Volatility and the Need for Hedging

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Volatility and the Need for Hedging

• ACCT 70053
• Spring 2008
• Robert L. Vigeland

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Volatility in Foreign Currency Markets

• On January 3, 2007, 1.00 0.7547 or 1.00
  1.325
• On December 31, 2007, 1.00 0.6794 or 1.00
  1.472
• The price of Euros (in Dollars) increased by 11
  in 2007.

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Volatility in Foreign Currency Markets
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Volatility in Foreign Currency Markets

• To purchase a European auto that sells for
  30,000 would have required 39,750 at the
  beginning of the year but 44,156 by year end, an
  11 increase.

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Volatility in Foreign Currency Markets

• Suppose a European manufacturer agrees to sell a
  machine to a U.S. company on September 1, 2007
  for 10,000,000, due on September 30, 2007. The
  exchange rate was 1.00 0.7323 on 9/1 and
  1.00 0.7012
• Value of the receivable in
• 9/01/07 10,000,000 _at_ 0.7323 7,323,000
• 9/30/07 10,000,000 _at_ 0.7012 7,012,000
• Loss
  311,000
• This loss could have been avoided or reduced with
  an appropriate hedging strategy.

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Volatility in the gold market

• On January 2, 2007, the spot price for gold was
  639.75 per ounce.
• On December 31, 2007, the spot price for gold was
  833.75 per ounce.
• The price of gold increased by 30 in 2007.
• Last week, the price of gold reached 900 per
  ounce.

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Volatility in the gold market
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Volatility in the gold market

• A jewelry manufacturer requires 5,000 ounces of
  gold per year to manufacture its products. This
  would have cost 3,198,750 at the beginning of
  2007 but 4,168,750 at year-end.

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Volatility in the gold market

• Suppose a manufacturer entered into a purchase
  contract on September 1, 2007 to buy 1,000 ounces
  of gold, to be delivered on September 30, at the
  spot price prevailing on the delivery date.
• Cost of gold
• 9/01 1,000 oz. _at_ 672.00 672,000
• 9/30 1,000 oz. _at_ 743.00 743,000
• Cost increase in 1 month 71,000
• This cost increase (and the resulting higher cost
  of goods sold expense) could have been avoided or
  reduced with an appropriate hedging strategy.

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Volatility in the 2 heating oil market

• On January 3, 2007, the spot price for 2 heating
  oil was 1.750 per gallon.
• On December 31, 2007, the spot price for 2
  heating oil was 2.840 per gallon.
• The price of 2 heating oil increased by more
  than 60 in 2007.

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Volatility in the 2 heating oil market
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Volatility in the 2 heating oil market

• A business in Boston uses 100,000 gallons of 2
  heating oil in a typical winter. This would have
  cost 175,000 at the start of the year but
  284,000 at year-end.

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Volatility in the 2 heating oil market

• Suppose a heating oil distributor enters into a
  contract on 9/1/07 to deliver 10,000 gallons of
  2 heating oil each month-end for a fixed price
  of 2.50 per gallon. The month-end prices were as
  follows September (2.305), October (2.495),
  November (2.755), and December (2.840).

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Volatility in the 2 heating oil market

• Here is the effect on the distributors income

This cost increase (and the resulting higher cost
of goods sold expense) could have been avoided or
reduced with an appropriate hedging strategy.
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Volatility in interest rates

• On January 2, 2007, the 12-month US LIBOR was
  5.34000.
• On December 27, 2007, the 12-month US LIBOR was
  4.34125.
• The 12-month US LIBOR decreased by nearly 100
  basis points in 2007.

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Volatility in interest rates
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Volatility in interest rates

• On a 100,000,000 floating rate loan at LIBOR, a
  lenders annual interest revenue would have been
  5,340,000 at the start of the year but only
  4,341,250 at year-end. This decline in revenue
  could have been reduced or avoided with an
  appropriate hedging strategy.