IntroductionDerivativeare financial contracts that derive its value from an underlyingasset. It’s an agreement between the buyer and the seller to purchase the assetat a specific price on a specific date.
The four basic types of derivativesare forward Contracts, future contracts option contracts and swap.The seller contract does not have to own the underlyingasset. He can accomplish the contract by giving the buyer enough money to buythe asset at the prevailing price. He can also give the buyer anotherderivative contract that offsets the value of the first. This makesderivatives easier to trade than the asset.
Hedging Hedging is an investment that protects your assets from risk.Hedging is to minimize or offset the chance that your assets will losevalue. It limits your loss.
Hedging is an investment to reduce the risk ofadverse price movements in an asset. The hedge is to take an offsettingposition in a relating security, like future contracts. BREAKING DOWN Hedging is like taking out an insurance policy. If youown a home in a flood-prone area, you will want to protect that asset from therisk of flooding – to hedge it, in other words – by taking outflood insurance. There is a risk-reward tradeoff inherent inhedging; while it reduces potential risk, it also chips away at potential gains.
Put simply, hedging is not free. In the case of the flood insurance policy, themonthly payments add up, and if the flood never comes, the policyholderreceives no payout. Still, most people would choose to take that predictable,circumscribed loss rather than suddenly lose the roof over their head.A perfect hedge is one that eliminates all riskin a position or portfolio. In other words, the hedge is 100% inverselyconnected to the vulnerable asset.
This is more an ideal than a reality onthe ground and even the hypothetical perfect hedge is not without cost. Basisrisk refers to risk that the asset and a hedge won’t move in oppositedirections as expected; “basis” refers to the discrepancy. Hedging Through Derivatives Derivatives are securities that change in terms of one ormore underlying assets; they include swaps, options, futures and forwardcontracts. The underlying assets can be bonds, stocks, commodities, currencies,indices or interest rates. Derivatives can be effective hedges against theirunderlying assets, since the relationship between the two clearly defined.The efficiency of a derivative hedge expressed in termsof delta, sometimes called the “hedge ratio.” Delta is the amount theprice of a derivative moves per one dollar movement in the price of theunderlying asset.
Call Option A call option is an agreement that gives an investor theright, but does not give the obligation, to buy a bond, stock, commodity orother instrument at a specified price within a specific time period. It may helpyou to remember that a call option gives you the right to call in, or buy, anasset. You profit on a call when the underlying asset increases inprice. How Options Work An options contract gives the holder the rightto buy one hundred shares of the underlying security at a specificprice, known as the strike price, up until a specified date, known asthe expiration date.
For example, a single call option contract may give aholder the right to buy one hundred shares of Apple stock at a price of onehundred dollars until Dec. 31, 2017. As the value of Apple stock goes up, theprice of the options contract goes up, and vice versa.
Options contract holderscan hold the contract until the expiration date, at which point they can takedelivery of the one hundred shares of stock or sell the options contract at anypoint before the expiration date at the market price of the contract at thetime. Speculator A speculator is a person who trades, commodities,bonds, equities or currencies with a higher average risk in return for a higher-averageprofit potential. Speculators take large risks, especially with respect toanticipating future price movements, in the hope of making quick, large gains.Speculatorsare typically sophisticated risk-taking investors with expertise in the marketsin which they are trading; they usually use highly leveraged investments, suchas futures and options.These investors are called speculators due to theirtendency to attempt to predict price changes in more volatile sections of themarkets, believing, or speculating, that a high profit will occur even ifmarket indicators may suggest otherwise. Normally, speculators operate in ashorter period than a traditional investor.
Principles behind Speculation Speculative activities carry high amount of risk, becausevarious market indicators do not support the likelihood of asset appreciation.Speculators are also more likely to purchase futures or options overtraditional stocks.MethodologyThe GroupFinancial Department take all the decisions except those decisions for riskhedging policy. The Group limits the usage of derivatives to sole the purposeof hedging clearly to identify the exposure. The Financial Risks Committee isresponsible for identifying, defining and approving financial risk managementpolicies, assessing risks, and approving and monitoring hedges.
In monthlybasis it meets and comprises representatives from the Group FinancialDepartment and the Corporate Financing Department. Derivative financial instruments To managefinancial exposures derivative financial instruments are used. Derivatives arefirst recognized at fair value on the date a derivative contract is enteredinto and are subsequently stately at their fair value. The Fair valueis based on the market value for listed instruments or on mathematical models,such as option pricing models and discounted cash flow calculations forunlisted instruments. Those models take into consideration the market data. Currency transaction risk The Corporate Financing Department monitor foreigncurrency transaction risk. All of the group companies calculate its accountingforeign exchange exposure in relation to its functional currency and hedges itsystematically. A number of temporary exemptions can be granted by the GroupFinancial Department when it is not possible to hedge a currency or when it hasjustified under exceptional market conditions.
The same type and equivalent maturities of the foreigncurrency payables and receivables netted off and only the net exposure hedged.The financial holding company or a bank can carry it out. It in turn assessesits own resulting exposure and hedges it with its banking partners. The forwardcurrency contracts are the fundamental hedging instruments. The structural portionof the exposure is hedged with long term instruments (six years maturitymaximum) and the operating part is hedged with short term instruments(generally maturity is shorter than or equal to three months).
Hedging andcurrency risk monitoring is based on Group internal levels and steps. Thetransactional currency risk alert system implemented throughout the Group underthe responsibility of the Corporate Department. These exposures tracked on amonthly basis on a detailed management report. Transactional Currency Risk This table setforth the Group transactional foreign currency accounting exposures (when amonetary asset or liability is denominated in a currency other than thefunctional currency), before and after hedging: At December 31, 2016, a subsidiary had net exposure inEUR for one hundred seven million euro,due to the change of its functional currency as of January 1, 2017. Thisexposure being hedged from the beginning of January 2017.At December 31, 2015, another subsidiary had net exposurein USD for fifty three million euro and in EUR for sixty six million euro, dueto the change of its functional currency as of January 1, 2016.
This exposurehad been hedged from the beginning of January 2016. A negative aggregate impact can come from unfavorable changein each of the foreign currencies mentioned in the table above against thefunctional currencies of the companies which have the currency transactionexposure, after hedging, of less than one million euro (2015: one million euro)in the consolidated income statement for every cent change. A symmetricalimpact can come from favorable change. It relatively has low sensitivity to thetransaction currency risk this is due to the objective described in paragraphabove “Currency risk”. Because of the low volume of cash flow hedgederivatives, the equity sensitivity to currency risk is not significant. Derivative contractual amounts This Group concluded long-term currency derivativecontracts with maturities between one and six years for a total amount of ninehundred fifty eight million euro (2015: one thousand two hundred eighteenmillion euro). The nominal amounts by major currencies bought against the euroare denominated in USD for one hundred fourty seven million euro (2015: twohundred twenty one million euro), in BRL for one hundred fourty five millioneuro (2015: two hundred six million euro), in CNH and CNY for three hundred sixty-five million euro (2015: threehundred ninety four million euro) and in THB for two hundred twenty millioneuro (2015: two hundred twenty million euro).
The maturity of the othercurrency derivative contracts does not generally exceed one year. Those amountsof the currency derivatives are given by currency below:
