...Neha Bhartiya PG-Fin Hedging through derivatives The basic purpose of derivatives is to provide the protection against unfavorable movements of the price at future date in order to reduce the financial risk. In other words, by the use of these instruments we can transfer the risk from those participants who desire to avoid it to the participants who are ready to accept the same. Any gain or loss in the original portfolio will be offset by a similar loss or gain in the derivative product used to hedge the portfolio. Hedging can be done through forwards, futures, options, swaps or by a combination of them. These instruments derive their value from the underlying asset. The research paper will focus mainly on the hedging instruments in India and will deal with the study and analysis of various models for hedging under derivatives in and outside India. It will also do a comparative analysis of hedging through futures and options. As the NSE figures show that in equity derivatives, almost 90% of activity is due to stock futures or index futures, whereas trading in options is limited to a few stocks, partly because they are settled in cash and not the underlying stocks. Exchange-traded derivatives based on interest rates and currencies are virtually absent. Indian commodity derivatives have great growth potential, but have not emerged yet. Similarly, credit derivatives, the fastest growing segment of the market globally, are absent in India and requires to be developed. Thus...
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...(a) Introduction Financial derivatives are a financial instrument that value is depend upon or derived from price of underlying items such as commodity, indicator or index. Financial derivatives enable participants involved to trade specific financial risks for example, interest rate risk, foreign exchange risk, equity and commodity price risk and credit risk to other entities who are more willing or better suited to take or manage these risks (International Monetary Fund, n.d.). Even though there are some speculators are aim to earn profit by using the financial derivatives. The main categories of derivatives are forward and futures contracts, options and swaps. They are financial instruments that are mainly used to protect against and manage...
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...Essay topic: why companies use currency derivatives? Currency derivative can be defined as a contract or financial agreement to exchange two currencies at a given rate or a contract whose value is derived from the rate of exchange of two currencies on spot (Shoup, 1998). Currency derivatives are developed and adopted to implement a strategy known as hedging, in which an organisation acquires a contract in order to offset an expected drop or rise in value of a position or future cash flow (Belk & Edelshain, 1997). This essay will outline the incentives and rationales behind an organisation that uses currency derivatives. There are three types of currency derivatives used in hedging, future contracts, forward contracts and options, although swaps are also commonly considered as a currency derivative (Shoup, 2008). These instruments are derived from a spot rate, which is the price of the “underlying currency” (Eiteman, Stonehill & Moffett, 2009). Options are normally more costly than future contracts and forward contracts, because options are rights rather than obligations to buy or sell a currency (gives buyers the right not to exercise the contract if the spot rate movement is not favourable) (Belk & Edelshain, 1997). Research in New Zealand indicates that 70% of currency derivative users used forwards, which are most prevalent currency derivative instrument (Chan, Gan & McGraw, 2003). This is possibly because forwards are easy to manage and understand and can be used in frequent...
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...TABLE OF CONTENTS DECLARATION ii LIST OF ABBREVIATIONS iii CHAPTER ONE: INTRODUCTION 1 1.1 Background 1 1.1.1 Derivatives 2 1.1.2 Foreign Currency Exposure of a Commercial Bank 3 1.1.3 Effect of derivatives on foreign exchange exposure 5 1.1.4 Commercial Banks in Kenya 6 1.2 Research Problem 7 1.3 Objectives of the Study 8 1.4 Value of the Study 9 CHAPTER TWO: LITERATURE REVIEW 10 2.1 Introduction 10 2.2 Theoretical review 10 2.3 Foreign Exchange Risk Management 13 2.6 Empirical Review 18 2.6 Summary of Literature review 19 CHAPTER THREE: RESEARCH METHODOLOGY 20 3.1 Introduction 20 3.2 Research Design 20 3.3 Study Population 20 3.4 Data Collection Procedures 20 3.5 Data Analysis and Presentation 20 REFERENCES 22 APPENDICES 26 LIST OF ABBREVIATIONS CBK – Central Bank of Kenya ERV - Exchange rate volatility FOREX – Foreign Exchange FX – Foreign Exchange IFE – International Fisher Effect IFX - Income from foreign currencies as a percentage of total income IRP – Interest Rate Parity MST – Market Segmentation Theory NA - Net Assets NFXNA - Net Foreign Currency Exposure Relative to Net Assets NFX - Net Foreign Currency Exposure NSE – Nairobi Securities Exchange OS - Ownership Status or Nature of Ownership PPP – Purchasing Power Parity CHAPTER ONE: INTRODUCTION 1.1 Background The traditional role for commercial banks has been perceived...
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...MANAGING F OREIGN E XCHANGE R ISK WITH DERIVATIVES by Gregory W. Brown* The University of North Carolina at Chapel Hill May, 2000 Version 3.4 Abstract This study investigates the foreign exchange risk management program of HDG Inc. (pseudonym), an industry leading manufacturer of durable equipment with sales in more than 50 countries. The analysis relies primarily on a three month field study in the treasury of HDG. Precise examination of factors affecting why and how the firm manages its foreign exchange exposure are explored through the use of internal firm documents, discussions with managers, and data on 3110 foreign-exchange derivative transactions over a three and a half year period. Results indicate that several commonly cited reasons for corporate hedging are probably not the primary motivation for why HDG undertakes a risk management program. Instead, informational asymmetries, facilitation of internal contracting, and competitive pricing concerns seem to motivate hedging. How HDG hedges depends on accounting treatment, derivative market liquidity, foreign exchange volatility, exposure volatility, technical factors, and recent hedging outcomes. * Department of Finance, Kenan-Flagler Business School, The University of North Carolina at Chapel Hill, CB 3490 – McColl Building, Chapel Hill, NC 27599-3490. Voice: (919) 962-9250, Fax: (919) 962-2068, Email: gregwbrown@unc.edu. A more recent version of this document may be available from my web page: http://itr.bschool...
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...vulnerabilities from major exchange rate movements, which could adversely affect profit margins and the value of assets. This paper reviews the traditional types of exchange rate risk faced by firms, namely transaction, translation and economic risks, presents the VaR approach as the currently predominant method of measuring a firm’s exchange rate risk exposure, and examines the main advantages and disadvantages of various exchange rate risk management strategies, including tactical vs. strategical and passive vs. active hedging. In addition, it outlines a set of widely-accepted best practices in managing currency risk and presents some of the main hedging instruments in the OTC and exchange-traded markets. The paper also provides some data on the use of financial derivatives instruments, and hedging practices by US firms. JEL Classification: F31, G13, G15, G32, M21 Keywords: Financial Risk, Financial Management, Foreign Exchange Hedging, Corporate Hedging Practices Corresponding address: 700 19th Street, N.W. Washington, DC 20431 e-mail: mpapaioannou@imf.org This paper draws heavily on various presentations on risk management while the author was the Director of Foreign Exchange Service of the WEFA Group. I thank Carlos Medeiros and a referee for helpful comments. As customary, the views expressed are those of the author and do not necessarily represent those of the I.M.F. 130 M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146 Introduction ...
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...values through hedging by reducing taxable income, agency cost and the cost of financial distress. This report provides a qualitative and quantitative analysis of corporate risk management for the company Air New Zealand. We uses a time series OLS regression model. The fair value of derivatives is used as dependent variable to measure the extent of financial instrument usage. The result shows that the use of derivatives by Air NZ fails to add value to the company. FINA781 Report Page 1 1. Introduction Air New Zealand Limited is the national airline and flag carrier of New Zealand. Based in Auckland, New Zealand, the airline operates scheduled passenger flights to 56 destinations locally and internationally. Air New Zealand is a member of the Star Alliance global airline alliance, having joined in 1999. Air New Zealand originated in 1940 as Tasman Empire Airways Limited (TEAL), a flying boat company operating trans-Tasman flights between New Zealand and Australia. TEAL became wholly owned by the New Zealand government in 1965, whereupon it was renamed Air New Zealand. The airline was largely privatized in 1989, but returned to majority government ownership in 2001 after a failed tie up with Australian carrier Ansett Australia. As of 2008, Air New Zealand carries 11.7 million passengers annually. Do hedging create firm value has been a popular topic argued through decades. In this report we are going to identify whether Air New Zealand create value through hedging. In this...
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...another financial asset from another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or (d) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments. A financial liability, on the other hand, means any liability that is (a) a contractual obligation: (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity...
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...products to enable hedging against market risk in a cost effective way. This industry-wide, cross-sectional study concentrates on recent foreign exchange risk management practices and derivatives product usage by large non-banking Indian-based firms. The study is exploratory in nature and aims at an understanding the risk appetite and FERM (Foreign Exchange Risk Management) practices of Indian corporate enterprises. This study focusses on the activity of end-users of financial derivatives and is confined to 501 non-banking corporate enterprises. A combination of simple random and judgement sampling was used for selecting the corporate enterprises and the major statistical tools used were Correlation and Factor analysis. The study finds wide usage of derivative products for risk management and the prime reason of hedging is reduction in volatility of cash flows. VAR (Value-at-Risk) technique was found to be the preferred method of risk evaluation by maximum number of Indian corporate. Further, in terms of the external techniques for risk hedging, the preference is mostly in favour of forward contracts, followed by swaps and cross-currency options This article throws light on various concerns of Indian firms regarding derivative usage and reasons for non-usage, apart form techniques of risk hedging, risk evaluation methods adopted, risk management policy and types of derivatives used. Key Words: Foreign Exchange, Financial Derivatives, Hedging,...
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...Thomas Foods Thomas Foods has hired me as a consultant to provide them with hedging options to mitigate their risk in regards to unexpected increase in harvested crop prices. Thomas Foods purchases produce from local farmers and sells to grocery stores throughout the country. Any variance in crop price has an effect on the operating income of the business and therefore it is extremely important in order to continue to be profitable that the prices of crops are forecasted correctly. Hedging options will allow Thomas Foods to ensure they are able to purchase crops at a guaranteed price and quantity, hence protecting the cash flow and operating income of the business. I have come up with three hedging options that would be best suited for Thomas Foods, the pros and cons of each, and included information regarding the accounting for these options as well as the guidance given by FASB. Hedging options that Thomas Foods has to mitigate the risk of paying more for harvested crops include: -Future contracts which are contractual agreements, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. So we can negotiate price now with our farmers on the prices that we will pay for the crops in the future and that price will be locked in. ("Futures Contract Definition | Investopedia," n.d.) -Forward contracts which are contracts that are customized contract between two parties...
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...Foreign Exchange Derivatives Definition Any financial instrument that locks in a future foreign exchange rate. These can be used by currency or forex traders, as well as large multinational corporations. The latter often uses these products when they expect to receive large amounts of money in the future but want to hedge their exposureto currency exchange risk. Financial instruments that fall into this category include: currency options contracts, currency swaps, forward contracts and futures contracts. Types There are three types of foreign exchange derivatives used for hedging as follows: I. Forward Hedging II. Money Market Hedging III. Option Hedging Forward Hedging It refers to the Contract to buy or sell an asset at a given price on a specific date in the future. Investors use this device to avoid major losses if the price of the asset changes dramatically before it is exchanged. Money Market Hedging It refers to the Borrowing and lending in multiple currencies, for example to eliminate currency risk by locking in the value of a foreign currency transaction in one's own country's currency. Option Hedging It refers to the right to buy or sell foreign exchange at a specified strike price in exchange of a certain option premium either at the option expiration date or during the option period. * If one acquires the right to purchase foreign exchange, it is called the call option. Buyer of the call option pays option premium & it will be...
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...Case Study on PepsiCo’s Use of Financial Derivatives 1. Introduction 1.1 PepsiCo’s History The Pepsi-Cola Company was incorporated in 1919 by Caleb Bradham, the inventor of the Pepsi-Cola soft drink. PepsiCo became a multinational beverage and snack food company in 1965 when Pepsi-Cola merged with Frito-Lay. Since the 1965 merger PepsiCo has expanded its operations by acquiring Quaker-Oats, Tropicana, and Gatorade brands. With sales of $66.86 billion in 2014 and with products sold in over 200 countries, PepsiCo is one of the leading food and beverage companies in the world (PepsiCo, 2014). 1.2 PepsiCo’s Industry The beverage and snack food industries are both in the mature stage in their life cycles, and companies in these industries largely depend on product innovation, brand recognition, and low prices to remain competitive. Like all companies PepsiCo faces risk of increases in operating expenses and decreases in net income due to market risk. Companies in PepsiCo’s industry have been forced to expand its product offerings into healthy foods and drinks due to an insurgent health and wellness in American culture. 1.3 PepsiCo’s Competitors PepsiCo’s top competitors consist of The Coca-Cola Company, Dr Pepper Snapple Group, and Nestle; additionally, because PepsiCo is a multinational company it must also compete with countless local snack and beverage companies across the globe. Coca-Cola has been viewed as PepsiCo’s main rival for around 100 years, and the competition...
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...Financial Institutions Center Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry by J. David Cummins Richard D. Phillips Stephen D. Smith 98-19 THE WHARTON FINANCIAL INSTITUTIONS CENTER The Wharton Financial Institutions Center provides a multi-disciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest. Anthony M. Santomero Director The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry By J. David Cummins Wharton School, University...
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...Variable Annuities—An Analysis of Financial Stability Ma rch 201 3 The Geneva Association (The International Association for the Study of Insurance Economics) The Geneva Association is the leading international insurance “think tank” for strategically important insurance and risk management issues. The Geneva Association identifies fundamental trends and strategic issues where insurance plays a substantial role or which influence the insurance sector. Through the development of research programmes, regular publications and the organisation of international meetings, The Geneva Association serves as a catalyst for progress in the understanding of risk and insurance matters and acts as an information creator and disseminator. It is the leading voice of the largest insurance groups worldwide in the dialogue with international institutions. In parallel, it advances—in economic and cultural terms—the development and application of risk management and the understanding of uncertainty in the modern economy. The Geneva Association membership comprises a statutory maximum of 90 chief executive officers (CEOs) from the world’s top insurance and reinsurance companies. It organises international expert networks and manages discussion platforms for senior insurance executives and specialists as well as policy-makers, regulators and multilateral organisations. The Geneva Association’s annual General Assembly is the most prestigious gathering of leading insurance CEOs worldwide...
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...cases. FHL has chosen to hedge with Forwards Exchange Contracts to hedge the foreign exchange risk. A forward contract is a contract to exchange a fixed amount of f financial assets on a fixed future date at a fixed price. The fair value of a forward contract is affected by changes in the spot rate and changes in the forward points. Although the Group has used forward contracts in the past, the adoption of IFRS 9 Hedge Accounting has not been applied because the tenure of the contracts was hedging against AUD/USD FX rates three months out from the accounting period. The Board has decided that the tenure should now look prospectively 6 months out which brings better value FEC’s with respect to the agreed Forward rate but equally the longer period creates more uncertainty, therefore the Board has elected to adopt Hedge Accounting. Background IFRS 9 Hedge Accounting states that derivative financial instruments are initially recognised at fair value on the date on which a derivative contract is entered into and are subsequently remeasured at...
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