hedging instruments

8/10/2019 Hedging Instruments

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Types of Exposures

Risks in Forex Operations &

Management

Hedging Strategies

Hedging Products


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Types of Exposures


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Balance sheet Segment Type of Exposures

1. Revenue Exposures Imports, Exports

2. Other Exposures(Non-revenue Inflow /

Outflow)

Royalty, FDI, Misc. payments /receipts, capital goods

3. Other Exposures

(Assets & Liabilities)

Loans, Deposits

4. Interest Rate Exposures Loans, Deposits


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Risks in Forex Operations &Management of Risk


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High volatility is the distinctive feature of foreign

exchange market.

Only a small percentage of foreign exchange

transactions are for commercial import/exportpurposes while the major chunk is traded for

speculative gains.

Globalization of Indian economy is increasingly

exposing the Indian corporate to greater forex risks.The uncertainty of the moves and lack of clear trend

rules the market.


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Depending on nature of exposure two types of risks

may be associated with the forex exposure:

1. Risk of Exchange Rate2. Risk of Intt. Rate Index (LIBOR) Movement


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Foreign Currency exposure in USD, EURO, JPY etc. Loans linked

to 6M USD LIBOR, 6M EURIBOR, 6M JPYLIBOR etc.

Exposure risk on two parameters:

1. Currency Risk: EURO and / or JPY appreciation against USD (with / without

USD appreciation against INR)

USD appreciation against INR

2. Interest Rate Risk:

6M JPYLIOBOR and / or 6M USD LIBOR and / or 6M EURIBOR

moving upwards over the tenor of the loan


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Company placed an order for purchase of some

machinery:

Time of placing order Time of paymentCost : USD 10.00 mio To Pay : USD 10.00 mio

USD/INR : 61.80 USD/INR : ????

What would be the conversion rate at the time ofpayment?


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One of the fundamental requirement for any business isMONEY and Corporate may not like to lose MONEY on

account of fluctuations in Currency Market.

With increased volatility, management of the financialrisks is necessary to gain competitive advantage.

More and more corporate are moving towards raising

foreign currency loans to reduce their interest cost andthey may not like to lose it on account of fluctuations in

currency market as well as interest rate.


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Hedging Strategies


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Hedging may be termed as a Risk Management

Strategy used in limiting or offsetting probability ofloss from adverse fluctuations in the prices of

commodities, currencies, or securities. In effect,

hedging is a transfer of risk; of course for a price.


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Unique to the company depending upon exposure and

Risk Management Policy.

May be of three types:

1.Complete Hedging2.Part Hedging

3.Do Nothing (No Hedging)

No best practice and a dynamic process, needs

flexibility depending upon varying company exposure

and varying market conditions.


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Is this a risk? Borrowing Rupees with a fixed rate of interest for 5

years

Borrowing Dollars with a floating rate of interest for 5

years Borrowing JPY with a floating rate of interest for 5

years

Depositing money for 6 months at a fixed rate with a

bankConcept: Can changes in market prices affect the value

of the contract?


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Why Have a Policy?

Formalises a thought process that may otherwise be

people dependent. Helps the Board of Directors articulate their

strategic view in terms of risk management.

Facilitates approval from Regulators wheresoever

necessary

Concept: Formalises a process.


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What is Risk?

The likelihood that your company will face a loss

owing to market movements.

Measurement of Risk

Factor Sensitivity

Calculation of the change in the market value of aportfolio of contracts for a given scenario, e.g. interest

rates moving up 1 bp, FX rates moving up 1%, etc.


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Financial instruments whose value is derived fromsome other asset.

Typically returns are based on movement in the value

of that asset.

DERIVATIVES

EXCHANGE TRADED

EX. EQUITY & FX

FUTURES

EQUITY & FX OPTIONS

OVER THE COUNTER(OTC)

EX. FORWARDS

OPTIONS

CURRENCY SWAPS

INTEREST RATE SWAPS


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Hedging Options forECB of JPY 9.12

billion


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Amount of ECB : JPY 9.12 billion

Costing : 6M JPY LIBOR + 57 bps

Repayment : 10 half-yearly instalment

Instalment Start Date : 18.04.2014Instalment End Date : 18.10.2018

Risks

1. Exchange risk on Principal repayment2. Exchange risk on Interest payment

3. Interest risk due to movement in JPY LIBOR


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SWAP is a contractual agreement to exchange specified

cash flows at future dates

Contracts constructed as multiple forward contracts

Advantages:

Hedging of risk beyond 3 years

Long term forwards are not available beyond 3 years

One rate for entire period of exposure or variable

rates for various maturities

Cost payable could be amortized over the life of

swap

Disadvantages:

Exit cost inflexible and less transparent.


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Swaps may be broadly categorised into:-

IRS Interest Rate Swap

POS Principal Only Swap

CIRS Currency and Interest Rate Swap

COS Coupon Only Swap


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An agreement between two parties (known as

counterparties) where one stream of future interestpayments is exchanged for another based on a specified

principal amount.

For example, NHPC has to repay loans linked to 6M

JPY LIBOR to the lender. To hedge the exposure on

account of movement in 6M JPY LIBOR, NHPC may

enter into a swap where NHPC will receive applicable6M JPY LIBOR on its hedged loan and pay the fixed

swap rate over the period of hedging.


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NHPC SBI

PAYS SWAP RATE

(x%)

PAYS LIBOR 6M

PAYSLIBOR

6M

LENDER

Effectively , NHPC pays fixedinterest rate of x% on the loan

linked to 6M LIBOR. So,

irrespective of where the LIBOR

is fixed on the respective LIBOR

setting dates, the company pays a

fixed interest rate for the tenor of

loan.


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Advantage

The risk of LIBOR moving upwards is completely

hedged.

Risks

NHPC will not be able to take advantage of lower

LIBOR if it moves below the present rates.

NHPC is open to USDJPY & USDINR exchange

rate.


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A POS involves two parties that exchange principal(notional or actual) with one another in order to gain

exposure to a desired currency. Periodic cash flows are

exchanged in the appropriate currency as per the

repayment schedule.

For example, NHPC has to repay loans in JPY to the

lender as per the repayment schedule. To hedge the

exposure on account of movement in JPY/INR, NHPC

may enter into a swap where NHPC will receive JPY

and pay INR at the swap rate.


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NHPC SBI

On repayment dates, INR at fixed rate

and x% fixed on o/s INR amount

JPY (As per repayment schedule)

JPY (as

per

repayment

schedule)

LENDER

Effectively , NHPC hedges itselfagainst the fluctuations in JPY/INR

for JPY loan. So, irrespective of

where the JPY/INR trades on

repayment dates, the company paysa fixed amount of INR at todays

spot ref and pays x% on o/s INR

amount instead of JPY.


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Advantage The risk of JPY/INR moving upwards is completely

hedged.

Risks

NHPC will not be able to take advantage of lower

rates if JPY/INR moves lower than the present

rates.

NHPC is open to LIBOR rate moving upwards.NHPC is open to JPY/INR movements on interest

portion.


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CIRS involves two parties that exchange principal(notional or actual) as also interest rate with one another

in order to gain exposure to a desired currency & interest

rate.

For example, NHPC has to repay a JPY loan linked to 6M

JPY LIBOR to the lender as per the repayment schedule.

To hedge the exposure on account of movement in

JPY/INR as also LIBOR, NHPC may enter into a swap

where NHPC will receive JPY at 6M JPY LIBOR and

pay INR at fixed interest rate as per the schedule.


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NHPC SBI

INR at fixed interest rate of X% (as

per repayment schedule)

USD AT 6M JPY LIBOR (as per

repayment schedule)

JPY at 6MJPY LIBOR

(as per

repayment

schedule)

LENDER

Effectively , NHPC hedges itselfagainst the fluctuations in

JPY/INR and 6M JPY LIBOR.

So, irrespective of where the

JPY/INR trades on repayment

dates or where 6M JPY LIBOR isfixed on resetting dates, the

company pays a fixed amount of

INR at a fixed interest rate.


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Advantage

The risk of JPY/INR & 6M JPY LIBOR

moving upwards is completely hedged.

Risks

NHPC will not be able to take advantage of

lower rates in JPY/INR &/or 6M JPYLIBOR rate moves lower than the present

rates.


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Coupon Only Swap involves two parties thatexchange interest payments from one currency to

another currency.

For example, NHPC has to repay JPY loan at

LIBOR 6M. If NHPC exchanges the interest

payments from JPY LIBOR 6M to INR Fixed, the

liability on account of interest payments shift toINR.


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NHPC SBI

Intt. payments in INR at x% at spot

(as per repayment schedule)

JPY LIBOR 6M (as per repayment

schedule)

JPY LIBOR

6M (as perrepayment

schedule)

LENDER

Effectively , NHPC converts its

interest liability from JPY

LIBOR to INR FIXED.

Principal payments, however,

are open to market fluctuations.


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Advantage The risk of 6M JPY LIBOR moving upwards is and

JPY/INR appreciation (on interest amount) is completely

hedged.

Disadvantages

JPY/INR exposure on principal amount has not been

hedged.

NHPC will not be able to take advantage of lower rates if

6M JPY LIBOR rate moves lower than the present rates.

NHPC will not be able take advantage of INR appreciation

against JPY on the intt. portion as rate it is already fixed.


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Type of

Structure

Exchange Risk

on Principal

Exchange Risk

on Interest

Interest Rate

Risk

CIRS Yes Yes Yes

POS Yes No No

IRS No No Yes

COS No Yes Yes


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Type of Structure NHPC Receives NHPC Pays

CIRS 6M JPY LIBOR + 0.57% 8.7975%

POS - 7.7975%

IRS 6M JPY LIBOR + 0.57% 0.9125%

COS 6M JPY LIBOR + 0.57% 1.0775%


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Other Hedging Products

Forward Contract

Options

Combinations


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Contract to buy or sell a specified amount ofcurrency at a specified price on a specified

future date.


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No exchange of money at the time of contract; settlement on

end date;

An obligation to buy/sell on settlement date at the contracted

rate;

Cancellation, partial or early delivery allowed as per relevant

guidelines;

Transparent Pricing;

Used to hedgeas also to Trade/Speculatei.e. profit from

currency movements as per relevant guidelines.


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At the time of booking a forward contract the customer can

choose for:

1. A fixed delivery date;

2. A period called option period (up to 1 calendar month)

within which the customer can deliver his part of thecontract on any date.

In both the cases, however, the forward rate is fixed.

However, in the latter case, as the customer is buying the

option to take delivery anytime during the contracted

month, the forward rate will be worse than that of a fixed

date delivery.


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ILLUSTRATION

FORWARD

IMPORT

CONTRACT

64

FORWARD

USD/INR

66

65

61

62

60

63

-

FORWARD

CONTRACT

PRO IT

LOSS


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Advantages of Forward Contract

Simple

Easy to use

Liquid

Transparent


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Disadvantages of Forward Contract..

No chance of participating in market

volatility.

The upside and downside (opportunity profit /

loss) theoretically unlimited.

INR based forwards demand and supply

dependent.


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An option is a financial contract in which

the buyer of the option has the right but

not the obligation, to buy or sell an asset,

at a pre- specified price, on or up to a

specified date.


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Buying Call option: Gives right to buy

Buying Put option: Gives right to sell

Strike Price: Rate at which option is to be exercised

Premium: Amount paid for buying the option

At the money: Strike price is equal to price of asset

In the money: Call option where asset price is higher than

strike price or put option where asset price is lower than strike

price.

Out of money: A call option where asset price is lower than

strike or put option where asset price is higher than strike.

The maximum loss to a holder of an option is the premium

paid which is to be paid upfront.


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The current rate

The strike rate

The time to expiration

The volatility of underlying

The Interest rates

Premium of Call Put

Higher strike price Lower Higher

Higher volatility Higher Higher

Longer option Higher Higher

time period


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Derivative Products : Options

nn

Buy CallBuy the right to Purchase

Optionto Buy

Profit potential unlimited

Loss limited to Premium

Must Pay a Premium

Sell CallSell the right to purchase

Obligationto Deliver

Profit potential limited to Premium

Loss unlimited

Receivesa Premium

Buy Put

Buy the Right to Sell

Optionto Sell

Profit potential unlimitedLoss limited to Premium

Must Pay Premium

Sell Put

Sell a right to Sell

Obligationto Purchase

Profit potential limited to PremiumLoss unlimited

Receivesa Premium


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Confidence High Low

View Buyer of USD Seller of USD Buyer of USD Seller of USD

INR Firming Keep exposure open Book Forward Buy a Call Buy a Put

INR Weakening Book Forward Keep exposure open Buy a Call Buy a Put


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Plane Vanilla Call Option

NHPC buys USD Call INR Put for USD 1mio @ 62.00

Benefit for Customer : NHPC is fully protected

against depreciation of INR beyond 62.00, at the sametime they can take benefit of appreciation of INR below

62.00.

Offers full hedge against currency movement.

Cost to Customer : Upfront premium paid by

customer to buy the option.


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Range Forward

NHPC Buy USD Call INR Put for USD 1 mio @ 70.00

NHPC Sell USD Put INR Call for USD 1 mio @ 61.00

Analysis:

By the structure NHPC has ensured that for it the rate will

not be worse than 70.00 or better than 61.00 and in between

NHPC is open to the market. By entering the structure NHPC will be able to reduce the

premium cost vis-a-vis the premium on Plain Call Option.


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Call Spread

NHPC Buy USD Call INR Put for USD 1.00 mio @ 65.00

NHPC Sell USD Call INR Put for USD 1.00 mio @ 75.00

Analysis:

Offers partial hedge and full opportunity.

On INR depreciation NHPC has limited his gain to

maximum of difference between the chosen levels,however, below 65.00 NHPC is open to market for

unlimited gain as no option will be exercised.


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Seagull

NHPC Buy USD Call INR Put for USD 1.00 mio @ 65.00

NHPC Sell USD Call INR Put for USD 1.00 mio @ 75.00

NHPC Sell USD Put INR Call for USD 1.00 mio @ 61.00

Analysis:

NHPC has limited its gain on INR depreciation to the

difference between levels of two Calls and for INRappreciation has limited its gain to the level of sold Put. In

other words its rate cantbe better than sold Put level (61.00).


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Plain Vanilla Option

(+)offers protection

(+) opportunity of participation in INR Appreciation

(-) Initial Cash Outflow

Call Spread

(+) protection up to certain level

(+) opportunity of participation in INR Appreciation

(-) Initial Cash Outflow

Seagull

(+) protection up to certain level

(-) No opportunity to participate in INR appreciation


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Customer Should Have:1. Board Approval

2. Risk Policy & Procedures

3. Exposures: Size And Tenor

4. Understanding Of Risks

5. No Net receipt of Premium

6. ISDA Documentation

7. For ECB: Loan Regn. No.


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Thank You

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