hedging provides to non-financial firms to manage financial risks. Also to analyze how does hedging add to the corporate value if it does.
Hedge can be describes as an investment which is intended to offset the potential losses which the company might have to face in future for the investment made. A hedge can be created by many forms of financial instruments which include insurance, swaps, forward contracts, stocks and many other financial instruments.
In simple words hedging is reducing/controlling the risk of the financial investment. This is done by taking a position (future market) which is opposite to the position taken in the physical market which aims to reduce or limit the risks of the financial investments. This is a two step process. Any loss or gain in a position in the cash because of changes in the price levels are dealt by changes in the value through a future position. For example, a football manufacturer can sell football futures to protect the value of his football prior to the football season. In case there is a dip in the price due to unforeseen circumstances then the loss is recovered through the future positions.
The Research Design includes a simple Questionnaire that has questions which duly identify the benefits and problems caused by hedging for the non-financial players by the commercial banks and forex companies and the mitigating steps that can be inferred by the research and an informal interview with the organization representatives.
The research is aimed at identifying the factors that are required for hedging which can lead to the ultimate profitability.
RESPONDENTS OF STUDY
The research thesis involves gathering first hand information from the professionals in the departments of banks, financial institutions and forex company personnel. The following Institutions, Banks and Exchange Company were contacted:
Fair & Square
Royal Bank OF Scotland
Lloyds Banking Group
SOURCES OF DATA
Bank of England
The following were the research questions of the research:
How hedging is done?
What are its advantages to non-financial firms?
What are its disadvantages to the non-financial firms?
In evaluating a company’s use of financial derivatives for hedging, the three most common ways are: 1) Foreign Exchange Risks 2) Interest Rate Risks 3) Commodity Risks
FOREIGN EXCHANGE MARKET
Exchange rate is the price at which a currency can be bought and sold in terms of another. This price can be the result of supply and demand for the currency in the open market or as fixed by edict of a government or its monetary authority, usually the central bank. Most of the time the value of the currencies is decided by the interaction of the free market forces playing their role – guided by the intervention of the monetary authorities to ensure currencies do not depreciate or appreciate, excessively. The monetary authorities would not be doing their duty if they did not intervene in the market place to smooth out excessive price movements. (Jorian, 2009)
Effects of Exchange Control
Foreign currency operators in countries with rigid exchange controls have little opportunity to exercise their skills. In some countries the authorities fix the exact buying and selling rates periodically, even daily, in which case active foreign exchange dealing is practically non-existent, unless there is a gap in the regulations permitting some arbitrage transactions between different currency bands. (Ali Fatemi & Carl Luft, 2002)
Where there are no (or practically no) exchange controls, the development and depth of the exchange market is a question of the willingness of the domestic banks to take views and to back these up with positions. Naturally, the size and volume of a domestic market in foreign currencies is limited by:
The size of the country,
The state of the economy
The number of participants.
Lack of exchange controls also means that the organizations operating in the foreign exchange market of a country will be responsible to ensure prudent dealing by imposing limits. However, instead of having exchange controls, the central bank or monetary authority may inhibit the freedom by setting capital and other ratios on the positions they are allowed to carry for a limited period. (Nicholas, 2003)
FACTORS AFFECTING EXCHANGE RATES
Following factors affect the exchange rates:
Fundamental / economic factors
This includes balance of payment approach, devaluation of currency, relative inflation rates, relative interest rates, sentiments of both investors and borrowers and the Central bank’s intervention. (Mark, 2007)
The factors under the political head that affects the forex rates are the changes in government policies, changes in government and the political instability.
Analysis of the technical factors can be conducted with the help of various types of charts with the chart pattern being reversal or continuation. There are also automated trading techniques that are available for the said purpose.
DEFINITION OF RISK
Financial risk is the possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives. Such constraints pose a risk as these could hinder a bank’s ability to conduct its ongoing business or to take benefit of opportunities to enhance its business.
Regardless of the sophistication of the measures, banks often distinguish between expected and unexpected losses. Expected losses are those that the bank knows with reasonable certainty will occur (e.g., the expected default rate of corporate loan portfolio or credit card portfolio) and are typically reserved for in some manner. Unexpected losses are those associated with unforeseen events (e.g. losses experienced in the aftermath of nuclear tests, Losses due to a sudden down turn in economy or falling interest rates). Banks rely on their capital as a buffer to absorb such losses but Forex Companies cannot because of low capital and no deposits. (Baily Nicholas, David Browne and Eve Hicks, 2003)
Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc., it is believed that generally the financial institutions face Credit, Market, Liquidity, Operational, Compliance / legal / regulatory and reputation risks.
FOREIGN EXCHANGE DEALING RISKS
The following two risks in foreign exchange dealing activities, which could result in losses:
Unfavorable movements in market prices caused by unanticipated changes in interest rates, exchange rates or volatility.
The failure (bankruptcy of counter parties) before their dealing commitments are settled
When dealing activities are conducted with full knowledge and authority of the general management of the concerned organization, these risks are controlled by the limits. However, if they are conducted without the full knowledge of general management or beyond their authority, these risks may not be controlled and the potential for loss could be magnified. (Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, 2003)
It is responsibility of market participants not only to ensure that they are dealing with knowledge and authority of their own management but also to warn their management of irregularities in dealing to prevent unwarranted losses to their own institutions and to counter parties. It is presumed that dealers recognize when unauthorized dealing occurs in their own institutions and that procedures are in place for them to inform their management. (Vincent 1988)
Characteristics of dealings that indicate unauthorized transactions are as follows:
A sudden increase in volume to levels considered too large in relation to the size of the organization. This could be questionable warning since the total volume of business that a bank/company can place in the market depends on its reputation, standing and credit-worthiness and it is practically impossible to ascertain the basis of operations of undoubted standing.
An unusual increase in the turnover in banks clearing accounts with central banks/correspondent banks, particularly if overdrafts were to occur frequently. As the turnover on clearing accounts aggregates the counter value of any number of deals, which by themselves might not arouse the suspicion of the counter parties to those deals, this could be a useful warning.
A change in normal pattern of dealing
Failure to receive confirmation of deals
No satisfactory response to requests for verification of outstanding contacts
A willingness or desire to deal at a price which is deliberately pitched outside the market level
Typical Exposure Level
Organizations spend significant dollars monitoring and controlling credit risk exposures. Assessing this risk is crucial to determining the safety and soundness of a financial institution. Capital must be held against credit exposures.
The measurement and control of market risk is evolving. While most banks have the highest exposure to credit risk, market risk is an important secondary risk. For trading portfolios, capital is required to be held against market risk exposures.
The ability of an exchange company and a bank to fund its deposits and asset allocation strategies is a critical consideration.
This is an emerging area of discussion. Most recent debacles are tied to significant operational shortcomings. As such, there is a debate whether and how capital should be charged for operational risk. The assessment of operational risk is still evolving.
There are, of course, some jurisdictions where legal risk is quite high; however, legal risk is often adequately controlled.
Reputational risk can cause significant problems and may be considered an “event” risk. Loss of reputation can cause institution failure; however, the occurrence of such massive reputational failure is often preceded by a catastrophic event, such as large publicized trading losses.
How hedging is done
The process of hedging involves a hedger who tries to fix the prices at some level aiming to ensure certainty in the revenue of sale or in the cost of production. It also involves active participation by the speculators who take positions on the basis of the movement in the prices and then they bet upon those prices. There are some arbitrageurs who make use of the inefficiencies of the prices and make high profits through the transactions. The spot prices and the futures remains correlated to each other.
ADVANTAGES AND DISADVANTAGES:
The following are the advantages and disadvantages of hedging to non-financial firms that have come out of the research that was conducted:
Non-financial firms can use futures options which can help them in minimizing the risks.
The costs of hedging can have an impact on the profits of the non-financial firms.
Hedging can help in making huge profits without taking many risks.
Risks and Profits are inversely related i.e. reducing risk will mean reducing profits.
Hedging helps in tough market and trade conditions.
The non-financial firms can’t trade in the day period which makes it hard for them to follow the hedging strategy as it is hedging is ideal for the short-term traders.
Hedging gives protections against price changes of commodities, inflation, interest rate changes and exchange rate changes.
If the market performance is stable then hedging will offer very little benefits.
The portfolio can help avoid the daily market volatility.
Often hedging requires large capital
It provides an opportunity to carry out complex trading which can help in earning maximum returns.
Hedging requires good trading skills and experience which makes the hedging strategy difficult to follow for the non-financial firms.
Jorion, Philippe (2009). Financial Risk Manager Handbook (5 Ed.). John Wiley and Sons. p. 287.
“A survey of financial centers: Capitals of capital.” The Economist.
Baily Nicholas, David Browne and Eve Hicks (2003), “UK Corporate use of Derivates,” The European Journal of Finance, pg. 169-193
Ali Fatemi & Carl Luft (2002), “Corporate Risk Management Costs and Benefits,” Global Finance Journal, pg. 29-38
Crockford, Neil (1986). An Introduction to Risk Management (2 Ed.). Cambridge, UK: Woodhead-Faulkner. p. 18.
Covello, Vincent T, Allen. Frederick H. (1988). Seven Cardinal Rules of Risk Communication. Washington, DC: U.S. Environmental Protection Agency.
Bent Flyvbjerg, Nils Bruzelius, and Werner Rothengatter, 2003, Megaprojects and Risk: An Anatomy of Ambition (Cambridge University Press)
Dorfman, Mark S. (2007). Introduction to Risk Management and Insurance (9 Ed.). Englewood Cliffs, N.J: Prentice Hall
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