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How does hedging work?

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Explain and give an example of how hedging works. Why does hedging provide price protection? Why does hedging remove further gains and losses?

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Problem: Explain and give an example of how hedging works? Why does hedging provide price protection? Why does hedging remove further gains and losses?

Solution:
A hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. To put it simple, hedge means that a buy some asset in one market and sell that same asset (or similar assets, gold and silver for example). in a different market, so that regardless of the price change of this asset, I ...

Solution Summary

This solution helps explain how hedging works and provides an example. It also discusses why hedging provides price protection and why it removes further gains and losses. The explanation is given in 451 words.

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Hedging using futures and options, working capital, after tax yield, borrowing rates, floats

Question 1
A gold-mining firm is concerned about short-term volatility in its revenues. Gold currently sells for \$300 an ounce, but the price is extremely volatile and could fall as low as \$280 or rise as high as \$320 in the next month. The company will bring 1,000 ounces to the market next month.
a. What will be total revenues if the firm remains unhedged for gold prices of \$280, \$300, and \$320 an ounce?
b. The future price of gold for delivery one month ahead is \$301. What will be the firm's total revenues at each gold price if the firm enters into a one-month futures contract to deliver 1,000 ounces of gold?
c. What will total revenues be if the firm buys a one-month put option to sell gold for \$300 an ounce? The put option costs \$2 per ounce.
Question 2
The Theodore Bruin Corporation, a manufacturer of high-quality stuffed animals, does not extend credit to its customers. A study has show that, by offering credit, the company can increase sales from the current 750 units to 1,000 units. The cost per unit, however, will increase from \$43 to \$45, reflecting the expense of managing accounts receivable. The current price of a toy is\$48. The probability of a customer making a payment on a credit sale is 92 percent, and the appropriate discount rate is 2.7 percent.
By how much should Theodore Bruin increase the price to make offering credit an attractive strategy?

Question 3
Suppose you are a wealthy individual paying 34 percent tax on income. What is the expected after-tax yield on each of the following investments?
a. A municipal note yielding 7.0 percent pretax.
b. A Treasury bill yielding 10 percent pretax.
c. A floating-rate preferred stock yielding 7.5 percent pretax.

How would your answer change if the investor is a corporation paying tax at 35 percent? What other factors would you need to take into account when deciding where to invest the corporation's spare cash?

Question 4
You need to borrow \$10 million for 90 days. You have the following alternatives:
a. Issue high-grade commercial paper, with a back-up line of credit costing .3 percent a year.
b. Borrow from First Cookham Bank at an interest rate of .25 percent over LIBOR.
c. Borrow from the Test Bank at prime.
Given the rates currently prevailing in the market (see, for example, The Wall Street Journal), which alternative would you choose?

Question 5
Each business day, on average, a company writes checks totaling \$12,000 to pay its suppliers. The usual clearing time for these checks is five days. Each day, the company receives payments from its customers in the form of checks totaling \$15,000. The cash from the payments is available to the firm after three days.
a. Calculate the company's disbursement float, collection float, and net float.
b. How would these values changes if the collected funds were available in four days instead of three?

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