Risk and Return in the Market Place

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1. Let's pick Walmart as the example. We will look at how Walmart and can use options to enhance return, and use forwards and futures (which in this particular case will be the same) to hedge risk.

For a company like Walmart, its daily cash flows are enormous. Often Walmart sells goods to consumers (and get paid immediately) but does not pay the supplier until a certain volume of these goods are reached. As such, Walmart has lots of short term cash available which they can invest. Using options wisely can greatly increase the short term returns of Walmart (this is called leverage). Consider the following example: Walmart has some cash (say 1 million) which they don't have to pay their suppliers until 2 weeks later. Walmart decides to buy some stocks. Here note that Walmart must choose their investments carefully because they cannot suffer any loss (assume that in this case Walmart does not have any extra cash other than the 1M immediately available in case of losses) because otherwise they don't have money to pay suppliers and that would damage Walmart's reputation. Say that Walmart gets a good deal with a bank would sell Walmart a 2 week bond that costs 999K and return 1M 2 weeks later. This secures that Walmart will have at least 1M by the time it needs to pay the suppliers. There is 1K left that Walmart can invest in any way it wants. If Walmart invests this 1K by buying options, then this greatly increases their chance to achieve bigger returns. Of course the downside is options are also risky and Walmart may lose the entire 1K, but this doesn't really matter because they are going to get another 1K in the form of interest from the bond. This is an example of enhancing returns with options.

In the second example, suppose that Walmart imports some products from Vietnam. Suppose further that Walmart expects the currency of Vietnam to appreciate in the next 6 months. To protect (or to hedge) their operations, Walmart may choose to buy some currency forwards (or futures) where they get a fixed exchange rate for the next year. This eases Walmart's planning process, because they don't have to worry about ...