I can take bigger bets
How to set up a Hedge? Suppose a small German manufacturing company has sold some auto parts to the US last week. They know they will receiver $400,000 six months from now. The value of this money is € 360,000 today, evaluated at today’s € /$ spot rate of 0.90. The company is worried about its exposure to the decline of the dollar. What can it do? Let’s assume that this is the only currency exposure that the company has. Suppose that the forward exchange rate F 6 € /$ = 0.91. • What are the different possibilities for hedging?
How to set up a Hedge? 1. Forward contract 2. Futures contract 3. Hedging using currency options Suppose that a put option to sell $400,000 with an exercise price 0.9 € /$, expiring in 6 months time, costs € 25,000 today. 400 350 300 250 450 500 550 Euro Euro/Dollar 1.00 1.05 1.10 1.15 1.20 1.25 0.95 0.90 0.85 0.80 0.75 Net Cash flow at maturity
Other Hedging Possibilities • Borrow in the currency where you have receivables. • Purchase raw materials using that currency. • Real Hedge: Sometimes financial hedges are not feasible or companies want to consider longer term solutions: For instance, Japanese car manufacturers exporting cars to the US. Rather than hedging, they set up plants in the US. • Basis Risk: If an airline wants to hedge the price risk of jet fuel it cannot do so perfectly because no futures on jet fuel are traded. Instead, they can hedge using heating oil or crude oil futures but this subjects them to basis risk (i.e., risk that the heating oil and jet fuel prices move in different directions). In this case, the amount that is hedged should be chosen to minimize the overall variability of the hedged position.
Structured Products Also structured products can be used to reduce risks ? • Commodity linked bonds (e.g., Shell issuing a bond with coupon tied to oil price). – Investors may want exposure to commodities (e.g., have opposite exposure or have restrictions to invest in commodities). Note positive tax effect! • Reverse Floating Rate note (life insurance company has low returns when interest rate is high). – A mutual fund may be interested to purchase. • Contingent Capital: E.g., an option to issue equity at a predefined price (or option not to repay debt) in case of a predefined event: e.g., less than 1% GDP growth,… • Structured products for investors: capital protection
16 1. Definitions and contract design 2. Benefits of contingent capital 3. Contingent Capital vs other risk financing instruments 4. Conclusions Financial Innovations: Contingent Capital
17 q Technically, it is an option giving the right to raise capital at predetermined terms upon the occurrence of an agreed-upon event.
- Summer '14