Essay Sample on Ways That Companies Hedge Risk

Future and forward contracts. Futures contracts are trade agreements that have standardized conditions, and they are traded via the exchange, and the prices keep on settling daily until the contract ends. A forward contract is a customizable and private agreement whose settlement happens at the end of the contract, and its trading is over-the-counter. It is traded at the prevailing prices stated on the date when the contract expires. Companies use forward and futures contracts to hedge the risk of the currency losing value in future dates due to the high inflation rate.

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Option contracts. These are trade agreements that exist between the seller and the buyer, and the purchaser has both the buying and the selling rights of the option or rather the asset at a future date on the current agreed-upon price. Option contracts normally involve trading commodities like gold, securities, and real estate, among others (Suriyadheepa & Thirumagal,2019). Investors enter into options contracts to hedge the risk of losing their money. For instance, currently, most investors have been purchasing gold option contracts to avoid losing their money because of the expected economic recession because of COVID-19.

Swaps contracts. These are financial derivatives between two parties where one party exchanges the cash flows of an asset for another asset. Swaps corporation mostly happens between corporations and international transactions. Apart from the fixed price at the end of maturity, the investor also earns interest on the swap. An example of a swap is where an investor from the US would swap the capital in dollars for an asset priced in euros.

Buying one asset and selling another. The buying and selling of stocks are very common. Mostly an investor is likely to sell an asset to make profits and buy another one that has the potential to appreciate at a higher rate in the future. This hedging happens to mitigate the risk of keeping assets whose value is depreciating or seems to have a very high depreciation rate shortly. For instance, one would sell the assets he owns in the form of stocks in company X and use the money to invest in real estate or gold.

Fairly pricing of spot and futures

Price of Tesla Inc. stock is $1650.71, and the dividend is at the interest rate of 1.83% as per today (Annachhatre,2020).

Definition of theories

1. a. Interest Rate Parity (IRP). It refers to the rate at which the interest rates between are indifferent Rand the spot exchange rate and forward exchange rates are equal. For instance, a Canadian dollar is a discount forward to the American dollar.
2. b. Expectations theory of forwarding rates. This theory explains that short-term interest rates can be predicted based on the present long-term interest rates. A good example is that if an investor buys one two-year bond and two one-year bonds, he will earn some interest from the two portfolios.
3. c. Purchasing power parity (PPP). This is an economic theory that uses the “basket of goods” strategy to determine the value of money for currencies for two different countries. For instance, an investor may buy goods worth $100 US dollar and compare them to a friend who bought goods worth 100 Canadian dollar. If the US dollar purchases more items than an equal amount of the Canadian dollar, then the US dollar has PPP.
4. d. International capital market equilibrium. The theory explains that the returns on investments i.e., nominal and real interest rates are indifferent between the two countries when their currencies have the same value. For instance, if an investor in Europe purchases stocks from Amazon using the dollar, the return on the capital will be indifferent.

References

Annachhatre, M. (2020). Currency Options, Swaps, and Futures.

Suriyadheepa, P., & Thirumagal, P. G. (2019). Comparative Analysis of Equity Index Futures. International Journal of Research in Engineering, IT and Social Sciences, ISSN, 2250-0588.