Question

Use real or hypothetical examples as a way to illustrate your explanation:

- Hedging Techniques: comparison of the two main hedging techniques

Answer 1

Hedging is the process of reducing or eliminating the risk in the stock or in the foreign currency transactions. Hedging can be  used in any type of transactins like in stock market , commodity market and transctions involving foreign currency risk.Hedging can be done using many techniques.

Techniques of hedging in stock market:

Hedging through future and contracts: In this tecquinue oppsite position from the cash market is taken in the future market. e.g. you have long position in the stocks, you can short the futures of that stock and vice versa.

Throgh buying any stock having negative correlation: In case you fear the price fluctuation of your stock , you can take another stock having negative correlation with your stock. Because if the price of your stock falls the price of the new stock will rise.

Taking oppsite positiion in the index: Suppose you have 100 shares (market value 200 each)of abc ltd having beta of 1.5. In order to hedge, you can short index of the value of 30000 (i.e.200*100*1.5).  

Techniques of hedging in transactions involving foreign currency:

Forward contract: If you have exported goods to a foreign country customer and have foreign currency receivable in say 1 month you can short forward contract of foreign currency in order to ifx the receivable amount in domestic currency. If you have imported and foreighn currency is payable then in that casee you should long foreign currency forward.

Money market Hedge:In money market hedging, the amount is borrowed from one currency and invested in other currency depending on the prevailing deposite and loan rates in the respective countries.

Example of money market hedge: and exporter is a UK based company. The value of invoice amount is USD 350000. Credit period is 3 months. Exchange rates as as follows:

Spot usd/pound=1.5865-1.5905

3Month Forward rates(usd/pound) = 1.6100-1.6140

Rates of interest are as follows:

	Deposite	Loan
USD	7%	9%
Pound	5%	8%

since exprter has receivable of USD 350000, he should creat payable of USD 350000 by borrowing from US the present value of 350000.

Amount to be borrowed= 342299 (i.e.350000/1.0225)

this amount will become 350000 in three months and shall be repaid out of the receivable from Us importer.

Borrowed money should be converted into pound and invested in pound.

Pound invested =215215 (i.e. 342299/1.5905)

Value of pound after 3 months=217905 (i.e. 215215*1.0125)

Hence he will certainly get 217905 pounds no matter what become the price of dollor in three months.

Further in the present case money market is more benificial than forward because if he had entered in to forward sell of dollor he would have got only 217391 pound (i.e.350000/1.6100).

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