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Hedging as a Risk Management Tool

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Vidushi Ramdawa

on 26 March 2013

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Transcript of Hedging as a Risk Management Tool

Mauritius Exports:
- Account for around 30 % of our GDP; and
- Generate a high rate of profit and foreign exchange earnings. Introduction Definition of Risk Management On the International level Hedging as a Risk Management Tool. Definition of Hedging Hedging is today’s key risk management
tool for financial professionals in a wide
variety of roles and markets.

In finance, a hedge is a strategy intended
to protect an investment or portfolio
against loss. It occurs when:
an investor buys low-risk government bonds over more risky corporate debt;
a fund manager hedges their currency exposure with currency derivatives and;
a bank performs a credit check on an individual before issuing them a personal line of credit. Inadequate risk management can result in severe consequences for companies as well as individuals.

E.g. the recession that began in 2008 was largely caused by the loose credit risk management of financial firms. Explanation on Hedging Allows financial professionals to accomplish a number of risk management objectives, from decreasing cash flow volatility and offsetting interest rate fluctuations to minimizing price risk, default risk, and more.

It usually involves buying securities that move in the opposite direction than the asset being protected. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

A hedge consists of taking an offsetting position in a related security, such as a futures contract.

E.g. of a hedge: if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. How do you protect your investment? When hedging, traders must often choose between futures and another derivative known as a forward. Another way to hedge is to purchase a put option contract on the shares. Hedging v/s Speculating Hedging and speculating are the two primary ways in which Forex derivatives are used. Speculators, on the other hand, want to incur risk in order to make a profit. Hedgers use Forex futures to reduce or eliminate risk by insulating themselves against any future price movements. Internal Hedging Techniques
E.g. invoicing in the home currency, bilateral and multilateral netting, leading and lagging, matching, restructuring.

External Hedging Techniques
E.g. forward markets, option forward exchange contract, money market hedge, futures Export-led economy
Exports vulnerable to real exchange rate variability
Hedging facilities expensive for small exporting firms “Trade and Development Act of 2000”

Export-oriented sectors encouraged to hedge with commercial banks part of their export receipts through foreign currency options or the use of foreign currency swaps. Swap Scheme - Put forward by the Bank of Mauritius (BoM) in December 2009 cater to the needs of the operators temporarily encourage them to have greater recourse to hedging instruments for securing their rupee earnings End-June 2010 Total value of swap transactions of USD 89.2 million Not been used since July of that year It is not easy to get rid of old habits!! No exchange controls on MUR spot and forwards

Normal market conditions:
Onshore average daily forward volume: USD 2M
Onshore forward transaction: USD 1M
Onshore forward spread: 10-15 pips (0.10-0.15MUR)
Implied option volume spread: 2 vol. 1. Forwards/Forex (FX) swaps Interest rate products:
•Interest rate swaps
•Interest rate options
•Swaptions 2. Options: Mauritius: •Collar •Leverage forwards •Pivot forward •Flexible forward •Capped forward •Seagull •Put options •Forward extra •Call options •Range forward •Break forward •Tracker forward •Forward extra plus •Participating forwards Background of Air Mauritius Flag carrier of Mauritius

Set up on 14 June 1967 by Air France

Fourth largest carrier in Sub-Saharan Africa

Services to over 30 destinations with 80
flights per week Financial information Net loss of 13.19 million Euros for the 1st quarter ending June 30. Revenue for the quarter fell 19.53 % to 74.52 million Euros against the previous year Unrealised losses on unexpired fuel hedge contracts- 32.6 million euro compared to 72.2 million euro at March 31 2009. 2 main factors contributed to this result: Fall in passenger and freight traffic The cost of fuel hedging(EUR 12.2 million) and its unwinding( EUR 4.8 million) Fuel hedging
AM use fuel hedging to reduce their exposure to volatile and potentially rising fuel costs.
A full hedge contract allows air Mauritius to establish a fixed or crapped cost, via commodity or swap option.
Cost of fuel hedging depends on predicted future price of of fuel. An interview with the Executive Director, the Chief Financial Officer – Jacques Desire Laval Elliah was carried out at the LUX* Resorts Floreal.

- Major player in the hotel industry in Mauritius, the Maldives and Réunion Islands.

- Dynamic and expanding hotel group with more than fifteen years of experience.

- Admitted to the Official List of the Stock Exchange of Mauritius in November 2005. LUX* Resorts Normally hedging is done to protect the company against the foreign exchange risk.

For e.g:
LUX* receives 60% of revenue in euros, 20% in US dollars, 10% in pounds and the balance in Mauritian rupees.

Most of the expenses is in Mauritian Rupees, therefore the company may end up receiving less Rupees if there is an appreciation.

On the contrary, in the case of depreciation of Rupees, we may receive money, which represents more profit for the company. What are the risks the company is exposed to?
Since derivatives are quite stimulative, the company is not engaged so much in these.

For example, if it is expected that Euros will be at Rs 41 next month and LUX* is negotiating with the bank today. Even if we have done our budget on a euro - rupee parity of Rs 39, LUX* can do a forward contract with the bank, stating that the company undertakes to sell to the bank 1 Million Euros at the end of the month and in return the latter should buy the Euros from LUX* at Rs 41.

This is a forward contract in Euro but LUX* is not engaged in the complex derivatives such as futures. Do you use some sort of derivatives or options? Primarily we go ahead performing a risk assessment, which is done by the Audit Committee, whereby we look at the environment, IT risk, foreign exchange risk, interest rate risk, and so on.

At LUX*, we identify the risk, assess them and then, identify the mitigating factor. The Risk managed in the company are as follows:
Industry risk,
Market risk
Information risk,
Human resource planning risk,
Political risk,
Credit risk What do you think of the risk Mgmt in your company and in Mauritius? For example, to mitigate the credit risk, we use an insurance cover, whereby in case a debtor who does not pay, we are 'safe', and can recover our investments.

However, some risks are inevitable, for instance political risk (e.g “coup d’état”): this can’t be insured in Mauritius. (This risk is very low in the country.)
We are insured against political risk for our Maldives company.
Yes, hedging is profitable; in fact hedging is what we should be doing nowadays!

Sometimes people do not know how to hedge and sometimes they tend to speculate. For example the air Mauritius hedging Do you think that hedging is profitable? The idea behind is to match revenue over expenses.
60% of the company’s revenues are in euros, perfectly matching with a 40% debt in the same currency.

20% of the revenues are in US dollars whereby the debt amount to 15%.

The revenue in Mauritian rupees amount to 10% with a debt of 20,% meaning that there is a risk in terms of Mauritian Rupees but the bulk of exposure has been perfectly matched in terms of foreign currency:

LUX* has revenue of 5 billion rupees with a 4.5 billion debt in the same currency. Normally LUX* deals with banks, such as The Mauritius Commercial Bank Ltd, State Bank of Mauritius Ltd, HSBC Limited (Mauritius, UK, Germany, Maldives), and so on.

It makes sense for them to contract a loan in Euro, since most of our company’s revenues are in that currency.

A small company generating only Rupees will not receive a loan in Euros from the bank. Some current figures at LUX* Resorts With which company do you normally hedge? Company Profile Set up to regulate and rationalize trade, in relation to essential commodities.
Importer of rice, wheaten flour, petroleum products and cement.
STC’s selling prices fixed by the Government.  Volatility in petroleum products prices is brought by: - Petroleum products and natural gas operate – subject to diverse price movements

- STC considers HEGDING to budget and plan for the months or years ahead regardless of situation in the energy markets

- Financial instruments used to hedge oil prices include swaps, call options, put options and collars Reduces the cost of capital Enables management to measure performance Secures company's objectives Stabilizes cash flows HEDGING Economic environment Strong demand Geopolitical uncertainties OPEC production policies Speculative activity Low petroleum inventories Hard to reconcile actual oil price movements on the world market with the domestic price changes. TREND OF WORLD PRICE VOLATILITY Subsequently consumers contributed Rs 3 per litre towards hedging losses. This amounted to Rs 100 million monthly towards payment of the losses.

During 2011, an amount of Rs 623,733,125 million has been collected, leaving a balance of Rs 885 million as at 31 December 2011 to be recoverable in the foreseeable future. Global Board of Trade(GBOT)

1st international multi-asset class exchange from Mauritius offering a basket of commodity and currency derivative products(metals, energy, agri-soft, and currency pairs)

Trading occurs on GBOT’s state-of-the-art electronic exchange platform with efficient clearing and settlement systems Foreign exchange hedging instruments help domestic corporate exporters to manage currency mismatches in their balance sheets while sustaining economic viability. GBOT exchange provides exporters with a good avenue to mitigate risks and safeguard against the vagaries of uncertain financial markets world over, while understanding well the products on offer and adapting to the best as per their business requirements. Factors driving growth of derivatives in our export market:
• Increased Volatility in Asset Prices

• Increased Integration of global financial markets

• Market improvement in communication facilities

• Development of more sophisticated risk management tools

• Innovations in the derivatives markets which optimally combine risk and returns of exchange traded products

• Transparency has resulted in a growing popularity of Exchange traded products over OTC products

• GBOT offers the following derivative products currently
- Commodity Futures : Gold , Silver (Crude Futures to follow) • Pricing – With integration of markets and better access to information, the overseas buyer is in a position to renegotiate his import price when prices drop

• Exchange Rate Volatility – The biggest uncertainty arises for volatile exchange rates – which impact pricing power and cash flows

• Global economic downturn a big concern for export driven economies

• Increase in cost of imported raw materials puts pressure on cost of finished goods for exports Challenges Faced by the Exporters • A clearly well defined hedge ratio for all economic activities that face external factor (eg: 50 % of exposure any time to be hedged)

• GBOT is able to offer hedging facilities for amounts as low as Euro 12,500/- , for small transaction costs.

• Explore natural hedges as under Invoice Exports in USD (instead of Euro), as their importing costs are in USD and minimize the currency risk How to overcome challenges WHY GBOT EXCHANGE ?
• Price transparency

• Can hedge small lots also (EUR and GBP 12,500 min , or USD / MUR 10,000)

• High Liquidity and two way quotes. No need to disclose if you are a buyer or seller.

• You can put your own bid or offer and get the benefit of spread.

• Low margin requirements (4 % against 10 % required for forward contracts)

• Extended hours of trading (10.30 am to 8.30 pm) • Helps in Price Discovery, due to the transparency of futures exchange.

• Provides an Insurance against adverse price movements

• Help hedge against inflation and deflation

• Generate returns that are not correlated with more traditional investments (Exchange gains /reduce the exchange losses)

• Derivatives transactions allow hedgers to take a large risk-cover while committing only a small amount of capital (4 % margin for futures). BENEFITS TO EXPORT SECTOR Giddy and Dufey, 1992 A spectrum of opinions regarding foreign exchange hedging 1. Some firms feel hedging techniques are speculative or do not fall in their area of expertise and hence do not venture into hedging practices. 2. Other firms are unaware of being exposed to foreign exchange risks. 3. And there are a set of firms who only hedge some of their risks, while others are aware of the various risks they face, but are unaware of the methods to guard the firm against the risk. With the globalization of trade and relatively free movement of financial assets,
1. Risk management through derivatives products has become a necessity in India also, like in other developed and developing countries.
2. As Indian businesses become more global in their approach, evolution of active and liquid Foreign Exchange derivatives markets is required to provide them with hedging products. Hedging in India - Businesses are increasingly alive for the application of innovative hedging techniques for protecting themselves against risks.

- Hence, an increasing awareness of the need for introduction of financial derivatives in order to enable hedging against market risk in a cost effective way. Hedging in India - Earlier, the Indian companies had been entering into forward contracts with banks.

- But many firms preferred to keep their risk exposures un-hedged as they found the forward contracts to be very costly. Hedging in India Ranbaxy and RIL:
depend heavily on forwards.
tailored to the exact needs of the firm Earnings of all the firms are linked to either US dollar, Euro or Pound: firms transact primarily in these foreign currencies globally. Analysis TCS:
hedges exposure to the US Dollar through options rather than forwards
Due to high volatility of the US Dollar against the Rupee. RIL, Maruti Udyog and Mahindra and Mahindra:
currency swaps
Swap usage is a long term strategy for hedging and suggests that the planning horizons for these companies are longer than those of other firms. Analysis Software firms- a limited domestic market and rely on exports for the major part of their revenues
Hence, require additional flexibility in hedging when the volatility is high. Infosys:
use of Range barrier options
strategy to tackle the high volatility of the dollar exchange rates Analysis Conclusion - We have used the research carried out on the management of financial risks with derivatives.

- Involves the collation of data through the analysis of the annual reports of 10 companies in the UK telecommunications industry and 10 companies in the US telecommunications industry.

Sample Selection

Firms meeting the following 3 criteria were involved in the research:
(1) The firms were in the telecommunication services industry
(2) The firm had been listed on the London Stock Exchange and the New York Stock Exchange.
(3) The firm is either a Multinational or a Domestic firm who is exposed to financial risks as a result of international competition. The UK and US telecommunication Industry Types of derivatives instrument used and risk hedged
The annual reports of the UK and US companies show that the OTC forward contract is the most common instrument used by companies to manage their foreign currency exposures.

Reasons are :
- flexibility,
- ease of use
- low transaction cost involved Non - Use of Derivatives
For the companies’ not using derivatives, reason stated by 33% of them:
There was no significant exposure to necessitate hedging, believing that the level of foreign currency payments and receipts has historically been very low on a net basis.
It has not been considered necessary to hedge.

Of these companies, 66% employ other forms of risk management techniques to hedge against exposure. This might be:
- by the diversification of risk with other parties
- through foreign direct investments in the local markets. Figure2: US firm derivatives by type of instrument and financial price risk Figure1: UK firm derivatives by type of instrument and financial price risk Financial Risk Management Objectives.

The annual reports show that for all the firms who hedge their currency transaction risks, the positions are made up of both foreign currency receivables and payables as well as expected future cash-flows.

The management of translation risk even though minimal with only 25% of the companies in the sample actively managing their translation exposures, is surprising, as the elimination of translational risk can give rise to further transactional exposure.

By trying to hedge translation exposure it can be said that companies are hedging against "paper losses" while at the same time incurring the risk of real losses from their hedging transactions. Type of derivative instrument used to manage exposure to contractual transactional commitments and expected future cash flows (economic exposure).

For companies seeking to manage these exposures, forward contracts proved to be the most used instrument.

The least used instrument for all exposure is futures contracts.

With the US companies, none at all use futures in the management of risks even though this is actively traded on the exchange markets in the US exchange markets. It can be said that in hedging contractual obligations, OTC forwards is the most popular derivative instrument used to hedge currency risk (80%; UK and 40%; US) and swaps are the most popular derivative instrument to hedge interest rate risks (60%; UK and 70% US). Vidushi Ramdawa Purnima Ramchandar Priya Mutty Aisha Lakhi Upasna Ajageer Lakshana Permessur Durvashee Parsennoo Geervanshi Dhunookdharee Source: Central Statistical Office Mauritius Source: Hedging of Forex Exposure through Currency Derivatives-Evidence From selected Indian corporates
Pondicherry University,
Puducherry QUESTION 6 QUESTION 5 QUESTION 1 QUESTION 2 QUESTION 3 QUESTION 4 Managing Transaction and economic exposure To sum up... Alternatives to hedging? No need to hedge exchange risk in a perfect capital market.
The higher risk, the higher profit potential.
If the exchange rate moves to the favour of the firm, remaining un-hedged will maximize the rewards. However, hedging is fundamental because market imperfections do exist:
1. Information Asymmetry
2. Transaction Costs
3. Default Costs
4. Progressive Corporate Taxes Note - Source of tables used: Dissertation and Thesis writing service.
Managing Financial Risks with Derivatives: The case of the UK Telecommunications Industry Mauritius Export sector Case Study: Air Mauritius STC GBOT Interview - LUX* Resorts On the International Level: India UK Alternatives to Hedging? Internal Hedging Techniques
E.g. invoicing in the home currency, bilateral and multilateral netting, leading and lagging, matching, restructuring.

External Hedging Techniques
E.g. forward markets, option forward exchange contract, money market hedge, futures Hedging Techniques
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