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Analysis of Different Methods of Hedging

6137 words (25 pages) Essay in Finance

08/02/20 Finance Reference this

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Introduction

This report will start by analyzing different methods of hedging and asses the different advantages and disadvantages with each method. It will then go on to suggest which hedging method is best for David Van Veen Ltd. The report will then analyze the possibility of a joint venture and asses the advantages and disadvantages. It will also asses the different sources of finance available for the joint venture and suggest the most appropriate source of finance. Finally, the report will look at the possibility of the company expanding into another country. The countries that have been selected for analysis and comparison are china and India.

 

Heading strategies

 

Definition of a Hedge

“A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.”  (Investopedia, 2019)

 

Hedging is like taking out an insurance policy. For example, if someone owned a home in a wild fire prone area, they would want to protect that asset from risk of fire. They can do this buy hedging against it therefore taking out wildfire insurance. They can prevent the fire from happening, but they can take steps to lower the loss from the fire. The tradeoff with hedging is while it reduces risk It takes away some of the gains/profit available. (Investopedia, 2019)

 

Forward Contract

A forward contract is a pre agreed contract between two companies/parties, in this agreement they agree to sell or buy the asset in question at a predetermined future date and a price decided when the contract is agreed. Forward contracts are most common way of hedging foreign currency risk. (Business Jargons, 2019)

There are numerous advantages to using future contracts, first being the fact, they have relatively low margins allowing parties to receive the lowest pricing possible. Secondly future contracts are on exchange so can reduce counter party risk. Finally, the cost for trading futures is very low compared to other hedging options such as currency forwards. (Good Money Guide, 2019)

There are also numerous disadvantages when using forward contracts such as some brokers may insist client’s close positions before delivery, and they are mainly traded on US based exchanges. Forward contracts also trade in lots of present amounts that are inflexible for exact accounting and are often not flexible for accounting purposes. (Good Money Guide, 2019)

Money market

A money market hedge is against exposure to foreign currency risk, generated from depositing or borrowing a large sum of money now to fix payment or receipts in a domestic currency. Any business that does foreign currency transactions where the payment/receipt is at a future date is open to the risk of the value of the foreign currency changing before payment/receipt. (Xplaind.com, 2019)

The first advantage of using a money market hedge is they are considered low risk due to the fact they are short term contracts and you receive your expected cash flow relatively quickly. Another advantage is the return is fixed, when you enter into a money market you know what you are getting as the return is fixed. Another advantage is most money market instruments have high liquidity therefore it is relatively easy to get to your capital if needed. (Budgeting.thenest.com, 2019)

There are numerous disadvantages to money market hedging such as loss of purchasing power, if an investor is generating 4% return but inflation is at 5% the investor is technically losing purchasing power. Another disadvantage is expenses can take away profits. As the investors are sometimes only earning 2-3% even small annual fees can have a large impact on the money that is generated. (Investopedia, 2019)

Options Hedge

Option contracts are an ideal tool to hedge against risk in stocks. Put options and call options are both great tools to help limit or eliminate loss when an investor is uncertain about the future of a stock. (Trading et al., 2019)

There are numerous different advantages to options hedging, first being the fact, they are flexible which allows them to be used to protect your down side. Options can also allow the investor to gain leverage and receive return of 100% or more. (Learnmoney.co.uk, 2019)

There are also numerous disadvantages when hedging with options such as the complicity, it can take a month to learn to understand how option hedging works. There can also be a low volume which in turn means they have a low liquidity which isn’t ideal if the investor needs the capital back. The final major disadvantage for using options to hedge is there is unlimited risk, meaning the loss can be relatively large. (Learnmoney.co.uk, 2019)

 

Summary of Hedging

From the calculations in the appendix one, forward contract would create £7,251,433, money market hedge would generate £7,390,517 and options hedge would generate £7,256,517. From this information on a financial basis options hedge would be the most beneficial for David Van Veen Ltd as it generates the largest amount of income.

Joint Venture

David Van Veen Ltd have been proposed a joint venture with Jas Group a new entry into the market. The joint venture will be in Germany. From the graph in appendix three it is clear Germany has a low interest rate that has fallen over the previous 12 months. As seen in appendix 4 Germany has also had a consistently high GDP since 2010.

Non-Financial Analysis

A joint venture is a join enterprise entered by two or more business for a specific project or other business activity. Join ventures are usually for specific projects and allow multiple businesses to work together combing their strengths. Joint ventures can be long or short term and are often separate business entities to which owners contribute assets and agree on how it should be managed. Joint ventures can be corporation, partnership or limited liability companies. (Small, 2019)

There are numerous justifications for going into a joint venture first being the fact it’s a temporary agreement with a goal such as creating a net profit. Another justification is the companies involved have access to resources they might not have had access to otherwise as they are coming together with other companies with different resources. the parties involved can also complete projects they might not have been able to finance or staff on their own. The final justification to go into a joint venture is all the risk and cost are shared between the companies involved. (Venture, 2019)

There are some limitations to entering a joint venture such as dealing with different companies who could have different work place cultures and management styles. This could lead to a clash of cultures and the project not going as planned. Either of the parties making poor tactical decisions or lack of commitment would affect the overall project for both companies. Another issue is if the parties involved come to a disagreement as if it’s equally split, they will have to come to a join agreement. Finally, as the risk and cost are shared so is the profit generated from the project. (Venture, 2019)

Factor

Germany

Political

Germany is a democratic republic, operating under a system called Grundgestetz which was published in the 1949 constitution document. Legislate, judiciary and executive are the 3 aspects to the government.

Economic

Social

Technology

Financial Analysis

“Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. NPV analysis is a form of intrinsic valuation and is used extensively across finance and accounting for determining the value of a business, investment security, capital project, new venture, cost reduction program, and anything that involves cash flow.” (Corporate Finance, 2019)

Net present value is a great indicator of future value of money as it takes into consideration the time value of money, allowing the company to estimate for much the amount will be worth in real terms. It also looks at earlier cash flows and looks at all the cash flows involved through the life of the project. Using discount factor also reduces impact of less likely future cash flows and allows companies to see if the project has a negative or positive net present value, allowing them to asses if they should go forward with the project. (Tutor2U, 2019)

There are a few limitations when using net present value first being it is a very complicated method that user may find hard to understand, it is also difficult to select the correct discount rate, and this can lead to projects being turned down that would have had a positive NPV with correct discount rate. The initial investment cost can also have a large affect on the NPV outcome therefor turning away some positive projects with high initial investment. (Tutor2U, 2019)

Summary of NPV Calculations

As seen in the appendix the net present value for the project is 3.06M meaning David Van Veen Ltd should go ahead with the project as it has a positive net present value, but they should also consider why their current operation in Germany hasn’t been a success and if this could affect the joint venture.

Expansion to China/India 

This section of the report will asses a possible expansion to china or India. What finances are available for the expansion and suggest which is most appropriate for David Van Veen Ltd. It will then look at the economic situation within the two countries and then go on to compare aspects such as GDP, barriers to entry, corruption and interest rates.

 

Sources of finance

There are numerous internal sources of finance such as reinvesting retained profits. This is a great source of internal finance as there is no interest or loss of assets. For large companies retained profits can often mean not paying dividends to allow you to re-invest allowing the shareholders shares to increase and a possible larger dividend in the following year. Sale of assets is another form of internal finance, this is where a company sells assets such as equipment, vehicles or buildings that are no longer needed. This method only works if the company has assets that another company may want to buy, and they aren’t essential anymore. (SmallBusiness, 2019)

Short term external sources of finance can be an ideal way to generate money for day to day purposes, paying unexpected bills or helping when business is slow. The first short term external finance a company should consider is bank over draft, this is simply where the bank allows the company to go into an overdraft at a pre negotiated rate to allow the business to survive until they receive payables. Another short-term external finance is trade credit, this is where suppliers allow companies to purchase supplies on credit and pay 30 days later when they have the finance to pay for the products. (eFinanceManagement.com, 2019)

Long term external finance can be finances such as equity shares, this is where a company shares the ownership rights to generate capital. This can be costly compared to debt finance as they will have to pay dividends and share bonus. Another type of long-term external finance are term loans, this is where the company apply for a loan of the bank and don’t have to sell shares or involve the public. Loans from the bank can be secured against assets to allow the bank more security when providing to loan. The final long-term external finance is a venture capitalist who will invest in the business in a similar way to equity share but leaves once the business has generated enough money for them, this is ideal for new business looking for fiancé to help them grow. (eFinanceManagement.com, 2019)

Recommendation

As David Van Veen Ltd have already got a gearing ratio of 87% the best source of finance would be an internal source such as retained profits as this will not further increase their gearing ratio which is already relatively high. As expanding into another country over draft wouldn’t be a suitable option as a large amount of money is needed. An external option that could work is to find a venture capitalist willing to invest in the move and then leave once the business is operating and has generated enough profit. David van Veen could also sell shares to create capital, but they need to ensure they keep control over 51% of the shares.

Chinese Economy

In 1978 china started a program to reform the economic structure, at this time the country ranked ninth in gross domestic product with 214 billion. Over the last 35-years china have seen phenomenal growth which has catapulted the country to second on the GDP ranking with a GDP of 9.2 trillion. (FocusEconomics | Economic Forecasts from the World’s Leading Economists, 2019)

 

As seen in appendix two the Chinese economy has been slower down over the last 7 years. The Chinese stock market was also the worst performer last year finishing on a 28% loss. Tech gain apple also released a statement claiming sales will not meet expectations this year. (BBC News, 2019)

Indian Economy

India has one of the fastest growing economies in the word and in the next 10-15 years is expected to be in the top three economic powers. India has established its self as the third largest start up base in the world with around 4,700 technology startups and GDP increase 7.2 percent in 2017 and 7% in 2018, consistently growing. With an expected labour force of 160 million by 2020 and increased labour participation.

China/India Comparison

Factor

India

China

GDP

2,600 Billion

9.2 trillion (9)

Interest rate

9.6

4.3

Barriers to entry

100th

78th

Corruption

78th

87th

(FocusEconomics | Economic Forecasts from the World’s Leading Economists, 2019)

(Tradingeconomics.com, 2019)

From this information china has a much larger economy with 9.2 billion GDP against India’s 2,600 billion. China also has a much lower interest rate and easier to enter but china’s economy has recently slowed down as discussed before whereas India’s economy is growing.

Appendices

Company profile

David Van Veen LTD is a multinational company based in the Netherlands and was founded in 1998. They are specialists within the financial services sector offering their service to private equity companies operating in the industrial and commercial property construction and development industry. David van Veen have subsidiaries in Germany, UK, Austria, America, Monaco, Poland and a head office in the Netherlands. The multination corporation currently has market capitalization of 2.2 billion euros.  (Module Content)

Appendix 1

Forward Contract

Forward      June    December

Amount Receivable (€)    4,000,000   4,000,000

Forward Rate      1.261    1.358

GBP Proceed as hedged    3,552,082.53  3,521,746.78

Carry Forward to 1/12     (1+10/2)   1.05    1.05

Total GBP       3,729,686.53   3,521,746.70

Total of Both Payments      7,251,433.31

Money Market

Money market      June     December

Amount Receivable (€)     4,000,000    4,000,000

Discount Factor (DF)        (1+6)/4  1.015  (1+6)*3/4 1.045

Current proceeding (€)    3,940,886   3,827,751.20

Current spot Rate     1.13    1.13

Current £ proceed     3,487,509.73  3,387,390.44

Carry forward rate period (1+10)*3/4   1.075   1.075

£ proceed 1st December    3,749,072.96  3,641,444.72

Total of both        7,390,517.41

Options Hedge   

options Hedge       June    December

Amount receivable     4,000,000   4,000,000

Put Options      2%*4M/1.13   1.7%*4M/1.13

% Spot Value      70,796.46   60,176.99

Carry forward premium cost  (1+10%/2) 1.075    1.075

       76,106.19   64,690.26

Gross put option Value    3,539,832   3,539,823

Carry forward    (1+10%/2)  1.05    1.05

£ Proceeds      3,716,814.15  3,539,823

         7,256,517.41

Net Present Value Calculations

Spot

0.882

Year 1

0.889

Spot^(n+1) =

(1.019/1.011)

x 0.8820

Year 2

0.896

Year 3

0.903

Year 4

0.910

Year 1

Year 2

Year 3

Year 4

Home (€) (11%)

1.260

1.399

1.552

1.723

CF from UK (£)

0.960

1.066

1.183

1.320

CF from UK (€)

1.080

1.190

1.310

1.450

Total (€)

2.340

2.589

2.862

3.173

Year 1

Year 2

Year 3

Year 4

Gross CF

2.340

2.589

2.862

3.173

OC

0.368

0.368

0.368

0.368

Depreciation

0.058

0.058

0.058

0.058

Overall OC

0.310

0.310

0.310

0.310

Inflation

1

1.013

1.026

1.039

Adjusted OC

0.310

0.314

0.318

0.322

DCF

2.03

2.275

2.544

2.851

    Year 1

Year 2

Year 3

Year 4

Year 5

CF

2.030

2.275

2.544

2.851

Tax

0.609

0.683

0.763

0.855

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

CF

2.030

2.275

2.544

2.851

Capital

-1

-1

Tax

-0.609

-0.683

-0.763

-0.855

CFAT

-1

1.030

1.666

1.861

2.088

-0.855

DF

1

0.909

0.826

0.751

0.683

0.621

PV

-1

0.936

1.376

1.398

1.426

-0.531

NPV

3.605

 

Appendix 2

(BBC News, 2019)

Appendix 3

(Anon, 2019)

Appendix 4

(Germany, 2019)

Appendix 5 china Pest

Factor

China

Political

Firms must abide by formal and informal rules set by the government. The political force is one of the most unsettled force in the world. Over the past few years china has been focused on developing the e-commerce.

The legal framework of e-commerce is still in the early stages and china have little experience for creating e-commerce legislation for areas such as property rights and tax. There are low regulations supporting the privacy, recognition of digital signatures, customer rights and validation of contracts yet.

Economic

Chinas GDP has seen large amount of growth over the past 5 years and is expected to pass USA soon, GDP per capita is also rapidly increasing showing citizens are adding value to the economy. The more worry aspect for china is the fact growth can slow down, inflation is extremely high and property price is high.

Social

China has a collective culture based on Geert Hofstede’s value dimensions. China has a high literacy rate with around 90% of the population being literate due to focus on education. There are around 420 million internet users in china with a high online shopping rate.

Technology

There is a lack of safe online credit card payment in china which has resulted in relatively low use online of credit cards. China has some of the most advanced technology in the world from space travel, electric cars, phones and high speed trains.

(Contributor, 2019)

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