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# Hedging, Insuring and Diversifying

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10.1 In the northeast United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of these people, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is \$2.25 per US gallon, but you think that in six months, when you'll need the oil, the price could be \$3.00, or it could be \$1.50.

A. If you need 350 gallons to survive the winter, how much difference does the potential price variance make to your heating bills?
B. If your friend Tom is running a heating oil business, and selling 100,000 gallons over the winter season, how does the price variance affect Tom?
C. Which one of you benefits from the price increase? Which of you benefits from price decrease?
D. What are two strategies you can use to reduce the risk you face? Could you make an agreement with Tom to mitigate your risk?
E. Assuming you are both risk-averse, does such an agreement make you both better off?

13.2 You have just received good news. You have a rich uncle in France who has decided to give you a monthly annuity of 2,000 pounds per month. You are concerned that you will become accustomed to having these funds, but if the currency exchange rate moves against you, you may have to make do with less.

A. If you are living in Canada, what does it mean for the currency exchange rate to move against you?
B. Would moving to France mitigate some of the risk? If so, how? If not, why not?
C. If you want to stay in Canada, and your grandparents, who have retired to Provence, receive a Canadian pension of C\$1100 each, what could you do to reduce the risk for all of you?

https://brainmass.com/economics/exchange-rates/hedging-insuring-and-diversifying-502988

#### Solution Preview

10.1 In the northeast United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of these people, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is \$2.25 per US gallon, but you think that in six months, when you'll need the oil, the price could be \$3.00, or it could be \$1.50.

A. If you need 350 gallons to survive the winter, how much difference does the potential price variance make to your heating bills?

In this scenario, I may have to pay \$262.5 (350 gallon*.75) more if the price increases or \$262.50 less, if the price declines. Hence, the variance could be \$262.50 on the either side.

B. If your friend Tom is running a heating oil business, and selling 100,000 gallons over the winter season, how does the price variance affect Tom?

For Tom, the price variance can result in either gain of 75,000 dollars or loss of the same amount in terms of revenues, if the expected ...

\$2.19

## Finance Questions: Hedging

11.3 You have learned about a number of ways of reducing risk, specifically hedging, insuring, and diversifying. In the table below, place an X in the cell for the technique being used to reduce risk. For each of the following below, identify if it is a strategy for hedging, insuring, or diversifying?
1. Placing an advance order with Amazon.ca, which agrees to charge you the lower of the advance price, and the price at the time your order is filled.
2. Purchasing a call option on a stock you think may go up in price.
3. Selling 200 shares of IBM and buying a mutual fund that holds the same stocks as the S&P index.
4. Selling a debt owed to you for \$.50 per dollar owed.
5. Agreeing to a long-term contract with a supplier at a fixed price.
6. Agreeing to a no-trade clause with the sports team that employs you.
7. Buying a Mac and a PC.
8. Paying a clown to perform for your child's birthday party six months before the birthday.

11.4 Suppose you own 100 shares of Dell Inc. stock. Today it is trading at \$15 per share, but you're worried Michael Dell might retire again, causing the price to go down. How would you protect yourself against his retirement, assuming you don't want to sell the shares today?

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