Appropriate Hedging- an Understanding and How It Can be Achieved
Written by QuantArt Market
Updated on : 30th October 2020
The objective of this paper is to understand the benefits of using ‘Appropriate Hedge’ strategies, and ways to achieve the same.
Appropriate hedging can be defined as hedges where ‘Benefit of hedging’ > ‘Cost of hedging’.
Such hedging brings the following advantages to the companies:
- Consistent cost savings compared to a benchmark -The benchmark can be an absolute one or a relative one. For example, targeting a benchmark 2.50% p.a. hedge cost as against the forward cost of 4.00% is an absolute targeting. Similarly, the target can be defined as 2.00% cost savings compared to an existing hedge strategy of no hedge or moderate hedge.
- Reduced P&L volatility – Hedging obviously brings significant stability to P&L and balance sheet and hence helps achieve increased valuation for the company. Stakeholders like equity and debt investors prefer stability in P&L.
- Avoid panic based on wrong decisions – Lack of appropriate hedging sparks reaction of losing money and leads one to wrong decisions. Often companies end up hedging under extreme pressure based on sentiments around. Such panic hedging invariably leads to losses.
- Avoid wasteful risk-taking – A fine balance between savings and risk mitigation takes an Fx portfolio of a company towards an efficient frontier where the reward for every dollar of risk taken is maximized and calculated precisely. Sharpe ratio, which measures savings against risk, is maximized when a portfolio reaches the optimum level. Taking more risk than required for a defined amount of savings is wasteful.
- Lenders push can’t result in efficient hedging – Lenders often push companies to hedge to protect DSCR and repayments. If the company is proactively hedging then lenders feel safe, comfortable, and better protected; and avoid pushing for simplistic hedge solutions. That leads to better optimization from the company’s point of view.