[Anonymous]

Not CPA exam related, but can someone in with some finance knowledge explain to me how hedging works? I just started a new job with a grain company and I’m kinda embarressed to ask these big questions still as Dec 1 was my start date. I’m still on the Fake it til you Make it Train.

[mla1169]

Hedging is an assumption that when one thing goes right the other will go wrong (basically).

Heres a real 4th grade explanation:

Hedging is buying stock in both hot dogs and prime rib. When the economy is fabulous, prime rib sales go up and hot dog sales decline. When the economy tanks hot dog sales go up and prime rib suffers.

The trick to hedging is figuring out what commodities have inverse relationships. Some people assume peanut butter has an inverse relationship to prime rib, but it may not be as good a hedge as hot dogs if that make sense?

FAR- 77
AUD -49, 71, 84
REG -56,75!
BEC -75

Massachusetts CPA (non reporting) since 3/12.

[OnMyWay732]

The example from @mla is good…

In real world, an investment company might buy farmland and then hedge it with a weather derivative that is the opposite of ideal farming weather.

If the weather stays how farmers want it, they'll make money off the farm land, but they they'll lose SOME from owning the weather derivative. Didn't make AS much as if they never bought the derivative. So why would they do that?

If the weather was NOT good for farming, they lost money on the farm land, BUT they didn't lose AS MUCH because they made money on the weather derivative.

I know it sounds crazy but I've seen that in auditing hedge funds before.

AUD - July 2014 - 76
REG - August 2014 - 82
FAR - November 2014 - 78
BEC - January 2015 - 81

DONE!!!!

Used Becker online. Who needs a text when you can burn your eyes out staring at the screen for months on end?

"Let me tell you something you already know. The world ain't all sunshine and rainbows. It is a very mean and nasty place and it will beat you to your knees and keep you there permanently if you let it. You, me, or nobody is gonna hit as hard as life. But it ain't how hard you're hit; it's about how hard you can get hit, and keep moving forward. How much you can take, and keep moving forward. That's how winning is done!"

[Anonymous]

That makes sense to me. So working off your explaination, hedging protects against big losses, but will also limit your profits to a certain extent?

[Anonymous]

Thanks guys! Extremely helpful!

[Anonymous]

Actually one more question. To “have covered their pre-hedge position” would mean that they have already purchased the derivative?

[OnMyWay732]

Sounds right to me

AUD - July 2014 - 76
REG - August 2014 - 82
FAR - November 2014 - 78
BEC - January 2015 - 81

DONE!!!!

Used Becker online. Who needs a text when you can burn your eyes out staring at the screen for months on end?

"Let me tell you something you already know. The world ain't all sunshine and rainbows. It is a very mean and nasty place and it will beat you to your knees and keep you there permanently if you let it. You, me, or nobody is gonna hit as hard as life. But it ain't how hard you're hit; it's about how hard you can get hit, and keep moving forward. How much you can take, and keep moving forward. That's how winning is done!"

[Anonymous]

I'm learning a lot from this room

[Anonymous]

I'm a fish out of water at this new company. I have limited agriculture knowledge and no experience dealing with it. I came from governmental auditing and here I am in internal auditing in a grain company. Trying to learn as much as I can through as many avenues as possible. Google is my friend today.

[Anonymous]

@onmyway732

any idea what a forward contract is? You seem to have a pretty good understanding of how this stuff works.

[OnMyWay732]

Yea, it's just a contract between two people with a set price at a future date.

Say it's January 1. You are growing potatoes. You're concerned that over the year the potato market will decline. Right now potatoes might be selling at $1000 a barrel. You think come October 31 it will go down to $500 a barrel. You may make a contract with another party (who is more optomistic about the potato market and thinks it will go up to $1500 a barrel) that on October 31, no matter how much a barrel of potatoes costs on that day, you will sell it for $1000. If the market price does go down below $1000 you made a profit. If it goes above $1000 you have a loss. The price to sell it is locked in to you and the buyer.

When you hear about a futures contract it is essentially the same thing except futures are exchange-traded, marked to market daily, and go through clearing houses that guarantee the transactions. Forwards (as you asked about) are private contracts that one party may default on the deal.

AUD - July 2014 - 76
REG - August 2014 - 82
FAR - November 2014 - 78
BEC - January 2015 - 81

DONE!!!!

Used Becker online. Who needs a text when you can burn your eyes out staring at the screen for months on end?

"Let me tell you something you already know. The world ain't all sunshine and rainbows. It is a very mean and nasty place and it will beat you to your knees and keep you there permanently if you let it. You, me, or nobody is gonna hit as hard as life. But it ain't how hard you're hit; it's about how hard you can get hit, and keep moving forward. How much you can take, and keep moving forward. That's how winning is done!"

[Anonymous]

Hedging is done in the futures market? Sorry if these questions are obvious..

[OnMyWay732]

Don't worry…most people hate derivatives. I like them.

Yea futures and forwards are essentially the same concept. Entering a future or forward contract is the hedge. The farmer knows that on October 31 he will be selling the potatoes no matter what. He's entering the contract to try and not have a loss on the sale. In the real world, hedges aren't always effective and he could lose money, such as if that barrel went up to $1500.

AUD - July 2014 - 76
REG - August 2014 - 82
FAR - November 2014 - 78
BEC - January 2015 - 81

DONE!!!!

Used Becker online. Who needs a text when you can burn your eyes out staring at the screen for months on end?

"Let me tell you something you already know. The world ain't all sunshine and rainbows. It is a very mean and nasty place and it will beat you to your knees and keep you there permanently if you let it. You, me, or nobody is gonna hit as hard as life. But it ain't how hard you're hit; it's about how hard you can get hit, and keep moving forward. How much you can take, and keep moving forward. That's how winning is done!"

[Anonymous]

Interesting. I must have slept through derivatives day at college. HA! Thanks for all your help. I reserve the right to ask you more stupid questions on this tomorrow…Deal?

[OnMyWay732]

Haha never a problem. I only remember touching on options and currency futures in grad school. I deal with derivatives daily at my job, that's the only reason I know the answers

AUD - July 2014 - 76
REG - August 2014 - 82
FAR - November 2014 - 78
BEC - January 2015 - 81

DONE!!!!

Used Becker online. Who needs a text when you can burn your eyes out staring at the screen for months on end?

"Let me tell you something you already know. The world ain't all sunshine and rainbows. It is a very mean and nasty place and it will beat you to your knees and keep you there permanently if you let it. You, me, or nobody is gonna hit as hard as life. But it ain't how hard you're hit; it's about how hard you can get hit, and keep moving forward. How much you can take, and keep moving forward. That's how winning is done!"

[Fanalyst]

I work in Corporate Finance and we deal with interest rate risk with treasury locks. For example, let's say we have $100M long term bonds at 6.0% interest that we can call at par on January 1, and $200M long term bonds at 5.75% that we can call at par on July 1st. Instead of immediately refinancing the $100M 6.0% bonds with more long term bonds, we wait to issue $300M in July when we call the $200M 5.75% bonds (a $300M deal has better pricing/terms than a $100M deal).

To cover those 6 months, we can use $100M short term debt (like commercial paper), but lock in today's low interest rates by buying “Treasury Locks.” This means that when we issue the $300M in July, we will use the benchmark treasury rate that we locked in on January 1 (ex. 3.25%). If rates in July have jumped up, we won on the deal, if they drop even lower, we lost on the deal. Either way though, we are happy because we refinanced at a lower rate and save millions in interest expense.

[Author]

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