Financial and Operational Hedging Techniques
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Introduction Overview of the hedging techniques In the financial market, almost all of companies need to face the currency risk. In order to manage the currency risk, companies will use different hedging techniques, such as financial and operational hedging techniques. For example, money market, futures contracts, options and forwards contracts are commonly used by firms, as well as operational hedging techniques. All of 4 types of financial hedging techniques are short-term hedge. Money market is a part of financial markets for assets involved in short-term borrowing,lending, buying and selling. Its features are high liquidity, lower risk, such as treasury bills. Futures contracts are future transaction for buying or selling, and made by Futures exchange. The date and place of the transaction have been provided. There are some features of futures contracts. Quantity, commodity and quality have been limited, excepting the price. Also, it cannot be done over-the-counter. Options is a financial tool, which based on futures. If purchaser hold the options, he/she will has a right, not the obligation, to buy from or sell to the seller of the provided commodity in the future as the same price as the price agreed now.
The last financial hedging technique, forwards contracts, is a non-standardization contact between two parties to sell or buy in the future. Curb-exchange and cash transaction are the feathers of forward contact. This essay will focus on two operational hedging techniques, market selection strategy and plant location strategy. The first one suggests that firms should diversify products into many markets as possible. The second one suggests that firms need to find out which location will be good for setting up production plant. Advantages and disadvantages of the hedging techniques Money market advantages 1. Fixed future rate 2. Flexible amount 3. To use it for currencies where forwards contacts cannot be used. Disadvantages 1. More complex 2. Fixed future rate lose chances to get the movements in exchange rate. Futures contacts advantages 1. Lower commission 2. Higher leverage 3. Reversing positions easily 4. Higher liquidity. Disadvantages 1. Highly risky from leverage 2. Standardized products, fixed amounts and terms 3. Leading to over-trading by lower commission 4. Just a partial hedge(Finance Learners 2014).
Options advantages1.leverage 2. Risk/reward ratio Allowing you to have limited downside but not a limited upside. 3. Unique strategies 4. Low capital requirement. Disadvantages 1. Lower liquidity 2. Higher spreads 3. Higher commission 4. Complicated especially for the beginners. 5. Time decay 6. Less information it is difficult to get some analyzed information. 7. Not available for all stocks(Thinktrade 2006). Forwards contacts advantages 1. Providing a complete hedge 2. Offering a price protection 3. Easy to understand 4. Over-the-counter products. Disadvantages 1. Having a default risk 2. Difficult to cancel contracts 3. No intermediate cash flows before settlement 4. Hard to find a counter-party. Market selection strategies advantages 1. Cash flow will be more stable 2. Reducing economic exposure rapidly. Operators need to find out the hedging technique which is suitable for their firms. Therefore, the virtue and drawback must be considered carefully. Some examples of firms use different hedging techniques to manage currency risk. ency risk) (source Center of business performance 2008)
A never used futures contacts, but it used forward contracts frequently when facing the transaction exposure. B company in translation exposure also used forward contracts frequently, but it never used the options and futures contracts. Telefnica, a Spanish telecommunication company, faced the exchange rate risk. Foreign currency risk primarily show up in connection with1. The international presence of Telefnica, and the investment and businesses in other countries, such as Latin America, use other currencies, not the euro. 2. Liabilities denominated in currencies are different with its own country, and this debt is not likely to be conducted. At the same time, the thing of depreciation in foreign currencies relative to euro, and the value of cash flow has a loss in such currencies. However, this loss is offset by the reduction in the euro value of liabilities denominated. The level of exchange rate hedging was changed by the type of investment. In 2011, Telefnicas net debt was equivalent to about 7,953m euro in Latin America(Telefnica 2011). However, its currencies in which this debt is denominated is merged in percentage to the cash flow of each currency.
The above hedge of exchange rate risks whether effective or not relies on which currencies depreciate relative to euro. In order to avoid decrease of the Latin America currencies relative to the euro, Telefnica group use the dollar-denominated debt. For instance, in spain, this is linked to an investment when it is suggested to be an effective hedge or in its own country. Meanwhile, the remaining exchange rate exposure on the income statement will be limited by the Telefnica Group to manage the exchange rate risk, no matter whether there are open positions. There are three reasons why such open position exposure can arise. 1. Because a tight market for local derivatives or difficulty in sourcing local currency finance, low-cost hedge cannot be arranged, such as in Argentina and Venezuela. 2. The accounting treatment of exchange rate risk is not similar between financing through intra-group loans and financing through capital contributions. 3. A policy decision that avoids the high cost of hedges. After Telefnicas subsidiaries hold the positions to reduce its direct exposure, it consider its foreign currency risk exposure at the Group level.
The Telefnica group try to make the sensitivity of exchanges gains or losses clear in exchange rates, and they assumed at the end of 2011, the relationship between exchange rate position and income statement were constant. Dollar appreciated against the Latin America currencies, and the euro against the rest of the currencies. As a result, in 2011 the exchange losses would be 111m euro for Telefnica. Therefore, Telefnica try to manage its exposure on a fluctuant basis. This firm used currency options and forward contracts to manage currency risk. Another example is Vodaphone which is a famous international mobile phone operators in the world. In the global financial market, the Vodaphone faced the foreign exchange risk. Its sterling share prices represents the value of its future various currencies cash flow, such as euro, US dollar. Therefore, the Group began to kept interest charges and the currency of debt in percentage to its expected future various currencies cash flow and try to hedge external foreign exchange risks during the transactions of other currency, and keep them above the minimum levels.
In the future, Vodafones future cash flow might be increased in the emerging markets, and more debt in these markets, currencies will be drawn. Vodafone used three financial hedging techniques, money market, options and forward contracts to manage the foreign currency risk. In 2013, 135 of net debt was denominated in currencies other than pounds. At the same time, buying 35 net debt forward in pounds in advance of sterling denominated shareholder returns, which came from the dividends and share buybacks. That means euro, US dollars and other debt to be served in percentage to expected future cash flows. Meanwhile, it can offer a partial hedge against income translation exposure. There was a foreign exchange management policy in Vodafone. Foreign exchange transaction exposure was maintained at 15m euro each currency over a 6 month period and each currency will be lower than 5m euro monthly. The Group also realized that foreign exchange movements in equity for the translation of net investment hedging instruments and could be balanced as investment in foreign operations. Because of an offset in currency translation of foreign operation, it is impossible to find net impact on equity for foreign exchange movements.
The last financial financial hedging technique is future contacts. Derivatives instrumentForeign exchangeInterest rate. OTC forwards and OTC option still were the ways that firm used frequently to manage currency risk. On the other hand, futures was just used to manage financial price risk. One possible reason why futures were not used commonly by firms is futures in currencies were not currently traded in UK exchanges. Therefore, firms are not likely to accept this instruments with higher transaction costs and lack of confidence. Forward contact offers a price protection for operators, and they can benefit from options as it just need with a low capital requirement, and it allows firms to have a unlimited upside. Therefore, firms face the exchange risk in the global financial market, regardless of small or large firms, options and forward contacts will be their common choice. To manage exchange risk, firms also can use operational hedging techniques. For example, the BMW Group managed exchange risk with a strategic(medium and long term) and an operating level(short and medium term).
In the medium and long term, the Group used natural hedging to manage the foreign exchange risk. It means the volume of purchases denominated in foreign currency and the number of local production needed to be increased. The BMW Group expanded its plants in Spartanburg and the USA. Also, the BMW Brilliance joint ventures new plant was set up in Tiexi in 2012. These two expansion helped BMW to reduce the foreign exchange risk in two major sales markets. The Group tried to diversify into many market as possible, and then expanded its plants to reduce exposure. In this case, market selection and plant location strategy had been used to hedge the economic exposure. BP, one of the biggest private oil companies in the world. As BP expands the global market, foreign currency exchange risk has been a important part that BP needs to focus on. Changing cost competitiveness and lags in market adjustment to movements in rate were caused by exchange rate fluctuations. the US dollar was the main basic economic currency of the Groups cash flows. In order to arise from currency movement against the US dollar, the Group tried to restrict economic and material transactional exposures. Firstly, handling of foreign currency exchange risks needed to be integrated.
After that, the material residual foreign currency exchange risk also needed to be managed. It is vital that reviewing the foreign exchange economic value at risk, and attempted to keep such risk below 400m US dollars of 12-month foreign currency value. The most crucial exposure linked to British and European operational requirements, and capital expenditure commitments. In this case, besides financial hedging techniques-forward contacts, options and future contacts, operational hedging techniques also used to manage the economic exposure, such as market selection strategy and production differentiation strategy. For instance, the BP tried to enter into more market to sell its oil, which is reducing exposure. Also, production plants were set up at the location with low cost of land. Managing currency risk, firms can choose different hedging techniques. Each techniques has its merits and demerits, and firms need to consider carefully and relate to its own business. Conclusion In the financial market, as firms enter into other countries, they will face foreign currency exchange risk and economic exposure.
In order to manage the risk and reduce the exposure, firms use different hedging techniques, such as options and forward contract, these two techniques provide firms with stable future cash flow, and reduce translation income exposure. Money market and futures are used occasionally by companies. Operational hedging techniques are commonly used by large firms, such as BMW and BP. Especially, car companies will like to use the operational to manage the economic exposure. Each techniques has it advantages and disadvantages, firms need to consider carefully and understand the whole financial market.
Finance Learners, (2014). Advantages and Disadvantages of Futures. online available from http//financelearners.blogspot.co.uk/2011/04/advantages-disadvantages-futures.html. 21 March 2014 Thinktrade, (2006). The advantages and disadvantages of options. online available from http//www.thinktrade.net/options-advantages-and-disadvantages.php 21 march 2014 Andrew, M.and Pauline, W. (2008) managing interest rate risk and foreign exchange risk disclosure of objective, polices and process. online available from https//www.icaew.com//media/Files/Technical/Research-and-academics/publications-and-projects/financial-reporting-publications/briefing-managing-interest-rate-risk-and-foreign-exchange-risk.pdf 21 March 2014 Telefnica, 2011. Derivative financial instruments and risk management policies.online. Available formhttp//annualreport2011.telefonica.com/pdf/risk-management-policy.pdf 21 March 2014 Vodafone, (2013). Annual report for the year ended 31 march 2013. Vodafone Group PLC. Y