Hedging Techniques Used by Large Firms - Essay Example

International Finance Contents Introduction 3 Answer 4 Hedging Techniques Used By Large Firms 4 Forwards 4 Futures 5 Options 6 Answer 2 7 Hedging Techniques Used By Small Firms. 7 Natural Hedging 7 Money Market Hedge 8 Forward Contract 8 Answer 3 9 Similarities and Differences in the Use of Hedging Techniques 9 Conclusion 10 References 11 Introduction Wealth is maximised by investment and not savings. Retail and wholesale investors put their money in various financial instruments to grow their wealth. With any investment decision, there is risk associated with it. This is the price the investors pay for their investments, if there is a possible downside. Though there are various investment options to reduce the risk outcome, investors always look for adopting strategies that will reduce the risk with low cost. The use of such strategies is known as hedging. Hedging means to insure against an anticipated loss. Though the negative event cannot be avoided, but the impact can be reduced. There are two types of risks vis-a-vis systematic and unsystematic risk. Investors usually hedge against systematic risk which includes financial risk, operational risk, liquidity risk, financing risk, currency risk, etc. Answer 1 Hedging Techniques Used By Large Firms According to the authors Clark and Ghosh, large firms usually balance their hedging techniques so as to minimise the cost of hedging. Corporate managers try to identify the risks facing the company so that they can strategise a suitable hedging technique to counter the effect of those risks. Big corporations are quite concerned with the foreign exchange risk, owing to their global business exposure. The author also stated that, the large corporations have global presence and trade across nations, thus vulnerable to currency risk as they have to trade in the local currency (Clark and Ghosh, 2004). Though there are various hedging techniques like futures, forwards, options, swaps and debt, but big corporations usually trade in futures, forwards, options and debt (Homaifar, 2004). Forwards As per the author Coyle, companies enter into an agreement with other party willing to buy/ sell currency. It is in the form of an agreement, where one party agrees to buy/ sell a specified amount of the currency at an agreed price, at an agreed time, delivery method to another party. Forwards trade takes place in two ways i.e. the spot market where the delivery takes place after T+2 days and the forward market where the price and other conditions are set before the delivery. The delivery takes place at a future date. In forwards contract companies usually face the counterparty risk, where one of the party refuses to buy/sell the derivative, thus putting the hedger at risk (Coyle, 2000). Example: X is an IT company that exports software services to Y, a company in the US. X expects a payment of $1 million after five months. Assuming the exchange rate is £1/$, it will receive £1 million at the end of five months. If during the period the exchange rate falls to £.5/$, its income drops by £.5 million and vice versa, resulting in exchange risk. In order to minimise the risk X can enter into a forward contract to sell $1 million at the end of five months at £1/$, thus mitigating its loss in case of exchange rate fluctuations. Forwards contract often fail as either of the party refuses to buy/sell the derivative at the agreed price, thus indicating high cost to the hedger. Futures The authors Hull, Treepongkaruna, Colwell, Heaney and Pitt states that, futures is quite like forwards, with subtle differences in quantity, price and place of trade. Futures usually have small quantities and are traded on stock exchanges like SIMEX in Singapore and LIFFE in London. Most big companies hedge their risk by trading in future derivatives. The underlying of the derivative is usually an asset like shares, currency, etc. Futures unlike forwards face no default risk, where either of the party fails to buy/sell (Hull, Treepongkaruna, Colwell, Heaney, Pitt, 2013). Example: Let us assume X is a UK based company, which bought 1 lot ($50000) dollar December at £1/$. If the exchange rate moves up i.e. dollar moves up to £1.5/$ by December, it gains as it receives dollar at £1/$ and if dollar would depreciate to £.5/$, then it would lose money as it could purchase dollar from the open market at a lesser price. Hedgers are protected as it involves the stock exchange that is regulated by the respective authority, thus waiving any kind of default risk bearing on the trade. Options According to the author Coyle, options are like futures and forwards, but it gives the party/ company engaged in the trade an option to buy (Call option) and sell (Put option). In other words it gives the investor the right and does not create any obligation to exercise the right. It is also a kind of financial derivative that has an underlying asset like stocks, indices, currencies etc and is also traded in the stock exchange and regulated by respective authority (Coyle, 2000). Example: Let us say that company X bought a December £1/$ call option for £50. The option basket comprises $50000, thus the full value of the trade would be £50000 and the option price is £50. Usually a call option is purchased anticipating an increase in the price of the underlying and vice versa, before the maturity date. It has no binding the hedger as it only confers the right to sell/ buy and not any obligation to do it. Though such hedging techniques are used to reduce the effects of risk, it may be subject to inherent risk as all such derivatives have an underlying asset, which may be subject to market risk. Though forwards contract is highly illiquid, futures and options are highly liquid as they are traded on the exchange. Answer 2 Hedging Techniques Used By Small Firms. The authors Rheinlander and Sexton are of the opinion that, there is a significant difference in the hedging technique used by small companies. They have limited in house resources to study various risks and hedge it accordingly. Moreover, they have limited exposure to exchange risk, owing to their business boundary. They lack the expertise of the big companies to trade in risky derivatives like futures and options; rather they use natural hedging techniques and forward contract to limit their risk exposure (Rheinlander and Sexton, 2011). Natural Hedging The authors Rheinlander and Sexton also state that, natural hedging is a simple way to reduce the impacts of exchange rate risk. Let us take an example of a situation where X is UK based company and Y is a US based company. X exports equipments to US and receives dollars as payment. Rather going for complicating derivative products, it parks its payment in a USD account and does not convert it in pounds. Now if X requires importing inputs for its business from US, it uses the amount in its USD account to pay for its inputs, thus it saves the costs associated with hedging in derivative products. Though such technique limits the fund availability for business operations, yet it offers simple solution to foreign exchange rate fluctuations (Rheinlander and Sexton, 2011). Money Market Hedge As per the authors Kenneth, Phillips and Surz, small companies have limited foreign trade comprising small trade amount, it does not engage in hedging techniques that will increase its overall cost, coupled with risk exposure of the underlying asset. SME’s have limited resources compelling them to hedge in low risk bearing assets. Money market hedge is a simple tool often used by SME’s to hedge exchange risk. It has no underlying assets and leverages the market interest rate to that of the loan interest rate. Under money market hedge, companies usually take a loan in foreign currency at present value, so that the interest payable and the principal equal the payment it expects in foreign currency. The loan amount is then converted in local currency at the spot exchange and invested in domestic market at the existing rate. Now, when the company receives its payment in foreign currency, it uses this amount to pay off its loan along with the interest amount. Thus recovering its interest cost, from its interest income, from the invested loan amount. Though it eliminates any kind of risks associated with underlying assets, still it may face interest rate risk i.e. higher cost of borrowing (Kenneth, Phillips and Surz, 2003). Forward Contract Owing to its simplicity and low risk bearing, SME’s at time prefer to hedge exchange rate fluctuations through forward contracts. Forward contract eliminates the risk of underlying assets or market risk, but there are chances of default risk. A forward contract is not binding on either of the parties entered in the agreement, as such trades are unregulated. It is merely a promise to pay or receive a certain amount at a specified rate (exchange rate), on a specified date as agreed upon by the parties to the contract. The parties to the contract may be companies, individuals, etc. It is a low cost technique to hedge exchange rate risk. SME’s enjoy the flexibility in quantity of forward contract, as there are no small denominations like in futures and options, Answer 3 Similarities and Differences in the Use of Hedging Techniques Large and small companies at times use similar techniques to hedge foreign exchange rate risk. Usually they employ different methods to mitigate risks, owing to their structural differences, business volume, and market coverage, lack of resources, skill and expertise. Large companies hedge its various risks, including its exchange rate risk by investing in derivatives like futures, options and swaps. They have the resource and in house teams working on risk hedging, thus invest in complex derivatives like options to be risk averse. SME’s hedge, using forward contract due to its flexibility and low market as well as interest rate risk. Companies irrespective of their size, invest in derivative to hedge risks. The nature of risk determines the use of various hedging techniques i.e. liquidity, financing, operational and market (Chew, 2013). The differences observed in the hedging techniques employed to counter the effect of exchange rate risk are mainly due to high costs associated with the derivative products. SME’s look to mitigate risks by employing techniques that has low risk and low cost like natural hedging and money market hedging. Large companies employ hedging techniques that have high liquidity like futures, options and swaps as they are traded on stock exchanges. Large companies need substantial working capital for its short term solvency; hence they trade in such derivatives that can be easily converted into cash. Large companies invest substantial amount in derivatives whereas small firms invest less in such asset class. The trade volume is another distinctive factor for which companies use different hedging tools. Inherent complexities and lack of expertise in derivative market limits the small companies leverage to engage in other hedging tools (Homaifar, 2004). Conclusion Risk is an inherent part of any investment. Companies look to mitigate the impact of risk by employing its resources in various financial instruments to protect itself from the exposure of such risks. Companies cannot hedge unsystematic risk, but hedges systematic risk. Owing to globalization the volume of foreign trade has risen over the years, so has the risk factors. Companies engaged in foreign trade are exposed to exchange rate risk, as they make / receive payments in foreign currency. Such risks arise mainly because of the demand supply mismatch. Dollar has now become the standard currency for trade across nations, as it is accepted by various companies. Hedging itself is considered to be risky, thus, companies try to maintain its earnings or minimise the impact of such foreign exchange fluctuation, which might reduce the earning potential of the companies. References Chew, H., D., 2013. Corporate Risk Management. New York: Columbia University Press. Clark, E., Ghosh, K., D., 2004. Arbitrage, Hedging, and Speculation: The Foreign Exchange Market. USA: Greenwood Publishing Group. Coyle, B., 2000. Hedging Currency Exposures. Kent: Global Professional Publishing. Homaifar, G., 2004. Managing Global Financial and Foreign Exchange Rate Risk. Hoboken: John Wiley & Sons. Hull, J., Treepongkaruna, S., Colwell, D., Heaney, R., Pitt, D., 2013. Fundamentals of Futures and options markets. Australia: Pearson Higher Education AU. Kenneth S. Phillips, S., K., Surz, J., K., 2003. Hedge Funds: Definitive Strategies and Techniques. Hoboken: John Wiley & Sons. Rheinlander, T., Sexton, T., 2011. Hedging Derivatives. Singapore: World Scientific. Read More