Derivatives and Risk Management

Questions: 1. To propose specific hedging strategies which require you to describe the following: i. the exposures to be hedged, ii. what percentage proportion of the exposure is to be hedged, iii. which derivative(s) are to be used to hedge each exposure, iv. the number of derivative contracts for each hedge, v. the delivery months (or duration of swaps) for each derivative, and vi. the prices at the time of making the recommendation - futures prices, option strike prices (including an explanation of the choice of strike price(s)] and theinterest rate for currency swaps (you will need to research this- use actual data). 2. Is the company adequately hedged? Why or why not? What are your recommendations? Answers: Introduction: (1). In the present report, we have selected a company named, Sonic Health Care Limited for the presenting recommendations about different hedging strategies using different transaction exposures. Actual data of financial year 2015 has been used for the said purpose assuming the hedging horizon of mid- December and for future and options, expiry date of December has been considered (sonichealthcare.com). In current market scenario, there are transaction, translation and economic or operating exposure, which are required to be hedged. Transaction and translation exposure falls under accounting exposure. i. Exposures that are required to be hedged, considering the selected company Pacific Energy Limited can be done through the following instruments: Forward contract Derivatives Money Market Hedge Currency invoicing and risk sharing Exposure netting. Forward contract is an arrangement by which two parties, buyer and seller agrees to enter in a contract on the spot date of the event to make payment in future at an agreed currency rate which takes place over the counter (Chance and Brooks, 2015). Derivatives comprise of Futures and Options which derives their value from underlying share price. Unlike forward contract, derivates are traded on exchange with mark to market feature in case of futures whereas, in case of options buyer has the right and not obligation to buy or sell the securities before a future fixed date in form of call or put option (Cuong and Toan, 2016). Money market, currency invoicing is a market where currencies are bought and sold at the rates regulated by Reserve Bank for the purpose of hedging (Devalkar, Anupindi and Sinha, 2016). Exposure netting means the set off between receivables and payables, which eliminates the risk as well as cost of the hedging process (Feng, 2015). From the data and explanations provided in the annual report 2015 (sonichealthcare.com), Sonic Healthcare Limited seemed to use currency and derivatives exposures to hedge itself. In the year 2015 Sonic Healthcare hedged itself for around 164,000 $ from forward contract. ii. Traditionally, there were two extremes to hedge the exposures, fully hedge i.e. 100% and no hedge (0 %). However, this strategy of hedging is not advisable as both the extremes involve either huge cost or huge risk. Therefore, to present an optimum proportion of exposure to be hedged was derived by Fisher Black formula which is used universally. The formula has been derived using the three inputs i.e. expected return on market portfolio and volatility of portfolio and market exchange rate (Tessema, 2016). It has also noted that there is another approach for optimum proportion of exposure to be hedged which is 50 % approach, known as minimizing, maximizing regret. This method is advised for short time periods and when the market rates maintain consistency with Purchasing power parity (PPP). iii. As mentioned in the above points, derivatives that should be beneficial to use are forward contract, futures, money market and netting of exposure (Wing and Jin, 2015). These derivates have been suggested with regard to market risk elimination, low cost in the course of hedging and parity in purchasing power for both payer and receiver. iv. Sonic Healthcare limited has received on exercising options, net cash amounted to $13M and number of options granted to its Directors in the month of September 2015, 2,465,418 options to one director and 1,181,485 options to another director. Further, the number of options granted in the current financial year is represented with the help of the following figure.Figure 2: Table showing number of options granted Figure 3: Table showing option plan v. The duration of swap of derivatives is the difference between the duration of fixed- rate bond and floating- rate bond, which is derived by dividing the present value of cash flows by the price of, bonds (Tessema, 2016). vi. Future price for the year 2015 of Sonic Healthcare Limited (sonichealthcare.com) as per Australian stock exchange was 50.180 $ with ASX code- AAA while that of US contracts 394.6 $. Options strike prices of both the US and Australia stock exchange revolves in the same direction i.e. $ 52.19 to 301.6 $ in the month of December horizon. This strike price has been selected to express the market volatility in the both the stock exchanges while interest swap rate is around 4%- 5%. Hence, it is advisable that to hedge the cash flows, company can use option spread by buying an option in Australia Stock Exchange at strike price $52.19 while going short in US stock exchange. (2). In considerations with the available data and prices, Sonic Healthcare Limited is partially hedged in the financial 2015 as well as in the year 2014. This was analyzed from its annual report wherein effective income from cash flow hedging stands to around $ 164,000 in 2015 and $ 1,550 in the year 2014. Though it seemed to be a sound hedge exposure (Wing and Jin, 2015), it is being recommended that the entity should maintain the strategy in future years including more transaction exposures in money market. Conclusion: The present report has been dealt with the various types of hedging strategies in the market portfolio and the exposure used by Sonic Healthcare Limited considering the factual data available from various sources. It has been recommended further that the enterprise is adequately hedged along with evidences and reasons thereof. Reference List: Chance, D. and Brooks, R., 2015.Introduction to derivatives and risk management. Cengage Learning. Cuong, D.X. and Toan, N.Q., 2016. Derivatives as the Price Fluctuation Risk Management for Vietnamese Coffee Exporters.Research in World Economy,7(1), p.p59. Devalkar, S.K., Anupindi, R. and Sinha, A., 2016. Dynamic risk management of commodity operations: Model and analysis.Indian School of Business Research Paper Series. Feng, Q., 2015, June. The use of derivatives, corporate risk management and firm financial performance: Evidence from non-financial listed companies in Zhejiang province, China. InEducation Management and Management Science: Proceedings of the International Conference on Education Management and Management Science (ICEMMS 2014), August 7-8, 2014, Tianjin, China(Vol. 7, p. 55). CRC Press. Tessema, A.M., 2016. Accounting for derivatives and risk management activities: The impact of product market competition.International Journal of Accounting and Information Management,24(1), pp.82-96. Wing, L.C. and Jin, Z., 2015. Risk management methods applied to renewable and sustainable energy: a review.Journal of Electrical and Electr