The Risk of Widening International Markets - Essay Example

Table of Contents: Contents: Page Nos. I. 3 II. Background 3 III. Research Aims 3 IV. Importance of Study 4 V. Literature Review 5 VI. Research Design and Methodology 10 -Data Collection Methods 10 -Analysis of Data and Interpretation of Findings 12 VII. Does Hedging Amplify Value? 12 VIII. Conclusion 13 IX. Limitations 13 X. References 14 List of Figures: I. Usage of derivatives across risk groups 6 Title: Hedging in Financial Risk Management Background: Even though financial risk has augmented significantly in current years, risk and risk management are not modern-day issues. The consequence of the widening international markets is that risk may start off with events thousands of miles away that have nothing to do with the household market. Information is available directly, which implies that alteration, and subsequent market responses take place very quickly. The economic environment and markets can be influenced very quickly by alterations in exchange rates, rates of interest, and commodity prices. Counterparties can become challenging. As a result, it is imperative to ensure financial risks are acknowledged and managed properly (What is Financial Risk Management?, n.d., p. 1). Research Aims: We would build up a positive hypothesis of the hedging behavior of value optimizing corporations. Hedging is treated by companies simply as a part of the organization’s financing decisions. The paper pays attention to the impact of the hedging strategy on the organization’s investment decisions. Our theory provides answer to the question- why some organizations hedge and others do not. The goal of hedging in risk management is to decrease the fundamental volatility of cash flows and curtail the likelihood of large losses. The current study intends to discuss this issue. Importance of the study: Risk provides the foundation for chance (Boyle, Coleman and Li, n.d., p. 1). Risk is the probability of losses resulting from events such as alterations in market prices. Events with a low likelihood of occurrence, but those causing a high loss, are predominantly troublesome since they are often not predicted (What is Financial Risk Management?, n.d., p. 1-2). Probable Size of Loss Likelihood of Loss Possibility for Large Loss High likelihood of Occurrence Possibility for Small Loss Low likelihood of Occurrence Financial risk arises through innumerable transactions of economic nature, comprising of sales and purchases, ventures and loans, and a variety of other dealing activities. It can occur as a result of legal deals, new schemes, mergers and acquisitions, debt financing, the power constituent of costs, or through the activities of supervision, stakeholders, contenders, foreign governments, or climate (What is Financial Risk Management?, n.d., p. 2). Approaches for risk management frequently occupy derivatives. Financial derivatives are a sort of hazard management tool (Risk Management and Financial Derivatives, n.d, p. 1). Derivatives are traded extensively among financial organizations and on structured exchanges. The value of derivatives agreements, such as futures, forwards, options, and swaps, is based on the cost of the fundamental asset. Derivatives’ operations are based on rates of interest, rates of exchange, commodities, equity and fixed earnings securities, credit, and even climate (What is Financial Risk Management?, n.d., p. 3-4). Literature Review: This section will emphasize on the fact that why and how the risk management is so important for any kind of investment decisions. According to Anderson, Bollerslev, Christoffersen and Diebold (2005), volatilities of returns of monetary asset and correlations are time-changeable, with unrelenting dynamics. Furthermore, asset returns volatilities are essential to finance, whether in asset pricing, portfolio allotment, or market risk dimension. Hence the domain of financial econometrics dedicates considerable concentration towards time-fluctuating volatility and related tools for its dimension, modeling and prediction (Anderson, Bollerslev, Christoffersen and Diebold, 2005). The role of the risk management function should be proportionate to the degree and intricacy of the derivative activities. (Risk Management of Financial Derivatives, 1997) Bodnar and Gebhardt (1998) illustrates that U.S. and German firms’ use derivatives principally to deal with foreign exchange (FX) and interest rate (IR) hazard. Approximately all German users, 95.9 percent utilize derivatives in FX management and 88.8 percent make use of derivatives in IR management. The comparable statistics for the U.S. firms are once more lesser, 78.6 percent and 75.9 percent, respectively. Considerable awareness is placed also on product price (CP) hazards by U.S. and German firms with approximately 40 percent of firms reporting usage in each nation (Bodnar and Gebhardt, 1998, pp. 6-7). Hedge funds, in short, are mainly unfettered, personal pools of capital (Kambhu, Schuermann and Stiroh, 2007, p. 2). In risk management of the fundamental assets using monetary derivatives, the basic plan is hedging, i.e., the dealer holds two places of equal quantities but of opposite courses, one in the fundamental market, and the other in the derivatives market, concurrently. While there are many differences of hedges and policies, they are all essentially built from a mixture or derivative of these advances (Lou, 2009, p. 3). In the absence of market inefficiencies, savers can undo any financial deals undertaken by a company so that the company value is autonomous of risk management policy (Boyer, Boyer and Garcia, 2005). Stock markets are not truly agreeable to total diversification. That is because big financial markets are in excess of a compilation of person’s uncorrelated risk issues. Experienced investors are always attempting to detect prototypes in the cosmos of stock returns (Brealey and Myers, 1988). Let ρ be the association of the returns between a stock S with instability σ and some tradable hazardous asset M with instability σM. Owing to the correlation amid each stock’s return and that of M, one can hedge the M-associated risk of any stock. If one has $100 invested in a stock S, one can short β times as many dollars of the aspect M against it, where β = ρ(σ/σM). β is the number of percentage points by which stock S is anticipated to go up when M increases by 1 percent. This factor-hedged portfolio, comprising of a $100 long position in the stock united with β times as much of a short position in M, will bear no net revelation to the price of M, since any rise in the price of the stock will, on average, be abandoned by a correlated reduction in worth of the short position in M. The net anticipated return on this factor-hedged M-neutral collection is relative to the return of the stock S less β times the return of M, explicitly μ – βμM. Assuming that there are no other features influencing the stock S, this remaining risk is inescapable. If one can expand over a large sufficient M-neutral portfolio of stocks so that their accrued inescapable risk cancels, then this M-neutral portfolio of zero instability must earn the risk-free rate r. The same must therefore be true of each M-neutral constituent of the portfolio. This causes the result: (μ-r)= β(μM − r) (Derman, n.d., p.3). This is the consequence of the capital asset pricing model or arbitrage pricing hypothesis: in a world of balanced investors, the surplus return one can anticipate from purchasing a stock is its β times the anticipated return of its hedgeable aspect (Derman, n.d.). There are several causes why companies may decide to hedge risks, and they can be generally categorized into 5 sets. First, the tax laws may gain those who evade risk. Second, prevarication against disastrous or extreme hazard may reduce the probability and the costs of suffering particularly for smaller businesses. Third, hedging against hazards may decrease the under investment difficulty prevalent in many companies because of risk averse executives and limited capital markets. Fourth, minimizing the revelation to some kinds of risk may offer firms with more autonomy to fine-tune their capital formation. Finally, investors may discover the financial statements of companies that do evade against irrelevant or unrelated hazards to be more informative than companies that do not (Risk Management- Profiling and Hedging, n.d, p. 13). Most companies enjoy positive instability because it permits them to receive extra profits. This approach, which is only worried about negative instability, is used when computing the Value at Risk (VaR) of a portfolio. Here the aim is to work out the amount of money $V that will stand for the utmost loss that the corporation is permitted to maintain over a particular period of time with a certain amount of assurance. In other words, the corporation will only lose in excess of $V over a definite time period with a particular likelihood (Singh, 2004, p. 5). Most corporations are offering service to their customers. These corporations are not chiefly skilled at forecasting variables for example exchange rates, interest rates, and commodity prices. It makes sense for these corporations to evade their revelation to these variables and focus their attempts on their main commerce in which they have specific skills and expertise. Hedging these hazards can provide abundant advantages to the corporation including lessening the probabilities of a cash crisis and financial suffering or even insolvency, making capital allotment well-organized, and permitting the corporation to give reliable returns to the corporation’s shareholders. Further, hedging permits for simpler and better performance appraisals of executives and business units since it permits the assessor to strip the results of price progresses that are not convenient by management (Singh, 2004). Nonetheless, a disagreement that is frequently presented against hedging by companies is that shareholders can carry out risk management implementations themselves through diversification and buying hedging devices. Thus, they do not require the corporation to run risk for them. However, this disagreement overlooks the trouble of asymmetric information where it presumes that the shareholders are just as well-informed about the corporation’s risks as is the corporation’s organizational structure. This is not often the situation; thus, making this opposition invalid (Singh, 2004, p. 7). Taleb (1997) asserted that from central banks to brokerages and corporations, institutional financiers are gathering to a new age group of striking and intricate options, contracts and derivatives. However, the assurance of ever larger revenues also generates the potential for disastrous trading losses. The key to trading derivatives sleeps in applying precautionary risk management methods that prepare for and avoid these awful downturns. Dynamic Hedging aims the real-world requirements of professional traders and money supervisors. Orol (2007) talks about the unruly investors who are shaking up the business world. Hedge fund supervisors are bucking conventionally passive financier approach by actively engaging in management and forcing for alterations in the companies. Thus this study evaluates the possible risk management analysis by means of hedging in a current economic scenario. Research Design and Methodology: 1. Data Collection Methods: The basic objective of our study is to make a proper evaluation of the risk management as a subject and to find out how hedge funds are influenced by recent sub-prime mortgage crisis only through methodical risk factors, and did not cause corruption among hedge funds. The study aims to reveal that the characteristic risk factor of hedge funds is mainly typified by alterations from a low instability regime to a high instability state that are not directly associated to market risk aspects. The data in this study should be collected from the secondary sources mainly from the authentic websites such as, the websites of the government. By expanding the analysis to the current sub prime mortgage crisis, we discover that the crisis influenced the hedge fund industry through the revelation to systematic risk features and manipulated the idiosyncratic instability of several approaches (ROK Daily: Subprime Crisis Good Opportunity for Hedge Funds, Expert Says, n.d.). However, for Emerging Markets and Long Short Equity approaches, idiosyncratic unpredictability has not been influenced. Therefore, we did not find any evidence of corruption among all hedge fund approaches. However, we found corruption among the chosen strategies: Convertible Bond Arbitrage, Equity Market Neutral, Event Driven Multi-Strategy, and Risk Arbitrage, that is, we viewed a sharp enhancement in the joint probability that all of these approaches demonstrate a high instability regime of the idiosyncratic risk aspect during August 2007 (Billio, Getmansky and Pelizzon, 2008, p. 1). In the usual course of the business sequence upswing, financing of new ventures followed an exact path from a traditional financing process (often called hedge financing) towards more delicate financing (this is often termed as speculative financing) of new venture projects (Davidson, n.d, p. 1). In the hedge finance process, the borrower anticipates the cash inflows produced by the acquired real venture will easily fulfill the upcoming contractual cash outflows mentioned in the debt agreement. In the situation of noncommercial occupant mortgages, where the house does not produce an upcoming cash inflow, a hedge finance borrower anticipates other resources of upcoming cash inflows will be voluntarily available to fulfill all the upcoming contractual cash outflows over the life of the exceptional mortgage bond (Davidson, n.d, p. 4). During the signing of the preliminary sub-prime mortgage debt responsibility, the borrower was led to consider that he/she was embarking on a hedge financing situation. In most sub-prime mortgages there is either no stipulation for early forestallment or else so large a forestallment penalty is mentioned that the borrower (and the lender) should be familiar with that “rolling over” the debt is not a feasible option. As a result, if the debtor is receptive to the forestallment penalty terms of the preliminary mortgage contract, then, the borrower could not even think of getting involved in provisional finance. Even if the borrower was not aware of the forestallment clause in the debt agreement, once this section is brought to the borrower’s notice, then, the borrower comprehends that if he/she could not meet the monthly debt servicing cash loss, he/she could never refinance this credit (Davidson, n.d, p. 5). We distinguish the revelation of hedge fund indices to risk factors. This approach permits us to analyze time-diversifying risk revelation and the phase-locking occurrence for hedge funds. In particular, the alterations in hedge fund revelation to a variety of risk factors openly account for the alteration in volatility of the market risk aspect. We have permitted for a possibility and found proof that all hedge fund policies display a high instability regime of the characteristic risk during the sample well thought-out (Billio, Getmansky, and Pelizzon, 2008, p. 28). 2. Analysis of data and Interpretation of Findings: The research which will be conducted will be quantitative in nature. In our present study we will look upon only one type of research method-quantitative. Quantitative research relies on subjective information because the participants’ input acts as the primary source of information to the researcher (Creswell, 2003, p. 30). Our research is mainly based on secondary sources accessible at authentic websites. Does hedging amplify value? Hedging hazards has both implied and unambiguous costs that can differ depending upon the hazard being hedged and the hedging instrument used, and the advantages incorporate better investment choices, lower distress expenses, tax savings and more educational financial statements. The trade off appears easy; if the advantages exceed the expenses, one should evade and if the expenses exceed the advantages, one should not. This easy set-up is made more complex when we think of the investors of the company and the expenses they face in hedging the same hazards. If hedging a given hazard creates advantages to the company, and the hedging can be done either by the company or by investors in the company, the hedging will insert value only if the charge of hedging is inferior to the company than it is to investors. Thus, a company may be able to evade its revelation to sector risk by obtaining companies in other businesses, but investors can evade the same risk by holding expanded portfolios. The premiums paid in attainments will dwarf the costs of the deals faced by the latter; this is obviously a situation where the hazard hedging policy will be worth destroying (Risk Management- Profiling and Hedging, n.d, p. 23-24). Conclusion: The expenses of hedging can be unambiguous when we use indemnity or put options that defend against disadvantage risk. While there are potential advantages of hedging and plenty of proof that companies resort to hedging, there is astonishingly little experiential support for the proposal that hedging enhances value. The companies that hedge do not appear to be aggravated by tax savings or decrease suffering costs, but more by decision-making interests – compensation structures and job defense are often tied to upholding more stable incomes. As the instruments to hedge risk – options, futures, swaps and insurance – all multiple, the suppliers of these instruments also have become more skilled at selling them to companies that often do not require them or should not be employing them (Risk Management- Profiling and Hedging, n.d, p. 34). In our further study, we will look into the sub prime mortgage crisis in details and what are their hedging techniques associated with risk management helps in minimizing risk. Limitations: The limitations to this study are that we are considering the recent economic crisis and not taking into consideration other situations. In this research we are not taking into account of the assessment of risks and application of risk management to the companies for taking strategic financial decisions. Thus, further research is possible in this study. References: 1. Anderson, T.G., Bollerslev, T., Christoffersen, P.F., Diebold, F.X., Jan. 2005. “Practical Volatility and Correlation Modeling for Financial Market Risk Management.” National Bureau of Economic Research. Available at: http://www.nber.org/papers/w11069.pdf?new_window=1 (Accessed on Aug. 31, 2009). 2. Boyle, K.A., Coleman, T.F., Li, Y, n.d.“Hedging a Portfolio of Derivatives by Modeling Cost” Available at: http://www.math.uwaterloo.ca/navigation/domOffice/Coleman/fin_papers/CIFEr_paper.pdf (Accessed on Aug. 31, 2009). 3. Bodnar, G.M., Gebhardt, G, April 1998. “Derivatives Usage in Risk Management by U.S. and German Non-Financial Firms: A Comparative Survey.” Available at: http://finance.wharton.upenn.edu/weiss/wpapers/98-3.pdf (Accessed on Aug. 31, 2009). 4. Brealey, R.A., Myers, S.C., 1988. Principles of corporate finance McGraw-Hill series in finance McGraw-Hill (Ohio). 5. Creswell, J. W., 2003. Research design: qualitative, quantitative, and mixed method approaches. Research Design: Qualitative, Quantitative, and Mixed Methods Approaches. SAGE (North East England). 6. Derman, E, n.d. “The boy’s guide to pricing and hedging” Available at: http://www.ederman.com/new/docs/risk-the_boys_guide.pdf (Accessed on Aug. 31, 2009). 7. Boyer, M, Boyer, M.M., Garcia, R, Dec. 2005. “The Value of Real and Financial Risk Management” Available at: http://www.cirano.qc.ca/pdf/publication/2005s-38.pdf (Accessed on Aug. 31, 2009). 8. Billio, M, Getmansky, M, Pelizzon, L, 2008. Crises and Hedge Fund Risk. Available at: http://www.dse.unive.it/fileadmin/templates/dse/wp/WP_2008/WP_DSE_billio_getmansky_pelizzon_10_08.pdf (Accessed on Sept. 3, 2009). 9. Davidson, P, n.d. “Is the current financial distress caused by the Subprime Mortgage Crisis a minksy moment? Or is it the result of attempting to securitize illiquid non commercial mortgage loans?”Available at: http://econ.bus.utk.edu/faculty/davidson/minksy7.pdf (Accessed on Sept. 3, 2009). 10. Kambhu, J, Schuermann, T., Stiroh, K.J., July 2007. “Hedge Funds, Financial Intermediation, and Systemic Risk” Federal Reserve Bank of New York-Staff Reports. Available at: http://www.newyorkfed.org/research/staff_reports/sr291.pdf (Accessed on Aug. 31, 2009). 11. Lou, M, June 2009. “Risk factor”. Available at: http://crugroup.com/Events/CRUEvents/NorthAmericanSteel/Documents/Factoring_in_price_risk(Materials_World_June09).pdf (Accessed on Aug. 31, 2009). 12. Orol, R.D, 2007. Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World. John Wiley and Sons (New Jersey). (http://books.google.co.in/books?id=DBNClmcUI4oC&printsec=frontcover&dq=Extreme+Value+Hedging:+How+Activist+Hedge+Fund+Managers+Are+Taking+on+the+World&ei=WgG6SsrFDIH6yASGyNnrDg#v=onepage&q=&f=false ) 13. “Risk Management- Profiling and Hedging”, n.d. Available at: http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/hedging.pdf (Accessed on Aug. 31, 2009). 14. “Risk Management and Financial Derivatives”, n.d. Available at: http://www.worldscibooks.com/etextbook/5855/5855_chap1.pdf (Accessed on Aug. 31, 2009). 15. “Risk Management of Financial Derivatives”, Jan. 1997. Comptroller’s Handbook. Available at: http://www.occ.treas.gov/handbook/deriv.pdf (Accessed on Aug. 31, 2009). 16. “ROK Daily: Subprime Crisis Good Opportunity for Hedge Funds, Expert Says”, n.d. Available at: http://www.acs.gov.cn/cms/sites/www/images/2008/2/21/ROK%20Dail1.doc (Accessed on Sept. 3, 2009). 17. Singh, K, April 2004. “Risk Management- Hedging Commodity Exposure” Available at: http://undergrad.wharton.upenn.edu/research/scholars/volume1/Karanjit_Singh_Research_Paper.pdf (Accessed on Aug. 31, 2009). 18. Taleb, N, 1997. Dynamic hedging: managing vanilla and exotic options Wiley series in financial engineering Volume 64 of Wiley Finance Volume 64 of Wiley Finance Editions Series. Series in financial economics and quantitative analysis. John Wiley and Sons (New Jersey). (http://books.google.co.in/books?id=-5-OldaTjVQC&printsec=frontcover&source=gbs_navlinks_s#v=onepage&q=&f=false ) 19. “The Subprime Mortgage Crisis: What are we headed?” n.d. Deloitte. Available at: http://www.deloitte.com/dtt/cda/doc/content/dtt_dr_emr2qse081707.pdf (Accessed on Sept. 3, 2009). 20. “What is Financial Risk Management?” n.d. Available at: http://media.wiley.com/product_data/excerpt/67/04717061/0471706167.pdf (Accessed on Aug. 31, 2009). Read More