I have tried to simplify the concept of hedging by this Article. There are 14 instruments available in Hedging I have covered 7 instruments in Part -1 and will cover remaining 7 instruments in Part -2 of the Article.
In the business there may be numbers of international transactions like export and import, payment of interest and repayment of loan by the firm which has borrowed money under External Commercial Borrowing (ECB). Further, multinational firms operating foreign subsidiaries which often receive money from the subsidiaries situated in the various countries. All these transactions are done in foreign currency.
All these different parties are exposed to the uncertainty about the fluctuation in the exchange rate of foreign currency. Likewise if a firm which has borrowed ECB is also exposed to the uncertainty in the rate of interest because, the rate of interest usually depends on the London Inter-Bank Offered Rate (LIBOR) which is of fluctuating nature.
It is obvious that any minor up word changes in the value of foreign currency or interest rate affects adversely to the profitability of a firm. In order to avoid any such situation a firm always wishes to eliminate such threats of uncertainty and can do by transferring the risk on the head of others. The action of eliminating the potential risk by transferring the same on the head of others is called ‘Hedging’. The hedging is known as ‘Risk Management’.
Hedging is an umbrella which provides various instruments to be used as per the requirement.The each instrument under hedging does not have value but they derive the value from the performance of another underlying entity such as an asset, index, or interest rate the transaction for which it is used and therefore it is called as ‘Derivatives’. The person or corporate who use the hedging instrument is known as a ‘hedger’and the person or corporate who takes risk is known as ‘speculator or trader‘. The person who wants to hedge for transferring /off setting potential loss by of any transaction by using any of the suitable instruments may do so by trading in the international market.
The following are the instruments available under Hedging.
1. Forward Exchange Rate Cover:
Forward exchange cover eliminates potential risk of increase in the value of the foreign currency. This instrument of hedging is used when long term foreign exchange loan is taken and there is a risk of increase in the value of the foreign currency in future.
Forward exchange cover means the currency rate quoted now for the delivery at some future specified date. Which means to pay today’s rate for foreign currency bought today but delivery of which is postponed till the specified day, on the said specified day the delivery of the bought currency will be made but, the price is the same which is fixed at the time of buying.
Under this type of transaction any increase or decrease in the price so pre fixed is to ignore.The cover may be in whole or in part of the transaction as per the choice of the hedger.
For example, A Ltd has entered into the Forward Exchange cover contract on 10.02.2014 with ABC Bank an authorized foreign exchange dealer, under the contract A Ltd has bought USD 10,00,000 @ Rs.62.20 =1 USD for re payment of its ECB loan of USD 10,00,000 which is going to be matured on 14.08.2014. On the specified date i.e. 14.08.2014, A Ltd will have delivery of USD 10,00,000 @ Rs.62.20 =1 USD but, suppose the exchange rate on the date of delivery is Rs.65.00 = 1USD or Rs.60.00=1USD, A Ltd will have to pay pre fixed rate Rs.62.20 per USD and not Rs.65.00 or Rs.60.00 per USD for USD 10,00,000.
The speculator i.e. ABC Bank will be responsible for any loss if the market rate of USD is Rs.60.00 and the Bank will enjoy profit if the exchange rate is Rs.65.00 per USD.
2. Forward interest rate cover
This instrument of hedging provides opportunity to lock in for the future date the present rate of interest for the loan to be borrowed in future. The difference between the actual interest rate on the date of roll over and the contracted rate is settled between the hedger and the Bank with which the Forward interest rate cover contact is executed.
For example,ABC Ltd wants to borrow ECB of USD 50 Million for infrastructure project in the August 2014.The current interest rate is 3.15 per cent .The ABC Ltd enters in to contract with XYZ Bank on 10.2.2014 for forward interest rate cover considering the rate of interest 3.20 per cent. At time of settlement i.e. actually when loan borrowed the rate of interest LIBOR is 3.30 per cent the XYZ bank will have to pay 0.10 per cent to ABC Ltd and if the LIBOR falls down then 3.20 per cent the contracted rate say 3.05 per cent ABC Ltd will pay the difference ie0.15 per cent to XYZ Bank.
By using the forward interest rate cover the borrower protect them from a rise in the interest rate. This is preferable to an interest rate swap when the borrower expect interest rate to rise in the short run but not in the long run.
3. Interest rate ceiling
Under this instrument of hedging the borrower can enter into a contract of interest rate ceiling with Bank. The interest rate ceiling provides protection in the rising rate environment to borrowers who have floating rate loan. Under this contract ceiling of the rate of interest is fixed when the daily average of market rate is higher the bank with which the contract is executed will reimburse the difference of the ceiling rate and the daily average market rate to the client. However, on the other hand the borrower can borrow at lower rate of the interest then the ceiling so fixed without any obligation.
A currency Swap is an agreement to exchange fixed or floating rate payment in one currency into floating or fixed payment of second currency including an exchange of the principal currency amounts. Under this agreement the borrower is allowed to redenominate a loan from one currency to another currency.
The redenomination of a loan from one currency to another currency is done at lower borrowing cost for debt and to hedge the exchange risk. The main object behind is to match the difference between the spot and forward rate of any currency over a specified period of time.
For example, Company A, a U.S. firm, and Company B, a European firm, enter into a five-year currency swap for $40 million. Suppose, the exchange rate at the time is $1.50 per euro (e.g. the dollar is worth 0.66 euro). First, the firms will exchange principals. So, Company A pays $ 40 million, and Company B pays 26.4 million euros. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).
Cross currency swap, in cross currency swap obligation denominated in one currency is exchanged with equal value in other currency. The following types of the cross - currency swaps are generally used:
Fixed to fixed currency Swap:
In this form of Swap, it may involve exchanging fixed interest payment on a loan in one currency for fixed interest payments on an equivalent loan of other currency.
Fixed to floating currency Swap:
In this form of Swap, fixed rate obligation in one currency is swapped by floating rate obligation of the other currency. For example, Euro at fixed rate can be swapped against US Dollar with LIBOR+floating rate.
5. Interest Rate Swap
Interest rate Swap means an agreement between two parties to exchange numbers of interest payments under the underlying loan. There is no exchange of the principal amount and totally independent silent transaction is made which does not affect the lender. Under the interest rate swap instrument of hedging affixed rate of interest is swapped for floating interest rate and vice versa.
For example, ABC Ltd of India has borrowed USD 10 million from XZY Bank of Singapore through ECB for 3 year maturity, the rate of interest is based on LIBOR and payment of the interest is on quarterly basis .The LIBOR at the time of disbursement of ECB is 2.09%,as the LIBOR is fluctuating, ABC Ltd expects rise in the LIBOR in the future. To eliminate risk of rise in the interest rate ABC Ltd enters in to Interest Rate Swap contract with Indian Branch of XYZ Bank and gets fixed the interest rate 2.25%. Now in any quarter the LIBOR goes up crossing the fixed interest rate 2.25% the Indian branch of XYZ Bank is liable to compensate ABC Ltd any increase beyond 2.25% but if the actual LIBOR is below 2.25% in any quarter say it is 1.95% in this case ABC Ltd will have to pay difference between fixed rate 2.25% and floating rate current LIBOR 1.95% to the Indian bank of XYZ Bank on the loan amount.
So here, there are two independent contracts one is with the lander XZY Bank of Singapore for ECB and other with Indian branch of XYZ Bank for Interest Rate Swap .The Interest rate Swap agreement will not affect the principal loan amount and the lander also.The most common swap is the floating rate to fixed rate exchange.
Types of Interest Rate Swaps
i. Where there is an exchange of interest obligation, interest rate swaps for payment of interest on debt, the Swaps is a liability swaps.
ii. Where there is an exchange of interest receipts, interest rate swaps for receipt of interest investment, the Swaps is called assets swaps.
The basic interest rate swap is called as Plain Vanilla. In addition to that the following are also types of interest rate swap which includes:
a. Fixed to floating swaps
b. Basis swaps
c. Forward swaps
d. Callable and Put table Swaps
e. Extendible swaps
6. Currency Futures
Currency future is like a future deal where in an agreement is entered to buy or sell a standard volume of specified currencies at the predetermined future date at the price agreed upon today. The unique feature is that it is a future deal in a specific currency such currency future is transacted on the floor of an organized future exchange.
7. Currency options
Under this instrument of hedging rights are given to the buyer to buy or sell currency at a specified exchange rate during the specified time period but there is no obligation on the part of the buyer that he has to buy or sell, he may buy or sell but transaction should be at the specified exchange rate, which is called as ‘Strike Price’, and during the specified period.
Currency options may be entered for either for a Put or Call option. Under put option the right is given to the seller of the foreign currency to sell and in call option the right is given to the buyer of the foreign currency to buy. The put option is exercised when the party requires foreign currency/exchange. By buying a put option the party sells home currency to buy the right amount of the foreign currency. On the other hand call option is entered to sell the foreign currency so that the same can be bought by exchanging the home currency.
Currency option is of two kinds’ European option and American option:
American Option may be exercised at any time but, before the expiration date.
The liberty allowed in the American option is not available in the European option. European option cannot be exercised at any time it should be exercised within the specified time period.