186 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
Issue #4: Value Hedging versus Cash-Flow Hedging?
An extreme form of grouping occurs if the company hedges all its exposures by one
single position. One simple strategy would be the following:
- Compute thePV, in forex, of allfccontracts. Call thisPV∗c(c for contract).
- Add afcposition in the bond or forward market withPV∗h(h for hedge)
- The naive full hedge solution would then be to setPV∗h= –PV∗c.
Example 5.13
Suppose the spot interest rates are 3.4 %p.a.compound for 5 years, and and 3.45
%p.a. compound for 6 years. Then, assuming these are the company’s onlyfc
positions, Whyran Cabels can hedge its 5- and 6-yearsekdebt as follows:
- ComputePV∗c= 100m/ 1. 0345 + 50m/ 1. 03456 = 125. 4 msek.
- Arrange a loan with the samePV. If the loan is for one year and the one-year
interest rate is 3 percent, the face value is 125. 4 × 1 .03 = 129. 2 m.
The reasoning behind this hedging rule is that, if the spot exchange rate moves, the
effect on thePVs of the contractual position and the hedge position will balance out,
thus leaving the firm’s totalPVunaffected. It is, however, important to realize that
this argument assumes that thefc pvs ofhandcare not changing, or at least that
any changes in thesepv∗s are identical. However, foreign interest rates can change,
and these shifts are likely to differ across the time-to-maturity spectrum. And even
if the shifts were identical for all interest rates, thePVof the 5- and 6-year items
would still change by far more than the 1-year position. Thus,PVhedging may again
induce a big interest-rate risk. This is why the full hedge with justpv-matching
was called “naive”, above.
This can be solved by throwing in an interest-risk management program. But
maturity mismatches can also lead to severe liquidity problems if short-term losses
are realized while the offsetting gains remain unrealized, for the time being. A
simpler solution would accordingly be to abandon thePV-hedging policy. If every
single exposure is hedged by a hedge for the same date, then the impact of interest-
rate changes is the same forPV∗handPV∗c. This would still be approximately true
if exposures are grouped into buckets that are not too wide, and if the hedge has
a similar time to maturity.^8 This is why, in Example 5.12, we hedged the 5- and
6-year loan by a position at 5.5 years. In fact, since the 5-year flow is much larger
(^8) Also, group inflows and outflows into separate buckets before you compute durations. (Dura-
tions for portfolios with positive and negative positions with similar times to maturity can lead to
absurdly large numbers, because of leverage.) Then add a hedge on the side with the smallerPV,
in absolute size.