Giddy | Hedging 1

Hedging Techniques

Dr. Ian Giddy

New York University

Techniques of Hedging

A brief comparison of hedging tools

Forwards, futures, swaps

Asset-liability matching

Pricing and linkages among the tools

Uses and abuses of options

When to use, and when not to use

Copyright ©2009 Ian H Giddy

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What Hedging Instruments?

What Protection Needed?

Volatility & Complex risks

Direction
Direction Or arbitrage

OTC options, Forwards, Exotics, Hybrids,

Futures, structured
Caps and Floors Swaps notes

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Tools for Hedging

Petrobras has to pay for equipment from Japan, in

Japanese yen, in 3 months

Borrow and pay now?

Use a forward contract/FX swap?

Pay later at spot?

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Forward Contracts, Futures

and Money Market Hedging

Money market hedging: match currency of assets
and liabilities

Forwards: Agreement to exchange currencies at
certain exchange rate in the future

Futures: Exchange-traded contracts for notional
future delivery, minimizing default risk via marking-to-
market

Currency swap: match payments on foreign-currency
debt

Interest-rate swap: change floating cost to fixed

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A Typical Forward Exchange Contract

We agree today to pay a certain price for a currency in

the future

JPY

Sony
Sony BBof
ofAA

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Forward Quotations

Source: ft.com

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The FX Swap Hedge

3-month Swap

3-month Forward Contract

l Dealers typically hedge a forward foreign-exchange

commitment with a spot plus “FX Swap”: spot sale
plus forward purchase of a foreign currency
l The FX swap rate is determined by the interest
differential

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Giddy | Hedging 5

The Roll-
Roll-Over Swap Hedge

3-month Swap 3-month Swap

6-month Forward Contract

l Dealers often hedge a long-term foreign-exchange

commitment with shorter-term contracts, which are
“rolled over” as they come due
l Corporations themselves do this too.

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Futures – Like Forwards, But Traded on an Exchange

Source: quotes.ino.com

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A Currency Swap: Used to Hedge Debt

IDR 100,000

Indosat
Indosat BANK
BANK
USD 10 USD 10

Indosat issues dollar debt, but wants rupiah financing

so exchanges its dollars for IDR equivalent
at today’s spot exchange rate

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Periodic Exchange of Interest

IDR 100,000

Indosat
Indosat BANK
BANK
USD 10

Fixed IDR 12%

Indosat
Indosat BANK
BANK
Floating USD
3-mo Libor

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Giddy | Hedging 7

Three Parts of a Currency Swap

IDR 100,000

Indosat
Indosat BANK
BANK
USD 10

Fixed IDR 12%

Indosat
Indosat BANK
BANK
Floating USD
Libor
IDR 100,000

Indosat
Indosat BANK
BANK
USD 10
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Interest Rate Swap

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Giddy | Hedging 8

Swap Quotations

Source: ft.com

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Managing Exchange Risk:

Tools & Techniques
Borrowing
Lending

Symmetrical contracts Kinky contracts

Forward contracts OTC options

Futures Exchange-traded
options

Swaps Exotics
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Spot, Forwards and Swaps in Indonesia

Forward and swap

transactions are
necessary for hedging

But they are declining
as a percentage of the
total in Indonesia

Source: Bank Indonesia Annual Report 2007

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“Cost of Hedging”
Hedging” is Neutral

Type of Hedge Cost of Hedging

Forward Forward premium

Money Market Hedge Interest rate

(Borrow to match differential
assets)
Do nothing Expected rate of
change of
exchange rate

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When Should We Use Options to Hedge?

Petrobras hedging cost of Japanese debt

FORWARD
CONTRACT

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When Should We Use Options to Hedge?

Petrobras hedging cost of Japanese debt CALL
OPTION
ON YEN

FORWARD
CONTRACT

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Option Hedges

Questions about options:

- When should companies use them?
- Which options?
- How much do they cost?
- Are they worth paying for?

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Hockey Sticks

CALL PUT

BUY

SELL

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Giddy | Hedging 12

View on Direction, Volatility or Both?

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The Hedging Choices

“Natural”
“Natural”
Hedge?
Hedge?

or

Derivatives?
Derivatives? Debt?
Debt?

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Giddy | Hedging 13

A Hedging Roadmap

Motivations for Hedge

Driven by Driven by company

company views needs

Volatility: options, Company has Company has

Direction: economic natural
forwards, debt exposure hedge

Market risk Forwards,

No need for hedging
remains swaps or debt
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Contact

Prof. Ian Giddy

NYU Stern School of Business
Tel +1.646.8080.746; Fax +1.866.369.9350
ian.giddy@nyu.edu
Web: giddy.org

Copyright ©2009 Ian H Giddy

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