Explain how companies can hedge risks in their operating costs by using each of the following instruments. Hypothetical examples are required.

1. Futures and forward contracts
2. Option contracts
3. Swap contracts
4. Buying one asset and selling another. What is the hedge ratio and how is it determined?

 

Answer:

1. Futures and forward contracts

Take a example of a company in US which export a good in France. Lets say the company has sold $1000 worth of goods but needs to bill it at buyers currency, i.e, Euro. Lets say current spt rate is 1$ = 0.97 Euro.

Therefore the bill is for 970 Euro which needs to be paid after 3 months. The company currently fears that if Euro appreciates in the future they will incur a loss. Therefore they hedge their currency risk by buying a futures on $/Euro to recieve fixed $ after 3 moths.

• Option contracts

Take an example of a US based oil drilling company. Lets assume that Mexico has discovered oil and inviting bids across the globe to drill it. The result of the bidding will be out after 3 months, the payout will be in Mexican Peso. The US company fears that if the Peso appreciates then they will have to incur losses. To hedge against this the company chooses a call option to buy $ at fixed rate in the future if the company gets selected for the project

Note that options are used when the transactions in the future are uncertain.

• Swap Contracts

There is a company with a loan having floating rate of interest, here the company fears that if the interest rates rises they will need to pay higher interest. To hedge from this they go into a interest swap with a financial institution providing Interest Swap, in which the company pays fixed rate to the institution and recieves floating rate as return. Thus this effectively makes the company's rate fixed and hedged from changes in rates.

• Buying one asset and selling another

This is used to hedge a company stock value. Let say a company operation is trading stocks. They want to hold on to one stock but wants to hedge against the down fall.

They can go with buying Put option and selling call to make the structure behave like a bond which is hedged against the market movement,

Stock + Put = Bond + Call

=> Stock + Put - Call = Bond

Hedge ratio is a ratio that shows the ratio of the asset's exposure hedged with the given hedging instrument

Hedge Ratio = Size of hedge/Size of asset exposure