Hedging Techniques: Analysis of pros and cons

This report will discuss the basics of hedging, advantages and disadvantages of hedging. There is description of methods and techniques used for hedging. This also discusses the primary need of hedging. Then follows the detailed calculations of the receivables of 500M pesos due in six months’ time and the best way of hedging to get the most of it. This report then goes on to discuss the forward contracts and futures along with forward options that are available for individual and basic differences between forward contracts and options

Introduction:

An unexpected change in exchange rates is the economic exposure which is commonly seen as a political disaster or natural disaster. The effect of economic exposures on exchange risks is kept out from this paper on one hand. On the other hand the cross-border firms do not get affected by the volatility of the exchange rates, in terms of the translation & transaction exposures.

“Foreign exchange risk does not exist; even if it exists, it need not be hedged; even if it is to be hedged, corporation need not hedge it.”

When compared with certain results this hypothesis seems to be inconsistent. Different ways have been found out by some empirical researches to hinder different exposures. For instance, in some real cases financial instruments or netting was applied.

Hedging and Importance

Normally foreign exchange rates are dictated based on the supply and demand of two currencies and are persuaded depending on both the interest and inflation rates of the corresponding countries. For entering into a contract both the parties those are going to buy & sell must have to be familiarised by the forward exchanging rate. Above all relationship between forward exchange rates, spot exchange rates, inflation and interest have to be introduced. Due to some factors such as government intervening and costs of transaction, relationship should not always be hold in the short run. But however the relationship could be hold on the long run by the four parties: purchasing power, expectations theory, the interest rate parity & the international Fisher effect.

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Types of exchange rate exposures:

In an international firm exchange rate losses those are unfavourable are protected by hedging currency exchange risk. Thus hedging currency exchange risk can be considered as one of the factors for eliminating risks. There are basically three forms of exchange rate exposures.

Transaction exposure

Translation exposure &

Economic exposure

Transaction exposure: It is caused when the organisation is driven into certain financial agreements or obligations. The future gains or losses of an organisation are completely dependent on the changes caused to the exchange rates in the future cash flows of the agreements or obligations.

The values that were before & after the accounts received & paid along with those engagements to buy or leasing financial cash flows do not match. The risk of transaction exposure is completely different from the risk of transaction exposure since the former one contains potential changes regarding cash flows.

Translation exposure: Translation exposure is also known as balance sheet exposure or accounting exposure. It is a kind of exposure which occurs when if the financial statements of all the affiliates have been consolidated by the parent company. The denominated currencies of the affiliates are quite different when compared to their parents.

Economic exposure: Economic exposure is also known as real exposure or operating exposure. It is mainly concerned about the risk of losses in exchange in association with the changes in future cash flows. It is completely different from the former two exposures which operate by long-term diplomatic decisions. There are mainly three barriers for non-financial organisations hedging currency risks compared to the financial organisations. Firstly, models to forecast forward are not well devised. Secondly, team of management is incessantly hesitant to hedge risks of FX & the team seems to risk-averse with respect to FX risks. Lastly, the risk management is less in non-financial firms compared to financial firms. The main purpose of hedging FX risks for most of the non-financial firms is for variance reduction in future cash flows.

Some of the advantages of corporate hedging are as below.

It can predict the cash flows of the firm that are generated internally & can arrange the financing plan of a firm either internally or externally. Also hedging helps for the smoothening of the net income of a firm, which proves to be valuable in the present financial market which focuses attention to quarterly earnings rather than the cash flows in the long-run. Based on the proponents of hedging, some of the many arguments are opposed to hedging. Spending on hedges of currency opt for an exceed in the loss in currency risk exposures. If the management fails in reducing the risks using hedging, rivalry arises between management & shareholders, where as the value of the shareholder crumbles.

There are several hedging instruments in order to protect our money from getting exposed to the above mentioned exposures/risks. These hedging techniques include spot, forward contracts, options, futures, currency swaps and so on usually referred to as derivatives.

The most frequently used instruments are:

Forward Contracts: The two parties enter a contract in which they agree on a favourable current exchange rate on a specified future date. Thus this guarantees a customized future payment and maturity date and eliminates future volatility. It is tailor made instrument that it includes and specifies all its parameters like money, date, exchange rate and denomination of payment. Also the cost of forward contracts is low comparing with other instruments and the settlement date is up to one year.

Futures: These are similar to forward contracts but are more standardised in terms of volume that is about to be exchanged. This is generally intended to speculating profits.

Spots: This allows us to buy or sell a currency at today’s exchange price and the day of settlement will be no more than two business days.

Currency Options: Options are like contracts but are more costly than contracts. It guarantees a worst-case exchange rate for the future purchase of one currency for another. There is a right to sell or buy but there is no obligation to do so as such giving the options holder substantial benefits.

Currency Swaps: These are in general long term high value transactions. By swapping their future cash flow obligations the counterparties are able to replace cash flows denominated in one currency with cash flows in a more desired currency.

As requested billing in U.S. dollars, forward contracts and money market hedge are some effective techniques of hedging and safe guarding the firm from any possible fluctuations and risks arising from the same.

In U.S. dollar billing we charge the goods at the rate in their home country but enter a contract based on the spot rate on the day of sale, and which means they need to pay the equivalent amount in dollars when the payment is due. Irrespective of the fluctuations of the currency rates the company is bound to make the payment of that exact amount of dollars at the end of contract or due date.

Forward contracts are mentioned above lock in the exchange rate on future currency transactions and thus reducing their exchange risk. The payment is due in future but the current exchange rate is used for entering into such a contract.

Money market hedge is a technique where in the company relies on borrowing and investing funds via money markets and using the spot rate to lock in the amount from the receivable. We borrow in the home currency the same amount that we are expected to receive ad invest in the other currency.

Billing in U.S. Dollars

As per our previous exports made to Mexico, we will receive 500 million Mexican Pesos. The spot rate of Peso/USD is 15.3555-15.3561, one of 15.3555 is the bid price at which the trader will buy from us and 15.3561 is the price at which he will sell.

So we need to buy 500 million Mexican pesos meaning we need to consider the spot exchange ask rate 15.3561. Thus the 500 million Mexican pesos will come to USD which is $32.5604 M.

Therefore we will be receiving a definite sum of $32.5604 M after the end of contract which is 6 months. So what ever is the exchange rate at the end of 6 months or whatever be the range of fluctuations we will get $32.5604 M.

But the company has to pay an equivalent of $32.5604M which is $32.5604M*15.3555 = 499.9812M pesos. This is mainly due to the depreciation of peso with respect to US dollars.

Forward Contract

Since the goods have been exported the importer is now short if 500 million Mexican pesos. By entering into a forward contract we sign an agreement with the importer, which states that the delivery of the equivalent of the amount due should be made after 6 months’ time at the forecasted forward rate which is 15.0123-15.0134 (peso/USD).

So as in the previous case we will be entitled to a sum of USD which turns out to be $33.3036 M. Hence we now entered into a future contract which gives us $33.3036 M at the end of 6 months.

While we receive $33.3036 M, as an equivalent to 500 M Mexican pesos, the importer needs to pay the trader an amount of $33.3036*15.0123 = 499.9636 M pesos.

However if the future rate increases then the importer is obliged to pay the 500M pesos at the prevailing spot rate. But in case the spot rate goes down then the importer has to meet the previously agreed rate for the payment.

Money Market Hedge

Here we are expected to receive 500 M pesos, so we borrow the same amount from a Mexican bank at the borrowing rate of 2.6% p.a. and we convert them to US dollars and invest the exact same amount in US dollars at 3.1% p.a.

We borrow 500M Mexican pesos at 2.6%, which is = 493.5834M and we convert them into dollars at the prevailing spot rate of 15.3561, which transforms to = $32.1425M and we invest them in US market at 3.1%, which gives us $32.1425*1.016 = $32.6568M. But once we receive the payment of 500M pesos the loan will have to be repaid and we have $36.6568M*15.0123 = 550.3029M pesos, whereas the loan amount is 500M*1.013 = 506.5M pesos. Which means we have a profit of 550.3029M-506.5M pesos = 43.8029M pesos, which in turn is = $2.9176M

Best Hedge

By observing the figures, it is clear that future contracts method is more beneficial than the rest of them. This hedging earns us $32.5604M by billing in U.S. dollars, $33.3036M in forward contracts and $32.6568M by money market hedging.

Derivatives

The derivative securities market has become quite large in recent years. In 2007, according to the International Swaps and Derivatives Association the notional value of all financial swaps stood at $587 trillion worldwide. The GDP of the entire world was only about $60 trillion by the year 2008.

The swaps and derivatives transfer risk from those who do not want to bear to those who are willing to bear for a fee. It is almost like insurance on property or automobile. For example, a put option is to safeguard if the price of a stock is expected to fall. And, like the insurance industry, both parties are mutually benefitted by this type of transaction; it is called hedging.

Bulk of the transactions in derivative securities is mainly based on speculation than for the purposing of hedging against foreign currency risks. These help in providing liquidity in the currency market apart transferring risk.

The sizes of banks and stock brokerage firms in derivative securities may give rise to huge loss which may well bring the entire financial system to a standstill. At the same time, some participants in these derivatives markets are reporting huge profits.

Swaps

The derivatives market involves more than just put and calls options. There are also contracts involving swapping fixed interest rate payment streams for adjustable or floating interest rate payment streams. Simply put its mutual agreement of two parties which satisfy both the parties.

Forward Contracts and Futures

Swaps, caps, and floors are recent innovations in the derivatives markets. The derivatives market traditionally included forward contracts in addition to options (puts, calls, warrants). A forward contract involved a commitment to trade a specified item at a specified price at a future date. The forward contract takes whatever form the two parties agree to. There is also a market for standardized forward contracts, which is called the futures market. The standardization makes possible a wider market with greater liquidity and efficiency. Often the futures markets eliminate the ties between specific parties, the party and the counter-party, and the risk that the other might not fulfil the contract. In the futures market everyone deals with the clearinghouse who guarantees fulfilment.

Forward exchange operations carry the same credit risk as spot transactions, but for longer periods of time; however there are significant risks involved. A forward contract requires delivery, at a fixed future date, of a specified amount of one currency against other foreign currency payment; the exchange rate is fixed at the time of writing the contract. It is to be noted that gain or loss on the forward contracts is irrespective of the current spot rate. The gain or loss exactly offsets the change in currency costs.

The major active participants in forward markets are arbitrageurs, traders, hedgers who seek to reduce their exchange risks by “locking in” the exchange rate on future trade or financial operations.

There are differences in even the quoted prices, commercial customers are usually quoted the actual price while the dealers quote the forward rate only as a discount/ premium on the spot rate.

These contracts are usually available for 1,2,3,6 or 12 months delivery. However forwards for odd maturities can also be formulated. With the increase in the maturity and volatility of the currency the bid-ask spread rises.

Forward Exchange Options Contract

In the options market there has developed some terminology that is somewhat intimidating to the uninitiated. A call option is the right to buy a share of a stock, the underlying security, at a specified price, called the exercise price or the strike price. A put option is the right to sell a share of a stock at a specified price, the exercise price or the strike price.

There is a limited time for the exercise of the call option. An American option can be exercised at any time up to and including the expiration date. A European option can only be exercised on the expiration date. The value of a call option at any time depends upon:

The current market price of the underlying security

The exercise price

The interest rate

Time remaining until expiration

The volatility of the price of the underlying security.

When any of these change the value of the option will change.

The options terminology that is most obscure is the use of Greek letters to refer to the response of the option value to changes in the variables which affect it.

Δ Delta = the change in the price of the option per unit change in the price of the underlying; i.e., the increase in option value if the current market price of the stock goes up by one dollar. Delta is important in creating a perfectly hedged portfolio. The rate of change of the delta of an option is called its gamma.

ρ Rho = the rate of change in the price of an option in response to a unit change in the interest rate.

θ Theta = the rate of change in the price of an option with respect to time; i.e., the change as the time until expiration decreases by one unit.

Vega (this is not a Greek letter) = the rate of change in the price of an option for a unit change in volatility.

Despite having the right to buy a call option or to sell a put option, the rights holder is not obliged to buy or sell but can do so at his will. This will give him total flexibility as to when to buy/sell his options