Financial Hedging and Its Instruments - Research Paper Example

Financial Hedging and Its Instruments Table of Contents Introduction 2 Hedging Instruments 2 Analysis 6 TESCO Plc 6 Balfour Beatty 8 GlaxoSmithKline (GSK) 12 Advantage and Disadvantages 12 Issues 15 Personal View 15 Conclusion 16 Reference 16 Bibliography 19 Introduction Financial hedging refers to the process of reducing or cancelling the unwanted business risk while still allowing the business to fetch profit from the investment activities. “It is a fundamental insight that, under uncertainty, risk-averse decision-makers will prefer stable income and consumption streams to highly variable ones. Under the assumption of risk aversion, a decision maker’s utility will therefore be higher, given that he is able to stabilise income or consumption streams” (Fender, “Derivatives, risk management and monetary transmission”). This report evaluates the financial instruments in the light of risk management system of three different companies. A personal view has been given after the analysis part. However, there have been certain constraints while conducting the analysis, as companies do not prefer to reveal much about their positions in hedging instruments. Hedging Instruments The financial crisis of the 1990s created enormous disruption and imposed huge costs of lost output in a number of emerging market economies. The crisis was particularly painful as local organisations had to face large exchange rate or interest rate risk with insufficient hedging possibilities. At this time, as the market was quite illiquid, even the massive undervaluation of assets was unable to attract foreign investors. This was the consequence of the companies’ inability to hedge certain types of market risks. As a consequence, the prospective benefits of global financial market integration were not fully exploited. However, over the past few years, the markets for hedging have expanded in size and scope. The establishment of bond and spot foreign exchange markets and derivative products has helped to enhance the hedging processes. The ever growing significance of the hedging instruments have been established by the fact that trading activities in the futures market on cash instruments have been larger than the conducts in the underlying cash market. These days a number of instruments have been used to hedge the assets and commodity price risks. However, the fundamental structures of these instruments are kept almost same across all financial markets (Mathieson, “Development of Market Based Hedging Instruments”). Many organisations buy insurance against a wide range of hazards on their assets. By purchasing insurance, the companies pass on the risk to the insurance company; this is done for certain amount of insurance premium. However the risks, covered by these kinds of financial instruments, have less probability of occurrence as compared to other financial risks. However, organisations may incur a huge loss if the assets are affected by these kinds of hazards. The most useful financial hedging instruments have been the derivatives. These are the financial instruments whose values are derived from other underlying assets. This means that the values of the derivatives are very much dependent on the price of the underlying assets. Derivatives can take a number of forms with a range of risk return trade off equations. Some of the significant derivative instruments are futures, forward contracts, swaps and options. Forward and Future Contracts Forward contract is an agreement to buy or sell a pre-specified amount of underlying asset at a specific price at a certain future date. The involved parties may take either long or short position in the contracts. The long position holder agrees to buy the underlying asset at some specific future date, while the person taking a short position would agree to sell off the same at some pre-specified date. The involved parties would negotiate regarding all the attributes such as quantity, delivery date and price of the underlying assets. The forward contracts are traded outside the exchanges, over the counter. Each of these contracts is customised according to the parties, involved in the contract. Due to this customisation, these kinds of contracts lack liquidity. Moreover, there are certain pitfalls of these kinds of derivatives. Future contracts are almost similar to the forward contracts. However, these are exchanges traded and standardised with standard underlying assets, standard quantity, quality and a standard time of delivery. Future contracts actually emerged to resolve the issues of illiquidity, counter party risks prevailing in the OTC market. A majority portion of the future traders offset their positions by entering equal and opposite transaction. Options A future contract is based on a transaction which is supposed to be settled in future at some specific conditions set today. “An option is a contingent futures contract, that is to say the conclusion today of a transaction that could develop in various ways according to various outcomes on the result of which the transaction depends” (Bouleau & Thomas, “The Unexpected Connection”). The holder of an option gets an opportunity to exercise his or her rights to buy or sell an asset at a pre-specified date for a specific price. Although, the holders enjoy their rights; but they do not have any obligation to exercise their rights. Fundamentally, there are mainly two types of options: call and put options. A call option offers the holder the right but not the obligation to buy an asset, while put option gives the opportunity to sell off an asset. There are certain other types of options such as straddle, collar, strangle and butterfly, which is seen as a combination of both the call and put options. Swaps Swaps are also customised instruments between two parties who can exchange cash flow stream according to the pre-specified arrangements. “A swap is a contract in which the parties agree to a stream of payments determined with reference to the price of an asset over time” (Saxena & Villar, p.72). There are two fundamental types of swaps which are mostly used by the organisations: Interest rate swaps and currency swaps. Interest rate swaps enables the traders to swap the cash flow stream based on the underlying interest rate. Currency swap entails the involved parties to swap off both the principle and the interest amount in different countries. The swap market is one of the major derivatives markets which have been experiencing rapid growth rate. Equity swap is another important financial instrument which has been used in hedging. In the swap agreements, the involved party is expected to get dollar amount at a fixed rate while the cash inflow of the other would be based on floating rate. Credit Derivatives In the recent years, it has been noticed that there has been a considerable growth in the credit derivative instruments. By buying the credit derivatives, the buyers of the financial instruments buy protection against the counterparty risk. These types of derivatives are very much complex in nature. Analysis This segment includes the hedging of three companies operating in three different industries. Tesco Plc, Balfour Beatty and GlaxoSmithKline are the three leading companies in their respective industries. All of these companies are deliberately chosen as all they have operations spread globally. TESCO Plc The main financial risks faced by Tesco group relate more to fluctuations in interest and foreign exchange rate. These risks mostly arise from the risk of default by counterparties, financial transactions and availability of funds to meet the required business needs. Hedging Interest Rate Risk The objective of this group is to limit the company’s exposure to raise the interest rates while retaining the opportunity to fetch benefits from interest rate reductions. The company uses a number of financial instruments to manage the interest rate risk, inherent to the business. These instruments include forward rate agreements, interest rate swaps, caps and floors are used to accomplish desired mix of fixed and floating rate debt. The company has a policy to fix or cap a minimum of 40 % of actual and projected debt interest costs of the group. At the year end of 2009, £6, 3 billion of debt has been in the fixed rate form. Moreover, further £0.7 billion of debt was capped or collared. Eventually, 72 % of the company’s debt amount has been fixed, capped or collared. The rest of the debt has been taken on floating rates. The group’s objective is to maintain a low cost of borrowing on their foreign exchange transactions. In the year 2009, currency movement has raised the net value of the Group’s overseas assets by £ 480 million. The group translates the overseas profits, which it does not currently seek to hedge, at average foreign exchange rates. Hedging Foreign Currency Risk The principal objective of the company in this segment is to reduce the effect of exchange rate precariousness on short term profits. The group hedges transactional currency exposures which could significantly put an impact on the group’s income statement by purchasing forwards, sales of foreign currencies and currency options. Majority of the group’s investments in the international subsidiaries are hedged by foreign exchange transactions in matching currencies. Hedging Credit Risk The credit risk management is to reduce the risk of loss emerging from default in the financial transactions across an approved list of counterparties with high credit quality. The group hedges its position with its counterparties. To reduce the counterparty default risk the credit ratings of the counter-parties are routinely monitored. Insurance Tesco purchases assets, earnings and ‘Combined Liability’ protection from the open insurance market. These insurances are taken at ‘catastrophe’ level only. The risk, which has not been transferred to the insurance market, is kept within the business group by using captive insurance companies such as Tesco Insurance Limited in Guernsey and Valiant Insurance Company Limited in the Republic of Ireland. Tesco Insurance Limited covers Assets and Earnings, while Valiant Insurance Company Limited covers Combined Liability (TESCO, “Risk Management”). Balfour Beatty Foreign Currency Risk Management The group operates globally and hence, is exposed to foreign exchange risks emerging from exposures in various currencies such as US dollars, Australian dollars, the Euro and Hong Kong dollars. Foreign exchange risks for the company emerge from future trading transactions, assets and liabilities and net investments in the foreign transactions. The group has a policy which demands its group companies to deal with the transactional foreign exchange risk against the functional currencies. Balfour Beatty treasure enters into forward contracts on behalf of those operating companies to fully hedge the foreign exchange risk over the pre set materiality level which has already been determined by the Financial Director. This is done in the wake of any position exposed to present or future foreign currency risk. As at the end of December, 2009, the group has entered designated forward exchange contracts against the prospective capital expenditure and inventory sales, expected to occur in the next years. The notional principal amount of the same is expected to come around £ 23 m and is considered to fall under cash flow hedging. The group has taken fair values loss of £ 2 m to the hedging reserves related to these forward contracts. At the year end, the cumulative amount in the hedging reserves related to the cash flow hedges is nil. However, in the past year, the company had been able to keep a hedging reserve with £ 2 m gain. The group’s investments in its foreign operations are exposed to foreign currency exchange rate risk. This risk is principally managed by forward foreign currency contracts by matching significant net assets denominated in the currencies other than Sterling. Balfour Beatty reviews its hedging policies periodically. In the year 2008 and 2009, the management has amended the policy to reduce the net assets level which is required to be hedged. The decision has been done considering the potential cash effect of the hedging programme against the potential impact of movements in the currencies. At the end of 2008, around 45 % of the net assets denominated with US dollar were hedged. Hedging Interest Rate Risk The group has been involved in various PPP projects. Balfour Beatty has been borrowing funds for their PPP concessions. The funds are borrowed at both floating and fixed interest rates and are available for sale financial assets. Hence, the interest risk emerges from such borrowings of the group. During the last two years, a major portion of group’s PPP borrowings is borrowed at variable rates of interest which has been dominated in Sterling. The notional principal amount of the outstanding PPP subsidiaries’ interest rate swaps outstanding at 31 December 2009 amounted to £ 269 m. These swaps are with maturities that match the maturity of the underlying borrowings, the duration of which ranges from one year to 25 years. At the end of the year, the fixed interest rates range from 4.5 % to 5.1 % and the principal floating rates are LIBOR. A 50 basis point decrease or increase in the interest rate of each of the currencies in which the financial instruments are held would lead to a £ 12 m decrease or increase in the amounts considered directly by the group as equity. The interest rate risk also emerges on the cash and cash equivalents, term deposits and non PPP borrowings of the group. A 50 basis point increase or decrease in the interest rate of each of the currencies in which financial instruments are held would lead to £ 2 m increase or decrease in the net investment income of the group (Balfour Beatty, “Principal Risks and Risk Management”). Commodity Price Risk Management In the normal operations of the group, Balfour Beatty is exposed to the commodity price risk. Last year, the group has entered into a number of commodity hedge contracts to manage the group’s exposure to the fuel prices. The value of the hedged fuel price amounted to £ 3 m. There is a high probability that there would be future fuel purchases in the years 2010 and 2011. In the wake of this forecast, the commodity hedge contracts have been designated as cash flow hedging. At the end of December 2009, the fuel hedge contracts had a fair value of nil. This reflects that in the present or past periods, no gains or losses have been realised in respect to these contracts, neither in the statement of comprehensive income in respect to the effective portion of the hedge nor in the financial performance statement in respect of ineffectiveness. Hedging Price Risk Almost the entire price risk exposure of this group emerges from the PP concessions, it has been involved in. At the commencement of the deal, a component of the unitary payment made by the client is expected to cancel or offset the impact of inflation on the cost of concession. This is done by indexing the payment of the clients. The extent of risk exposure is quite equivalent to the extent by which the inflation differs from the index used. Credit Risk Credit risk arises from the probability that the counterparties will default on the obligations resulting in financial loss. The group is exposed to a number of credit risks while dealing in cash and cash equivalents and derivative financial instruments. Credit exposure of the customers can result in the credit risk of the group including outstanding receivables and committed future transactions. However, the group has a policy to evaluate the credit worthiness of potential customers prior to entering a transaction. For the cash and cash equivalents, derivative instruments the group usually deposits funds only with the counterparties, which are independently rated as minimum long term credit rating of A. At the end of December, derivatives instruments worth of £27 m did not meet this criterion due to exceptional decline in the general credit ratings for all the companies. Moreover the group had to face operational and relational difficulties in transferring certain balances. No potential loss has been expected from the counterparty defaults. The credit rating of the financial institution is usually considered to determine the amount of duration for each investment set under individual risk limit. The utilisation of these credit limits are regularly monitored by the management. At the end of December, £ 27 m could not meet certain policies due to operational and economic reasons. The group’s customers are significant as they are public or quasi public sector entities with high credit ratings. Due to the high quality nature of the customers, the credit risk for the company from the customer perspective is quite low. The maximum exposure to credit risk which also includes the value of the financial assets is calculated as net of any allowance for losses. GlaxoSmithKline (GSK) GSK has its operations spread worldwide. As a result, the company is exposed to a number of financial risks such as credit risk, interest rate risk and exchange rate risks. GSK held derivative financial instruments which amounted to a fair value of £ 168 million. These are mostly related to hedging exchange on translation of currency assets on consolidation. However in the year 2008, the derivatives value was almost 5 times the value of the instruments in the year 2009. The company uses interest rate swaps to reduce or remove the company’s exposure to volatile interest rates. The duration of the swap agreements match the duration of the principal instruments. The company does not hedge its foreign currency transactions emerging out of internal and external trade flows. The company has estimated its maximum credit risk to be around £ 13,434 m. However, the company monitors its risk management on a regular basis (GSK, “Financial Instruments and Related Disclosures”). Advantage and Disadvantages Short and Ultra-short ETFs The advantage of short ETF is that it gives return provided the value of the underlying index goes down. The ETFs provide an equivalent gain against the drop in the values of the index. Moreover, these ETFs provide a ‘floor’ restraining the potential loss of the investors. Ultra short ETFs are more like the short ETFs. An ultra short ETF allows the investors to double their returns. A significant disadvantage of all these short ETFs is that they are not good investment decisions for traders with a buy and hold strategy, as most markets are expected to increase in the long run. The disadvantage of the short and ultra short ETFs is that the upside potential gains are quite limited. Forwards and Futures Forward contracts are bilateral contracts and hence, are exposed to counterparty default risk. Another issue with these kinds of contracts is that if one of the parties wants to reverse the contract, he or she has to deal with the same counterparty. This is expected to result in high transaction cost. However, the market for forward instruments has changed. Before 1980s, one of the oldest financial hedging instruments which had been traded over the counter market (OTC) is forward contract. As of now, in certain markets, the picture has changed. The forward contracts are found to be traded as an exchange traded instrument (Mathieson, “Use of Market Based Interest Rate Hedging by Indebted Developing Countries”). Some of these forward contracts have been standardised, such as in case of foreign exchange. As the liquidity and transaction volume of the instruments have increased, the transactional cost has gradually decreased for the forward instruments. The future contracts are standardised contracts. Hence, there is enough liquidity in the trading of these financial instruments. These contracts give the traders the ability to control a large amount of money with small amount of capital. “Liquid markets easily match a buyer with a seller, enabling traders to quickly transact their business at a fair price” (Chicago Board Of Trade, “Liquidity”). As the future contracts are very much liquid in nature, it becomes easier for the traders to find counterparties for their contracts. Financial integrity and transparency can be attained by trading the futures contracts. Options Options are mostly traded over the counter market. However, these are also traded in the organised markets where the relationship between supply and demand is continuously monitored and the trading is done at a low transaction cost. Such markets have been in existence since the very beginning. However, in the last thirty years there has been an exceptional growth in these organised markets for derivatives. Swaps These financial instruments are traded over the counter and so the traders are required to deal with counterparty risk, since one of the parties may fail to perform his or her obligations. However, with the diversification of counterparties, the traders can remove or reduce the inherent counterparty risk in the swap agreements. Issues There are certain issues with these instruments. Over the counter derivatives are not much liquid as they are customised according to the negotiation between the two parties. Exchange traded derivatives such as futures have solved this issue of illiquidity. Introduction of the exchanges has made it possible to enhance the financial integration among these instruments. However, still most of these derivatives are traded over the counter, where the counterparty risk is quite high. The recent recession has proved that even credit derivatives can fail to give enough protection to the involved parties. That is why organisations must use derivatives to hedge the risk. However, the market as well as the position is required to be monitored regularly. Personal View All of the above mentioned companies have their operations spread in more than one countries. It has been found that most of these companies are mostly exposed to credit risk, interest rate risk, foreign exchange risk and liquidity risk. Companies use a number of financial instruments such as swaps, options, forwards and futures to hedge these risks. Interest rate swaps have been a favourite instrument for companies wanting to hedge the interest rate risks. Two of the companies have been using currency swaps and forward contracts on currencies to hedge the exchange rate risks. However, it has been noticed that companies have controlled the use of derivatives to hedge the financial risks. Rather, they would like to prevent the risk by regular monitoring of their risk management system. The companies are using monitoring and control more than financial instruments. Conclusion Hedging, which enables the investors to increase the expected utility via investment diversification is much in vogue among the risk-averse investors. However, in recent days, competitive business environment has made business institutions prone to risk. In the wake of recent financial downturn, the existing pitfalls in the global financial system have come into light more prominently than ever. Moreover, as more and more companies are going global and operations are becoming more complex in nature; companies are finding it more difficult to deal with the risks inherent in business. Organisations are exposed to a wide range of risks such as credit risk, market risk and operational risk. As a consequence, ‘hedging’ has become an integral part of the organisational strategic management. Reference Balfour Beatty. “Principal Risks and Risk Management”. 2009. Delivering Long Term Growth. November 11, 2010. < http://www.investis.com/bby/investors/reports/2010rep/ar2009/ar2009.pdf>. Bouleau, N. & Thomas, A. Financial Markets and Martingales: Observations on Science and Speculation. Wales, UK: Springer, 1999. Chicago Board of Trade. 2004. CBOT:Trading In Futures–An Introduction. November 11, 2010. . Fender, I. “Derivatives, risk management and monetary transmission”. November, 2000. BIS Working Papers, 94. November 11, 2010. < http://www.bis.org/publ/work94.pdf>. GSK. “Financial Instruments and Related Disclosures”. 2009. “GSK is Changing”. November 11, 2010. < http://www.gsk.com/investors/reps09/GSK-Report-2009-full.pdf>. Mathieson, J., D. Managing Financial Risks in Indebted Developing Countries. Washington, DC: International Monetary Fund, 1989. Saxena, S. & Villar, A. 2008. Financial globalisation and emerging market capital flows. BIS Papers, 44.November 11, 2010. < http://www.bis.org/list/bispapers/index.htm>. TESCO. “Risk Management”. 2009. Annual Report 2009. November 11, 2010. < http://www.investis.com/tesco/pdf/repp2009.pdf>. Bibliography Brealey, R., Myers, S., Franklin,A. & Mohanty, P. Principles of Corporate Finance. New York, NY: McGraw-Hill, 2008. Jorion, P. Financial Risk Manager Handbook. New Jersey, US: John Wiley & Sons, 2007. Mongelli, P., F. 2008. European Economic and Monetary Integration and the Optimum Currency Area Theory. Economic Papers, 302. Oracle ThinkQuest. No Date. Advantages & Disadvantages. 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