HEDGINGSUBHA CPRIST UNIVERSITY

Hedging

HedgingInsuring 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

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Need for HedgingMovements 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.*Hedging

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Perfect Hedging

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

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Hedge FundAn 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 . *Hedging

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Hedging StrategiesBuying 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

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Long HedgeA 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 .*Hedging

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Micro HedgeAn 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.*Hedging

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Hedging TransactionA 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.*Hedging

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ContHedging 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.*Hedging

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Hedging InstrumentsHedging InstrumentsContractual hedgesForward market hedgeFutures market hedgeOptions hedgeMoney market hedgeNatural hedgesLeads and lagsCross hedgingCurrency diversificationRisk sharingPricing of transactionsParallel loansCurrency swapsMatching cash flows*Hedging

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Contractual HedgesIn 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.*Hedging

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Money Market HedgeThis 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

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ContAn 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.*Hedging

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Natural HedgesIt 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.*Hedging

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Leads and Lags

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.*Hedging

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Risk SharingIt 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.*Hedging

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Foreign Exchange Risk

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

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Cont

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*Hedging

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THANK YOU*Hedging

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