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10 Business Snapshot 1.1 Hedge Funds


Hedge funds have become major users of derivatives for hedging, speculation, and arbitrage. A hedge fund is similar to a mutual fund in that it invests funds on behalf of clients. However, unlike mutual funds hedge funds are not required to register under U.S. federal securities law. This is because they accept funds only from ®nancially sophisticated individuals and do not publicly o€er their securities. Mutual funds are subject to regulations requiring that shares in the funds be fairly priced, that the shares be redeemable at any time, that investment policies be disclosed, that the use of leverage be limited, that no short positions be taken, and so on. Hedge funds are relatively
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Note that a company might do better if it chooses not to hedge than if it chooses to hedge. Alternatively, it might do worse. Consider ImportCo. If the exchange rate is 1.7000 on October 14 and the company has not hedged, the £10 million that it has to pay will cost $17,000,000, which is less than $18,405,000. On the other hand, if the exchange rate is 1.9000, the £10 million will cost $19,000,000Ðand the company will wish it had hedged! The position of ExportCo if it does not hedge is the reverse. If the exchange rate in September proves to be less than 1.8400, the company will wish it had hedged; if the rate is greater than 1.8400, it will be pleased it has not done so. This example illustrates a key aspect of hedging. Hedging reduces the risk, but it is not necessarily the case that the outcome with hedging will be better than the outcome without hedging.

Hedging Using Options
Options can also be used for hedging. Example 1.2 considers an investor who in May of a particular year owns 1,000 Microsoft shares. The share price is $28 per share. The Example 1.2 Hedging with options It is May. An investor who owns 1,000 Microsoft shares wants protection against a possible decline in the share price over the next two months. Market quotes are as follows: Current Microsoft share price: $28 Microsoft July 27.50 put price: $1 The investor buys 10 put option contracts for a total cost of $1,000. This gives the investor the right to sell 1,000 shares for
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