HEDGING

SUBHA C
PRIST UNIVERSITY

Hedging

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

3

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.
Hedging

Perfect Hedging
4

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
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 .
Hedging

Hedging Strategies
6

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

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 .

Hedging

Micro Hedge

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.
Hedging

Hedging Transaction
9

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.

Hedging

Cont

10

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.
Hedging

Hedging Instruments
11

Hedging
Instruments

Natural hedges
Contractual hedges
1.Forward market hedge
2.Futures market hedge
3.Options hedge
4.Money market hedge

Hedging

1.Leads and lags

2.Cross hedging
3.Currency diversification
4.Risk sharing
5.Pricing of transactions
6.Parallel loans
7.Currency swaps
8.Matching cash flows

Contractual Hedges
12

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.
Hedging

Money Market Hedge

13

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

14

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.

Hedging

Natural Hedges
15

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.

Hedging

Leads and Lags

16

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

Risk Sharing

17

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.

Hedging

Foreign Exchange Risk

18

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

Hedging

19

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.

Foreign Exchange Risk

20

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

Hedging

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THANK YOU

Hedging