Companies face different kinds of risks which results in decreased profitability e. g. due unforeseen changes in costs, taxes, demand, selling price, interest rates etc. Therefore companies are forced to come up with ways of reducing these risks. Some of these ways include entering into financial contracts that use derivatives to hedge against risk (Pandey, 2005). Derivatives are items that do not have independent values rather they have derived values. They are basically financial instruments that profits from an underlying assets. The most common types of derivatives are options swaps, forwards and futures contracts.
Companies reduce risks or hedge itself against risk by using derivatives (Pandey, 2005). Future contracts entails entering into a contract to deliver a specific quantity of items in the future at an agreed price which is set today. There is no exchange of money when entering the contract (which is binding to both parties regardless of the circumstances). Future contracts are standardized in nature and traded in organized exchanges. Companies that are exposed to interest rate or exchange rates fluctuations normally use financial futures to hedge against any potential risk.
Equity prices are usually affected by the financial cost interest and dividends associated with such assets hence can fluctuate overtime. If an investor holds share, he has to decide whether to hold on to the asset and earn dividends or sell off the asset and earn interest on the cash realized. Likewise to an investor who wants to buy an asset. The investor can decide to buy at the current price or enter into a futures contract and buy it at a future price. If he buys using the future contract, he will earn interest on purchase price but will forego dividends since he does not hold the shares now.
Therefore; Future prices =spot price (1+rf)^t-dividends foregone Where rf=risk free interest rate t=period (Pandey, 2005) For Dells Inc stock, the spot rate as at June 8, 2009 was $12. 28. Assuming that the risk free rate of interest is the rate on 10 year Treasuries which is equal to 3. 125%, the company’s dividends in years prices will be $1. 21(Assuming all earnings is paid ), then, Future price=100*12. 28(1+0. 3125)^1-100*1. 21=$401. 75 (Yahoo Finance, 2009) This indicates that an investor will lose $1228-401. 75=$826. 25 if he enters into a equity futures contracts.
From the calculations above, the company’s price seem to be very volatile and therefore the price is expected to be lower than the current price of $ 12. 28 i. e. 401. 75/100 shares=$4. 0175 per share The company’s stock is risky going by the calculations above. The trend of the share price has been that of downward sloping. The price dropped from a high of $ 40 in 2005 to a low of $12. 28 in June 2009 (Yahoo Finance, 2009) Apart from financial derivatives, an investor can opt for other investment if they offer a greater return at a lower risk than the equity.
Some of these alternative investments include bank interest rates, treasuries, bonds annuities, REITS etc. All these depend on the available money for investment. If all these investments promise higher returns then, an investor has to foregone equity futures (Pandey, 2005). The Certificate of Deposit (CD) 1 year rate offered by Ally Bank, Midvale Utah is 2. 4% for no minimum deposit. Therefore if the rate of return from the future contract is lower than this rate then an investor will opt for the CDs (Bank Rates, 2009).
Capital asset pricing model (CAPM) a) The estimated beta coefficient for Dell Inc is 1. 388. A portfolio is a collection of individual securities. Investors are normally assumes to be risk averse according to the portfolio theory and therefore hold well-diversified portfolios. To do this an investor will hold assets which are inversely correlated i. e. risk free and risky assets. Portfolio risk can be systematic and unsystematic. Systematic risk can be reduced by diversification while unsystematic cannot be eliminated by diversification (Pandey, 2005).