What is hedging ?.....

Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes. The purpose of hedging is loss minimization, not profit maximization.

How hedging works.

Corporate Risk Management

Define

Measure

Manage

Monitor

Business Setup
USA G5 International Corp.

Europe G5 International Co. Ltd.

Asia G5 Asia pacific Pte. Ltd.

G5 International (I) Pvt. Ltd.

G5 Italiana SpA.

Types of foreign exchange risk exposure

Revenue mismatch risk exposure Translation risk exposure Revaluation risk exposure Interest rate risk exposure Economic risk exposure

Revenue mismatch
Revenue mismatch risk arises, when the revenues are denominated in currency other than the functional currency. This exposure arises from the movement of exchange rate between the date of the transaction to the date of the cash outflow or inflow.

Paid in Currency Euro

G5 International (I) Pvt. Ltd.

Sale in Currency Euro

G5 Italiana SpA.

Euro 1 M booked as sales (credit period 45 days ) on 1st Sept 2012, Spot rate Euro 1 = Rs. 67.00 Revenue recognised Rs. 67 M

Revenue mismatch

Euro 1 M paid against sales on 15th Oct. 2012, Spot rate Euro 1 = Rs. 65.00 Rs. Credited in bank Rs. 65 M & 2 M loss booked in P & L

Rs. 2M

Translation Risk Exposure

Translation risk is the risk of profit erosion of a parent company, on consolidation of statement of accounts of subsidiary companies that have a functional currency different from the parent companys currency, due to adverse movements in the currency exchange rate.
USA G5 International Corp.

Europe G5 International Co. Ltd.

Asia G5 Asia pacific Pte. Ltd.

G5 Italiana SpA.

G5 India Pvt. Ltd.

For eg. At the time of budget it is been forecasted that G5 International Corp. will get profit of US$ 2 M ( budget rate 49 ) hence Rs. 98 M, same has been communicated to G5 India Pvt. Ltd. at the end of financial year Indian entity has achieved profit of 98 M but US$ is depreciated to Rs. 51 hence profit earned in rupees Converted in US$ @ 51 hence achieved US$ 1.92 M & lost US$ 0.08 M.

Revaluation Risk Exposure

Revaluation risk arises when a company is required to hold cash in currencies other than their Balance sheet currency and also have monetary assets/liabilities denominated in other currencies.

For eg. G5 International (I) Pvt. Ltd. holds cash & Bank balance, monitory assets & liabilities in various currencies like INR, USD, EUR, GBP, SGD etc. which need to be revalued at the end of each financial year. Revaluation difference will be accounted in profit & loss account which will impact profit of the company.

Interest Rate Risk exposure

Interest rate risk arises when a company borrows funds at the floating interest rate. Risk of fluctuation in the floating interest rate increases the exposure.

Floating interest rate comprises of LIBOR interest rate (floating) + fixed rate. For eg. LIBIOR 0.25 + fixed rate 5.00 so total interest rate will be 5.25 which will float according to changes in LIBOR rate.

Economic Risk exposure

Economic risk is the extent to which a firms market value, in any particular Currency is sensitive to unexpected changes in foreign currency. Exchange rate fluctuations determine competitiveness or affect future cash flows and profitability, even though the firm may not have any direct exposure to the exchange rate. For example, ABC Ltd. can be outperformed by its Philippines competitors if PHP depreciates more than INR.

For eg. : India company expected to receive US$ 2 M after three months. The anticipated sum is Rs. 108 M at the rate of US$ 1 = Rs. 54 ( spot rate ). Suppose US$ expected to depreciate against rupee in near future to Rs. 50 Indian company will loose Rs. 8 M But the forward rate is Rs. 52.5 & company opt to buy forward contract then company is restricting the loss to Rs. 3 M

For eg. : India company expected to Pay US$ 2 M after three months. The anticipated sum is Rs. 108 M at the rate of US$ 1 = Rs. 54 ( spot rate ). Suppose US$ expected to appreciate against rupee in near future to Rs. 58 Indian company will loose Rs. 8 M But the forward rate is Rs. 56.5 & company opt to buy forward contract then company is restricting the loss to Rs. 3 M

Hedging instruments
Spot Transaction Outright market Forward Transaction Forward swap market Futures transactions Call options Options Transaction

Hedging instruments
Exotic option Swap transaction Foreign debt EEFC accounts

Put options