Hedging with Examples

In today’s global economy, a finance manager may come across wide array of risks and challenges related to financial risks while working in some non-financial organization. These challenges are inherent in management of organizational financial matters in global economy of today.

In today’s economy, there are many types of risks organizations may face like: – Operational inefficiency, Laws and regulations, Business environment, Repute of organization and financial risks. Financial risks usually attribute to financial operations of the business. It take different forms depending on the circumstances like, risk of financial loss, currency risks, financing risks, interest rate risks, credit risks, cash flow risks, liquidity risks ecectra. How significant these risks are for an organization varies widely from organization to organization. For example, an organization who has international operations is more exposed to currency risks relatively to a firm which operates domestic business. A financial institution will be more exposed to credit risks, relative to other non-financial organization. Hence, it varies from one organization to another.

The disasters in financial risk management, multinational organizations came across in last fifteen years have highlighted the significance of risk management for good governance. It also triggered unwarranted attention towards internal control and governance. Over the period, managers of the companies have, by large, recognized the value addition, an effective financial risk management may ensure to the organization. The language of financial risk management has started permeating in day to day operations of companies. Now all the major decision making regarding budgetary choices, consideration of investment proposals, choosing between operating plans and other significant pivotal decisions are made keeping in view their risk implications as now stakeholders of companies want to know more about the risks organization is taking.
 

Introduction

In this research paper, we have thrown light on the nature of financial risks, components of financial risk management and different methods to undergo decision making in uncertain circumstances. An effective financial risk management framework keep into consideration the organizational context while drafting of apt financial risk management strategies.

Types of Financial Risks

Financial risks are actually the possibilities that organization may incur losses on its failure to meet its financial objectives. This risk attributes to the uncertainty organization have about commodity prices, interest rates, foreign exchange rates, credit rating, prices of equity, liquidity, organizational access to financing ecectra. These financial risks are interlinked with each other and do not work independently. For example, interest rates and exchange rates are directly correlated with each other and strongly interlinked and this interconnection should be kept into consideration while designing financial risk management systems. (Brucaite & Yan, 2016)
We have categorized financial risks in following categories:-

• Market Risks
• Credit Risks
• Liquidity / Financing Risks

Exposure of Sand Fire Resources NL to Financial Risks

Financial price exposure of non-financial corporations consists of unexpected changes in interest rates, prices of commodities and foreign exchange rates. Financial price exposure implies that future cash flows of the company are significantly influenced owing to changes in financial prices. As we all know that value of the company can be determined by looking at the present value of its cash flows therefore, value of companies are highly sensitive to changes in financial prices.

Sand Fire Resources NL is exposed to variety of financial risks like foreign exchange price exposure and Commodity pricing risk as company is Australia based and its sales of Gold and Copper are distributed round the world. (Bartram, Dufey, & Frenkel, 2005). It is also exposed to the risk of volatility in interest rates as company has already taken syndicated bank loan amounting US$ 600 million (Euro variable 200£ million) for 10 years, against which annual interest payments made by the company at the floating rate of 2.5% above 3 months US dollar LIBOR rate. However, floating rate rather fixed rate has somehow lessened the risk of interest rate volatility.

Company is subject to exchange rate risk owing to higher volatility of exchange rate of US dollars in London Inter-Bank market, as compare to other financial prices. If we compare the standard deviations of financial risks i.e. commodity price, interest rate, exchange rate etc.,  we will witness that there is high volatility trend in commodity price and interest rates as compared to foreign exchange rates. High ratio of foreign to total sales by Sand Fire Resources implies that there is strong correlation between variation (depreciation/appreciation) in dollar pricing and decrease/increase in value of company’s stock.

Interest rate exposure may also badly affect the value of Australian company by means of changes in cash flows which are generated from operational activities. These changes in cash flows may arise in the wake of change in interest rates which directly impacts the cost of capital of the company.

Sand Fire Resources’ Sales are also exposed to commodity price exposure. Commodity price exposure means that an unexpected variation in the price of commodities may affect the value of company. Though changes in the production factors have the potential to directly affect the cost and revenue of the company, however some inputs and outputs (referred to as commodities) are traded in international financial markets on futures/spot exchange rates. (Woods & Dowd, 2016).

If Sand Fire Resources should hedge its financial risk exposures or not:-

Until recently, there have been very little efforts by analysts to determine the fact that if companies are successful in covering or mitigating the risk of financial price exposures by means of using hedging instruments.

There are many factors which influence company’s decisions to hedge its financial risk exposure.  Considerations of risk aversion, asymmetrical information, tax reductions, managerial compensations, transactional costs owing to financial distress influence companies’ decisions to covering the risk by hedging. Behind hedging motives, the major factor taken into consideration by the companies is of imperfect capital markets. In order to overcome its imperfection, corporate hedging policies aid companies in reducing the cost of bankruptcy, cash flows volatility, high cost of external financing, asymmetrical risk, agency cost etc.  (Bartram, Dufey, & Frenkel, 2005).
In corporate risk management framework, the extent to which hedging strategies are formulated depends on the incentives and benefits companies seek by means of hedging. There are also some factors specific to companies which act as a determinant of hedging strategies.

There are many theoretical models which stipulate why companies should use certain derivatives to hedge financial risk exposures rather than choices contracts. In order to cover the risk of commodity price exposure, Sand Fire Resources should choose between options and forward contracts while making hedging financial instrument choices. (Woods & Dowd, 2016). Usage of derivatives for merely hedging needs is a sign of positive corporate governance framework hence results in high value of company in optimum circumstances.

Recommendations to SRN Management on whether to use Options or/and Futures (Forwards) to implement the hedges

Companies who are operating in mining industry (specially, gold and copper) are recommended to employ selective derivative financial instruments i.e. options and futures (forward contracts) for hedging financial risk exposure as these selective financial instruments provide substantial gain in cash flows from derivative transactions.[sky]

Unfortunately, use of selective financial instruments which includes swaps, options, futures, forwards have received very minute attention in formulation of corporate hedging strategies. All such studies which are empirically based on company specific determinants also take into account interest rates, foreign currency variations and commodity price derivatives, either separately, or in combination for more than one type of risk.

Statistically speaking; Options, swaps and futures (forward contracts) are the most common choices in managerial preferences for hedging interest rate volatility and currency exchange exposure. However, to mitigate the risk of interest rate exposure, swap contracts are the most preferred ones followed by options and futures (forward contracts).
These selective derivatives financial instruments for hedging different types of financial risks exposure answers lot of questions about the reliance of choices for each type of risk exposure relative to other. Studies reflect that option and forward contracts are the most commonly used selective derivative instruments for hedging financial risk exposure of companies. (“Options Strategies”, 2016). It also indicates the common usage of selective derivative financial instruments in hedging practices permeating in majority of corporations. Investors take these complicated decisions about reaching optimum level in their corporate hedging practices by strictly adopting high corporate governance practices. Empirical studies reflect that derivatives’ choices for particular financial risks exposure are determined by many company specific factors which include, volatility of cash flows, systematic risk company wide and idiosyncratic volatility. (Ponce & Guillen, n.d.)

If we summarize it, after thorough analysis of potential risks which are faced by Sand Fire Resources, I have suggested some hedging practices in order to mitigate the risk which are as follows:-

1) As per case study, SRN has already taken syndicated loan facility on floating rate of 2.5% above 3 month US$ LIBOR rate, hence no need to hedge the risk as borrowing has not been obtained on fixed rate. However, in order to mitigate or cover the risk of default from repayment of loans or bank deposits, credit default swaps (CDS) should be sought as a selective hedging instrument.

2) As SRN is an Australian based firm, losses owing to depreciation in Australian dollar currency can be hedged by extending Australian $/ US $ future contracts.

3) As SRN deals in copper and gold, therefore in order to lock the future selling price of copper and gold, futures of gold and copper should be shortened in gold and copper future markets.

Hedging Schedule

SRN has planned to hedge its receivables from copper sales for the month of November and December amounting 700,000 US dollars each. It is anticipating hedging its receivables by purchasing futures (forward contracts) in order cover transactions’ exposure. SRN may have expected depreciation in Australian dollars over the course of time, hence they have expected that their receivables from Copper will be decreased in value. Hence in order to mitigate the risk of this exchange rate risk exposure, SRN has decided to enter into forward market and take a short position to sell US dollars in future which will offset the loss which is likely to be sustained by SRN owing to fall in Australian dollar in future. Moreover, SRN is also susceptible to commodity price exposure therefore it has planned to hedge its commodity pricing (Copper) for the months of November and December 2016 by entering into forward contracts. (“The Options & Futures Guide”, 2016)

Commodity pricing strategy and sensitivity of demand to competotirs’s pricing falls under the scope of company’s exchange exposure. Hence, by setting flexible pricing strategy, companies can cover the risk of exchange rate exposure easily. Industries involved in mining business have to make few critical decisions related to currency risk which have huge impact on the market as mining industry has high economies of scale which implies that they are price taker rather than price setter. (Mariano, n.d.)

If SRN is anticipating bearish trend on copper in the months of November and December, it can earn profit by shortening copper futures in copper future market. SRN may counter the loss owing to decline in copper price by shortening one or more than one copper future contracts at a future exchange.

As per case study, SRN wishes to hedge fifty percent of its copper production for the months of November and December with exchange traded futures.
Short Copper Futures Strategy = Sell High, Buy Low.

Since each Grade A Copper future contract represents 25 tons of copper,