Hedging product

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Information about Hedging product
Finance

Published on March 10, 2014

Author: RajSharma19

Source: slideshare.net

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Basic hedging product a ppt

FOREIGN EXCHANGE RISK AND HEDGING PRODUCTS

STARTERS 1. WHAT ARE VARIOUS TYPES OF RATES? 2. WHY DO RATES MOVE? 3. WHAT IS THE IMPACT? 4. WHAT ARE HEDGING PRODUCTS? 5. IS FOREX BUSINESS RISKY / PROFITABLE? 6. DO WE NEED THIS BUSINESS? 7. HOW DO WE IDENTIFY NEED (POTENTIAL)? 8. HOW DO WE ASSESS / MONITOR THE LIMITS? 9. WHAT CHECKS & BALANCES ARE NEEDED? 1. WHAT ARE VARIOUS TYPES OF RATES? 2. WHY DO RATES MOVE? 3. WHAT IS THE IMPACT? 4. WHAT ARE HEDGING PRODUCTS? 5. IS FOREX BUSINESS RISKY / PROFITABLE? 6. DO WE NEED THIS BUSINESS? 7. HOW DO WE IDENTIFY NEED (POTENTIAL)? 8. HOW DO WE ASSESS / MONITOR THE LIMITS? 9. WHAT CHECKS & BALANCES ARE NEEDED?

LEARNING TOPICS 1. PRODUCTS 2. RBI GUIDELINES 3. BANK GUIDELINES A. ASSESSMENT OF LIMITS B. MONITORING C. DOCUMENTATION D. ISSUES 1. PRODUCTS 2. RBI GUIDELINES 3. BANK GUIDELINES A. ASSESSMENT OF LIMITS B. MONITORING C. DOCUMENTATION D. ISSUES

COMMON EXPOSURES • EXPORTS / IMPORTS • FCNRB LOANS • PCFC/EBR • TRADE CREDITS – BUYER’S CREDIT – SUPPLIER’S CREDIT • EXTERNAL COMMERCIAL BORROWINGS (ECB) • FOREIGN CURRENCY CONVERTIBLE BONDS (FCCB) • ANY OTHER EXPOSURE TO INTEREST RATES / CURRENCIES • EXPORTS / IMPORTS • INWARD / OUTWARD REMITTANCES • FCNRB LOANS • PCFC/EBR • TRADE CREDITS – BUYER’S CREDIT – SUPPLIER’S CREDIT • EXTERNAL COMMERCIAL BORROWINGS (ECB) • FOREIGN CURRENCY CONVERTIBLE BONDS (FCCB) • FOREIGN CURRENCY EXCHANGEABLE BONDS (FCEB) • ANY OTHER EXPOSURE TO INTEREST RATES / CURRENCIES • EXPORTS / IMPORTS • FCNRB LOANS • PCFC/EBR • TRADE CREDITS – BUYER’S CREDIT – SUPPLIER’S CREDIT • EXTERNAL COMMERCIAL BORROWINGS (ECB) • FOREIGN CURRENCY CONVERTIBLE BONDS (FCCB) • ANY OTHER EXPOSURE TO INTEREST RATES / CURRENCIES POTENTIAL IDENTIFICATION.ppt • EXPORTS / IMPORTS • INWARD / OUTWARD REMITTANCES • FCNRB LOANS • PCFC/EBR • TRADE CREDITS – BUYER’S CREDIT – SUPPLIER’S CREDIT • EXTERNAL COMMERCIAL BORROWINGS (ECB) • FOREIGN CURRENCY CONVERTIBLE BONDS (FCCB) • FOREIGN CURRENCY EXCHANGEABLE BONDS (FCEB) • ANY OTHER EXPOSURE TO INTEREST RATES / CURRENCIES

24 hour Market Mumbai New YorkBahrain Frankfurt Zurich London 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Tokyo HK Singapore Mumbai Los Angeles Sydney Sydney

RUPEE

USD 6-M LIBOR

INR-SENSEX

RISK & IMPACT • TYPES: – CURRENCY RISK OR EXCHANGE-RATE RISK – INTEREST RATE RISK • IMPACT: – THE UNCERTAINTY OVER THE ULTIMATE COSTS LEADS TO INEFFICIENT PRICING ESPECIALLY IN A COMPETITIVE ENVIRONMENT • RESULT: • SUDDEN CHANGES IN CASH FLOW • PROJECT COST ESCALATION • LOSS OF BUSINESS ETC. • TYPES: – CURRENCY RISK OR EXCHANGE-RATE RISK – INTEREST RATE RISK • IMPACT: – THE UNCERTAINTY OVER THE ULTIMATE COSTS LEADS TO INEFFICIENT PRICING ESPECIALLY IN A COMPETITIVE ENVIRONMENT • RESULT: • SUDDEN CHANGES IN CASH FLOW • PROJECT COST ESCALATION • LOSS OF BUSINESS ETC.

RISK-HEDGING o FACTS o RETURN IS A FUNCTION OF RISK- NO RISK NO REWARD o A “HEDGE” IS A WAY OF TRANSFORMING RISK NOT ELIMINATING o HEDGING INVARIABLY INVOLVES VIEW TAKING o EVERYBODY DOES NOT HAVE THE SAME INFORMATION o PROBABILITY IS GOOD THEORY BUT DOES NOT REPLACE REAL LIFE o NOTHING COMES FREE – EXCEPT RISK o FACTS o RETURN IS A FUNCTION OF RISK- NO RISK NO REWARD o A “HEDGE” IS A WAY OF TRANSFORMING RISK NOT ELIMINATING o HEDGING INVARIABLY INVOLVES VIEW TAKING o EVERYBODY DOES NOT HAVE THE SAME INFORMATION o PROBABILITY IS GOOD THEORY BUT DOES NOT REPLACE REAL LIFE o NOTHING COMES FREE – EXCEPT RISK

DERIVATIVES HEDGING TOOLS

PRODUCTSPRODUCTS

DERIVATIVES FINANCIAL INSTRUMENTS WHOSE VALUE/ PAY OFF IS DERIVED FROM VALUE OF AN UNDERLYING ASSET. COMMON DERIVATIVE PRODUCTS FORWARD CONTRACTS -USD/INR, CROSS, THIRD COMMON UNDERLYING ASSETS COMMODITIES FORWARD CONTRACTS -USD/INR, CROSS, THIRD OPTIONS -PUT, CALL & COMBINATIONS SWAPS -PRINCIPAL, INTEREST & BOTH FUTURES -CURRENCY, EQUITY COMMODITIES FOREIGN EXCHANGE (ASSETS & LIABILITIES AND REVENUE FLOWS) INTEREST RATES EQUITY SHARES

FORWARD CONTRACTSFORWARD CONTRACTS

Value Date - Time Scale Time Scale Cash Tom Spot Forward Maturities Cash Deal is done today for delivery Today Tom Deal is done today for delivery Tomorrow Spot Deal is done today for delivery on 2nd Business Day Forward Deal is done today for delivery beyond Spot Date

FORWARD CONTRACTS • A CONTRACT TO BUY OR SELL A SPECIFIED AMOUNT OF CURRENCY AT A SPECIFIED PRICE FOR A SPECIFIC FUTURE DATE. • BOTH A RIGHT AND AN OBLIGATION TO BUY OR SELL • ADVANTAGE: – SIMPLE , LIQUID , TRANSPARENT – REQUIRES NO OUTLAY OF FUNDS UPFRONT. – WINDOW OPTION OF 30 DAYS • DISADVANTAGE: – NO PARTICIPATION IN MARKET VOLATILITY – PROFIT AND LOSS ONLY CRYSTALLIZED ON DUE DATE – OPPORTUNITY PROFIT / OPPORTUNITY LOSS UNLIMITED • A CONTRACT TO BUY OR SELL A SPECIFIED AMOUNT OF CURRENCY AT A SPECIFIED PRICE FOR A SPECIFIC FUTURE DATE. • BOTH A RIGHT AND AN OBLIGATION TO BUY OR SELL • ADVANTAGE: – SIMPLE , LIQUID , TRANSPARENT – REQUIRES NO OUTLAY OF FUNDS UPFRONT. – WINDOW OPTION OF 30 DAYS • DISADVANTAGE: – NO PARTICIPATION IN MARKET VOLATILITY – PROFIT AND LOSS ONLY CRYSTALLIZED ON DUE DATE – OPPORTUNITY PROFIT / OPPORTUNITY LOSS UNLIMITED

FORWARD CONTRACTS EXPORTER: SPOT: 50.00 + 3M FWD 0.50 Ps RIGHT: PROTECTED RANGE 47.50 51.5050.50 RIGHT: PROTECTED RANGE OBLIGATION: OPPORTUNITY LOSS RANGE

• Rate Calculation: – Exports/Imports Bid / Ask – Cash/Tom/Spot • Forward Rates – Example: Spot Rate:50.50/51 FORWARD CONTRACTS • Rate Calculation: – Exports/Imports Bid / Ask – Cash/Tom/Spot • Forward Rates – Example: Spot Rate:50.50/51 PERIOD PREMIUM FWD. RATE 1 MONTH 0.30/0.31 50.30/50.32 2 MONTHS 0.40/0.41 50.40/50.42 3 MONTHS 0.50/0.51 50.50/50.52

FORWARD CONTRACTS • IMPORTANT OPERATIONAL GUIDELINES: – CANCELLATIONS: • PROFIT/LOSS PASSED ON TO THE CUSTOMER (PROFIT WILL BE PASED ON ONLY IF BOOKED UNDER DE METHOD) • CANCELLATION TO BE DONE ON OR BEFORE DUE DATE. – ELSE PROFIT NOT GIVEN TO THE CUSTOMER BUT LOSS PASSED ON • FOR EARLY CANCELLATIONS OPTION TO RECEIVE PROFIT AT DISCOUNTED RATE (PLR). LOSS TO BE DEBITED IMMEDIATELY. • OVERDUE CONTRACTS MUST BE CANCELLED WITH IN 3 DAYS. AT CARD RATES.(FEDAI clarification dated 12/03/2013) • PERIOD IS ALLOWED FOR BANK TO COMPLETE PROCESS NOT FOR CUSTOMER TO WAIT FOR RATE ADVANTAGE. ** • IMPORTANT OPERATIONAL GUIDELINES: – CANCELLATIONS: • PROFIT/LOSS PASSED ON TO THE CUSTOMER (PROFIT WILL BE PASED ON ONLY IF BOOKED UNDER DE METHOD) • CANCELLATION TO BE DONE ON OR BEFORE DUE DATE. – ELSE PROFIT NOT GIVEN TO THE CUSTOMER BUT LOSS PASSED ON • FOR EARLY CANCELLATIONS OPTION TO RECEIVE PROFIT AT DISCOUNTED RATE (PLR). LOSS TO BE DEBITED IMMEDIATELY. • OVERDUE CONTRACTS MUST BE CANCELLED WITH IN 3 DAYS. AT CARD RATES.(FEDAI clarification dated 12/03/2013) • PERIOD IS ALLOWED FOR BANK TO COMPLETE PROCESS NOT FOR CUSTOMER TO WAIT FOR RATE ADVANTAGE. **

OPTIONSOPTIONS

OPTIONS A CONTRACT WHEREBY THE BUYER ACQUIRES RIGHT BUT NOT OBLIGATION TO PURCHASE/ SELL A SPECIFIED ASSET AT A PREDETERMINED PRICE ON A SPECIFIED DATE. ( EUROPEAN OPTION) • ADVANTAGE: – OPPORTUNITY PROFIT UNLIMITED – OPPORTUNITY LOSS LIMITED TO THE PREMIUM PAID • DISADVANTAGE: – PRICING LESS TRANSPARENT THAN FORWARD. FACTOR OF A) SPOT B) STRIKE C) MATURITY D) INT. DIFF E) VOLATILITY – UPFRONTPREMIUM PAYMENT(RBI has allowed for staggered pa. – SPECIFIC DATE MATURITY- NOWINDOW OPTION A CONTRACT WHEREBY THE BUYER ACQUIRES RIGHT BUT NOT OBLIGATION TO PURCHASE/ SELL A SPECIFIED ASSET AT A PREDETERMINED PRICE ON A SPECIFIED DATE. ( EUROPEAN OPTION) • ADVANTAGE: – OPPORTUNITY PROFIT UNLIMITED – OPPORTUNITY LOSS LIMITED TO THE PREMIUM PAID • DISADVANTAGE: – PRICING LESS TRANSPARENT THAN FORWARD. FACTOR OF A) SPOT B) STRIKE C) MATURITY D) INT. DIFF E) VOLATILITY – UPFRONTPREMIUM PAYMENT(RBI has allowed for staggered pa. – SPECIFIC DATE MATURITY- NOWINDOW OPTION

OPTION RIGHT: PROTECTED RANGE EXPORTER: SPOT: 50.00 + 3M FWD 0.50 Ps 47.50 51.5050.50 ATM 1.00 RIGHT: PROTECTED RANGE NO OBLIGATION: OPPORTUNITY PROFIT RANGE

OPTIONS- GLOSSARY • CALL OPTION • PUT OPTION • OPTION BUYER • OPTION SELLER • EXPIRATION • STRIKE RATE • PREMIUM • IN THE MONEY • OUT OF MONEY • AT THE MONEY • AMERICAN OPTION • EUROPEAN OPTION • BARRIERS • CALL OPTION • PUT OPTION • OPTION BUYER • OPTION SELLER • EXPIRATION • STRIKE RATE • PREMIUM • IN THE MONEY • OUT OF MONEY • AT THE MONEY • AMERICAN OPTION • EUROPEAN OPTION • BARRIERS

OPTIONS CALL PUT BUYER RIGHT BUT NOT OBLIGATION TO BUY RIGHT BUT NOT OBLIGATION TO SELL RIGHT BUT NOT OBLIGATION TO BUY RIGHT BUT NOT OBLIGATION TO SELL SELLER POTENTIAL OBLIGATION TO SELL POTENTIAL OBLIGATION TO BUY

HOW TO CHOOSE? V I E W IMPORTERS CONFIDENCE HIGH LOW USD FIRMING FORWARD RATE TO BE LOCKED IN BUY AN USD CALL OPTION USD FALLING KEEP THE EXPOSURE OPEN BUY AN USD CALL OPTION V I E W IMPORTERS CONFIDENCE HIGH LOW USD FIRMING FORWARD RATE TO BE LOCKED IN BUY AN USD CALL OPTION USD FALLING KEEP THE EXPOSURE OPEN BUY AN USD CALL OPTION

HOW TO CHOOSE? V I E W EXPORTERS CONFIDENCE HIGH LOW USD FIRMING KEEP THE EXPOSURE OPEN BUY USD PUT OPTION USD FALLING FORWARD RATE TO BE LOCKED IN BUY USD PUT OPTION V I E W EXPORTERS CONFIDENCE HIGH LOW USD FIRMING KEEP THE EXPOSURE OPEN BUY USD PUT OPTION USD FALLING FORWARD RATE TO BE LOCKED IN BUY USD PUT OPTION

OPTION- VARIETIES RANGE FORWARD RIGHT: PROTECTED RANGE NO RIGHT & NO OBLIGATION RANGE-OPEN Sell Call 48.00 50.00 52.50 51.00 50.50 ATM RIGHT: PROTECTED RANGE OBLIGATION: OPPORTUNITY LOSS RANGE NO RIGHT & NO OBLIGATION RANGE-OPEN Buy Put

OPTION-VARIETIES +0.50 SEA GULL RIGHT: PROTECTED RANGE NO RIGHT & NO OBLIGATION RANGE-OPEN RIGHT & OBLIGATION RANGE 48 50.25 52 51.0049.75 +0.50 50.50 ATM OBLIGATION: OPPORTUNITY LOSS RANGE

SWAPS • SWAP IS A CONTRACTUAL AGREEMENT TO EXCHANGE SPECIFIED CASH FLOWS AT FUTURE DATES • WITHOUT ALTERING THE EXPOSURE, RIGHTS AND OBLIGATIONS ARE EXCHANGED • IN CASE OF AMORTISATION WORKS AS MULTIPLE FORWARD CONTRACTS • KEY USES: – COST SAVING OR YIELD ENHANCEMENT ON EXISTING EXPOSURE – HEDGING OF EXISTING RISK – MECHANISM TO ACCESS THE BENEFITS AVAILABLE IN THE MARKETS WHICH ARE OTHERWISE CLOSED TO THEM – ALTERING THE NATURE OF ASSET OR LIABILITY SYNTHETICALLY WITHOUT ANY CHANGE IN THE UNDERLYING. • SWAP IS A CONTRACTUAL AGREEMENT TO EXCHANGE SPECIFIED CASH FLOWS AT FUTURE DATES • WITHOUT ALTERING THE EXPOSURE, RIGHTS AND OBLIGATIONS ARE EXCHANGED • IN CASE OF AMORTISATION WORKS AS MULTIPLE FORWARD CONTRACTS • KEY USES: – COST SAVING OR YIELD ENHANCEMENT ON EXISTING EXPOSURE – HEDGING OF EXISTING RISK – MECHANISM TO ACCESS THE BENEFITS AVAILABLE IN THE MARKETS WHICH ARE OTHERWISE CLOSED TO THEM – ALTERING THE NATURE OF ASSET OR LIABILITY SYNTHETICALLY WITHOUT ANY CHANGE IN THE UNDERLYING.

USD Cash Flows USD Liability PRINCIPAL ONLY SWAP Bank A Corporate INR Cash Flows @ spot (pays premium x%)

Bank Bank Pays Floating Interest Rate 6mL(1.60)+300 INTEREST RATE SWAP Bank Corp Pays Fixed $ Interest Rate 5.40% Corporate

USD Cash Flows USD Liability (FCL) CIRS Pays Floating Interest Rate (L+300) INR Cash Flows @ spot Corp Pays Rs Fixed Interest Rate 11.95% BANK CORPORATE USD loan converted into a INR loan synthetically

GUIDELINES 1. Comprehensive Guidelines on derivatives: Modifications:RBI Circular 02 Nov 2011 2. RBI Circular: 15 Dec 2011:limit reduced to 25% for importers on past performance basis 3. RBI Circular 13 Jan 2014:100% Cancellation and rebooking allowed for current account transactions( if contract booked under D.E.) 4. FEDAI Clarification : • FC booked in respect of all current account transaction irrespective of tenor can be cancelled and rebooked freely. • FC booked in case of capital account transaction where the residual maturity of underlying is less than one year can be freely cancelled and rebooked • RBI Circular :18 June 2013: Deferment of option premium is allowed. • RBI: 15.01.2014 :Monitoring of Un-hedged FC exposure : Provisioning 1. Comprehensive Guidelines on derivatives: Modifications:RBI Circular 02 Nov 2011 2. RBI Circular: 15 Dec 2011:limit reduced to 25% for importers on past performance basis 3. RBI Circular 13 Jan 2014:100% Cancellation and rebooking allowed for current account transactions( if contract booked under D.E.) 4. FEDAI Clarification : • FC booked in respect of all current account transaction irrespective of tenor can be cancelled and rebooked freely. • FC booked in case of capital account transaction where the residual maturity of underlying is less than one year can be freely cancelled and rebooked • RBI Circular :18 June 2013: Deferment of option premium is allowed. • RBI: 15.01.2014 :Monitoring of Un-hedged FC exposure : Provisioning

GENERAL GUIDELINES CUSTOMER SHOULD HAVE: BOARD APPROVAL RISK POLICY & PROCEDURES BALANCE SHEET EXPOSURES SIZE AND TENOR UNDERSTANDING OF RISKS NO ENHANCEMENT OF RISK PROFILE PROPER LIMITS IN PLACE CUSTOMER APPROPRIATENESS CUSTOMER SHOULD HAVE: BOARD APPROVAL RISK POLICY & PROCEDURES BALANCE SHEET EXPOSURES SIZE AND TENOR UNDERSTANDING OF RISKS NO ENHANCEMENT OF RISK PROFILE PROPER LIMITS IN PLACE CUSTOMER APPROPRIATENESS CAS & MARGIN MATRIX.ppt

PAST PERFORMANCE DOCUMENTARY EVIDENCE BOOKING ON DECLARATION BOOKING ON PRODUCTION OF UNDERLYING(15 DAYS TIME ALLOWED FOR PRODUCTION OF UNDERLYING) SEPARATE LIMITS FOR EXPORTS AND IMPORTS(reduced to 25%) CAN BE CANCELLED AND REBOOKED WITHOUT RESTRICTIONS CONTRACTS BOOKED >75% OF LIMIT ONLY ON DELIVERY BASIS AND CANNOT BE CANCELLED SIZE AND TENOR OF CONTRACT NOT TO EXCEED UNDERLYING. CONDUCT CONTRACTS BOOKED >75% OF LIMIT ONLY ON DELIVERY BASIS AND CANNOT BE CANCELLED SIZE AND TENOR OF CONTRACT NOT TO EXCEED UNDERLYING. PERIODIC CERTIFICATION ANNUAL ; >50% LIMIT; EVIDENCE BEFORE MATURITY/CANCELLATION PROFIT WILL BE PASSED ON CANCELLATION (ON OR BEFORE DUE DATE) AGGREGATE BOOKED DURING THE YEAR AND OUTSTANDING AT ANY TIME NOT TO EXCEED LIMIT IF CANCELLED PROFIT WILL NOT BE PASSED ON

SME-LIBERALISATION • SME’S HAVING DIRECT AND / OR INDIRECT EXPOSURES TO FOREIGN EXCHANGE RISK ARE PERMITTED TO BOOK / CANCEL / REBOOK FORWARD CONTRACTS WITHOUT PRODUCTION OF UNDERLYING DOCUMENTS SUBJECT TO : – THE ENTITY SHOULD QUALIFY AS SME AS DEFINED BY RBI. (ME >5-10 & >2-5CR )(SE <5 &<2CR) – CONTRACTS CAN BE BOOKED THROUGH AD’S WITH WHOM THE SME’S HAVE CREDIT FACILITIES. – THE TOTAL FORWARD CONTRACTS BOOKED SHOULD BE IN ALIGNMENT WITH CREDIT FACILITIES AVAILED BY THEM. – SME’S ARE ALSO PERMITTED TO USE FOREIGN CURRENCY RUPEE OPTIONS FOR HEDGING THEIR EXPOSURES AFTER PRODUCTION OF UNDERLYING DOCUMENTS OR UNDER PAST PERFORMANCE ROUTE. – CAS NEEDS TO BE APPROVED ** • SME’S HAVING DIRECT AND / OR INDIRECT EXPOSURES TO FOREIGN EXCHANGE RISK ARE PERMITTED TO BOOK / CANCEL / REBOOK FORWARD CONTRACTS WITHOUT PRODUCTION OF UNDERLYING DOCUMENTS SUBJECT TO : – THE ENTITY SHOULD QUALIFY AS SME AS DEFINED BY RBI. (ME >5-10 & >2-5CR )(SE <5 &<2CR) – CONTRACTS CAN BE BOOKED THROUGH AD’S WITH WHOM THE SME’S HAVE CREDIT FACILITIES. – THE TOTAL FORWARD CONTRACTS BOOKED SHOULD BE IN ALIGNMENT WITH CREDIT FACILITIES AVAILED BY THEM. – SME’S ARE ALSO PERMITTED TO USE FOREIGN CURRENCY RUPEE OPTIONS FOR HEDGING THEIR EXPOSURES AFTER PRODUCTION OF UNDERLYING DOCUMENTS OR UNDER PAST PERFORMANCE ROUTE. – CAS NEEDS TO BE APPROVED **

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