Hedging Techniques Adopted by Large Corporations - Essay Example

Finance and accounting Introduction The global financial markets have experienced a number of challenges over the past few decades. The main reasonsbehind these challenges are increased volatility in exchange rates, interest rates and commodity prices (Giddy, 2009). The prices of the commodities have also encountered rapid fluctuation due to various economic factors. The commodities are usually traded in exchanges and prices are not set by an entity or individual. The underlying assets or commodities are traded with the help of derivatives, which helps in hedging the risk of losing any amount that is caused by fluctuations in prices as a result of interest rate and exchange rates. Large corporations employ the derivatives in order to hedge the risk that is related to foreign transactions. Hence, the derivatives can be stated as the financial instruments that are exchanged between two parties, who are involved in the trade (Wells, 2011). The value of financial instruments is derived from the underlying prices of the assets or even the interest rates. The derivatives not only help the corporations to hedge the risk related to the transaction but it also safeguard the value of the assets for future use. There are basically four types of derivatives that are used by the large corporations for hedging risks associated with any transactions or assets. The financial instruments are future contract, forward contract, option contract and swaps. The underlying assets take into account interest rates, exchange rates, commodities, stock indices and bond indices. The derivatives are basically used for trading in interlinked markets such as exchanges that are present in both international and national level (Wells, 2011; Giddy, 2009). Hedging techniques adopted by large corporations Trading in each pair of currencies takes into account two parts such as the spot market and forward market. The spot market is the place where the payments are made in the second business day. The forward market rate is the price of the foreign currency, which is set and agreed upon in the actual exchange. In the forward market, the delivery will take place at a specific date in future (Giddy, 2009). Forward contract Forward contract is the best derivative which is used for hedging the risk that is associated with the transactions that are denominated in the foreign currencies. The contracts are not standardized products and they are generally traded in over-the-counter (OTC) (Giddy, 2009). The main advantage of the contracts that it can be tailored according to the requirement of the contract holders. There are generally two persons in the contract, where the sellers and buyers are responsible for executing the transactions at a date that is predetermined during the preparation of the contract (Liew, 2008). However, the buyer is liable to make the payment on that date when the asset is delivered. It can be stated that the contract price is determined at the inception level due to which the value of the asset become zero to the sellers and buyers. However, it is observed that the asset value keeps on changing over a period of time. Here, the forward contract plays a pivotal role in mitigating those risks that are associated with the change in asset price. The price change brings benefit to one party while the other is bound to suffer. The property makes a zero-sum game for the parties in the contract (Giddy, 2009). The main features of forward contract are discussed henceforth. They are known to be bilateral contracts, which are generally exposed to the counter-party risk. The contracts can be customized in a manner for satisfying the needs of contract holders. The price of contract is not quoted in publicly (Giddy, 2009; Wells, 2011). Example: The most renowned and famous name in the history of derivatives is the Morgan Stanley, which is known to be the forward contract merchant (Wells, 2011). Two types of participants in the forward contract market are described henceforth, which are speculators and hedgers. The hedgers aim at stabilizing the revenue or cost and do not seek to earn profit from the business operation. The losses or gains incurred in the transaction are offset to a specific degree in the market for underlying assets. The speculators on the other hand are interested to possess the underlying assets. They bet on the prices that may rise in future. In this transaction they seek to earn profit. The hedgers are interested with the forward contract than the speculators (Lavino, 2007; Malkiel and Saha, 2009; Liang, 2007). Future contract The future contract is usually traded in exchanges, where the contracts are settled at the end of the trading days. It is traded in the market-to-market daily and this option reduces the default risk to a great extent. The seller and buyer of the contract have to deliver the bond margin. At the end hours of the trading days, the gains and losses are calculated separately from the profit margin (Lavino, 2007; Malkiel and Saha, 2009; Liang, 2007). Beside the forward contract, the next best developed market for hedging the exchange rate risk is the future market (Mitchell and Stafford, 2008). It is quite similar to the rules and regulations of forward contract as it also aims at delivering underlying assets at future date and predetermined price. One of the important features of future contract is its time pattern of the cash flow that takes place between two parties i.e. seller or buyer regarding the transactions. The cash changes hand everyday during the duration of the contract and the changes in the price are observed every day (Stulz, 2011). The cash compensation feature of the contract aims at eliminating the default risk. The forward and future contracts are similar and they also tend to have identical rates. The large corporations usually employ forward and future contracts for hedging their risk associated to any transactions (Liang, 2007; Lavino, 2007; Malkiel and Saha, 2009; Liang, 2007). The main characteristics of future contract are elaborated in this section. The contracts have counter-party risk as the contracts are bilateral in nature. The contracts can be customized and thus it has unique characteristics with expiration data, asset type and quality and also contract size. These contracts are available in exchanges and not in public. The contract is delivered and settled on the expiration date. If one of the parties reverses the contract, it goes to counter party, who remain in a monopoly situation and have the ability to command for the prices they want (Malkiel and Saha, 2009). Example: The financial crisis of 2008-2009, there was changes in availability of food items in the commodity market and this implied that the grocery business was filtered at a normal basis (Cosgrove, 2013). The major food companies such as Hormel, Kraft and many more had used futures contract to operate effectively in the market and satisfy their customers (Cosgrove, 2013). Hedging techniques by small firms Options Option contract is observed to exist between two parties basically the seller and buyer of the options. It gives the right to the buyers to purchase an asset from a seller of the same. The seller has to obey the terms and condition of contract. The option contract, which is attached with the purchase of asset, is known as the call option. The option associated with sale of asset is called as put option. In this contract, the price of the underlying assets is pre-determined and it can be purchased or sold in a future date. Here, the price is known as exercise or strike price. It can be stated that purchase and sale of an asset at a future date is a common process. The date is known as the date of maturity (Ramadorai, Hsieh and Naik, 2010; Mitchell and Stafford, 2008). There are two types of options: American and European style. The American style is exercised before the date of maturity of contract however; the European style is used at or after the maturity date. These types of contracts have intrinsic or premium value. Here, the market value is the price at which the sellers or buyers can spend for entering into a contract (Ramadorai, Hsieh and Naik, 2010; Mitchell and Stafford, 2008). Here, intrinsic value is defined as the price, which is paid by the rational investor during the maturity of contract. The value for a call option is observed to be greater than zero and also higher than the difference between exercise and market price of the underlying asset. The value is positive when the market value is higher than exercise price. Option is called in-the-money when intrinsic value is positive; it is known asout-of the money when the value is zero (Stavetski, 2009). There are many small firms who uses option contract so as to make a profitable business. However, firm like Blackrock Inc use option contract and it has helped the company to raise many buyers as they are willing to pay high amount on the new contracts (Forbes LLP. Com, 2015). Swaps Swap is an agreement, which is linked with future exchange of assets; this indicates that liability for one is the cash flow for another. Two types of swaps are generally observed in financial derivatives i.e. currency swaps and interest rate. Currency swaps are referred to the instruments that are used for determining currency at a period of time. However, the interest rate calls for the most important agreement existing between two parties (Teo, 2009). Here, the interest payments are made at a future date. These swaps generally bear zero value during the inception of contract. If there are changes in interest rate or exchange rate, the agreements tend to give positive value for both the parties. These parties receive the net cash receipts and the reverse happens with the counter party. Swaps are generally types of forward contracts and they play a significant role in international finance. These are private agreements that exist between two parties for exchanging cash flow in future in accordance to the prearranged formula. The agreements that exists between the two parties aim at exchanging different streams of cash flow (Stanyer, 2010; Ramadorai, Hsieh and Naik, 2010; Mitchell and Stafford, 2008). Comparing different derivative techniques used in large and small firms The major differences between the main financial instruments that are used by small and large forms i.e. forward and future contracts are significant. Every large corporation like Morgan Stanley and Blackrock Inc use the forward and future contracts respectively in order to hedge the risk associated with the transactions. The contracts are developed by the companies in order to mitigate the counter party risk (Mitchell and Stafford, 2008). Difference Futures contracts are sold in the stock exchanges as compared to the forward contracts, which are exchanged over-the-counter. The main terms of the future contract is standardized whereas customized in case of forwards. The future contracts are more liquid than the forwards. Margin payments are required in case of future contracts whereas no such margins are needed for the forward contract (Mitchell and Stafford, 2008). The proceeds of the future contract are settled everyday whereas in case of forward are settled at the end of a definite period of time, which is pre-determined during the time of preparation of the contract. The future contract is reversed with participants of any exchange whereas the forward contract can be used among the counter party. However, difference can also be drawn between the option and future contract. Future contract gives the holder an obligation to sell or buy any underlying asset, whereas the option contracts offer the right to the holder but not the obligation for buying or selling any asset. However, swaps are prepared between two parties, where they agree to deliver cash flows to the other. The cash flows are computed on the basis of the notional principle amount; this is not swapped between counterparties (Mitchell and Stafford, 2008). Reference list Cosgrove, S., 2013. How The Grocery Industry Is Using Futures Markets. [online] Available at: < http://openmarkets.cmegroup.com/6844/how-the-grocery-industry-is-using-futures-markets > [Accessed 6 March 2015]. Forbes LLP. Com, 2015. Interesting Blackrock Put And Call Options For October 16th. 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Hedge funds: performance, risk and capital formation, Journal of Finance, 63, pp. 1777–1803 Stanyer, P., 2010. Guide to investment strategy: how to understand markets, risks, rewards and behaviour. 2nd ed. London: Profile Books Limited. Stavetski, E. J., 2009. Managing hedge fund managers: quantitative and qualitative performance measure. Hoboken, New Jersey: John Wiley & Sons, Inc. Stulz, R.M., 2011. Hedge funds: past, present, and future. Journal of Economic Perspectives, 21, pp. 175–194. Teo, M., 2009. The geography of hedge funds. Review of Financial Studies 22, pp. 3531–3561. Wells, D., 2011. Latest Word on the bankruptcy code’s safe harbour for forward contracts. [online] Available at: < http://www.wellscuellar.com/Speeches/SafeHarbor2011.PDF > [Accessed 6 March 2015]. Read More