Professional Documents
Culture Documents
Particulars
Sr. No
1.
Introduction
2.
Types of Hedging
3.
Pg. No
2
11
6.
19
7.
Management of NPAs
21
10.
Conclusions
29
11.
Bibliography
30
1
INTRODUCTION
Hedging is often considered an advanced investing strategy, but the
principles of hedging are fairly simple. With the popularity - and accompanying
criticism - of hedge funds, the practice of hedging is becoming more widespread.
Despite this, it is still not widely understood.
Although it sounds like your neighbor's hobby who's obsessed with his
topiary garden full of tall bushes shaped like giraffes and dinosaurs, hedging is a
practice every investor should know about. There is no arguing that portfolio
protection is often just as important as portfolio appreciation. Like your neighbor's
obsession, however, hedging is talked about more than it is explained, making it
seem as though it belongs only to the most esoteric financial realms. Well, even if
you are a beginner, you can learn what hedging is, how it works and what hedging
techniques investors and companies use to protect themselves.
What Is Hedging?
The best way to understand hedging is to think of it as insurance. When
people decide to hedge, they are insuring themselves against a negative event. This
doesn't prevent a negative event from happening, but if it does happen and you're
properly hedged, the impact of the event is reduced. So, hedging occurs almost
everywhere, and we see it everyday. For example, if you buy house insurance, you
are hedging yourself against fires, break-ins or other unforeseen disasters.
Portfolio managers, individual investors and corporations use hedging
techniques to reduce their exposure to various risks. In financial markets, however,
hedging becomes more complicated than simply paying an insurance company a
fee every year. Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements. In
other words, investors hedge one investment by making another.
Technically, to hedge you would invest in two securities with negative
correlations. Of course, nothing in this world is free, so you still have to pay for
this type of insurance in one form or another.
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Although some of us may fantasize about a world where profit potentials are
limitless but also risk free, hedging can't help us escape the hard reality of the riskreturn tradeoff. A reduction in risk will always mean a reduction in potential
profits. So, hedging, for the most part, is a technique not by which you will make
money but by which you can reduce potential loss. If the investment you are
hedging against makes money, you will have typically reduced the profit that you
could have made, and if the investment loses money, your hedge, if successful, will
reduce that loss.
which allows the company to buy the agave at a specific price at a set date in the
future. Now CTC can budget without worrying about the fluctuating commodity.
If the agave skyrockets above that price specified by the futures contract, the
hedge will have paid off because CTC will save money by paying the lower price.
However, if the price goes down, CTC is still obligated to pay the price in the
contract and actually would have been better off not hedging.
Keep in mind that because there are so many different types of options and
futures contracts an investor can hedge against nearly anything, whether a stock,
commodity price, interest rate and currency - investors can even hedge against the
weather.
The Downside
Every hedge has a cost, so before you decide to use hedging, you must ask
yourself if the benefits received from it justify the expense. Remember, the goal of
hedging isn't to make money but to protect from losses. The cost of the hedge whether it is the cost of an option or lost profits from being on the wrong side of a
futures contract - cannot be avoided. This is the price you have to pay to avoid
uncertainty.
We've been comparing hedging versus insurance, but we should emphasize
that insurance is far more precise than hedging. With insurance, you are completely
compensated for your loss (usually minus a deductible). Hedging a portfolio isn't a
perfect science and things can go wrong. Although risk managers are always
aiming for the perfect hedge, it is difficult to achieve in practice.
these investors there is little point in engaging in hedging because they let their
investments grow with the overall market.
Even if you never hedge for your own portfolio you should understand how
it works because many big companies and investment funds will hedge in some
form. Oil companies, for example, might hedge against the price of oil while an
international mutual fund might hedge against fluctuations in foreign exchange
rates. An understanding of hedging will help you to comprehend and analyze these
investments.
TYPES OF HEDGING
The trader might regret the hedge on day two, since it reduced the profits on the
Company A position. But on the third day, an unfavorable news story is published
about the health effects of widgets, and all widgets stocks crash: 50% is wiped off
the value of the widgets industry in the course of a few hours. Nevertheless, since
Company A is the better company, it suffers less than Company B:
Value of long position (Company A):
Day 1: $1,000
Day 2: $1,100
Day 3: $550 => ($1,000 $550) = $450 loss
Value of short position (Company B):
Day 1: $1,000
Day 2: $1,050
Day 3: $525 => ($1,000 $525) = $475 profit
Without the hedge, the trader would have lost $450 (or $900 if the trader took the
$1,000 he has used in short selling Company B's shares to buy Company A's shares
as well). But the hedge the short sale of Company B net a profit of $25 during a
dramatic market collapse.
Natural hedges
Many hedges do not involve exotic financial instruments or derivatives such
as the married put. A natural hedge is an investment that reduces the undesired risk
by matching cash flows (i.e. revenues and expenses). For example, an exporter to
the United States faces a risk of changes in the value of the U.S. dollar and chooses
to open a production facility in that market to match its expected sales revenue to
its cost structure.
Another example is a company that opens a subsidiary in another country
and borrows in the foreign currency to finance its operations, even though the
foreign interest rate may be more expensive than in its home country: by matching
the debt payments to expected revenues in the foreign currency, the parent
company has reduced its foreign currency exposure. Similarly, an oil producer may
expect to receive its revenues in U.S. dollars, but faces costs in a different
currency; it would be applying a natural hedge if it agreed to, for example, pay
bonuses to employees in U.S. dollars.
One common means of hedging against risk is the purchase of insurance to
protect against financial loss due to accidental property damage or loss, personal
injury, or loss of life.
Cotton Textiles
Silk Textiles
Woolen Textiles
Readymade Garments
Hand-crafted Textiles
Jute & Coir
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Current Scenario
Readymade Garments
2% 2%
Cotton Textile
16%
Manmade Textile
40%
4%
Handicrafts
Silk & Handloom
Wool & Woolen Textiles
16%
Others
20%
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US$ Billions
$15.00
$10.00
$5.00
$0.00
FY06
FY07
FY08
FY09
FY10
FY11
Below is a gist of various schemes by the GOI for promotion of this industry:
FDI: 100% FDI allowed in textiles under the automatic route thereby
promoting the development of the industry and capital inflow in the country.
Welfare Schemes: 161.10 million weavers and ancillary workers offered
health insurance & life insurance under the handloom weavers
comprehensive welfare scheme and 7.33 lacs artisans provided health
coverage under the Rajiv Gandhi Shilpi Swasthya Bima Yojna.
E-marketing: The central cottage industries corporation of India (CCIC) and
the handicrafts &handlooms export council of India (HHEC) have developed
various e-marketing platforms to simplify marketing issues.
Skill development: The integrated skill development scheme offers training
assistance to the workers for enhancement of skills. All 3 sub sectors of the
textile industry viz. Textiles & Apparels, Handicrafts and Jute & Sericulture.
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Credit linkages: As per the credit guarantee program, over 25000 artisan
credit cards have been supplied to various artisans and 16.50 million
additional applications for issuing up credit cards are under consideration.
Financial package for waiver of overdues: The GOI has announced a
package of US $ 604.56 Million to waive off overdue loans in the handloom
sector.
Other regulations: Government has also levied regulations to prohibit child
labour. Also government has brought in regulations for better wages and
compensation to workers who develop respiratory diseases due to paint
pigments used for dying of the fabrics and yarns.
Textile Parks: The GOI has approved 40 new textile parks to be set up and
this would be executed over a period of 36 months. Thereby leveraging
further employment in this industry.
Recent developments: Along with the increasing export figures in the Indian
apparel sector in the country, Bangladesh is planning to set up two special
economic zones for attracting Indian companies in view of the duty free
trade between the two countries. The 2 SEZs are expected to come up on
100-acres plot of land in Kishoreganj & Chattak in Bangladesh. Italian
luxury major Canali has entered into a 51:49 joint venture with Genesis
luxury fashion which currently has distribution rights of Canali-branded
products in India. The company will now sell Canali branded products in
India exclusively.
Technological upgrades
Enhancement of productivity
Quality consciousness & Strengthening of raw material base
Product diversification, Increase in exports and innovative marketing
strategies
Financing arrangements
Increasing employment opportunities
Integrated human resource development
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Risk and return go hand in hand. While the level of risk increases with
increasing expectations in the returns required, there are certain risks which are
associated with current level of business and the concern is not necessarily about
the increase in the return or a potential loss but to safeguard or be sure of the
current business situation. One such risk associated with the international business
is the risk associated with the currency fluctuations. Such risks usually affect the
business in various ways and impact the costs/revenue/expenditure and eventually
performance of any company/ organization involved with international business.
Currency Fluctuations
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Example:
A Taiwanese company has the following USD exposures:
i. Owns a factory in Texas worth US$5 million.
ii. Agreement to buy goods worth US$2 million.
iii. Biggest competitor is a US company.
What happens if the dollar appreciates?
i. NT$ value of US factory goes down (translation exposure).
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ii.
iii.
Translation Exposure:
The exposure of an MNCs consolidated financial statements to exchange
rate fluctuations is known as translation exposure. In particular, subsidiary earnings
translated into the reporting currency on the consolidated income statement are
subject to changing exchange rates. From a cash flow perspective: The translation
of financial statements for consolidated reporting purposes does not by itself affect
an MNCs cash flows. However, a weak spot rate today may result in a weak
exchange rate forecast (and hence a weak expected cash flow) for the point in the
future when subsidiary earnings are to be remitted. From a stock price perspective:
Since an MNCs translation exposure affects its consolidated earnings and many
investors tend to use earnings when valuing firms, the MNCs valuation maybe
affected. An MNCs degree of translation exposure is dependent on: The
proportion of its business conducted by foreign subsidiaries, the locations of its
foreign subsidiaries, and the accounting methods that it uses.
Transaction Exposure:
The degree to which the value of future cash transactions can be affected by
exchange rate fluctuations is referred to as transaction exposure. Transaction
exposure measures changes in the value of outstanding financial obligations
incurred prior to a change in exchange rates but not due to be settled until after the
exchange rates change. Thus, this type of exposure deals with changes in cash
flows that result from existing contractual obligations.
Transaction exposure arises from:
i. Purchasing or selling on credit goods or services whose prices are stated in
foreign currencies.
ii. Borrowing or lending funds when repayment is to be made in a foreign
currency.
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iii.
iv.
Operational Exposure:
Operating exposure, also called economic exposure, competitive exposure,
and even strategic exposure on occasion, measures any change in the present value
of a firm resulting from changes in future operating cash flows caused by an
unexpected change in exchange rates.
Measuring the operating exposure of a firm requires forecasting and
analyzing all the firms future individual transaction exposures together with the
future exposures of all the firms competitors and potential competitors worldwide.
Operating exposure is far more important for the long-run health of a business than
changes caused by transaction or accounting exposure. Operating exposure is
inevitably subjective, because it depends on estimates of future cash flow changes
over an arbitrary time horizon. Planning for operating exposure is a total
management responsibility because it depends on the interaction of strategies in
finance, marketing, purchasing, and production.
An expected change in foreign exchange rates is not included in the
definition of operating exposure, because both management and investors should
have factored this information into their evaluation of anticipated operating results
and market value. From an investors perspective, if the foreign exchange market is
efficient, information about expected changes in exchange rates should be reflected
in a firms market value. Only unexpected changes in exchange rates, or an
inefficient foreign exchange market, should cause market value to change.
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Whether this reduction of variability in cash flows then sufficient reason for
currency risk management is a continuing debate in financial management and
corporate finance and there are several schools of thought to the same.
Opponents of currency hedging commonly make the following arguments:
i. Stockholders are much more capable of diversifying currency risk than the
management of the firm.
ii. Currency risk management does not add value to the firm and it incurs costs.
iii. Hedging might benefit corporate management more than shareholders.
Proponents of currency hedging cite:
i. Reduction in risk in future cash flows improves the planning capability of
the firm.
ii. Reduction of risk in future cash flows reduces the likelihood that the firms
cash flows will fall below a necessary minimum (the point of financial
distress).
iii. Management has a comparative advantage over the individual shareholder in
knowing the actual currency risk of the firm.
iv. Individuals and corporations do not have same access to hedging instruments
or same cost.
Hedging of currency in it-self is a process and undergoes a step by step
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Contractual Hedges:
Forward contracts:
A forward contract is an agreement between a firm and a commercial bank
to exchange a specified amount of a currency at a specified exchange rate (called
the forward rate) on a specified date in the future.
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A currency call option grants the holder the right to buy a specific currency at a
specific price (called the exercise or strike price) within a specific period of time.
A call option is
in the money if exchange rate > strike price,
at the money if exchange rate = strike price,
out of the money if exchange rate < strike price.
Firms may purchase currency call options to hedge payables, project bidding, or
target bidding.
A currency put option grants the holder the right to sell a specific currency at a
specific price (the strike price) within a specific period of time.
A put option is
in the money if exchange rate < strike price,
at the money if exchange rate = strike price,
out of the money if exchange rate > strike price.
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v.
vi.
vii.
viii.
Currency Diversification
Use of marketing strategies
Use of product management
Transferring the risk to the buyers
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An illustrative interpretation of the cycle time in the typical value chain shared
earlier could be as below:
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Identifying Exposures:
With the growing currency fluctuations in US dollars and Euro, and the
company being 100% export oriented, the complete business revenue of the
company is exposed to currency fluctuations risk. While the rupee has been stable
against Euro, it has been volatile against the US dollar although recent trends have
seen rupee depreciating against the same.
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USD/INR as on
delivery date
1$ = Rs. 56.00
1$ = Rs. 56.00
As seen above, a hedged exporter will not earn any profit or incur any loss
on account of a forex fluctuation. However, there could be gain (on account of a
forward contract) in the price realization since the company follows a cost plus
model with current INR costs as the base cost to arrive at selling price for a
particular contract. This is however a notional gain.
Considering an export order for 1000 shirts @USD 10 each and spot rate assumed
at Rs.53.00
Payment terms are 90 days
Particulars
US $
INR
Quantity
100
100
Selling price per piece
$10
Total Selling Price
$1,000
(a)
Cost price per piece
424
Total Cost price
42,400
(b)
Total cost price in $
$800
(c=b/53)
Expected Gross Margin in $
$200
(d=a-c)
Keeping the cost price constant at Rs. 42,400 and selling price at 54.20 on date of
maturity
Price realization in INR
54,200
(e=a*54.2)
Cost in INR being constant
42,400
(b)
Actual Gross Margin in INR
11,800
(f=e-b)
Actual Gross Margin in $
$218
(g=f/54.2)
Change in Gross Margin in $
$18
(h=g-d)
Change in Gross Margin in %
8.9%
(i=h/d%)
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ii.
Mahalaxmi hedges its funds it is advisable that they survey the market at
least intermittently if not regularly.
iii.
Money market hedge: The exporter may also get into money market hedge
and borrow foreign currency to be received, convert to domestic currency
and invest for future use. This would however invite risks in case if rupee
appreciates.
iv.
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