CITY UNIVERSITY OF HONG KONG

DEPARTMENT OF ACCOUNTANCY

Introduction to Hedging

1. Introduction
2. The Structure of Hedging Activities
3. Different Categories of Financial Risk
3.1 Interest Rate Risk
3.2 Commodity Price Risk
3.3 Foreign Exchange Risk
3.4 Credit Risk
4. Reasons to Manage Risk
4.1 Increase Debt Capacity
4.2 Maintaining the Optimal Capital Budget Over Time
4.3 Avoid Financial Distress
4.4 Comparative Advantage in Hedging
4.5 Reduce Borrowing Costs
4.6 Reduce Tax Payment
5. Methods of Managing Risk
6. Forward Contract and Futures Contract
6.1 Differences Between Futures Contracts and Forward Contracts
6.2 Using Forward and Futures Contracts to Hedge Commodity Price Risk
6.3 Example of Hedging Commodity Price Risk
7. Basis and Basis Risk
8. Option Contracts
1 INTRODUCTION

Prior to the late 1980s, the typical textbook on corporate finance contained virtually no
mention of risk management and most corporations exhibited little interest in this topic. Now,
however, risk management has become one of the most important responsibilities of the
treasurers in large corporations throughout the world.

Risk management entails assessing and managing, through the use of financial derivatives,
insurance, and other activities, the corporation’s exposure to various sources of risk.

The trend toward greater attention to risk management is due to a number of factors, most
notably, the increased volatility of interest rates and exchange rates, and the increased
importance of multinational corporations. In addition, the growing understanding of
derivative instruments has also contributed to their increased acceptance as tools for risk
management.

Financial risks such as interest rate risk, commodity price risk, foreign exchange risk and
credit risk are handled directly through the corporate treasury functions. They may use
hedging techniques including contractual hedge and financial hedge. The process is
facilitated by new innovations in financial derivatives. The Treasury Department is
responsible for assessing and managing this risk at the transaction level if the financial risk
management function is centralized. Otherwise, the Head of business unit will be the one
responsible if the function is decentralized.

2 THE STRUCTURE OF HEDGING ACTIVITIES

Firms must consider the organization of their risk management activities. Should risk
management be centralized, operating out of the firm’s Treasury Department, or should
hedging be performed at the level of the individual divisions? The answer to this question
depends on the level of expertise in the various divisions, the availability of information
about the divisions’ exposures, the transaction costs of hedging, and the motivation for
hedging.

At present, most risk management programs are implemented at the corporate rather than the
divisional level. One reason for this has to do with the costs of trading. In illiquid markets,
trading costs can be high, and it might make sense to consolidate trading. Consolidating
allows the exposures of each of the business units to be netted against one another. Corporate
managers then execute trades in the financial markets to hedge only the firm’s aggregate
exposure. A second reason has to do with the relatively newness of the field of risk
management and the likelihood of limited expertise in it at the divisional level. A final reason
is the fixed costs associated with setting up a risk management department.

3 DIFFERENT CATEGORIES OF FINANCIAL RISK

3.1 Interest Rate Risk

Interest rate risk is the risk that changes in interest rate will affect financial
performance by increasing interest expenses or reducing interest income, depending
on its movement in an upward or downward direction. A company needs to be aware
of the impact on its income and/or cash flow for a given change in interest rates.
3.2 Commodity Price Risk
Commodity price risk is the risk that a change in the price of a commodity that is the
key input or output of a company will adversely affect its financial performance.
Often commodity prices may also have a foreign currency component in their pricing
and this amplifies the risk to company. The approach to managing commodity price
risk is similar to the management of foreign exchange risk.

3.3 Foreign Exchange Risk

Foreign exchange risk is the risk that the rate of exchange used to convert foreign
currency revenues, expenses, assets or liabilities to the home currency will move in an
unfavourable direction that causes profit and/or net worth to decline. There are 3 types
of foreign exchange risk: (1) transaction risk, (2) translation risk and (3) economic
risk.

3.4 Credit Risk

Credit risk is the risk that the other party to a financial transaction will not meet their
financial obligations on time (or at all). Delayed payments from customers will
provide a cash flow deficiency and incur a cost in the form of loss in interest earned,
while defaulted payments incur immediate cost.

4 REASONS TO MANAGE RISK

4.1 Increase Debt Capacity

Risk management can reduce the volatility of cash flows, and this decrease the
probability of bankruptcy and the firm can use more debt, which can lead to higher
stock price due to the interest tax savings.

4.2 Maintaining the Optimal Capital Budget Over Time

Risk management can alleviate the problem of the need to raise fund externally when
we have a bad year, thus avoiding the high flotation costs with external equity
finance.

4.3 Avoid Financial Distress

Risk management can reduce the likelihood of low cash flows and avoid the costs
associated with financial distress, such as loss of potential customers, weakened
relationships with suppliers and distractions to managers.

4.4 Comparative Advantage in Hedging

Theoretically, investors can perform the hedging, but usually, they lack the expertise
and information in order to hedge efficiently. It is therefore better for the firm to
hedge.

4.5 Reduce Borrowing Costs

By using derivative instruments call “swaps”, borrowing costs may be reduced.

4.6 Reduce Tax Payment

By stabilizing the earnings of the firm, firm can reduce the tax payment due to the
treatment of tax credits and the rules governing corporate loss carry-forwards and
carry-backs. Moreover, when volatile earnings lead to bankruptcy, tax carry-forwards
are generally lost.
5 METHODS OF MANAGING RISK

5.1 A firm that needs to borrow long-term in the future has a long position in bonds. By
issuing bonds, it has to sell the bond at the price determined by the prevailing interest.
Wealth would decrease in response to a decrease in bond price (ie increase in interest
rates). Interest rate exposure can be hedged with interest rate futures, options and
swaps.

5.2 A firm is long in the goods it sells, and short in the goods it buys. These exposures
can be managed with forward or futures contracts.

5.3 A domestic firm which exports good to foreign market will receive foreign currencies.
When the firm receives the foreign currencies, it has to sell the foreign currencies, so
it has a long position in them. The risk of devaluation when selling the foreign
currencies can be offset by forward/futures contracts, or by acquiring liabilities in the
foreign currency.

6 FORWARD CONTRACT AND FUTURES CONTRACT

A forward/futures contract is a contract made today for the delivery of an asset in the future.
A forward/futures contract is a legally binding commitment to make or take delivery of a
given quantity of a given asset at a given time in the future. The buyer of the forward/futures
contract agrees to pay a specified amount at a specified date in the future in order to receive a
given asset at the exercise price. If at maturity:
Actual price > Exercise price—Profit
Actual price < Exercise price—Loss

A forward contract is a contract made between two parties while a futures contract is traded
in the futures exchanges.

6.1 Differences Between Futures Contracts and Forward Contracts

6.1.1 Futures are “marked to market” daily. The daily gain or loss from holding a
futures contract is transferred between traders each day.
6.1.2 Margins must be posted on futures contracts.
6.1.3 Forward contracts tend to be customized, where futures contracts are
standardized so that they can be widely traded on exchanges.
6.1.4 Futures contracts often have active secondary markets, forward contracts do
not.

6.2 Using Forward and Futures Contracts to Hedge Commodity Price Risk
A producer or user of commodity can “lock in” the transaction price through a
forward or futures contract. This reduces uncertainty about future revenues or
expenses. A producer (farmer) is long in the crop to be sold at a future date. A user (a
food processing firm) is short in the commodity used in future production. The basic
idea is to balance a natural long (or short) position with an offsetting short (or long)
position, in order to reduce risk and have profitability determined by operating
activities.
6.3 Example of Hedging Commodity Price Risk
On January 1, a silver plate producer plans to buy 20,000 ounces of silver in June 30
to fill a contract based on a silver price of $25/oz. On January 1, cash silver price is
$25/oz. In the futures market, silver futures with maturity in April and July are
available and are trading at $25.5/oz and $26/oz respectively. He establishes a hedge
with July silver futures. After establishing the hedge, silver price increases. On June
30, the producer purchases silver in the cash market at $31/oz and sells his future
position at $31.2/oz. Determine the hedge position the producer should take and
calculate the gain/loss in futures and the net price paid by the producer.

1. He originally has a short position in silver so he buys futures and takes a long
hedge position.

2. Net purchase price of silver:

Per oz Total
Cash price in June $31.00 $620,000
Less: Gain in futures
market ($31.2 - $26) $5.20 $104,000
Net purchase price $25.80 $516,000

7 BASIS AND BASIS RISK

In futures markets, the spread between a futures price and the underlying spot price is known
as the futures basis and is defined as the difference between the spot price and the futures
price.
Basis = Futures Price – Spot Price
A basis exists because of the “cost of carry” inherent in the spot instrument. Carrying cost
are interest and storage cost less return of holding the underlying asset. Basis for financial
assets may be negative – for example, the dividends on a share index portfolio accrue to the
holder may be greater than the interest cost.

If market prices are in equilibrium, the carrying cost of owning the asset should equal the
basis. Otherwise, risk-free arbitrage profits are possible by taking opposite positions in the
futures and spot markets. As expiry approaches the price of futures contract moves toward
the price of the underlying instrument and on expiry date, they should be the same. If the
asset to be hedged is the same as the one underlying the futures, then the basis on expiration
is equal to zero.

Basis risk is the risk that the price of a future will vary from the price on the underlying cash
instrument as expiry approaches, creating an imperfect hedge. This can occur when futures
contracts are used to hedging and the futures contract is not written on the underlying that is
being hedged - for example using a futures contract written on a silver futures that has
different quality of silver from the silver used by the silver plate producer.

Basis risk may also occur if a futures contract whose maturity is not the same as the time
horizon of the hedger is used. In the previous example, the silver plate producers needed the
silver in 6 months’ time. However, futures contract available in the exchange market has
maturities in 4 months’ time or 7 months’ time which differ from the time horizon of the
hedger.

8 OPTION CONTRACTS

What is an option?

An option is a contract in which one party gives another the right, but not the obligation, to
buy from (or sell to) him an asset at a specified price on or before a specified date.

Types of option contracts

Rights, warrants and executive options issued by a company to its stockholders, lenders and
executives giving them the option to subscribe to the company’s common stocks.
Exchange traded options on common stocks, foreign currencies, interest rate, stock price
indexes and commodities are traded on markets such as Chicago Board Options Exchange.

Tailor made options between banks and their corporate clients on interest rate and foreign
currencies are arranged through Over-the-Counter (OTC) market.

Terminology

Call vs put

Call – gives the option buyer right to buy a specified asset.

Put – gives the option buyer right to sell a specified asset.

American vs European

American – exercisable on or before the expiration date

European – exercisable only at the expiration date

Exercise price (or strike price) – price at which the asset may be bought or sold

Expiration date – the last date on which the option may be exercised

In the money call option – stock price > exercise price

In the money put option – exercise price > stock price

Out of the money call option – stock price < exercise price

Out of money put option - exercise price < stock price

At the money – stock price = exercise price

Option seller (Grantor, Writer) – the option seller receives the option price for taking on the
price risk.
Option value at expiration:
Call option value = exercise value = max [stock price – exercise price, 0]
Put option value = exercise value = max [exercise price – stock price, 0]

Payoff to various parties at expiration date on XYZ Ltd.’s stock option

Call option – option price $1.5, exercise price $24

Put option – option price $1.0, exercise price $24

Buyer of call option Seller of call option

Profit

0 1.5
24 25.5
1.5 Stock 0
price
24 25.5

Loss

Buyer of put option Seller of put option

23

0 1.0
23 24
-1.0 Stock price 23 24

-23
Before expiration, the option price will be above the exercise value. The difference between
the option price and exercise value is the option premium. Investors are willing to pay a
premium above the exercise value because there is still time and chance for the stock price to
increase more before expiration and the investors will gain more when exercise the option at
expiration.

Example:

A call option with an exercise price of $25, has the following values at these prices:

Stock Price Call Option Price

$25 $3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50