Hedging

Presented by: Nadeem Ahmad-FM/11/009 Ankur Tagra-FM/11/010 Sunay Kasliwal-FM/11/002 Samsher Yadav-FM/11/020

Hedging
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Insuring against transaction risk to reduce or

eliminate the effects of unexpected changes in exchange rates. You can hedge only at market rates. The effects of expected changes in exchange rates are incorporated in these market rates. Hedging is insurance. The purpose of hedging is to reduce or eliminate risks, not to make profits.
Hedging

Need for Hedging

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Movements in exchange rate offsets the changes in

price level. The changes in exchange rate do cause both gain and loss to firms involved in foreign transactions but the gain and losses tend to average out over the period. The shareholders are competent enough to minimize the currency risk through diversification of their portfolio. Hedging helps to maintain the cash flow.

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Perfect Hedging
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A position undertaken by an investor that would

eliminate the risk of an exiting position or a position that eliminates all markets risk from a portfolio in order to be a perfect hedge ,a position would need to have a 100% inverse correlations to the initial position .As such the perfect hedge is rarely found .

Hedging

Hedge Fund
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An aggressively managed portfolio of investment

that uses advanced investment strategies such as leverage ,long ,short derivatives positions in the both domestic and international markets with the goal od generating high returns . Legally hedge funds are most often set up as private investment partnership that are open to a limited number of investors and require a very large initial minimum investment .

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Hedging Strategies
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Buying Hedge A transactions that commodities

investors undertake to hedge against possible increase in the price of the actuals underlying the futures contracts . Also called a long hedge, this particular strategy protects investors from increasing prices by means of purchasing futures contracts . Many companies will to attempt to use a long hedge strategy in order to reduce the uncertainty associated with the future prices.
Hedging

Long Hedge
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A situation where an investors has to take a long

position in futures contracts in order to hedge against future price volatility .

A long hedge is beneficial for a company that knows

it purchase as asset in the future and wants to lock in the price .

A long hedge can also be used to hedge against a

short position that has already been by the investor .

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Selling Hedge
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A hedging strategy with the sale of futures contracts

are meant to offset a long underlying commodity position. Also known as short hedge .

This type of hedging strategy is typically used for the

purpose of insuring against a possible decrease in commodity prices .

By selling a futures contract

an investor can guarantee the sale price for a specific commodity and eliminate the uncertainty associated with the goods.

Hedging

Micro Hedge
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An investment technique used to eliminate the risk

of a single asset.
In most cases ,this means taking an offsetting

position in that single asset.

If this asset is part of a larger portfolio, the hedge

will eliminate the risk of the one asset but will have less of an effect on the risk associated with the portfolio.
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Hedging Transaction
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A type of transaction that limits investment risk with

the use of derivatives, such as options and futures contracts.

Hedging transactions purchase opposite positions in

the market in order to ensure a certain amount of gain or loss on a trade.

They are employed by portfolio managers to reduce

portfolio risk and volatility or lock in profits.

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Cont
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Hedging transactions are subject to ordinary gain

and loss tax treatment.

However, hedging losses of limited partners are

usually limited to their taxable income for the year.

Hedge funds use this sort of transaction extensively.

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Hedging Instruments
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Hedging Instruments

Contractual hedges
1. Forward market hedge 2. Futures market hedge 3. Options hedge 4. Money market hedge
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Natural hedges
1. 2. 3. 4. 5. 6. 7. 8. Leads and lags Cross hedging Currency diversification Risk sharing Pricing of transactions Parallel loans Currency swaps Matching cash flows

Contractual Hedges
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In the forward market hedge, the exporter sells

forward and the importer buys forward, the foreign currency in which the trade is invoiced. In the futures contract similar transactions are found. In the currency options market, the importer buys a call option or sells a put option or performs both the functions simultaneously. The exporter buys a put option or sells a call option or performs both.
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Money Market Hedge

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This hedge involves a money market position to

cover a future payables or receivables position.

An importer who has to cover future payables first

borrows local currency, then converts the borrowed local currency into the currency payables and finally, invests the converted amount for a period matching the payments to be made for the import.

Hedging

Cont
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An exporter who has to hedge the receivables first

borrows the currency in which the receivables are denominated, then converts the borrowed currency into local currency and finally invests the converted amount for a maturity coinciding with the receipt of export proceeds.
It can be covered or uncovered.

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Natural Hedges
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It is applied when the contractual hedge to give good

results.
Sometimes the currency to which the firm is exposed

cannot be hedged in the absence of a forward or money market.

When a perfect contractual hedge is not available,

the firm adopts the natural hedge.

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Leads and Lags

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Lead means accelerating or advancing the timing of

receipt or of payment of foreign currency.

Lag is decelerating or postponing the timing of

receipt or payment of foreign currency.

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Cross Hedging
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It is adopted when the desired currency cannot be

adopted. The firm has first identify a foreign currency that can be hedged, and at the same time, volatility of which is highly correlated with that of the desired currency. The hedging of the identified currency will be a substitute of the desired currency. A good example is cross hedging a crude oil futures contract with a short position in natural gas.
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Currency Diversification
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The smaller the number of currencies in which a firm

transacts, the greater will be the magnitude of risk.

If the number is quite large, there is every possibility

that if one currency depreciates other currency appreciates.

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Risk Sharing
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It is a contractual arrangement through which the

buyer and the seller agree to share the exposure.

Both the parties agree to this proposal if their

business relationship is long term.

A base rate is fixed with mutual consent that is

generally the current spot rate.

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Pricing Transactions
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It involves marking up/down of prices as also billing

in a desired currency.
In invoicing of transactions, the exporter may be

willing to invoice the bill in its own currency but if the importer is dominant, the bill is normally invoiced in the importers currency.

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Parallel Loans
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A parallel loan involves two parent companies taking

loans from their respective national financial institutions and then lending the resulting funds to the other company's subsidiary. It is often known as back to back loan or credit swap loan. For example, ABC, a Canadian company, would borrow Canadian dollars from a Canadian bank and XYZ, a French company, would borrow Euros from a French bank. Then ABC would lend the Canadian funds to XYZ's Canadian subsidiary and XYZ would lend the Euros to ABC's French subsidiary.

Hedging

Currency Swaps
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A swap that involves the exchange of principal and

interest in one currency for the same in another currency.

For example, suppose a U.S.-based company needs

to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange.

These two companies could arrange to swap

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Matching of cash flows

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A firm matches its foreign currency inflow with the

outflow in that currency not only in respect of size but also in respect of timing.
For this purpose, the firm must have both inflows

and outflows in the same currency.

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Foreign Exchange Risk

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Types of foreign exchange risk

Transaction risk measures changes in the value of outstanding financial obligations due to exchange rate changes.

Operating risk also called economic risk, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates.

Hedging

Cont
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Translation

risk also called accounting risk, is the changes in owners equity because of the need to translate financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements.

Tax

risk as a general rule only realized foreign losses are deductible for purposes of calculating income taxes.

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Foreign Exchange Risk

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Moment in time when exchange rate changes

Accounting risk

Operating risk

Changes in reported owners equity Change in expected future cash in consolidated financial statements flows arising from an unexpected caused by a change in exchange rates.change in exchange rates.

Transaction risk
Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates. Time

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Hedging