This blog is written by Mr. Muneeb Sultan, Associate Internal Audit Services. Please read this blog and provide your valued comments
HEDGING is a risk management strategy. Hedging involves reducing or eliminating financial risk by passing that risk on to someone else. It can provide certainty of cash flows, which helps with budgeting, encourages management to undertake investment, reduces the possibility of financial collapse and makes for a more attractive company to risk-averse staff.
Following are some areas of hedging and their risks
Currency Hedging :
Foreign currency hedging specifically tries to reduce the risk that arises from future movements in an exchange rate. This is a two-way risk since exchange rates can move adversely or favorably. Management generally hedges for adverse movements only, for example higher costs and reduced income.
Interest rate hedging:
Financial managers face risk arising from changes in interest rates, i.e. a lack of certainty about the amounts or timings of cash payments and receipts.
Many companies borrow, and if they do they have to choose between borrowing at a fixed rate of interest (usually by issuing bonds) or borrow at a floating (variable) rate (possibly through bank loans).There is some risk in deciding the balance or mix between floating rate and fixed rate debt. Too much fixed-rate debt creates an exposure to falling long-term interest rates and too much floating-rate debt creates an exposure to a rise in short-term interest rates.
In addition, companies face the risk that interest rates might change between the point when the company identifies the need to borrow or invest and the actual date when they enter into the transaction.
Managers are normally risk-averse, so they will look for techniques to manage and reduce these risks.
Instruments for Hedging Currency Risk
You can hedge currency risk using one or more of the following instruments:
Currency forwards: Currency forwards can be effectively used to hedge currency risk. For example, assume a U.S. investor has a euro-denominated bond maturing in a year’s time and is concerned about the risk of the euro declining against the U.S. dollar in that time frame. The investor can enter into a forward contracts to sell euros (in an amount equal to the maturity value of the bond) and buy U.S. dollars at the one-year forward rate. While the advantage of forward contracts is that they can be customized to specific amounts and maturities, a major drawback is that they are not readily accessible to individual investors. An alternative way to hedge currency risk is to construct a synthetic forward contract using the money market hedge.
Currency futures: Currency futures are used to hedge exchange rate risk because they trade on an exchange and need only a small amount of upfront margin. The disadvantages are that they cannot be customized and are only available for fixed dates.
Currency Options: Currency options offer another feasible alternative to hedging exchange rate risk. Currency options give an investor or traders the right to buy or sell a specific currency in a specified amount on or before the expiration date at the strike price.
Instruments for Hedging Currency Risk
Forwards: A forward contract is the most basic interest rate management product. The idea is simple, and many other products discussed in this article are based on this idea of an agreement today for an exchange of something at a specific future date.
Forward Rate Agreements (FRAs): An FRA is based on the idea of a forward contract, where the determinant of gain or loss is an interest rate. Under this agreement, one party pays a fixed interest rate and receives a floating interest rate equal to a reference rate. The actual payments are calculated based on a notional principal amount and paid at intervals determined by the parties. Only a net payment is made – the loser pays the winner, so to speak. FRAs are always settled in cash.
FRA users are typically borrowers or lenders with a single future date on which they are exposed to interest rate risk. A series of FRAs is similar to a swap (discussed below); however, in a swap all payments are at the same rate. Each FRA in a series is priced at a different rate, unless the term structure is flat.
Futures: A futures contract is similar to a forward, but it provides the counterparties with less risk than a forward contract – namely, a lessening of default and liquidity risk due to the inclusion of an intermediary.
Swaps: Just like it sounds, a swap is an exchange. More specifically, an interest rate swap looks a lot like a combination of FRAs and involves an agreement between counterparties to exchange sets of future cash flows. The most common type of interest rate swap is a plain vanilla swap, which involves one party paying a fixed interest rate and receiving a floating rate and the other party paying a floating rate and receiving a fixed rate.
Options: Interest rate management options are option contracts for which the underlying security is a debt obligation. These instruments are useful in protecting the parties involved in a floating-rate loan, such as adjustable-rate mortgages (ARMs). A grouping of interest rate call options is referred to as an interest rate cap; a combination of interest rate put options is referred to as an interest rate floor. In general, a cap is like a call and a floor is like a put.
Stations: A swaption, or swap option, is simply an option to enter into a swap.