Analysing the Various Financial Risks to Companies

Derivatives

It is a kind of financial Security whose price is derived from or dependent upon one or more underlying assets.A The derivative itself is simply a contract between two or more parties. ItsA value is determinedA by variationsA in the underlying asset.A Some common underlying assets includeA stocks, bonds,A commodities,A currencies and interest rates. Derivatives are mostly characterized by high leverage.A Forward contracts, Future contracts, swaps and optionsA are the most common types of derivatives.

Derivatives are generally used as a mechanism to hedgeA risk, but can also be used forA speculative purposes. For example, an American investor buying shares of a European companyA of a European exchange (using Euros to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could buy currency futures to lock in a specified exchange rate forA the future stock sale and currency conversion back into US Dollars.

Hedging is the process of taking a short-term position in the futures market that is equal to, yet opposite, one's position in the cash market in order to prevent that cash position against loss due to adverse price fluctuations. This form of risk management can be achieved through various types of futures and options contracts traded on a several exchanges, and are usually used by corporations, money managers the ability to hedge means that industry can decide on the amount of risk it is prepared to accept. It may wish to eliminate the risk entirely and can generally do so quickly and easily using the Mismanaging price risk means achieving greater control of either the cost of inputs, or revenues from sales, or both; planning for the future based on assured costs and revenues; and eliminating concerns that a sharply adverse move in a metal's price could turn an otherwise flourishing and efficient business into a loss maker. Hedging is the opposite of speculation and is basically undertaken in order to reduce an existing physical price risk, by taking a compensating position in the futures market. Speculators come to the futures market with no initial risk. They assume risk by taking futures positions. Hedgers reduce or eliminate the chance of further losses or profits, while the speculators risk losses in order to make profits.

Speculation

SpeculationA is an action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the purchase ofA equity or lending of money,A assetsA orA debtA but in a way that has not been given thorough analysis or is thought to have lowA margin of safetyA or a significant risk of the loss of the principal investment.

Speculators may rely on an asset appreciating in price because of number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, buyers' changing perceptions of the worth of a stockA security, fluctuating economic conditions, economic factors associated withA market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities.

There are also some financial vehicles that can be classified as speculation. For example, tradingA commodity futures contracts, such as for oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative.

Financial speculation can involve theA buying, selling, holding, andA short-sellingA ofA stocks, commodities,A bonds,A currencies,A collectibles,A real estate, derivatives, or any valuableA financial instrumentA to profit from fluctuations in its price, irrespective of its underlying value.

Arbitrage

AnA arbitrageA is a type of transaction or portfolio. Actually, the term is used in two different ways, so it refers to either of two very different types of transactions or portfolios. People also speak of arbitrage as an activity the activity of seeking out and implementing either of the two types of arbitrage transactions or portfolios. AnA arbitrageurA is an individual or institution who engages in such arbitrage.

An arbitrage is a portfolio or transaction that makes a profit without anyA risk. For example if aA futures contract trades on two different exchanges. If, at one point in time, the contract is bid atA USDA 45.02 on one exchange and offered at USD 45.00 on the other, a trader could buy the contract at one price and sell it at the other to make a risk-free profit of a USD 0.02.

Such arbitrage opportunities reflect minor pricing differences between markets or related instruments. Profits per transaction tend to be small, and they can be consumed entirely byA transaction costs. Accordingly, most arbitrage is done by institutions that have very low transaction costs and can make up for small profit margins by doing a large volume of transactions.

Option Strategies

A Option strategyA is the buying and/or selling of one or range ofA option positions and possibly anA underlyingA position. Options strategies can support movements in the underlying that are bullish, bearish or neutral. In the case of neutral strategies, they can be further divided into those that are bullish on volatility and those that are bearish on volatility. The option positions taken can beA longA and/or shortA positions inA callsA and/orA putsA at various strikes.

Before you purchase or sell options you need a strategy, and before you choose an options strategy, you need to be aware of how you want options to work in your portfolio. A particular strategy is victorious only if it performs in a way that helps you meet your investment goals. If you expect to increase the income you receive from your stocks, for example, you'll choose a diverse strategy from an investor who wants to lock in a purchase price for a stock she'd like to own.

One of the advantages of options is the flexibility they offer; they can complement portfolios in many different ways. So it's worth taking the time to recognize a goal that suits you and your financial plan.

Forwards

A forwardA is a non-standardized contract between two parties to purchase or sell an asset at a specified future time at a price agreed today.A  It costs nothing to enter a forward contract. The party agreeing to purchase the underlying asset in the future assumes aA long position, and the party agreeing to sell the asset in the future assumes aA short position. The price which is agreed upon at the inception of the contract is called theA delivery price, which is equal to theA forward priceA at the time the contract is entered into.

The price pertaining to underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of purchase/sell orders where the time of trade is not the time where theA securities themselves are exchanged.

Futures

A standardized exchange-traded contract that requires delivery of a commodity, currency, bond or stock index, at a specified price, on a specified future date. Unlike options, futures require an obligation to buy. The risk to the holder is infinite, and because the pay off pattern is symmetrical, the risk to the seller is unlimited as well. Money lost and gained by each party are equal and opposite in a future contract. In other words, future's trading is a zero-sum game. Futures contracts are forward contracts, meaning they represent a promise to fulfill a certain transaction at a future date. The exchange of assets occurs on the date mentioned in the contract. Futures are different from generic forward contracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearinghouses. In order to make sure that payment will occur, futures have a margin requirement that must be settled daily.

Currency Risk

Many Corporations use derivatives for hedging foreign-currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates willA adversely impact business results.A 

Let's consider an example of foreign-currency risk with XYZ Corporation, a hypothetical U.S.-based company that sells widgets in Germany. During the year, XYZ Corp sells 100 widgets, each priced at 10 euros. Therefore, our constant assumption is that XYZ sells 1,000 euros worth of widgets:A 

When the dollar-per-euro exchange rate increases from $1.33 to $1.50 to $1.75, it takes more dollars to purchase one euro, or one euro translates into more dollars, meaning the dollar is weakening or depreciating. As the dollar weakens, the same number of widgets sold translates into greater sales inA dollar terms. This shows how a weakening dollar is not all bad: it can boost export sales of U.S. companies. A 

The above example shows the "good news" event that can occur when the dollar depreciates, but a "bad news" event happens if the dollar appreciates and export sales end up being less. In the above example, we made two very important simplifying assumptions that affect whether the dollar depreciation is a good or bad event:A 

(1) we assumed that XYZ Corp. manufactures its product in the U.S. and therefore its inventory or production costs is inA dollars. If instead XYZ manufactured its German widgets in Germany, production costs would be incurred in euros. So even ifA dollar sales increase due to weakening of the dollar, production costs will go up too! This effect on both sales and costs is called aA natural hedge: the economics of the business provide their own hedge mechanism. In such a case, the higher export sales are likely to be mitigated by higher production costs.A 

(2)A A  We also assumed that all other things are identical, and often they are not. For example, we ignored any secondary effects like whether XYZ can adjust its prices and effects of inflation. Most multinational corporations are faced with some form of foreign-currency risk even after natural hedges and secondary effects.A 

Now let's illustrate a simple hedge that a company like XYZ might use. To minimize the effects of any USD/EUR exchange rates, XYZ purchases 800 foreign-exchange futures contracts against the USD/EUR exchange rate. The gain in each futures contract has a value equal to above the $1.33 USD/EUR rate. (Only because XYZ took this side of the futures position, somebodyA - the counter-party - will take the opposite position):A 

If the dollar were to depreciate instead, then the increased export sales are mitigated (partially offset) by losses on the futures contracts.

Hedging Interest-Rate RiskA 

Companies can hedgeA interest-rate riskA in various ways. Consider a company that wants to sell a division in one year and at that time to receive a cash windfall that it wants to "park" in a good risk-free investment. If the company believes that interest rates will drop between now and then, it could buy (take a long position on) aA TreasuryA futures contract. The company is effectively locking in the future interest rate.A Here is an example of a perfect interest-rate hedge used by XYZ Corporation.

The Company had two interest rate swaps outstanding at September 30, 2004,A designated as a hedge of the fair value of a portion of fixed-rate bond. The change in fair value of the swaps exactly offsets the change in fair value of the hedged debt, with no net impact on earnings. A A A 

XYZ is using anA interest rate swap. Before it entered into the swap,A the company wasA paying aA floating interest rateA on some ofA its bonds. For example, a common scenario would be to payA LIBORA plus something and to reset the rate every six months. We can illustrate these floating rate payments with a down-bar chart:A A A 

Now let's look at the impact of the swap, illustrated below. While receiving floating-rate payments the swap arrangement requires XYZ to pay fixed rate of interest. The received floating-rate payments as shown in the upper half of the chart below are used to pay the pre-existing floating-rate debt.A 

XYZ is then left only with the floating-rate debt, and has therefore managed to convert a variable-rate obligation into a fixed-rate obligation with the addition of a derivative. The variable-rate coupons that XYZ received exactly compensates for the company's variable-rate obligations.

Commodity or Product Input HedgeA 

Companies that depend on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. In the past, most airlines have given a great deal of consideration to hedging against crude-oil price increases.

For example XYZ ltd produces agricultural products, herbicides and biotech-related products.A It uses futures contracts to hedge against the price increase of olive and corn inventory. XYZ ltd uses futures contracts to prevent itself against commodity price increases; these contracts hedge the committed or future purchases of, and the carrying value of payables to growers forA olive and corn inventories.

Pension funds

Many pension funds are starting to like the idea of derivatives. As funds and their sponsors search for more effective ways to manage risk, they are realizing that derivatives can alter the nature of that risk in ways that are not possible in the cash markets.

Pension funds are exposed to many risks, some of which they take actively while others they may be taking passively. Funds actively take equity and credit risk, for example, because they feel they are being adequately rewarded. Passive risks include movements in the present value of their liabilities due to changes in interest and inflation rates. Many funds do not believe they are being adequately compensated for these risks. The importance of derivatives is that they can be used to improve the return profile of their active risks, and to neutralize unwanted passive risks.

These passive risks are usually created by a mismatch between a fund's assets and its liabilities. A pension fund can use interest rate swaps, for example, to remove the risk that a change in interest rates will have an impact on its funding level. Or it can enter into an inflation-linked swap so that it is no longer exposed to changes in the experienced rate of inflation. The up-front costs of neutralizing these risks can be low.

But as with any investment strategy, there is a downside as well as an upside. A pension fund that enters into an interest rate swap is no longer vulnerable to a fall in interest rates - but neither will it benefit from a rise. Similarly, if a fund uses inflation swaps to protect itself against a rise in inflation it will no longer benefit from a fall.

Another passive risk pension funds face is that of corporate sponsor default. An interesting possibility for some funds would be to neutralize this risk by buying protection for any funding deficit in the credit default swap (CDS) market. This strategy would entail paying an annual premium to counterparty, and receiving a pre-agreed sum of money that would cover the deficit if the sponsor defaulted. The size of the premium would depend on the credit quality of the sponsor.

Hedge funds

AA hedge fundA is not highly regulatedA investment fundA that is typically open to a limited range of investors who pay aA performance feeA to the fund'sA investment manager.

Every hedge fund has its own investment strategy that basically determines the type of investments it undertakes and these strategies are highly individual. As a class, hedge funds embark on a wider range of investment and trading activities than traditionalA long-only investment funds, and invest in a broader range of assets includingA longA andA shortA positions inA shares,A bondsA andA commodities. Hedge funds often try toA hedgeA some of the risks inherent in their investments using a variety of methods, notablyA short sellingA andA derivatives. Hedge funds dominate certain specialty markets such as distressed debt and trading within derivatives with high-yield ratings.

Modern portfolio theory segregates the return on an investment portfolio into market related component multiplied by beta, a measure of volatility, and alpha, the specific return associated

with portfolio that is independent of the market. Alpha measures a Hedge fund manager's skill in creating excess return over the market benchmark.

Alpha does involve leverage, but the risk can be mitigated with the cash freed up by the use of derivatives is invested in assets that have no correlation with the passive part of the alpha. A market neutral hedge fund, for example, should offer an Alpha return with no correlation to the stock market.

Advantages of Hedge Fund Investing

Mostly hedge funds bank on the prosperity of only one investment and are not overly diversified investments.

Aggressive investment strategies such as short-selling or borrowing money to purchase more assets (leverage buying) can legally be utilized

Extremely huge gains in the millions are the potential reward for investing in hedge funds

Disadvantages of Hedge Fund Investing

Hedge funds are extremely risky and huge sums of money can be lost in the blink of an eye

The performance fee for the hedge fund manager may encourage them to take bigger risks with investor's money which may result in large losses

There are very few government regulations regulating hedge fund investments

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