5.3. USING FORWARD CONTRACTS (2): HEDGING CONTRACTUAL EXPOSURE 187
than the 6-year one (100m versus 50m), the hedge horizon should perhaps be closer
to 5 years than to six. For example, one could go for a duration-matched hedge, the
one that protects the company against small, parallel shifts in the term structure:^9
Example 5.14
Assuming the same data, Whyran Cabels can do the following:
- ComputePV∗c= 100m/ 1. 0345 + 50m/ 1. 03456 = 125. 4 msek
- Compute the duration:^100 m/^1.^034
5
125. 4 m ×5
1. 034 +50 m/ 1. 03456
125. 4 m ×6
1. 0345 = 5.15 years
(5 years, 54 days).- Arrange a loan with the samePVand duration. If 5- and 6-year rates move
by the same (smallish) amount, then the effect of a shift in the term structure
will equally affect the hedge instrument and the hedged positions.
As a final note, we add that complete value hedging, where the company takes one
single position per currency to cover all the risks related to that currency regardless
of their time to maturity, is mostly a textbook concept, even in financial companies.
What does happen is hedging of net exposures that expire at dates that are close to
each other; fewCFOs are venturing to go any further. The complexity of the interest
hedge, and the need to continuously update the interest and currency positions are
obvious issues. Also, bear in mind that even if thePVs of the combined exposures
and of the hedge could be kept in perfect agreement, there still is the problem that
the expiry dates do not match. Cash losses may be matched by capital gains, but the
latter are unrealized and unrealizable, implying that there could be serious liquidity
problems. Another issue with company-value hedging is that even “contractual”
exposures are neverquitecertain, as we already noted; moreover, most cashflows
foreseen for a few months out are not contractual anyway, and uncertainties about
non-contractual foreseen flows are often deemed to be too high to make hedging safe
or reliable, to managers. We return to the issues associated with non-contractual
cash flows in Chapter 13. Value hedging, in short, mainly exists in academic papers,
where the managers and bankers have already read the article and therefore are as
well informed as the author of the article assumes them to be. In reality, value
hedging is confined to a few very simple, well-understood structures like risk-free
forex positions or derivatives rather than being applied to the company as a whole.
This finishes our discussion of the second way companies and individuals use
forward contracts, hedging. Later on in this book we will discuss other applications
of hedging, including hedging of operating exposure (Chapter 13) and hedging for
the purpose of managing and pricing of derivatives (Chapters 8, 9, and 14). The
third possible application of forward contracts is speculation, as discussed in the
next section.
(^9) If duration is not a familiar concept, close your eyes and think of England; then skip the
Example.