Risk Management Basics
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- Relative Risk Reduction Formula
What is Hedging?
Hedging is an insurance-like investment that protects you from risks of any potential losses of your finances.
Hedging is similar to insurance as we take an insurance cover to protect ourselves from one or the other loss. For example, if we have an asset and we would like to protect it from floods. As humans, it is not in our hands to directly protect it from the flood but in this case, we can take an insurance cover so that if there is any damage to our property on account of floods, we get compensated for the same.
- A hedge is an investment which has a similar purpose as that of insurance. The purpose is to eliminate or reduce the risk by offsetting the potential loss. If we are reducing the risk through hedging, then we might reduce the reward also. In the case of insurance, we pay a premium and we might not even get any benefit from the premium if there is no flood during the tenure of the policy.
- Similarly, it isn’t free either. We have to pay a cost for it which reduces the overall rewards which we get.
- Normally, a hedge consists of taking an offsetting position in related security which offset the risk of any adverse price movements. It can be done through various financial instruments such as forward contracts, futures, options, etc.
Most of the areas under the scope of business and finance can be covered under-hedging.
Let us take an example of a manufacturing organization that supplies its products in the local market and is also involved in exports. Let’s assume that it’s export sales form 75% of its revenue. The company will have an inflow of foreign currency as a primary source of revenue. The value of this foreign currency may keep fluctuating and could lead to gains/losses.
In order to restrict this potential loss, the company might consider this through either of the following activities:
- Build its own factory in a foreign country so that goods manufactured there can easily be sold without any foreign currency fluctuations. This is one way to avoid currency risk.
- They can also enter into a contract with a bank to sell their foreign currency at a fixed rate by paying the fees/premium for the same.
- Enter into a contract with its major customers to pay them in their home currency.
So a company can hedge a given risk in more than one way. The organization can decide which of the available options is the best (given the availability of its resources and the constraints).
How does Hedging Work?
Hedging can be done for items which have a fixed value or for items which have a variable value.
Let us try and understand these in more detail:
#1 – Hedging for Fixed Value items
A fixed value item is one which has a fixed value in your books of accounts and requires an outflow of a fixed amount of cash in the future.
Some examples of Fixed Value Items are:
- Fixed interest loan is taken by the company with semi-annual fixed interest payments.
- Fixed coupon non-convertible debentures issued by the company with annual interest payments
As it is obvious, in this type of a hedge, the amount/rate is fixed much in advance and this may / may not be in sync with the current market rates when the payment actually takes place. This is the reason why the companies enters into hedging even for fixed value items.
Hedging Example – Fixed Value items
Let us say the organization has issued non-convertible debentures at 8% p.a. coupon rate and coupons are paid annually. In this case, the organization feels that the interest rate prevailing in the market at the time of the next coupon payment (due in a month) is going to be lower than 8% p.a.
So the organization decides to enter into a hedging contract with a bank where it will receive 8% p.a. interest on the underlying amount of the non-convertible debentures from the bank and in return pay LIBOR + 0.25% p.a. interest on the underlying amount.
Following will be cash-flows which the organization will incur if the interest rate decreases (Case A) or the rate decreases (Case B):
|Payments without hedging||Case A||Case B|
|Actual coupon payment||$ 8,00,000||$ 8,00,000|
|Payments with hedging|
|LIBOR Rate at the time of payment||7.25%||8.25%|
|Interest rate at which the organization will have to pay the bank||7.50%||8.50%|
|(LIBOR + 0.25%)|
|Actual coupon payment||$ 8,00,000||$ 8,00,000|
|Add: Organization will pay the bank||$ 7,50,000||$ 8,50,000|
|Less: Organization will receive from the bank||$ 8,00,000||$ 8,00,000|
|Net Payment||$ 7,50,000||$ 8,50,000|
|Benefit / (Opportunity Loss) on account of hedging||$ 50,000||($ 50,000)|
#2 – Hedging for Variable Value items
As opposed to the fixed value items, variable value items have fluctuating cash flow at the time of payment.
Examples of Variable Value Items are:
- Variable interest loans (these loans are generally based on some benchmark rates + a fixed percentage above it)
- Foreign exchange transactions
- Variable non-convertible debentures
Hedging Example – Variable Value items
Now let us say that the organization has taken a loan of $ 1,00,00,000 which has a semi-annual interest payment at LIBOR + 0.50% p.a. The current LIBOR rate is 7% p.a. but the organization believes that the LIBOR rate is going to increase in the near future. So the organization enters into a contract with the bank where it will receive LIBOR + 0. 50% p.a. and pay a fixed rate of 7% p.a. to the bank.
Following will be cash-flows which the organization will incur in the given two scenarios:
|Payments without hedging||Case A||Case B|
|Fixed %age above LIBOR||0.50%||0.50%|
|Total interest rate applicable||8.00%||6.75%|
|Interest Payment||$ 8,00,000||$ 6,75,000|
|Payments with hedging||Case A||Case B|
|Interest Rate payable to the bank||7.00%||7.00%|
|Actual coupon payment||$ 8,00,000||$ 6,75,000|
|Add: Organization will pay the bank||$ 7,00,000||$ 7,00,000|
|Less: Organization will receive from the bank||$ 8,00,000||$ 6,75,000|
|Net Payment||$ 7,00,000||$ 7,00,000|
|Benefit / (Loss) on account of hedging||$ 100,000||($ 25,000)|
From the above, the organization has restricted its outgoing payment to $ 7,00,000 irrespective of the market rate. This is the opposite of the Fixed Value hedge where they let go a fixed outgoing payment and converted it to flexible payments.
This has been a guide to what is Hedging. Here we discuss how hedging works for fixed value items and variable value items along with practical examples. You may learn more about derivatives from the following articles –