1. Suppose after you graduate, you plan to be a stock analyst for a big financia
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Question
1. Suppose after you graduate, you plan to be a stock analyst for a big financial institution. You know that if the stock market increases in value, your will get a good job with a good salary. If the stock market declines, you will get a job, but the salary will be lower. Can you hedge your salary risk using futures contract?
2. A New Zealand company produces 10,000 ounces of gold per year. It uses a quarter of its production for making gold jewelry sold at a fixed price through stores in Australia and New Zealand, and the rest is sold on the market, where the gold price is determined in US dollars. Australia’s profits are repatriated to New Zealand. The company’s CEO wants to use futures contractc to hedge the entire production. He calls you to seeks your opinion. Recommend a seinsble hedge stragtegy that would be in line with the CEO’s wishes (assume x is the quantity used for making gold jewelry in the New Zealand).
Explanation / Answer
hedge salary risk using futures contract:
Retail investors can use futures contracts on the S&P 500 Index to hedge the risk of theirportfolios, just as institutional investors do. In fact, an S&P 500 futures contract was created specifically with retail investors in mind—the S&P 500 e-mini contract. Introduced in 1997, the e-mini contract is valued at $50 times the futures value of the index, while the standard S&P 500 contract—often referred to by names such as “the Big S&P” and “the Big Car”--currently uses a multiplier of $250.
What is the effect of the different multipliers? Well, when the price of a standard S&P 500 futures contract is 1400, the contract value is $250 x 1400 = $350,000, but when the price of an e-mini contract is 1400, the contract value is only $50 x 1400 = $70,000. When you are trying to hedge the risk of your stock portfolio using a futures contract, you want a contract that is close in value to the value of your portfolio. The values of the portfolios of many retail investors are closer to $70,000 than to $350,000, and if you’re lucky enough to have a portfolio worth more than $70,000, you can use multiple contracts. For instance, if the value of one contract is $70,000, two S&P 500 e-mini contracts could be used to hedge a $140,000 portfolio.
2.
Private equity. The very term continues to evoke admiration, envy, and—in the hearts of many public company CEOs—fear. In recent years, private equity firms have pocketed huge—and controversial—sums, while stalking ever larger acquisition targets. Indeed, the global value of private equity buyouts bigger than $1 billion grew from $28 billion in 2000 to $502 billion in 2006, according to Dealogic, a firm that tracks acquisitions. Despite the private equity environment’s becoming more challenging amid rising interest rates and greater government scrutiny, that figure reached $501 billion in just the first half of 2007.
Private equity firms’ reputation for dramatically increasing the value of their investments has helped fuel this growth. Their ability to achieve high returns is typically attributed to a number of factors: high-powered incentives both for private equity portfolio managers and for the operating managers of businesses in the portfolio; the aggressive use of debt, which provides financing and tax advantages; a determined focus on cash flow and margin improvement; and freedom from restrictive public company regulations.
But the fundamental reason behind private equity’s growth and high rates of return is something that has received little attention, perhaps because it’s so obvious: the firms’ standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement, selling them. That strategy, which embodies a combination of business and investment-portfolio management, is at the core of private equity’s success.
Public companies—which invariably acquire businesses with the intention of holding on to them and integrating them into their operations—can profitably learn or borrow from this buy-to-sell approach. To do so, they first need to understand just how private equity firms employ it so effectively.
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