HEDGING OF EXPOSURES

While exposure is the act of exposing or laying open or subject to an act of influence of a particular transaction, Hedging is any technique designed to reduce or eliminate financial risk. Hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk.

Forward Contracts
A forward contract is a binding agreement (obligation) to buy/sell an underlying asset in the future, at a price set today
Futures contracts are the same as forwards in principle except for some institutional and (minor) pricing differences.

A forward contract specifies at origination The features and quantity of the asset to be delivered The delivery logistics, such as time, date, and place The price the buyer will pay at the time of delivery Note that forward price (F) at initiation is typically set such that forward premium=0

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Payoff on a Forward Contract

Payoff for a contract = its value at expiration

Payoff for
Long forward = Spot price at expiration Forward price Short forward = Forward price Spot price at expiration

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Payoff diagram for forwards at expiration

Long and short forward positions on the S&R 500 index

Long forward payoff = (ST F0,T) Short forward payoff = (F0,T ST)
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Forward Market Hedge

Involves a forward contract and a source of funds to fulfill that contract. The forward contract is entered at the time the transaction exposure is created. Offsetting receivables/payables denominated in a foreign currency with a forward contract to sell/buy that currency.
Covered hedge Uncovered or open hedge Cost of forward cover
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Money Market Hedge

Involves a contract and a source of funds to fulfill that contract. In this case, the contract is a loan agreement. Reversing foreign currency receivables/payables by creating matching payables/receivables through borrowing in the money markets.
Covered hedge Uncovered or open hedge Cost of money market hedge Covered interest arbitrage
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Introduction
A derivative (or derivative security) is a financial instrument whose value depends on the value of other, more basic underlying variables/assets:
Share options (based on share prices) Foreign currency futures (based on exchange rates)

These instruments can be used for two very distinct management objectives:
Speculation use of derivative instruments to take a position in the expectation of a profit. Hedging use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow.
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IN SUMMARY
A Forward Contract booked by an Exporter seeks to protect his profitability from his business operations (Export of T-Shirts in the present examples) As long as the Forward Contract is not cancelled, and the contracted export takes place, the Exporter does not make any gains/losses on account of the fluctuations in the foreign currency versus INR (if exports invoiced in foreign currency If a Forward Contract(Exports) is cancelled, there could be a gain for the Exporter , if the foreign currency (vs INR) price depreciates as on date of cancellation as compared to the spot rate on date of booking the contract. If a Forward Contract(Exports) is cancelled, there could a loss to the Exporter , if the foreign currency (vs INR) price appreciates as on date of cancellation as compared to the spot rate on date of booking the contract.

Disadvantages of Forward Contracts

Locks an Exporter into a fixed rate of exchange ( 1 $ = Rs 39.00 say ) Exporter has to deliver the underlying whatever may be the Exchange Rate on date of delivery .

Advantages in booking Forward Contracts

1. No upfront fees 2. Fx risk due to currency fluctuation completely eliminated

3. Profit on cancellation if spot USD/INR lower than Rs 39.00 on date of cancellation

Basics of Options
Options give the option holder the right, but not the obligation to buy or sell the specified amount of the underlying asset (currency) at a pre-determined price (exercise or strike price). The buyer of an option is termed the holder, while the seller of the option is referred to as the writer or grantor. Types of options:
Call: gives the holder the right to buy Put: gives the holder the right to sell
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Basics of Options
An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date.
A European option can be exercised only on its expiration date, not before.

The premium, or option price, is the cost of the option.

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Option Pricing & Valuation

An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM).
An option the would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the-money (ITM). An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is referred to as out-of-the money (OTM).
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Call Options
A non-binding contract (right but not an obligation) to buy an asset in the future, at a price set today
Only the owner of the option has rights The seller of a call option is obligated to deliver if asked

Preserves the upside potential, while eliminating the unpleasant downside (for the buyer)

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Some option terms

Strike (or exercise) price: the amount paid by the option buyer for the asset if he/she decides to exercise Exercise: the act of paying the strike price to buy the asset Expiration: the date by which the option must be exercised or become worthless Exercise style: specifies when the option can be exercised
European-style: can be exercised only at expiration date American-style: can be exercised at any time before expiration

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Put Options
A put option gives the owner the right but not the obligation to sell the underlying asset at a predetermined price during a predetermined time period The seller of a put option is obligated to buy if asked

Payoff/profit of a purchased (i.e., long) put

Payoff = max [0, strike price spot price at expiration] Profit = Payoff future value of option premium

Payoff/profit of a written (i.e., short) put

Payoff = max [0, strike price spot price at expiration] Profit = Payoff + future value of option premium
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Put Payoffs at expiration

250 200 150 100 50

Profit

0 800 -50 -100 -150 -200 -250

Put Owner 900 1000 1100 1200 Put Writer

S&R Index

Long Put payoff = max(0, K-ST) Short Put payoff = -1*max(0, K-ST)
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Option Pricing & Valuation

Call
Intrinsic value
in the money at the money out of the money

Put
max(X - ST, 0)
X ST > 0 X ST = 0 X ST < 0

max(ST - X, 0)
ST X > 0 ST X = 0 ST X < 0

Time Value

CT Int. value

PT Int. value
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Option Pricing & Valuation

current exchange rate (S) as S , Call and Put
strike price (X) as X , Call and Put time to expiration (T) as T , both volatility of the exchange rate () as , both domestic interest rate (id) as id , Call and Put foreign interest rate (if) as if , Call and Put

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Options A better hedging tool

PUT OPTION : Gives the buyer (exporter) the RIGHT but not the OBLIGATION to deliver (SELL) the underlying (USD/INR) on a specified future date at a specified exchange rate fixed now (1 $ = Rs39.00 say ) .
CALL OPTION : Gives the buyer (importer) the RIGHT but not the OBLIGATION to take delivery (BUY) underlying (USD/INR) at a specified exchange rate fixed now (1 $ = Rs 39.00 say )

OPTION PREMIUM
The buyer of the option pays an upfront fee (premium) to the seller of the Option

Options Market Hedge

Offsetting a foreign currency denominated receivable/payable with a put option or a call option in that currency. Valuable hedging tool when:
Waiting on the outcome of a bid denominated in foreign currency Using of foreign currency price list Shifts in competitors currency
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Advantage of Put Options over forward contracts for and Exporter

Forward contract Put option

Locks in forward rate (at 1$ = Rs39.00 say ) Unable to enjoy upside ( 1 $ = Rs 49.00 )

The exporter is under no obligation to exercise option and deliver underlying at contracted rate. Will exercise Option and deliver underlying if rate is say 1 $ = Rs 35.00 Will not exercise Option if rate is say 1 $ = Rs 49.00

Disadvantages of Options as compared to Forward Contracts

Forward Contract Put Option No uprfront fees for booking contract >Upfront fees payable , depending on volatility of USD/INR Upside available only if exchange rate exceeds fee/premium for buying the Option. Example : Option Price 1 $ = Rs 39.00 Premium = Rs 2.00 Upside available only if USD/INR exceeds - Rs 41.00

Forwards versus Options

Value of Forward/Put Option at Expiration .

$0.90 $0.75 $0.60 $0.45 $0.30 $0.15 $0.00 -$0.15 -$0.30 -$0.45 -$0.60 -$0.75 -$0.90
$0.00 $0.10 $0.20 $0.30 $0.40 $0.50 $0.60 $0.70 $0.80 $0.90 $1.00 $1.10 $1.20 $1.30 $1.40 $1.50 $1.60 $1.70 $1.80

Value of Forward Sale at Expiration Value of Put at Expiration

Spot Rate at Expiration

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