DERIVATIVES AND RISK MANAGEMENT

CLASS 1
A. Course Introduction
Background readings
Bank on It: Upheaval Breeds Derivatives, The Wall Street Journal (WSJ), 1994.
Future Shock, The Economist, 1994.

These easy-reading articles reflect the debate about derivatives in the mid 1990s and
illustrate how fundamental and necessary the knowledge of derivatives has become. As you
read these articles, think about:
Whether the need for derivative products will increase or decrease as the result of the
recent financial meltdown.
Who needs and should be allowed to buy and sell derivatives.

B. Forward and futures contracts: structure and payoffs

Background readings: Fundamentals of Futures and Options Markets, 9th (or 8th) Ed., (John
Hull)
Chapter 1, sections 1.1-1.4; 1.8 Hedging using forwards only; 1.9 Speculation with
futures only; 1.10; 1.11)


Case: Mazda Reports (Wall Street Journal article, in course packet)
1. Describe the risk exposure that Mazda and Mitsubishi tried to hedge.
2. Describe how they did the hedging. What does it mean to enter a forward contract to sell a
foreign currency (or any asset or commodity, in general)?
3. Did Mazda and Mitsubishi achieve their objective from selling dollar forward? Compare to
the case of Southwest Airline (WSJ article Hedge Hog Southwest Air in course
packet). What are the similarities and differences? Then compare to the experience of
Southwest Airlines in the fall of 2008 (Southwest, Continental Swing to Losses, WSJ
article in course packet). In your opinion, should companies hedge?
4. According to High Yen Hits Japan Exporters (WSJ article in course packet), who are
the various parties hurt by the recent surge in Yen (relative to $ and Euro)? How exposed
is Toyotas operating profit to the Yen/$ exchange rate?
5. Mitsubishi had entered in April 1995 a forward contract to sell $ (buy Yen) for 90 Yen/$.
Suppose that the contract matured October 31, 1995 (the day before the article was
written), when the dollar traded in the spot market at 102 Yen. How much in Yen was the
company hurt (or helped) by the forward contract for every $ it contracted to sell? What
 would that loss (profit) be had the $ closed at 95 Yen? 90 Yen? 85 Yen? Plot the
companys profit/loss from the contract on a graph as a function of the spot price on
October 31.
6. Suppose that the Bank of Tokyo was the counterparty to the forward contract (i.e., the
party that bought Dollarand sold Yenforward). Plot the banks profit/loss from the
contract on a graph as a function of the spot price on October 31 (consider again spot
prices of 85 Yen, 90 yen, 95 Yen, and 102 Yen).
7. Consider a Japanese company that imports computers from HP in the U.S. and pays in
dollar. How would that company hedge its exposure with currency forwards?
8. Consider the following 2-year trend in the Yen/$ exchange rate (data as of January 5,
2005). The dollar had trended down over this period. If you were managing Mazda or
Mitsubishi on Jan 5, 2005, would you have entered forward contracts to sell dollar or
would you have waited in hopes the dollar would appreciate?

USD to JPY (YHO)

Last Trade: 104.04

Trade Time: 8:49PM ET

Bid: 104.04

Ask: 104.10