[Anonymous]

I am having a hard time understanding hedging against risks. Wiley has two questions which I cannot seem to comprehend even after reading the solution. Can someone help me, please. Here are the questions:

1) Strobel Company has a large amount of variable rate financing due in one year. Management is concerned about the possibility of increases in short-term rates. Which of the following would be an effective way of hedging this risk?

A) Buy Treasury notes in the futures market

B) Sell Treasury notes in the futures market

C) Buy an option to purchase Treasury bonds

D) Sell an option to purchase Treasury bonds

Answer: B

2) An American importer of English clothing has contracted to pay an amount fixed in British pounds three months from now. If the importer worries that the US dollar may depreciate sharply against the British pound in the interim, it would be well advised to:

A) Buy pounds in the forward exchange market

B) Sell pounds in the forward exchange market

C) Buy dollars in the futures market

D) Sell dollars in the futures market

Answer: A

[Anonymous]

The key to answering hedging question lies in your ability to think like a gambler. Allow me to explain…

1. We (management) believe interest rates are fixing to rise. If we're right about this assumption, then that means we're going to have to shell out more money when we make our scheduled loan repayments to the bank. How might we combat this negative kind of situation? Simple… we need to raise money now so that we can afford to make higher loan repayments down the road.

A. Buying T-Bills wouldn't make sense for two reasons. First off, T-Bills don't pay out very much interest. We need more money to service our debt, and low paying T-Bills won't cut it. Second, we're trying to increase our cash reserves, not further deplete it. Buying T-Bills would only serve to drain current cash on hand. A is out

C and D have something in common, “options”. In order to purchase an option, you must be willing to immediately pay for that option. Aren't we trying to preserve cash??? Let's say we do purchase the option and it turns out that it was a bad move. We can abandon the option, but we'd also have to abandon the money we paid to buy the option so C and D are out.

B – Process of elimination, and let's not forget that by selling T-Bills now, we're raising our cash reserves. Winner!

2. If you're worried that the value of a dollar will depreciate against the pound, then you need to go ahead and purchase pounds with existing dollars because if your prediction comes true, you'll need more dollars to buy a pound.

So back to my original point.. in Question # 1 we're betting that interest rates are going to rise. We're not totally sure that they will, but we're willing to gamble on it by selling off our existing T-Bills because we want to have enough cash to meet our upcoming loan obligation. Isn't that a bit of a gamble? Remember, we're not sure rates will really rise… we only think they will. If we hold on to our existing T-Bills we'll derive a small amount of income the interest we receive from the government.

Question # 2… we have to pay our British vendor in their home currency. We think it's going to cost even more US Dollars to buy enough British Pounds to pay off the vendor. By buying the required amount of British Pounds now, we know exactly how much it's going to cost us to cover our looming debt. If we wait and find out that our prediction was right, it'll take even more US Dollars to cover that debt. Remember… it's all based on predictions/emotions. It's gambling!

Hope this helps!

[Anonymous]

Thanks BluMerle! Your explanation was extremely helpful. I am somewhat of a gambler (poker), so when you explained it in gambling terms it really clicked for me! Now, the questions seem so easy, lol. I just needed a better explanation, so thanks again =)

[Author]

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