Financial Hedging Techniques - Essay Example

Financial Hedging Techniques In financial accounting, hedging can be defined as a strategy for investment risk management (Brandt 2003: 120). Hedgingis used to offset or limit the probability of a loss occurring as a result of upheavals in the prices of goods, currencies, or securities. Hedging can be regarded as a form of risk transfer that does not include the purchase of an insurance policy. The investment risk can be hedged or reduced by using call options, put options, short selling or futures contracts. All these different hedging techniques are designed to enable an organization to reduce the volatility of a portfolio by reducing the risk of a loss. The approach to decreasing the possibility of a loss from an investment is usually undertaking an additional investment for purposes of upsetting loss in the future. As hedging minimizes the possibility of a loss occurring, it also minimizes the profit potential. Hedging Techniques Used by Large Firms A large firm or corporation is defined differently depending on the country and the industry under which it operates (Fonseca and Rustem 2012: 2530). For instance, a large firm in a developing country may be considered as a small firm or a medium one in a developed country. In addition, a large firm in the retail industry may be regarded as a small firm relatively to a large firm in mineral and mining industry within the same nation. Generally, the size of a firm is determined by considering different organizational aspects including the turnover, the amount of profits made, the number of employees and the number of countries in which it operates. Typically, a large firm employs thousands of employees and may operate in more than one country, have annual revenues more than billion dollars. Large companies also own huge valuable assets spread across different regions within or without a country. All large firms are also considered as autonomous legal entities. This means the owners have limited liabilities. Examples of large firms include Wal-Mart Inc, grocer J Sainsbury, Royal Dutch Shell, SABMiller, Toyota Motors Corporation and The Boeing Company. Every firm that accepts foreign currency as part of its payment or receipts faces currency risk. Currency risk can be defined as is a type of risk that emanates from the changes in the price of a currency against other currencies. Hedging techniques refers to the different strategies used by firms to minimize the risk on investment. The hedging techniques used vary from one organization to the other depending on the nature of the investment and the size of the company (Wang, Wu, and Yan 2015: 153). In fact, most large firms seem to utilize similar hedging techniques, while small firms also utilize almost similar strategies and hedging techniques. This happens as a result of the similarity in complexity and structure between firms of similar sizes. There are four major hedging techniques used by large firms include: options, forward, futures and money market hedging. Forward technique refers to a non-standardized contract arrangement between two parties to buy or dispose of an asset at a future on a pre-agreed price. Under forward contract (hedging technique), the buyer and seller of the asset in question assume long and short positions respectively. The buyer and the seller settle on a price known as the delivery price, which is basically similar to the forward price set when the contract commenced. In cases involving exchanges, it is usually the anticipation of the buyer that currency appreciates in the future whereas the seller prays that the currency depreciates in the near future. In a case where a company is bound to receive large volume of foreign currency as payments from its customers, the company has a high propensity to go ‘short’ because of a possible risk of currency depreciation. On the other hand, if the company expects to make payments to its suppliers in foreign currency, possible future currency depreciation is likely to make it go ‘long’ on the forward contract. For example, if Kantox Limited, a UK based firm, enters in agreement with a U.S. based supplier, the depreciation of the US. Dollars against sterling pound would make the company go long. Another hedging technique commonly used by large firms is money market. In this technique, money is viewed as a commodity, which makes money market an integral part of financial markets for assets of companies that aid short-term borrowing and lending (Khazeh 2006). Foreign currency exchange is a major part of money market, where firms exchange foreign currencies in future at a prearranged time. Firms usually finance their foreign exchange balances through foreign exchange swap, which is made up of spot and forward foreign exchange dealings executed at the same time thus offsetting. Upon settling of foreign exchange dealing, the holder remains with a positive position with regard to one currency, but negative on another. Firms usually close out their foreign balances and re-institute them the next day in order to pull together or pay overnight interest accrued on the balances through tom-next swaps. Also, firms use future contract, which entails an agreement between the buyer and the seller to trade a standardized asset for a specific price at a future date. The assets traded in some cases are not traditional ones, but financial instrument like currency or bonds among others. In the future contracts, the buyer of the assets goes long whereas the seller goes short in a similar way to forward contract. Many large firms also utilize currency option technique as their finance hedging method. Options method refers to a contract for the delivery of a currency in future to be exchanged for another currency (Khazeh 2006). The option holder has the right to purchase or sell the currency at a price agreed by the involved parties. The agreed price is also referred to as strike or exercise price. The holder’s right to purchase the currency is referred to as a call and the right to sell the currency is referred to as a put. The holder must pay a premium to acquire these rights. Hedging Techniques Used by Small Firms A small firm is also defined based on its physical size, number of employees, range of products and the amounts of profits made. Most small firms have a few hundred employees, several assets here and there and simple management structure (Ruf 2012: 300). The profits made range from several thousand dollars to several million dollars. Most of these small firms are family owned, partnerships or sole proprietorships. They utilize simple management as compared to elaborate and complex management structures utilized for large firms. Small firms or business mostly operate within one country. In Australia for example, a small firm is one which employees between 15 and fifty people. In the United States, for a firm to qualify as a small corporation, it has to employee not more than 500 employees. Small firms are the commonest organizations in most countries as they are easy to establish and run. Their operations and profitability mostly depend on the economic systems in operation. Most small firms make small investments due to the fact that they have limited access to investment capitals. As such, they also utilize less complex hedging techniques compared to large firms. Most small firms use futures and options as the preferred hedging technique. These hedging techniques are convenient for small firms due to the fact that they cover small niches that cannot be profitably covered by large corporations. A small business can also immensely benefit from internet marketing due to its ability to serve specialized market niches. As small businesses are not tied to any bureaucratic inertia, they are able to respond quickly to customer needs in the market. The proprietors of small businesses also tend to have intimate relations with their customers and this leads to greater accountability and maturity on the part of the proprietor. Small business should, however, guard against undercapitalization which is the leading cause of bankruptcy for small organizations. Options as a hedging technique are of two major types: put and call options (Wong 2011: 660). The put option or put is a device used in the stock market which gives the owner of the put, the right, but not the obligation, to sell the underlying asset at the strike price by a predetermined date which is also called the maturity or expiry date to a given party (Wong 2014). This hedging technique is common in stock exchange and is used to prevent the risk of stock prices depreciating below a specified price (Iron and Kifer 2011) This is possible because in case the prices go below a specified price of the put option, the owner has the right but not the obligation to sell his or her stock at the specified price. The seller of the put has the obligation to buy the asset at the strike price. The risk of loss is eliminated because even if the stock becomes worthless, the put buyer will receive at least the strike price specified. The call option relates to quantity bought as opposed to the price of the commodity and is also a common hedging strategy for small businesses. Futures contract is a hedging technique where the risk is eliminated by fixing the selling price today (Choi 2008: 308). The payment is, however, delivered on a future date. Futures are important hedging techniques as they mitigate risk of default by either party in the intervening period. In this regard, both parties to the bond have to make initial performance bond in form of cash. This is called a margin and can be set as a ratio of the futures contract. To guarantee that an agreement exists, the margin must be maintained throughout the life of the life of the contract. The performance bond (margin) is typically 5%-15% of the contract value. Futures contracts also minimize counterparty risks apart from credit risks. This is because futures trade is executed by a clearing house. The clearing house buys from the seller and sells to the buyer and assumes the risks related to buying and selling of the stock or the commodity under consideration. Similarities and Differences of these Techniques All the hedging techniques are similar in that they are all used to reduce the possibility of a risk occurring (Loss 2012: 90). These techniques can also be used to offset investment risks. Apart from reducing risks, hedging techniques also reduce the profitability potential of a business. Additionally, all hedging processes are expensive. In this regard, extensive hedging may not be sustainable or desirable for any organization. Hedging can be cost effective only when it is used sparingly and for major investments. Most investors who opt to use any hedging technique would likely spend all of his or her investment profits. This is a major concern because hedging as a process is not in itself profitable. It only helps to reduce or eliminate losses from an investment. Finally, most hedging techniques rely on the creation of a long term contract between two traders. The contracts must be maintained throughout if hedging is to be effective. Both future and forward contracts permit the buying and selling of assets a future date at a pre-agreed price. Different hedging techniques, however, vary in terms of efficiency, cost and application (Wong 2011: 950). Futures contracts are standardized contract whereas forward contracts are flexible private arrangement between transacting parties. Options differs from futures in that accords the buyer the right, not obligation to purchase or sell an asset whereas futures obligates the buyer to purchase and asset and the seller to sell in the future at a pre-0determined price. Futures contracts are more effective compared to options or ETFs because they eliminate different kinds of risk as opposed to credit risks only. While forward and future contract techniques may be similar in some aspects, forward lacks interim partial settlements unlike future contracts. Most other hedging techniques specialize or eliminating or offsetting credit risks by establishing an alternative investment. As far as futures contracts are concerned, clearing margins ensure that companies honour their contracts with their clients while customer margin illustrates customer commitment and pledge to honour the contract. Conclusion Hedging is a very popular practice in the current business world. Hedging has been used for many years to reduce the possibility of a loss or to offset losses. Today, with new technologies and increased knowledge, hedging processes have been transformed in complexity to become even more appropriate for modern times and circumstances. Almost all hedging process is expensive undertakings and should, therefore, be used only sparingly, preferably for extremely risky undertakings. It is also important for individuals and organizations to recognize and appreciate the fact that high risk is associated with likelihood for profitability. In this regard, organizations should not be afraid to take risks because some risky undertakings can result in hefty benefits. Although hedging is used side by side with investment to reduce the risk of losing invested amount, the most appropriate hedging technique of all time would appear to be to avoid the investment undertaking. The organization or individual should, therefore conduct a sufficient analysis of the investment and the benefits, both in the short term and in the long term of the investment. Hedging should be used preferably for risky investments which have the potential of bringing about long term benefits. Bibliography Brandt, M. (2003) Hedging Demands In Hedging Contingent Claims. Review of Economics and Statistics 85 (1), 119-140 Choi , M. (2008) Currency Risks Hedging For Major And Minor Currencies: Constant Hedging Versus Speculative Hedging. Applied Economics Letters 17 (3), 305-311 Iron, Y. and Kifer, Y. (2011) Hedging Of Swing Game Options In Continuous Time. Stochastics: An International Journal of Probability and Stochastic Processes 83 (4-6), 365-404 Fonseca, R. and Rustem, B. (2012) Robust Hedging Strategies. Computers & Operations Research 39 (11), 2528-2536 Khazeh K., and Winder, R.C., (2006) ‘Hedging Transaction Exposure through Options and Money Markets: Empirical Findings’. Multinational Business Review, 14(1), 79 - 92 Loss, F. (2012) Optimal Hedging Strategies And Interactions Between Firms.Journal of Economics & Management Strategy 21 (1), 79-129 Ruf, J. (2012) HEDGING UNDER ARBITRAGE. Mathematical Finance 23 (2), 297-317 Wang, Y., Wu, C., and Yang, L. (2015) Hedging With Futures: Does Anything Beat The Naïve Hedging Strategy?. Management Science 150123053710000 Wong, K. (2011) Production And Hedging Under State-Dependent Preferences. J. Fut. Mark. 32 (10), 945-963 Wong, K. (2014) Ambiguity And The Value Of Hedging. Journal of Futures Markets DOI: 10.1002/fut.21678. Read More