20 25 30 Portfolio Size 13 35 40 45 50 Standare Deviation Standard Deviations... 0.08 0.06 0.04 0.02 0.00 0 5 10 15 20 25 30 Portfolio Size 14 35 40 45 50 Standare Deviation Standard Deviations of Portfolios, rho = 0.2, sig = 0.2 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 Diversifiable Security Risk Nondiversifiable Security Risk 0 5 10 15 20 25 30 Portfolio Size 15 35 40 45 50 Standare Deviation Standard Deviations of Portfolios, rho = 0.0, sig = 0.2 0.20 0.18 0.16 0.14... Deviation Standard Deviations of Portfolios, rho = 0.0, sig = 0.2 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 All risk is diversifiable 0 5 10 15 20 25 30 Portfolio Size 16 35 40 45 50 Standare Deviation Standard Deviations of Portfolios, rho = 1/(1-50) = -0.0204, sig = 0.2 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 0 5 10 15 20 25 30 Portfolio Size 17 35 40 45 50