Hedging Techniques in a nutshell

 

Hi all, I am sure we all heard about 'Hedging' and might be wondering how many types of them are there. I have a concise list of them for your easy understanding.

 

Currency Risk Hedging Methods:

Currency of Invoice = Make payments or receive money in home currency. (Approach, but not Hedging)

Matching = Matching payments against receipts of a company. (Approach, Balance sheet Hedge)

Netting = Credit balances are netted off against debit balances. There is also Bilateral Netting & Multilateral Netting. (Balance sheet hedging)

Leading = If receivables FX is going to decrease (depreciate), the company will demand immediate payment by offering discount or may choose factoring. (Approach, Balance sheet Hedge)

Lagging = If the FX rates will decrease in the future, the company will delay payments. (Approach, Balance sheet Hedge)

Forward Exchange Contracts = Same as Futures contracts but not standardised contracts. (Hedge instrument used for transaction risk)

Money Market Hedging = Uses Money markets to borrow, convert to foreign currency, deposit and use the receipts to pay loan. Simultaneously, borrowed money in bank deposit is used to make payments. This earns interest on deposit as well as pays interest if foreign currency is purchased with borrowed money. (Approach, to reduce transaction risk)

Asset and Liability Management = Borrows in the foreign currency and uses the foreign receipts to repay the loan. (Approach, but not Hedging)

Currency Options = Gives the right to buy or sell. (Hedging derivative to reduce transaction risk)

Currency Futures = Contract with a predetermined settlement price & date. (Hedging derivative for transaction risk)

Synthetic Futures = Some currencies are not allowed to trade and these are used instead. (Hedging derivative for transaction risk)

Offsetting = Offsetting loss on Spot Market with Gain on Futures Market. (Hedging derivatives for transaction risk)

Future/ Forward Spots Rates are forecasted using IRPT & PPPT.

 

Interest Risk Hedging Techniques:

Matching and Smoothing = Also called as cash flow matching. All outflows or inflows are offset with inflows and outflows. This is impractical to manage transactions in millions. (Approach, Balance sheet Hedge)

Asset and Liability Management = Borrowed assets yield interest and stops earning before the liability could be cleared. To avoid this, duration is adjusted. (Approach, Balance sheet Hedge)

Forward Rate Agreements = Hedges for favourable and adverse interest rate movements. (Hedging Derivative for transaction Risk)

Interest Rate Guarantee = It is an expensive option on FRA and used as protection from falling interest rates. (Hedging derivative for transaction Risk)

Hedging Fall = Protects from falling interest rates on investment yields by locking in yield through Eurodollar Futures or T-Bills.

Hedging Rise = Locks in Eurodollar rates to reduce borrowing costs. (Hedging derivatives for transaction Risk)

Synthetic Hedging = Spot security + Futures Contract = Synthetic security. (Hedging derivative for transaction risk)

Strip Hedging = Buying different Futures contracts with different delivery dates to reduce exposure. (Hedging derivative for transaction risk)

Stack Hedging = Buying various Futures contracts with close delivery dates to improve liquidity. (Hedging derivative for transaction risk)

Portfolio Insurance = Stock index Futures are sold and bought periodically until desired results are achieved. (Hedging derivatives for transaction Risk)

Options, Futures, Interest rate Caps, Swaps & Floors and Collars. (Hedging derivatives for transaction Risk)

Credit Risk Hedging Derivatives = CDS

Other Risk Hedging Derivatives = Index, Commodity and individual stock Futures.

Eliminating the Risk = Hedging the Risk

Reducing Risk Exposure = Hedging the Exposure

 

The above are some of the commonly known techniques used to Hedge Risk which are used to hedge. Since, I am not a professional Hedger, leave a comment if there are any other techniques prevalent in the markets. Next, if you want these techniques expounded, hey, there is always 'Google' or 'Bing' to get more information.

I will be back if I find anything small but interesting. Godspeed!

 

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