Treasury and Risk Management

Question: Discuss about the Treasury and Risk Management. Answer: Introduction: This report discusses about Hedging and its application through an example under Treasury and Risk Management. The investment avenues are always risky and the financial markets are subject to fluctuations which put the investments exposed to a high risk. Not only investment, business which run on different resources and raw materials (resources and raw materials are different as per the industry and sector in which it is involved), are also subject to high economic risk which may lead to change in the prices these resources and turn around the entire profit margins or the feasibility of the business being performed. Hedging is one such technique which the business may anticipate the trend and according take a safe risk position by entering into futures or options. Futures / Options are those financial instruments which are traded at a decided price against the current spot prices. Options make the contracts obligatory for the holder to execute while futures do not have any obligation associated with them. In this report we shall discuss on how any business entity may use the futures to hedge the risk involved in the price fluctuations. (NYU, NA) (Montana, NA) Hedge ratio is defined as the size of future contracts in relative to the spot price elements. It is formulated as: where, is the correlation coefficient between the spot price element and the future contract element ; s is the standard deviation of spot price element; and F is the standard deviation of future contract. (DAHL, NA) Futures have been one of the highly effective hedging techniques as understood from different literature and research works held (Actuaries, NA) (Giddy, NA) (Kenourgios, 2008). In this report, we shall apply the future hedging concepts and hedging ratios to understand their implications. Given is the case study of a company which uses Liquid X an alternative energy source. The recent movements on the price of oil have caused volatility in the price of Liquid X and so the company wishes to hedge its exposure to Liquid X. It is also given that the price changes of liquid X have a 0.7 correlation with gasoline futures price changes and the company will lose $500,000 for each 1 cent increase in the price per gallon of Liquid X over the next two months. It is understood that Liquid X has a standard deviation that is 50% greater than price changes in gasoline futures prices. Provided, futures contracts on Liquid X are non-existent and the company uses gasoline futures to hedge its exposure to Liquid X and assuming each gasoline futures contract is on 40,000 gallons; price of Liquid X post 2 months increased by 2% from $2.5 per gallon, the following questions are answered adopting the hedging techniques and concepts. What should be the hedge ratio in the use of gasoline futures to hedge its exposure? Given, Standard deviation of Liquid X is 50% greater than the gasoline, Minimum Variance Hedge Ratio = 0.7 * 1.5 = 1.05 What is the company's exposure measured in gallons of Liquid X? Given company will lose $500,000 for each 1 cent increase in the price per gallon of Liquid X over the next two months. The risk exposure is given at $500,000 per cent increase in fuel price per gallon Given, increase in price of Liquid X is 2% = 0.02*2.5 = 0.05 = 5 cents Thus the exposure is 5 x $500,000 for 5 cents which is equivalent for 2,500,000/2.5$= 1,000,000 gallons. Thus the companys exposure is 1 million gallons of Liquid X What position measured in gallons, what is the type of position should the company take in gasoline futures to hedge its exposure? Thus the company should take position of 1.05X1000000 which is equivalent to 1050,000 gallons in gasoline futures. It should take the long position while hedging as the prices are subject to rise. How many gasoline futures contracts should be traded in this hedging strategy? Given each contract has 40000 gallons of gasoline. Thus, 1050,000 gallons of gasoline futures correspond to 1050000/40000 = 26.25 contracts. Rounding off, 26 gasoline futures contracts should be traded in this hedging strategy. After two months, what is the gain/loss in the spot market and the trading gain/loss on the futures contracts in part d? After two months the spot price of Liquid x is given as = $ 2.5 x (1+2%) = $ 2.55 No of future contracts held = 26 No of gallons corresponding to the future contracts = 26 x 40000 = 1040000 The cost incurred to buy 1.04 million gallons of Liquid X: @ Spot Price of $ 2.55 per gallon = $ 2652000 @ executing future contract price of $ 2.5 per gallon = $ 2600000 Thus as the price has increased, the company will execute the future contracts and would be able to gain $ 52000. As may be observed form historical times, emerging economies always are vulnerable to the changes in the interest rates of the United States. In general, the emerging economies are dependent upon developed economies for capital sources, deficits and other financial supports. Thus change in interest rates in the United States would adversely affect these emerging economies like Asia. Every emerging economy has its own nature and thus the impact varies from economy to economy. The Asian economy has been observed historically to have adverse effect with the increase in interest rate of the United States due to increase in domestic interest rate, reduction in domestic consumption, fall in GDP, reduction in capital flows and so on. The details are more elaborately discussed below. The interest rates fluctuation would affect the GDP of the economies due to fall in consumption due to increased cost of borrowing affecting end utility costs in the economy. Increased interest rates in the United States attract investors to invest in the United States assets thus redirecting the capital flows and affecting the foreign investment into the Asian economy. The increased interest rate in the United States gets transmitted to the domestic economy and would reduce the exports further effecting the economic growth. The increased interest rate leads to appreciation of the United States dollar and thus results in depreciation of other currencies especially of emerging economies like Asia. As mentioned above due to non-uniformity of the emerging economies, the effect of the increased interest rates varies from economy to economy leading to increased volatility in the markets and risk in the investments. Overall, the increase in interest rate is not quite favorable to the Asian or emerging economies due to the above discussed reasons. (Acumen, NA) Bibliography Actuaries, NA. Hedging in Financial Markets, s.l.: Actuaries. Acumen, NA. What's the likely impact of rising US interest rates. [Online] Available at: https://acumen.sg/whats-the-likely-impact-of-rising-us-interest-rates/ DAHL, NA. Optimal Hedge Ratio, s.l.: s.n. Giddy, NA. Hedging Techniques, s.l.: s.n. Kenourgios, D., 2008. Hedge Ratio Estimation and Effectiveness. International Journal of Risk Assessment and Management. Montana, NA. Hedging Strategies using Futures and Options. Classnotes. NYU, NA. Risk Management- Profiling and Hedging. Stern.