An Introduction to hedging

3NS Capital Ventures

Introduction
This presentation deals with understanding the idea behind hedging and trying to look at the concept of hedging and its uses by corporates from a laymans point of view. The presenter does not claim expertise in the topic. Although effort has been put into the presentation to make the concept more accessible to each and every listener. Comments, suggestions and doubts are more than welcome.

Definition of hedging
A hedge is a financial term denoting an investment position intended to offset potential losses that may be incurred by a companion investment.

Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment.

The word hedge is from Old English hecg, originally any fence, living or artificial.

Categories of hedgeable risk

Commodity Risk- a farmer can choose to hedge against violent fluctuations in the unit price of his crop by taking a position in the commodities futures and options markets.

Credit Risk- the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate. Credit default swaps are sold by insurance companies which act a hedge if the borrower defaults.

Categeroies of hedgeable risk

Foreign Exchange Risk- hedging is used both by financial investors to deflect the risks they encounter when investing abroad and by nonfinancial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure. Currency swaps are a tool used to hedge against losses due to foreign exchange risks. Interest Rate Risk- the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps

Categories of hedgeable risk

Equity Risk- the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. An investor can use futures and options to hedge against violent changes in prices. For example to hedge against a major fall in a stock that an investor is invested in, he or she can take a bearish or short position in the futures or options market to offset the risk from a fall in prices. Volatility Risk- Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlying is a major influencer of prices. VIX and the black swan index, are examples of instruments which can be used to hedge against volatility.

Practical uses of hedging for corporates

The economic liberalization facilitated the introduction of derivatives based on interest rates and foreign exchange. The primary purpose of these derivatives has been to mitigate risk as mentioned earlier . India has opened up only recently in the last two decades to such practices and derivative use is highly regulated due to the partial convertibility of the rupee. Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates, quantified in terms of exposures. The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management.

Kinds of foreign exchange exposure

Risk management techniques vary with the type of exposure (accounting or economic) and term of exposure. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries financial statements into the parents reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent. Economic exposure is the extent to which a firm's market value, in any particular currency, is sensitive to unexpected changes in foreign currency.

Kinds of foreign exchange exposure

Currency fluctuations also affect a firm's balance sheet by changing the value of the firm's assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in foreign banks; this type of economic exposure is called balance sheet exposure. Transaction Exposure is a form of short term economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility.

Understanding forex risk and using hedging as a tool to manage forex risk
Exchange rate changes are not easily predictable. Exchange rates react to new information in an immediate and unbiased manner. Information on direction of exchange rates arrives randomly so exchange rates also fluctuate randomly. Corporates mostly choose to hedge or not to hedge at their own discretion unless there is a mandate to do so in a specific situation. Some choose to hedge all their risks while others choose to hedge only some. The existence of different kinds of market imperfections, such as incomplete financial markets, positive transaction and information costs, probability of financial distress, and agency costs and restrictions on free trade make foreign exchange management an appropriate concern for corporate management.

Understanding forex risk and using heding as a tool to manage forex risk
It has also been argued that a hedged firm, being less risky can secure debt more easily and can enjoy a tax advantage.

Research on firms by relevant researchers using multivariate analysis has shown a statistically significant association between the absolute value of forex exposures and the percentage use of forex derivatives on this absolute value showing that the use of such derivatives is actually turning out to be fruitful for firms with foreign exposure.

Forex risk management framework

Once the exposure is recognized, the following operations can by performed by a corporate firm to manage its risk : Forecast: Forecast on the market trend of forex rates must be performed for the typical 6 month period. The forecast should be based on valid assumptions and the probability of the said forecast being correct should be estimated. Risk Estimation: Based on the forecast, a measure of VAR and the probability of the risk should be ascertained. All types of riskoperational, systemic, etc should be taken into account Benchmarking: A firm has to set its limits for handling foreign exchange exposure. The firm should understand its own financial strength and cash flows and take forex riska accordingly.

Forex risk management framework

Hedging: Based on the limits a firm set for itself to manage exposure, the firms then decides an appropriate hedging strategy. There are various financial instruments available for the firm to choose from: futures, forwards, options and swaps and issue of foreign debt. Stop loss: a stoploss is a measure of discipline of the firm. The firm has its own estimates of the variations of exposure it can realize. The firm should accept its mistake and appropriate measure should be taken to keep the risk in control. Reporting and review : Continuous reporting and reviews must take place to keep a check on the strategies being used and understand the scope of improvement in the strategies

Hedging strategies/instruments
Forwards: A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. E.g if RIL wants to buy crude oil in US dollars six months hence, it can enter into a forward contract to pay INR and buy USD and lock in a fixed exchange rate for INR-USD to be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this example the downside is an appreciation of Dollar which is protected by a fixed forward contract. The main advantage of a forward is that it can be tailored to the specific needs of the firm and an exact hedge can be obtained. On the downside, these contracts are not marketable, they cant be sold to another party when they are no longer required and are binding.

Hedging strategies/instruments
Futures: A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market. Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. In this example, RIL will have to go to the US currency futures market and enter a transaction whose value must equal its forex exposure. Options: An options contract gives a firm the right but does not require an obligation by the firm to fulfil the condition of the right. A call option is the right to buy and a put option is the right to sell. Both these rights can be bought or sold based on the requirement. For example, RIL can buy call options on the USD to mitigate the upside risk on the currency. If the dollar depreciates, then RIL can buy the dollars from the market but if the movement is unfavourable then RIL can exercise the option at the exercise/strike price-making both the choices favourable.

Hedging strategies/instruments
Swaps: Swaps are used for hedging credit risks, interest rate risks and forex risks. A foreign currency swap contract is one where the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. Consider an export oriented company that has entered into a swap for a notional principal of USD 1 mn at an exchange rate of 42/dollar.The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures

Hedging strategies/instruments
Foreign debt: Consider a company which exports products to another country and the company is to receive a payment in foreign currency some months from now. To avoid a situation where the foreign currency might appreciate and the earnings are reduced in the domestic currency, the company takes a loan in the foreign currency and converts it into the domestic currency at the present forex rate. The company can invest the proceeds of this money under the assumption that the said investment will return as much money as to counter the lending rates for the said number of months before receiving the payment.

Determinants of hedging decisions

Production and trade versus hedging decisions- there is not much of a contagion between production and trade against hedging, hence these activities can be performed seperately without being mixed. Cost of hedging- In the presence of efficient markets, the cost of hedging in the forward market is the difference between the future spot rate and current forward rate plus any transactions cost associated with the forward contract. The costs of hedging, assuming efficiency in foreign exchange markets result in pure transaction costs. The three main elements of these transaction costs are brokerage or service fees charged by dealers, information costs such as subscription to Reuter reports and news channels and administrative costs of exposure management.

Determinants of hedging decisions

Factors affecting the decision to hedge foreign currency risk: Research in the area of determinants of hedging separates the decision of a firm to hedge from that of how much to hedge. There is conclusive evidence to suggest that firms with larger size, R&D expenditure and exposure to exchange rates through foreign sales and foreign trade are more likely to use derivatives. Factors affecting the decision to hedge and the degree of hedging follow: Firm size: Risk management involves fixed costs of setting up of computer systems and training/hiring of personnel in foreign exchange management. Moreover, large firms might be considered as more creditworthy counterparties for forward or swap transactions, thus further reducing their cost of hedging. The book value of assets is used as a measure of firm size.

Determinants of hedging decisions

Leverage: According to the risk management literature, firms with high leverage have greater incentive to engage in hedging because doing so reduces the probability, and thus the expected cost of financial distress. Highly levered firms avoid foreign debt as a means to hedge and use derivatives. Liquidity, Profitablity and Sales growth: Firms with highly liquid assets or high profitability have less incentive to engage in hedging because they are exposed to a lower probability of financial distress. Liquidity is measured by the quick ratio, i.e. quick assets divided by current liabilities). Profitability is measured as EBIT divided by book assets. Sales growth is a factor determining decision to hedge as opportunities are more likely to be affected by the underinvestment problem. For these firms, hedging will reduce the probability of having to rely on external financing. Sales growth is obtained using 3 years geometric sales growth rate.

Conclusion
Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call and put, cross currency and range-barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. Developments in these regards need to take place.