Definition of Hedging

 A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a
hedge consists of taking an offsetting position in a related security. It refers to a settlement
between two parties whose aim is to reduce the level of future risks in the event of an adverse
price movement of an asset. In a literal definition, hedging means a sort of insurance cover to
protect a given asset from future risks. But in the financial market, it’s more of shielding a
portfolio through using one financial instrument to offset the risk of the other investment. It
minimize or offset the chance that your assets will lose value. It also limits your loss to a known
amount if the asset does lose value.
 In simple words, hedging is like insurance. It means insuring themselves against a negative event.
This doesn't prevent a negative event from happening, but if it does happen and you're properly
hedged, the impact of the event is reduced.
 Example of Hedging: If you own a home in a flood-prone area, you will want to protect that asset
from the risk of flooding – to hedge it, in other words – by taking out flood insurance. In this
example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if
and when a flood occurs or if you buy homeowner's insurance, you are hedging yourself against
fires, break-ins or other unforeseen disasters.
Types of Hedging
(Based on time)
 Anticipatory Hedging: Anticipatory hedging is where hedging is taking a future
position in anticipation of a later transaction. Ex. Producer of palm oil intends to
sell his palm oil in 2 months could lock in the price by selling the future contract
today.
 Hedging the current market position: It is taking a future position opposite to the
current physical position held. For example, where a fund manager with portfolio
of shares could hedge against a fall in share prices by selling stock index futures
contracts today (taking a futures position opposite to the current position of
holding a portfolio of shares).
 Types of Hedging
 FORWARD
A forward contract is a customizable agreement to accommodate the parties involved in the buying and selling of a given asset. Usually, it’s based on a
future date and price. Because it’s non-standardized, it’s often used for hedging, but it can also be used for speculation. When comparing it to other
standardized future contracts, the main benefit lies in the ability to customize it to accommodate different commodities, delivery dates, and even amounts.
Even better, the transaction can be either in cash or delivery basis – often referred as over-the-counter (OTC). Use forward contracts to offset exchange
prices. Forward (or a Forward Contract) is a non-standardized contract to buy or sell an underlying asset between two independent parties at an agreed price
and a specified date. It covers various contracts like forwarding exchange contracts for currencies, commodities, etc.
 FUTURES
A futures contract is an arrangement between a buyer and a seller to buy and sell a given asset at a future date on a predetermined price. It includes future
speculation, which enables buyers to sell their assets at higher rates in future if price increases; and future hedging, which does not give the buyers an
advantage over selling their security at higher prices. Instead, it reduces loses if the risk ever occurs.
Futures (or a Futures Contract) is a standardized contract to buy or sell an underlying asset between two independent parties at an agreed price, standardized
quantity, and a specific date. It covers various contracts like currency futures contracts, etc. Futures contracts trade on organized exchanges that determine
standardized specifications for traded contracts. All futures contracts for a given item specify the same delivery requirements and one of a limited number of
designated contract maturity dates, called settlement dates.
 MONEY MARKETS
It is one of the major components of financial markets today, where short-term lending, borrowing, buying, and selling are done with the maturity of one
year or less. Money markets cover a variety of contracts like money market operations for currencies, money market operations for interest, covered calls on
equities, etc. Money markets cover many types of financial activities of currencies, money market operations for interest, calls on equities where short-term
loans, borrowing, selling and lending happen with a maturity of one year or more.
Other Types: Hedging with swaps, Hedging with foreign currency futurres, heding with foreign currency options.
HEDGING STRATEGIES

 THROUGH ASSET ALLOCATION

You can do this by diversifying your portfolio with more than one type of asset. For e.g.
you can invest 70% in equity and the rest 30% in other more stable assets, to create a
balanced portfolio.

 THROUGH STRUCTURES
You can do this by investing a portion of the portfolio in debt and the other in derivatives.
Where debt portion brings stability to the portfolio, the derivatives help in protecting it
from the downside risk.

 THROUGH OPTIONS
This technique involves call and puts options of assets. This helps the investor to safeguard
their portfolio directly.
HEDGING STRATEGIES

 Derivatives:
These are financial contracts that derive their value from an underlying real asset, such as a stock. the two most common
of which are options and futures where option is the most commonly used derivative. It gives you the right to buy or sell a
stock at a specified price within a window of time.
 Diversification:
The practice consists of buying recession-resistant-stocks like utilities to hedge against luxurious goods with higher margins.
Even though diversification hedging may result in profits, it can lead to even higher risks since there are no guarantees as
compared to derivative hedging practices. For example, Rachel might invest in a luxury goods company with rising margins.
She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat
that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends. You own an
assortment of assets that don't rise and fall together. If one asset collapses, you don't lose everything. For example, most
people own bonds to offset the risk of stock ownership. When stock prices fall, bond values increase. That only applies to
high-grade corporate bonds or U.S. Treasurys. The value of junk bonds falls when stock prices do because both are risky
investments.
 Spread Hedging:
The investor buys a put with a higher strike price and then sells one with a lower price with the same expiration date. Note
that this only provides limited protection, as the maximum payout is the difference between the two strike prices.
TYPES OF HEDGING STRATEGIES

 Arbitrage involves taking opposite positions on two markets, in order to hedge

physical pricing on different markets for the same or similar products.
 Averaging is a strategy whereby, instead of hedging against a single price fixed on a
single date, average transactions settle against average prices observed over a
certain period of time.
 Offset is a simple offsetting of the physical market exposure.
 Price Fixing involves taking advantage of the current favourable market levels for
the future physical transactions.
Options

 Options are type of financial derivative. They represent a contract sold by one
party to another party. Option contracts offers the buyer the right, but not the
obligation, to buy or sell a security or other financial asset. It includes an agreed-
upon price during a certain period of time or on a specific date.
An Option Contract consists of the
following two parties:
 .Holder: Buyer of the Contract
. Writer: Seller of the Contract
When the Holder of the option contract chooses to initiate the transaction, he is
said to be exercising the option.
 When the holder does not initiate or exercise the contract, then the contract
eventually expires.
Call option

Call options give the holder the right to buy 100 shares of an underlying stock at a
specific price, known as the strike price, up until a specified date, known as the
expiration date.
For example, a single call option contract may give a holder the right to buy 100
shares of Apple stock at $100 up until the expiry date in three months. There are
many expiration dates and strike prices for traders to choose from. As the value of
Apple stock goes up, the price of the option contract goes up, and vice versa. The call
option buyer may hold the contract until the expiration date, at which point they can
take delivery of the 100 shares of stock or sell the options contract at any point before
the expiration date at the market price of the contract at that time
Put Option & major other options

Put options are traded on various underlying assets, including stocks, currencies,
commodities, and indexes. The specified price the put option buyer can sell at is
called the strike price(fixed price).
 American and European options
 The key difference between American and European options relates to when the
options can be exercised:
 A European option may be exercised only at the expiration date of the option, i.e.
at a single pre-defined point in time.
 An American option on the other hand may be exercised at any time before the
expiration date.
Put Option

 A put option is an option contract giving the owner the right, but not the
obligation, to sell a specified amount of an underlying security or an asset at a
specified price within a specified time frame.
How Do Put Options Work?

 Put options are traded on various underlying assets, including stocks, currencies,
commodities, and indexes. The specified price the put option buyer can sell at is
called the strike price.

 A put option becomes more valuable as the price of the underlying stock
depreciates relative to the strike price. Conversely, a put option loses its value as
the underlying stock increases. It also decreases in value as the expiration date
approaches.
Examples

 The strike price is the price at which an option buyer can sell the underlying asset.
For example, a stock put option with a strike price of 10 means the put option
buyer can use the option to sell that stock at $10 before the option expires.

 For example, if the stock is trading at $11 on the stock market, it is not worthwhile
for the put option buyer to exercise their option to sell the stock at $10 because
they can sell it for a higher price ($11) on the stock market.
Assumptions of the Black Scholes Model

1. The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might seem a serious
limitation to the model considering the observation that higher dividend yields elicit
lower call premiums. A common way of adjusting the model for this situation is to
subtract the discounted value of a f.uture dividend from the stock price.

2. European exercise terms are used

Most companies pay dividends to their share holders, so this might seem a serious
limitation to the model considering the observation that higher dividend yields elicit
lower call premiums. A common way of adjusting the model for this situation is to
subtract the discounted value of a future dividend from the stock price
3. Markets are efficient
This assumption suggests that people cannot consistently predict the direction of the
market or an individual stock. The market operates continuously with share prices
following a continuous Itô process. To understand what a continuous Itô process is,
you must first know that a Markov process is "one where the observation in time
period t depends only on the preceding observation." An Itô process is simply a
Markov process in continuous time. If you were to draw a continuous process you
would do so without picking the pen up from the piece of paper
4. 4. No commissions are charged
Usually market participants do have to pay a commission to buy or sell options. Even
floor traders pay some kind of fee, but it is usually very small. The fees that Individual
investor's pay is more substantial and can often distort the output of the model.
5. Interest rates remain constant and known
The Black and Scholes model uses the risk-free rate to represent this constant and
known rate. In reality there is no such thing as the risk-free rate, but the discount rate
on U.S. Government Treasury Bills with 30 days left until maturity is usually used to
represent it. During periods of rapidly changing interest rates, these 30 day rates are
often subject to change, thereby violating one of the assumptions of the model.
6. Returns are lognormal distributed
This assumption suggests, returns on the underlying stock are normally distributed,
which is reasonable for most assets that offer options
Limitation

The Black-Scholes model has one major limitation: it cannot be used to accurately
price options with an American-style exercise as it only calculates the option price at
one point in time -- at expiration. It does not consider the steps along the way where
there could be the possibility of early exercise of an American option. As all exchange
traded equity options have American-style exercise (i.e. they can be exercised at any
time as opposed to European options which can only be exercised at expiration) this is
a significant limitation.
CALL OPTION

 A CALL OPTION IS AN OPTION CONTRACT THAT GIVES THE BUYER THE

RIGHT TO BUY THE UNDERLYING ASSET AT THE STRIKE PRICE AT ANY
TIME UP TO THE EXPIRATION DATE.
STRIKE PRICE

 THE STRIKE PRICE IS THE PRICE AT WHICH AN OPTION BUYER CAN BUY
THE UNDERLYING ASSET.
 FOR EXAMPLE, A STOCK CALL WITH A STRIKE PRICE OF 10 MEANS THE
OPTION BUYER CAN BUY THE STOCK AT $10 BEFORE THE OPTION
EXPIRES.
 IT IS AN OPTION AVAILABLE TO THE CALL BUYER TO ‘CALL THE STOCK
AWAY’ FROM THE SELLER BEFORE THE EXPIRATION BUT NOT AN
OBLIGATION. IF THE BUYER WANTS HE CAN LET THE OPTION GO WITH
THE EXPIRATION OF TIME.
 FOR EXAMPLE IF THE STOCK IS TRADING AT $9 IN THE STOCK MARKET
IT IS NOT WORTHWHILE TOBUY THE STOCK $10 BECAUSE THEY CAN BUY
IT FOR A LOWER PRICE ON THE STOCK MARKET.
 THE CALL BUYER HAS THE RIGHT TO BUY A STOCK AT THE STRIKE
PRICE FOR A SET AMOUNT OF TIME. IF THE PRICE MOVES ABOVE THE
STRIKE PRICE, THE OPTION WILL BE WORTH THE MONEY (INTRINSIC
VALUE).
 ONCE BOUGHT THE TRADER CAN SELL THE OPTION FOR A PROFIT OR
EXERCISE THE OPTION AT EXPIRY (RECEIVE THE SHARES).
 FOR THESE RIGHTS THE BUYER PAYS A ‘PREMIUM’.
 WRITI NG CALL OPTION IS A WAY TO GENERATE INCOME. THE INCOME
FROM A CALL OPTION IS LIMITED TO THE PREMIUM RECEIVED THOUGH
WHILE A CALL BUYER HAS UNLIMITED PROFIT POTENTIAL.
IN AND OUT OF THE MONEY...

 CALL OPTIONS CAN BE IN THE MONEY OR OUT OF THE MONEY.

 IN THE MONEY MEANS THE UNDERLYING ASSET PRICE IS ABOVE THE
CALL STRIKE PRICE.
 OUT OF THE MONEY MEANS THE UNDERLYING ASSET PRICE IS BELOW
THE CALL STRIKE PRICE.
 WHEN YOU BUY A CALL OPTION YOU CAN BUY IT IN, AT OR OUT OF
MONEY.
Put call parity

 Put-call parity is a principle that defines the relationship between the price
of European put options and European call options of the same class, that
is, with the same underlying asset, strike price and expiration date.
 Put-call parity states that simultaneously holding a short European put and
long European call of the same class will deliver the same return as
holding one forward contract on the same underlying asset, with the same
expiration, and a forward price equal to the option's strike price. If the
prices of the put and call options diverge so that this relationship does not
hold, an arbitrage opportunity exists, meaning that sophisticated traders
can theoretically earn a risk-free profit. Such opportunities are uncommon
and short-lived in liquid markets.
Equation expressing put-call parity

C + PV(x) = P + S

C = price of the European call option

PV(x) = the present value of the strike price (x), discounted from the value on the
expiration date at the risk-free rate
P = price of the European put
S = spot price or the current market value of the underlying asset
Example
 Say that you purchase a European call option for TCKR stock. The expiration date is one year
from now, the strike price is $15, and purchasing the call costs you $5. This contract gives
you the right—but not the obligation—to purchase TCKR stock on the expiration date for
$15, whatever the market price might be. If one year from now, TCKR is trading at $10, you
will not exercise the option. If, on the other hand, TCKR is trading at $20 per share, you
will exercise the option, buy TCKR at $15 and break even, since you paid $5 for the option
initially. Any amount TCKR goes above $20 is pure profit, assuming zero transaction fees.
 Say you also sell (or "write" or "short") a European put option for TCKR stock. The expiration
date, strike price, and cost of the option are the same. You receive $5 from writing the
option, and it is not up to you to exercise or not exercise the option, since you don't own it.
The buyer has purchased the right, but not the obligation, to sell you TCKR stock at the strike
price; you are obligated to take that deal, whatever TCKR's market share price. So if TCKR
trades at $10 a year from now, the buyer will sell you the stock at $15, and you will both
break even: you already made $5 from selling the put, making up your shortfall, while the
buyer already spent $5 to buy it, eating up his or her gain. If TCKR trades at $15 or above,
you have made $5 and only $5, since the other party will not exercise the option. If TCKR
trades below $10, you will lose money—up to $10, if TCKR goes to zero.
Currency Swap

A currency swap, also known as a cross-currency swap, is an off- balance sheet

transaction in which two parties exchange principal and interest in different
currencies. The parties involved in currency swaps are generally financial institutions
that either act on their own or as an agent for a non-financial corporation. The
purpose of a currency swap is to protect the financial institution to exposure to
exchange rate risk or reduce the cost of borrowing a foreign currency.
 What Is a Currency Swap ?

• A currency swap involves the exchange of both the principal and the interest rate in one
currency for the same in another currency. The exchange of principal is done at market rates
and is usually the same for both the inception and maturity of the contract.

• In the case of companies, these derivatives or securities help to limit or manage exposure to
fluctuations in interest rates or to acquire a lower interest rate than a company would
otherwise be able to obtain. Swaps are often used because a domestic firm can usually
receive better rates than a foreign firm.

• A currency swap is considered a foreign exchange transaction and, as such, they not legally
required to be shown on a company's balance sheet. This means that they are "off-balance
sheet" transactions, and a company might have debt from swaps that are not disclosed in
their financial statements.
Drawbacks
Credit Risk

This is the major risk faced by a swap dealer—the risk that a counter party will default on its end
of the swap

Mismatch Risk

It’s hard to find a counterparty that wants to borrow the right amount of money for the right
amount of time.
 Example :-

• Company A exchanges $100 million USD with Company B in return for 74 million pounds. This is an exchange rate of 0.74 USD/GBP
(equivalent to 1.35 GBP/USD). At maturity, the notional dollar amounts are exchanged again. Company A receives their original $100
million USD and Company B receives 74 million pounds.

• Company A and B might engage in such a deal for a number of reasons. One possible reason is the company with US cash needs British
pounds to fund a new operation in Britain, and the British company needs funds for an operation in the US. The two firms seek each other
and come to an agreement where they both get the cash they want without having to go to a bank to get loan, which would increase their debt
load. As mentioned, currency swaps don't need to appear on a company's balance sheet, where as taking a loan would.

• Having the exchange rate locked in lets both parties know what they will receive and what they will pay back at the end of the agreement .

• While both parties agree to this, one may end up better off. Assume in the scenario above that shortly after the agreement the USD starts to
fall to a rate of 0.65 USD/GBP. In this case, Company B be would have been able to receive $100 million USD for only $65 million GBP had
they waited a bit longer on making an agreement, but instead they locked in at $74 million GBP.
IBM-WORLD BANK CURRENCY
SWAP CASE STUDY
Underlying Situation:
 The World Bank borrows funds internationally and loans those funds to developing countries
for construction projects. It charges its borrowers an interest rate based upon the rate it has to
pay for the funds. The World Bank looks for the lowest cost borrowing.
 Problem for the World Bank: The Swiss government had imposed a limit on World Bank
borrowings in Switzerland. The World Bank had borrowed its allowed limit in Switzerland
and the same was true of West Germany.

 In 1981, IBM had large amounts of Swiss franc (CHF) and German deutsche mark (DEM)
debt and thus had debt payments to pay in Swiss francs and deutsche marks.
 IBM and the World Bank worked out an arrangement in which the World Bank borrowed
dollars in the U.S. market and swapped the dollar payment obligation to IBM in exchange
for taking over IBM's Swiss franc and deutsche mark obligations.
Underlying Situation:
 The World Bank borrows funds internationally and loans those funds to developing
countries for construction projects. It charges its borrowers an interest rate based upon
the rate it has to pay for the funds. The World Bank looks for the lowest cost
borrowing.
 Problem for the World Bank: The Swiss government had imposed a limit on World
Bank borrowings in Switzerland. The World Bank had borrowed its allowed limit in
Switzerland and the same was true of West Germany.

 In 1981, IBM had large amounts of Swiss franc (CHF) and German deutsche mark
(DEM) debt and thus had debt payments to pay in Swiss francs and deutsche marks.
 IBM and the World Bank worked out an arrangement in which the World Bank
borrowed dollars in the U.S. market and swapped the dollar payment obligation to
IBM in exchange for taking over IBM's Swiss franc and deutsche mark obligations.
 The World Bank
The World Bank wanted debt in CHF and DEM. But, it was not allowed. It could
issue USD debt, at an attractive USD rate. Solomon Brothers suggested - Both
parties could benefit from USD for DEM and CHF swap. Solomon Brothers
proposed a simple currency swap:
 Swap Details
The World Bank issued a USD bond.
Issue date: August 11, 1981, settling on August 25,
August 25, 1981 became the settlement date for the swap.

The first annual payment: March 30, 1982

The next coupon date on IBM's bonds -i.e., 215 days, rather than the usual 360
from the swap starting date.
 The first step was to calculate the value of the CHF and DEM cash flows. At that
time, the annual yields on similar bonds were at 8% for CHF and 11% for DEM.
 The discount rates were calculated. It is a factor which, when multiplied by a
predicted future cash flow from a loan or some other form of debt, gives its
present value.

Date Days CHF DEM

3.30.82 215 .9550775 .9395764
3.30.83 575 .8843310 .8464652
3.30.84 935 .8188250 .7625813
3.30.85 1295 .7581813 .6870102
3.30.86 1655 .7020104 .6189281
Next, the bond values were calculated:

 NPV(CHF) = 12,375,000 [.9550775 + .8843310 + .8188250 + .7581813 +

.7020104 ]= CHF 191,367,478.

 NPV(DEM) = 30,000,000 [9395764 + .8464652 + .7625813 + .6870102 +

.6189281]= DEM 301,315,
 The terms of the swap were agreed upon on 11 August, Thus, The World Bank would have been left exposed to currency risk
for two weeks until AUG 25.

 The World Bank decided to hedge the above derived NPV amounts with 14-days currency forwards
 Benefit to IBM:
No longer exposed to currency risk.
Capital gain from USD appreciation.

 Benefit to The World Bank:

Access to CHF and DEM financing at lower rates than current market rates.

 World bank received two deposits from IBM:

CHF 191,367,478 + DEM 301,315,273

 IBM received a USD 205.485 M deposit from World bank.

Case Study:-BMW Hedging Strategy
HISTORY:

BMW GROUP, OWNER OF THE BMW, HAS BEEN BASED IN MUNICH SINCE ITS FOUNDING
IN 1916. OVER TIME, THE COMPANY LOST ITS MARKET SHARE IN GERMANY, AND BY
2011, LESS THAN 20% OF BMWS SOLD WERE SOLD IN GERMANY. SINCE 2011, BMW HAS
SEEN SIGNIFICANT GROWTH IN MARKETS LIKE INDIA, CHINA, AND RUSSIA. IN
RECENT YEARS, CHINA HAS BECOME BMW’S FASTEST-GROWING MARKET,
ACCOUNTING FOR 14 PER CENT OF BMW’S GLOBAL SALES VOLUME IN 2011.
BMW’s transaction and operating exposure

 Due to external factors affecting negatively, such as, the ongoing weakening of US dollar and
currencies like, yen in which the company is operating is leading to high cost of raw materials.

 Since the company is buying raw materials for its production from different countries like Japan, etc.
therefore the company’s expenses are in foreign currency and for which it is subjected to exchange rate
fluctuations, which will determine the operating exposure to BMW.

 Moreover, its operations are in almost all of the major countries around the world where its sales
subsidiaries are located. The revenue generated from these countries in currencies such as Japanese
Yen, US dollars, etc. are then converted into euros as a base currency. These transactions give rise to
transaction exposure where the transactions are exposed to exchange rate risks.
BMW Hedging Strategy

BMW took two simultaneous paths to reduce exposure.

 Firstly, it uses natural hedging through which the company tries to match the currency of its
operating revenues with its operating expenses in order to cancel out any exchange rate effects to
some extent. Company has issued instructions and risk figures for its global network, while all of
its local treasury centers were to review the exposure on weekly basis which is then evaluated at
the central treasury department.

 Secondly, BMW uses an internally developed model, which it used to plan foreign exchange
hedging. This model shows that an equilibrium rate, for all major currencies that BMW deals
with, indicating their over or undervaluation. The model mainly focused on long-term hedges
usually for six years. The difference between the equilibrium rate and spot rate are then evaluated
for evaluating the exposure.
part from this, company also produces a 100% hedge by using two options consisting of long
and short, by which it produces non-zero option, so it incurred no expense in using them. For
example, company receiving the premium on one sold instrument and on other hand had to pay
premium on bought instrument, as a consequence the premium cancels out the cost leaving the
company neither better off nor worse off.

 Furthermore, the company also uses ‘cascade strategy’ in order to hedge foreign currency.
In which the initial coverage was less that 100% of the estimates while for the actual
subsequent business years the coverage ratio began to fall. This is therefore used to
evaluate the varying amount of hedging in different periods.
Appropriateness of Equilibrium Exchange Rate

 The range of equilibrium exchange rate as used by BMW as a part of its currency hedging
strategy, that is, 1.15 US$/€ to 1.17 US$/€ might be appropriate in relation to shorter term
expectations of the exchange rates. But for the longer run the range might become unsuitable for
BMW to be used as the equilibrium rate used for conversions of currency into euros.

 The reasons for the inappropriateness of the equilibrium exchange rate range for its long-term
usage are possibly the fact that economies are exposed to rapid changes in relation to changes in
government policies of the economy. Since, BMW’s operations are carried out in several
economies around the world which means that the company is not only open to changes in its
domestic economic factors but also due to changes in other economies.
THANK YOU!!

Presented By:
Abhishek Mishra (002)
Aneisha Kaushik (05)
Anushka Sikarwar (85)
Bharat Talreja (12)
Bhawna Vishwakarma (13)
Sankalp Vijayvargiya (58)
Sarthak Joshi (59)
Shivam Sharma (60)
Srijan Singh (92)