A report on the hedging strategy of CITIC Pacific Limited

This report is to check the hedging strategy that was used and lead to the huge loss of CITIC Pacific Limited and point out the importance of managing foreign exchange exposure through select appropriate hedging strategies. The huge loss of CITIC Pacific Limited and its cause is discussed in the first part. The importance of hedging and the tools of hedging are respectively reviewed in part two and part three. Finally, suggestions are given out on how to design proper hedging strategies for different enterprises.

The huge loss of CITIC Pacific LimitedOn October 2008 21st, shares in CITIC Pacific (Listed in the HKEx) halved (http://news.bbc.co.uk/1/hi/business/7683160.stm) after the news of huge loss of foreign exchange was released. The next day, the share price fell sharply by 24.69%.

The transaction is a 25-year long magnetite investment project with total value of about 42 billion U.S. dollars. It is a normal course of business involved in large amount of money. The risk of exchange rate is obvious in such a long period and it’s common to enter into foreign exchange forward contracts. However, CITIC Pacific has chosen Accumulator contract with Australian dollar as target. That is to say, CITIC Pacific has the right to purchase Australian dollar with a discount when it’s appreciating but there is an upper limit; if Australian dollar depreciates in the period stipulated in the contract, CITIC Pacific has to buy it in double amount at the negotiated price and there is no lower limit. With the outbreak of the global financial crisis (http://www.eurotopics.net/en/magazin/magazin_aktuell/finanzkrise-2008/debatte-kapitalismus-11-2008/), the Australian dollar devaluated more than 10.8 percent in a period of time as short as one month, which directly lead to the huge loss of CITIC Pacific.

It’s supposed to select simple and traditional financial derivatives to deal with the foreign exchange risk according to the principle of security and stability when the transaction is involved in such a large amount. However, the operator of this contract chose Accumulator which is complex and high-risk, based on his subjective assumptions about the trend of Australian dollar. Finally, it resulted in the huge loss. It is perceived that the speculative operation is the root cause.

The importance of hedgingWith the globalization, the production and operation activities of enterprises are not confined to one country, but increasingly involved in foreign suppliers as well as foreign markets. To settle the accounts of all kinds of transactions, foreign exchange is widely used. While foreign exchange fluctuates more frequently and violently, the risk enterprises are facing is becoming larger and larger. Nowadays, Exchange rate risk management has become one of the most important objectives.(Rawls S W, Smithson C W. 1990, 1:6-18)The most important thing is to enhance the awareness of the foreign exchange risk (Brealey, R., and Myers, S. 2002.)

Besides, enterprises must make a good hedging strategy in accordance with their needs to minimize or resolve the changes in prices and foreign exchange risks. Hedging is to reduce the risk resulted from the change of future market by using futures, forward or options. For example, the introduction of futures hedging greatly enhanced the transactions and circulation efficiency of in-kind goods, and played a significant role in fixing the profits of both sides of supply and demand against the risks arising from fluctuations in prices. If the value of derivatives is far greater than the amount of in-kind goods, it should be regarded as speculation instead of hedging. Moreover, the risk in the future will be enlarged with a multiple.

In fact, even if CITIC Pacific had to choose “Accumulator” for some reason, the company could also sign other derivatives contracts and restructure the strategies of hedging to decrease the risk of exchange rate fluctuations.

Hedging toolsAny single financial derivatives such as forwards, futures, options and swaps can be used to manage exchange rate risks.

Forwards contracts are the most basic and most commonly used financial derivatives. In theory, it has been proved that futures and swaps can be equal to the combination of forwards. (Hull J C, 1997)Generally, a foreign exchange settlement contract will be signed by banks and their customers, which stipulates the type of foreign currency to be used, the sum, the exchange rates and duration. On the due date when income or expenditure of foreign exchange occurs, currency exchange settlement will be operated in accordance with the contract.

In order to improve efficiency, it’s necessary to adjust the hedging when using forward contracts. (Brealey R, Kaplanis E. 1995)When the interest rate fluctuates randomly, the forwards strategy can be divided into three smaller parts: the Minimum Variance Hedging, Merton / Breeden Hedging and speculation. (Briys E, Solnik B. 1992)When the interest rate is certain, there is no price difference between futures contracts and forward contracts. Perfect hedge can be achieved, no matter what type of hedging tools is used. However, the two is no longer able to replace each other when interest rates move randomly, because of the existence of marking to market in futures market operation.

The above selection is based on the effectiveness of futures and forwards. Next, the selection rules will emphasis on other features. Futures contracts are standardized by the Exchange, where the transactions usually take place. Forward contracts are signed between financial institutions or between financial institutions and their clients privately. The transactions usually happen in the over-the-counter trading market. Compared to futures contracts, forward contracts are more flexible and customers can decide their own amount of the transaction, instead of being restricted by the criteria established by the exchange. As a result, when deciding which tool to use between the futures contracts and forward contracts, the company needed to take into account the size of the contract, and whether can they find a suitable one in the exchange. If not, forward contracts maybe considered with priority.

Compared to forward and futures contracts, options developed a lot in function, and therefore are more widely used.

An option contract provides firms insurance so that investors are protected from the loss when the price changes in a negative direction, and when the price moves in a favorable direction, the firms are still able to gain profit from them. Long position of option contract has the right to choose whether or not to purchase the target asset at the determined price in a particular period of time, while long position of futures or forward contracts has an obligation to buy the underlying asset.

Investors have to pay an option premium to achieve the option contract. Correspondingly, the largest loss of the investors is the already-paid premium. There is no need to pay any fee when futures or forward investors are going to sign the contracts. However, the potential gains and losses are very large.

The currency swap contracts can be used as the combination of a series of forward contracts.

How to design proper hedging strategiesWhen there are lots of financial derivatives to choose from in the exchange rate risk management, it’s complex to decide how to conduct a reasonable and proper choice. First of all, what kind of subject is managing the risk should be taken into consideration. Is it an export or import company, or a commercial bank? Then comparisons between any two types of basic currency derivatives should be made. In this case, there will be a variety of possible combinations. For example, export enterprises with forwards and options, import companies with options and futures, commercial banks with forwards and swaps, etc.

For a particular enterprise, the first thing is to identify its operating environment, then define its expected utility function, and maximize this function. Finally, the optimal hedging tool can be derived. These procedures constitute the process of setting up and using exchange rate risk hedging tool selection model.

Take exporter for example. The currency futures market and the currency options market are given unbiased and the influence of interest rates is neglected. In a single period of maximizing expected utility, the risk-aversing exporter will choose the currency futures contracts to manage its foreign exchange rate risk. In other equal conditions, exporter will choose the type of hedging tool which will minimize the fluctuation of its net income at the end of the volatility. Using currency futures contracts could cover its exposure to exchange rate risk, and fix its net income at the end of the volatility, while using the options contracts can not completely eliminated the uncertainty.

The above method is suitable for experienced enterprises. For those who are not so experienced, it’s recommended that they can try some relatively simple hedging tools to cover their own foreign exchange rate exposure. Before put them into practice, they should make a thorough study and assessment of the risk resulting from using the hedging tools. It’s of significant importance to fully understand the hedging tool that will be used, whatever type it is. As they are able to understand the hedging tools more deeply and use them more smoothly, the enterprises can extend to some more complex ones gradually.

This investment of CITIC Pacific can be considered as an import business, just to the opposite of export. As a result, the risk it bears should be the opposite and therefore, for CITIC Pacific, the best hedging tool is purchasing currency options: a put option of Australian dollars, which could help to avoid risks brought about by the depreciation of the Australian dollar. Moreover, its net income can be determined and CITIC Pacific would be able to receive the scheduled proceeds.

SummaryTo sum up, managing foreign exchange rate risk through appropriate hedging strategies is important for a firm, especially when its business becomes global.

Through the analysis of huge loss of CITIC Pacific Limited, it can be concluded that before selecting a hedging strategy, the firms are supposed to know it thoroughly. The objective of using hedging tools should be reducing exchange rate risk and using any risky derivatives in the hope of gaining some benefits should be regarded as speculation and it’s dangerous for the operation of the firms.

References:

Rawls S W, Smithson C W. Strategic risk management. Journal of Applied Corporate Finance, 1990, 1:6-18)Brealey, R., and Myers, S. (2002) Principles of Corporate Finance, 6th edition, NewYork: McGraw-Hill Higher Education.

Hull J C. Optionsfuturesand other derivatives seurities.3rd ed. Upper Saddle River: Prentice-Hall199749-141Brealey R, Kaplanis E. Discrete exchange rate hedging strategies. Journal of Banking and Finance, 1995, 19:765-784(Briys E, Solnik B. Optimal currency hedging ratios and interest rate risk. Journal of International Money and Finance, 1992, (11): 431-445)