Hedging

The Hedging is a financial technique that helps to reduce or mitigate the effects of measurable type of risk from the future changes in the fair value of commodities, cash flows, securities, currencies, assets and liabilities. It is a kind of an insurance that do not eliminate the risk completely but mitigate its effect. In other words, it is a risk-reducing tool wherein the firm uses the derivatives and other instruments to offset the future changes in the value of securities, currencies, assets, etc. The firm uses several derivatives or other instruments to hedge against the exchange rate risk. These are:

1. Risk Hedging with Forward Contracts.
2. Risk Hedging with Future Contracts.
3. Risk Hedging with Swaps
4. Risk Hedging with Option Contracts
5. Risk Hedging with Insurance.

The following are the main advantages of risk management through hedging:

• The financial risk management helps the firm to increase its debt capacity. Through risk management, the firm is able to understand the types of financial risks associated with its investments that helps an organization in the minimization of the cost of financial distress.
• The financial risk management enables the managers to hedge against the probable movements in the exchange rates and interest rates. These are the factors that are beyond management’s control and cannot be predicted with certainty. Thus, it encourages the managers to direct their efforts towards the improvement of the operations rather than worrying about the factors that are not under their control.
• It helps to differentiate between the effects of fluctuation in the external factors Viz. Exchange rates and interest rates and the management’s performance. Even if the company hedges its risk and suffers a huge loss, then it can be said that the management is bad.

Thus, the primary objective of this risk management tool is to reduce the risk, not to save cost or earn profits.

Risk Hedging with Forward Contracts

The Forward Contract is an agreement between two parties wherein they agree to buy or sell the underlying asset at a predetermined future date and a price specified today. The Forward contracts are the most common way of hedging the foreign currency risk.

The foreign exchange refers to the conversion of one currency into another, and while dealing in the currencies, there exist two markets: Spot Market and Forward Market. The Spot market means where the delivery is made right away, while in the forward market the payment is made at the predetermined date in the future.

In the spot market, the rate is the current rate, which is prevailing at the time the currencies are being exchanged. Whereas, the rate in the forward market is the rate which has been fixed today or at the time the transaction is agreed to but the actual delivery takes place at a specified date in the future. Thus, forward currency contracts enable the parties to the contract to lock the exchange rate today, to buy or sell the currency on the predefined future date.

The party who agrees to buy the underlying asset at a specified future date assumes the long position, whereas the seller who promises to deliver the asset at a rate locked today assumes the short position. In a forward currency contract, the buyer hopes the currency to appreciate, while the seller expects the currency to depreciate in the future. Thus, the gain and loss of the buyer can be calculated as follows:

Gain = Spot Rate– Contract Rate
Loss = Contract Rate – Spot Rate

Where, the spot rate is the actual rate prevailing at the future date while the contract rate is the rate which was locked at the time transaction was agreed upon.

The forward contracts are similar to the options in hedging risk, but there is a significant difference between these two. The parties to the forward contracts are obliged to buy or sell the underlying securities at a specified date in the future, whereas in the case of the options, the buyer has the right to whether exercise the option or not. The other difference is that the forward contracts do not require any upfront payment in the form of premium which is very much required when buying the options contracts.

Risk Hedging with Future Contracts

The Future Contract is a standardized forward contract between two parties wherein they agree to buy or sell the underlying asset at a predefined date in the future and at a price specified today. The future contracts are a relatively less risky alternative of hedging against the fluctuations in the currency market.  

The parties to the currency future contracts fix the rate today while the actual payment or the delivery is made on the specified date in the future. There are two types of futures: Commodity Futures and Financial Futures. In commodity future, the contract is for the commodity such as cocoa or aluminum, while the financial futures refer to the future contract in financial instruments such as treasury bills, stock or currency. The investor has a choice to exchange his currency either in the spot market or the futures market. In the spot market, the currency is exchanged at the current rate and the payment is made right away, whereas, in the future market, the exchange rate is fixed today while the actual payment is made at the defined future date. The difference between the spot and the future market can be illustrated in the form of an equation given below:

Future Price/ (1+Risk-free rate of interest) = Spot price – Present value  of interest or dividend forgone

Where, the Spot price is the current exchange rate prevailing at the time the currencies are being exchanged, while the contract rate is the rate which has been locked at the time the parties agreed to the transaction. Through this formula, both the parties to the future contract decide whether they have incurred gains or suffered losses. Here also, the buyer hopes that the currency may appreciate while the seller expects that the currency will depreciate.

Difference Between Forward Contracts and Future Contracts

The Future Contracts are the standardized Forward Contracts wherein two parties mutually decide to sell or buy the underlying asset at a predefined future date and at a price locked today. These are considered as a less risky alternative of hedging against the currency market fluctuations.

If the future contracts are the forward contracts, then why it is considered as a separate tool of hedging? Well, these contracts do look alike but are different from each other. These differences are explained in the points given below:

1. The forward contract is a more customized contract wherein the terms are negotiated between the buyers and sellers, whereas the future contract is a standardized contract where, date, quantity, and delivery conditions are standardized.
2. The forward contracts have no secondary markets while the future contracts are traded on the organized exchange.
3. In the case of a forward contract, usually, no collateral is required, whereas, in the case of a future contract the margin is required.
4. The final settlement of the forward contracts is done on its maturity, whereas the future contracts are “marked to market” on a daily basis, which means the profits and losses of these contracts are settled daily.
5. The forward contracts often end with the deliveries, whereas the futures are mostly settled with the differences.

Risk Hedging with Swaps

A Swap is a financial agreement wherein the parties agree to trade cash flows over a period of time. It is the portfolio of a forward contract that involves multiple exchanges over a period of time while the forward contract involves a single transaction at a specific future date.

The swaps are the highly liquid financial derivatives and have the following distinct features:

• It involves the effective translation of fixed rate borrowing to the floating rate borrowing and vice-versa. The difference in the interest amount is either paid or received, as the case may be.
• It applies to both the new and the existing borrowings.
• In accounting, it is treated as an off-the-balance-sheet transaction.
• It is considered as a distinct contract from the underlying loan agreement.
• There is no exchange of principal repayment obligations.

The Swap contracts are a more flexible financial instrument and can be used in many situations.The two most common forms of swaps are Currency Swaps and Interest Rate Swaps. These two swaps can be combined in case the loan is in two currencies and needs to be swapped.

Currency Swaps: The currency swap includes the exchange of cash payments in one currency for the cash payments in another currency. Simply, in a currency swap contract, the principal, and interest in one currency is exchanged for the principal and interest in another currency. Thus, currency swap includes:

• Exchange of principal amounts
• Exchange of interest payments during the term of the loan
• Re-exchange of the principal amount at the maturity of the loan term.

Often, the international companies find difficult to raise foreign currency to make the investments in abroad and therefore, the currency swaps are used to overcome such problem.

For example, If an Indian company wants to make an investment in the US, but the US government regulations restrict the purchase of US dollars to make the investments. In such situation, the Indian company is allowed to lend rupees and borrow US dollars and to do so, it might find the company in the US that requires Indian rupee to invest in India and would lend rupee to that company and borrow US dollars in return.

Interest Rate Swaps: The interest rate swap contract includes the exchange of one stream of interest obligation for another. Simply, it is the form of transaction that allows the company to borrow capital at a fixed interest rate and exchange its interest payments with interest payment at a floating rate and vice-versa.

For example, A company has a 10 year fixed rate loan of Rs 50 Lacs carrying the interest rate of LIBOR plus 200 basis points. The principal amount is to be repaid at the end of 10 years. The company wants to convert its fixed rate obligation into the variable rate obligation. The company can either borrow a loan of Rs 50 Lacs on a floating rate basis and pay the fixed rate obligations of the earlier loan through its proceeds, but this method is quite expensive. Thus, a less expensive option would be to use the currency swaps, wherein the company can convert its fixed rate obligations to the floating rate obligations.

Risk Hedging with Options Contracts

An Option is an agreement wherein the seller grants the right to the buyer, not the obligation to buy or sell the security at a predetermined price for a specified period of time. Simply, An option is right and does not constitute the obligation on the part of both the sellers and buyers to buy or sell the underlying security at a predefined price during a specified period.

A foreign currency option is the most flexible derivative that helps in reducing the foreign exchange risk. Suppose, there is an Indian manufacturing company that import spares in bulk. The company expects the price of the spares to increase in the future. To tackle such situation the company may buy the options to lock in the price of spares today and take the final delivery on a specified future date. In order to buy the options, the company has to pay a premium to the option seller. In case, the price falls, then the buyer has the right to not to exercise his option and can buy the spares from the spot market.

Also, the options contracts on interest rates and commodities help the managers to manage the financial risk efficiently. Hence, the options provide protection against the risk and benefit from the changes in the currency or price.

Risk Hedging with Insurance

Many companies buy insurance to hedge against the different kinds of risks, such as the risk of property damage, risk of fire, risk of plant destruction, the risk of liabilities, etc

When a company buys the insurance, it pays a premium to shift the risks to the insurance company. Which insurance company the firm prefers over the others depends on the advantages and disadvantages offered by each. The main advantages are:

• It has the expertise to price the risk reasonably due to its considerable experience in the same field.
• It also has the experts who give advice on measures to reduce risks and may offer reasonable premium policies to the clients who follow their advice.
• Due to the specialization, the insurance company may provide low-cost claims administration service.
• It has the capacity to pool risks since it holds a large and diversified pool of assets.

As against the above advantages, there are following limitations:

1. The administrative cost is very high
2. Often, the insurance companies face the problem of adverse selection wherein it is difficult to distinguish between the good and bad risks.
3. The high loading cost, which represents the difference between the premium amount and the expected payoff from the insurance policy.

Thus, insurance is the most common form of hedging tool which companies use to protect themselves against the uncertain losses