BAB 11

DERIVATIVES AND HEDGING ACTIVITIES

DEFINING RISK
Some risks relate to the effect of price changes on the value of assets and liabilities
and the amount of contractual and forecasted future cash flows. The management of these
risks is often referred to as hedging. We use the terms hedging and risk management
identically. Hedging is designed to protect the firm against adverse movements in prices,
interest rate and foreign currenc exchange rates. Hedging transaction include, but are not
limited to, futures contracts, options, forward contracts, interest rate swaps, currency swaps,
and combined interest rate and currency swaps. Firm may hedge existing assets and
liabilities, firm commitments, and forecasted transactions.
We define risk as potential variability of financial outcomes, or uncertainty. Future
financial outcomes of firm activities are uncertain because they depend on unknown future
prices. In some cases, this price risk is uncontrollable as it depends on factors such as
technological change.
Some price risk, however, relate to standardized commodities, interest rates, and
foreign currency exchange rates. These risks can be managed by using derivatives and other
hedging techniques. We say managed rather than reduced because risk management often
involves replacing one risk with another one rather than reducing risk in an absolute sense.

FOREIGN CURRENCY RISK

Firms that operate across national borders are exposed to the risk of changes in
currency exchange rates. We examined the effects of exchange rate changes on reported
sales, income, cash flows, assets, liabilities, and net worth. These effects also distort financial
ratios based on these data. Firms with foreign currency risk must, therefore, first decide
whether to hedge the accounting risk or the economic risk of foreign operations.

INTEREST RATE RISK

When businesses borrow funds, the interest rate may be either fixed or variable. When
the interest rate is variable, future interest expense and interest paid are uncertain as they
depend on the future level of the reference rate. From the lender (creditor) point of view,
variable rate loans or investments make future interest income and interest received

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uncertain. When the interest rate is fixed, however, future interest expense (income) and
interest paid (received) are known.

COMMODITY RISK
Oil companies like PT. Chevron Pacific Indonesia (former as PT. Caltex Pacific
Indonesia) are engaged in the exploration, production, refining, and marketing of crude oil.
The revenues, expenses, and cash flows of these activities depend on the price of oil and gas,
commodities whose price is the same for all producers and consumers. Chevron cannot
control that price and the related uncertainty of future financial results. Other commodities
have similar effects on firms that either produce or use them, including:
1. Other energy sources such as coal
2. Industrial metals such as iron, steel, aluminum, and copper
3. Precious metals such as gold, silver, and platinum
4. Agricultural commodities such as cotton, wheat, coffee, and sugar.

RISK OF CHANGES IN MARKET VALUE

Fluctuations in foreign currency exchange rates, interest rate, and commodity prices
can also affect the market value of assets and liabilities. For example, when the coupon rate
is fixed, the market value of a bond varies inversely with interest rate changes.
One consequence of the interrelationship of income/cash flow risk and market value
risk is that managing one risk necessarily changes the other. Transactions that eliminate the
market value risk (such as interest rate swaps) increase the income/cash flow risk. A second
issue is that the accounting risk is often different from the market risk. When the fixed rate
bond is carried at amortized cost, changes in its market value have no impact on the reported
balance sheet.

EVENT RISK
Sales and earnings of a given company are affected by innumerable events beyond its
control. Firms can protect themselves, however, against some adverse events. For example,
firms buy insurance against losses due to fire or storms. Hedging is another form of
insurance. For example, weather derivatives reduce the risk to the firm of abnormal weather
conditions. Credit risk. The risk that the firm will not receive payment, is another form of
event risk.

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BASIC DERIVATIVES AND HEDGING GLOSSARY
Financial instruments deriving their value from changes in
Derivatives the value of an index, interest or exchange rates, or
another financial instruments (the underlying)
Financial instrument or transaction used to manage risk
Hedge
exposure
The management of some risks relate to the effects of price
change on the value of assets and liabilities and the
amounts of contractual and forecasted future cash flows
and designed to protect the firm against adverse
movements in prices, interest rates, and foreign currency
Hedging (risk management)
exchange rates. Hedging include future contracts, options,
forward contracts, interest rate swaps, currency swaps,
and combined interest rate and currency swaps. Firms may
hedge existing assets and liabilities, firm commitments, and
forecast transactions
Risk Management Foreign currency risk, interest rate risk, commodity risk,
categories risk of changes in market value and event risk

Cash, a contract that requires the delivery or exchange of

Financial instrument cash or another financial instrument with another entity, or
an ownership interest in another entity
The specified risk (price, exchange rate, interest rate) that
Underlying
is being hedged.
Contractual agreement between a buyer and a seller to
deliver an asset in exchange for cash or another financial
Forward Contract
instrument at a specified future date. Price is fixed at the !
contract date for the life of the contract.
Standardized forward contract normally traded on an
Futures Contract organized exchange. The contract is marked to market
daily, and margin is required
An agreement that gives one party the unilateral right to
Option
buy (call option) or sell (put option) a specified quantity at

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 a specified price (the exercise price) until a specified
maturity date
Contractual agreement between a buyer and a seller to
deliver an asset in exchange for cash or another financial
Spot Contract
instrument. However, delivery may occur at a later
(setdement) date
Contract that exchanges one series of payments for another
Swap (interest rate swap, and combined currency and interest
rate swap)

SPOT & FORWARD TRANSACTION

Forward Premium : Forward rate > Spot rate
Forward Discount : Forward rate < Spot rate

𝐹−𝑆 12
𝐹𝑂𝑅𝑊𝐴𝑅𝐷 𝑃𝑅𝐸𝑀𝐼𝑈𝑀 (𝐷𝐼𝑆𝐶𝑂𝑈𝑁𝑇) = 𝑋
𝑆 𝑚𝑜𝑛𝑡ℎ 𝑜𝑓 𝑓𝑜𝑟𝑤𝑎𝑟𝑑

F - S 12
FORWARD PREMIUM (DISCOUNT) = % per annum
Example:
SPOT RATE = $2.40/£
30 - DAYS FORWARD RATE = $ 2.41 / £
TRANSACTION = £ 100,000

We Perform Transactions:
1. Buy Sterling Against U.S Dollars (Sell $) For Spot Delivery, And
2. Sell Sterling Against U.S Dollars (Buy $) For Delivery 30 Days Later
Catatan : Kesimpulan transaksi dilihat atau ditentukan dari ....... /£ nya di spot rate yang
lebih kecil U.S Dollar - nya

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 DATE TRANSACTION CURRENCY
$ £
Day 1 Buy sterling against dollars spot - 240,000 + 100,000
Sell sterling against dollars for
delivery in 30 days n.c.f n.c.f
Day 31 Sell sterling against dollars as per +241,000 -100,000
contract on day 1
Notes : +: cash flow -: cash outflow n.c.f : no cash flow

2,41 − 2.40 12
𝐹𝑂𝑅𝑊𝐴𝑅𝐷 𝑃𝑅𝐸𝑀𝐼𝑈𝑀 (𝐷𝐼𝑆𝐶𝑂𝑈𝑁𝑇) = 𝑋 = 0,049 = 5% 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚
2.40 1

KASUS 1 :
SPOT RATE $1.80/£
3 - MONTHS FORWARD RATE $ 1.79 / £
Diminta:
1. Bagaimana kesimpulan transaksi yang harus dilaksanakan ?
2. Buatkan tabel yang memperlihatkan cash flows (day 1) dan cash flows (3 months)
3. Apakah forward premium atau forward discount yang terjadi atas mata uang sterling ?

FOREIGN EXCHANGE QUOTATIONS

A foreign exchange quotation is the price of a currency expressed in terms of another
currency. Quotations in the foreign exchange market generally made in terms of local
currency (the local unit of account) per unit foreign currency. Thus, in the United States,
exchange rate are quoted in American terms of dollars per foreign monetary unit for
example, $ 0.2 / FF and in France the quotations are made in terms of French fram ; per unit
of foreign exchange for example , FF 5.00/ $. In the same manner, we can express a quote for
the German mark, in American dollar terms, $ 0.50 / DM. The major exception to this
practice in the United Kingdom, where foreign exchange prices are quoted in terms of
foreign monetary units per pound sterling, for example, $ 2.20 / £ and FF 11.00/£.
A foreign exchange quote involves statements about two currencies simultaneously.
For example, if the price of the mark against the dollar moves from $ 0.50 / DM to $ 0.53 /
DM, we can say that the mark has appreciated relative to the dollar by $ 0.03. This is the
same as saying that the dollar has depreciated relative to the mark.

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RECIPROCAL RATE
If we wish to translate the quote of $ 0.50 / DM from American terms to German
terms, we need only take the reciprocal of 0.50 as follows :

If $/DM = 0.50 then DM/$ = 1 /0.50 = DM 2.00/$

CROSS RATE
Having understood how the terms in which a quote is given can be changed by taking
the reciprocal of the given quote, we can extend this concept to more than two currencies.
The exchange rate between two given currencies can be obtained from the rates of these two
currencies in terms of a third currencies. The resulting rate is called the cross rate. For
example:
$0.50/DM and $1.80/£

From these quotes we can obtain DM / £ and £ / DM as follows :

DM/£ = DM/$ x $/£ and £/DM = £/$ x $/DM
Thus, DM/£ = 1/0.5 x 1.80 = DM 3.6000/£
And, £/DM = 1/1.80 x 0.50 = £ 0.2778/DM

COMPARING QUOTES FROM DIFFERENT TRADERS

The computation of reciprocal rates and cross rates facilitates the comparison of
quotes given by different sources when the quotes are expressed in different terms. As an
example, consider the following quotes given by two traders, in their respective local terms:
New York Frankfurt
$0.51/DM DM 2.00/$

To be able to compare the two quotes directly, we must first express them in the same
terms, say, DM/$. This requires the computation of the reciprocal rate of $/DM in New York.
The DM/$ rate for the two traders are as follows :
New York Frankfurt
DM 1,96/$ (= 1: 0,51) DM 2.00/$ (as originally given)
NY = buy $, sell DM Frankfurt = buy DM, sell $

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Conclusion / recomendation :
If we want to buy dollars against marks, we would prefer to do this with the trader in New
York, if we want to sell dollars against marks, we would prefer todo this in Frankfurt.

The difference in quotatiion is called arbitrage. A discrepancy in quotes between two trader
offers an opportunity fo somebody to profit by buying one currency against another from one
trader at a price and reversing the transaction with the other trader at a higher price. The
individual who performs these transactions is the arbitrageur.

KASUS 2 :
New York Zurich
$0,60 / SwF SwF 1,67 / $
$0,51 / DM SwF 0,87 / DM

Diminta:
1. Apakah terjadi transaksi arbitrage ?
2. Bagaimana transaksi dilakukan di New York dan Zurich ?

OUTRIGHT RATE
The quotations for forward rates can be made in two way. They can be made in terms of the
amount of local currency at which the quoter will buy and sell a unit of foreign currency.

Swaps Rate
The fonvaid rates can also be quoted in terms of points of discount and/or premium
from spot, it is used in inter-bank quotations. The outright rate is the spot rate adjusted by the
swap rate.. To find the outright forward rates when the premiums ordiscounts on quotes of
forward rates are given in terms of points (swap rate), the points are added to the spot price
if the foreign currency is trading at a forward premium; the points are subtracted from the
spot price if the foreign currency is trading at a forward discount. The resulting number is
the outright forward rate. For example, when asked for spot, 1 - , 3 - , and 6 - month quotes
on the French franc (FF), a trader based in the United States might quote the following :

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 SPOT 1 – MONTH 3 – MONTH 6 – MONTH
SWAP RATE 0,2186 / 9 2/3 6/5 11/10

If Bid < Offer (in forward) -> Premium, see 1 - month 2 < 3
If Offer < Bid -> Discount, see 3 - months 5 < 6
The outright rates:
Maturity Bid Offer
SPOT .2186 .2189
1 – MONTH .2188 .2192
3 – MONTH .2180 .2184
6 – MONTH .2175 .2179

KASUS 3:
£ : $ 2.0015/30 19/17 26/22 42/35
SwF : $ 0.6963/69 4/6 9/14 25/38
Diminta: susun tabel the outright rates !

FOREIGN EXCHANGE AND MONEY MARKET

Indicators : FEM -> exchange rates
MM -> interest rates
If a bank borrows 30-day marks in the inter-bank market at 13 % and invests the
proceeds in a 30-day dollar placement with another bank of comparable credit standing at 15
%, the bank's risk is that the dollar may depreciate against the mark before the two
transactions mature. Such a depreciation of the dollar could convert the initial 2 % interest
gain intc a net loss.
Spot rate $ 0,4800 /DM
30 – day forward rate $ 0,4812 /DM
30 – day interest
rates: DM 13%
US$ 15%

Interest differential 2% in favor of the $

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 0,4812 − 0.4800 12
𝐹𝑂𝑅𝑊𝐴𝑅𝐷 𝑃𝑅𝐸𝑀𝐼𝑈𝑀 (𝐷𝐼𝑆𝐶𝑂𝑈𝑁𝑇) = 𝑋 = 0,03 = 3% 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚
0.4800 1

That is, the premium of the forward mark against the dollar, 3 %, is larger than the
interest differential of 2 % in favor of the dollar. Thus, there is an incentive to profit from
covered-interest arbitrage. The arbitrageur could realize 1 % profit by performing the
transactions described in the following table :
Borrow US$ - 15%
Convert US $ into DM spot :
Invests DM +13%
Sell DM forward against $ +3%
Net profit +1%

Borrow DM - 13%
Convert US $ into US $ spot :
Invests $ +15%
Sell $ forward against DM -3%
Net loss -1%

Example : $100.000
DATE TRANSACTION CURRENCY
$ DM
Day 1 Borrow $ at 15 % pa for 30 days +100,000 -
Sell $ against DM spot -100,000 +208,333
Invest DM at 13 % for 30 days - 208,333
Sell DM against $ for delivery in 30
days ncf ncf
Net cash flows 0 0
Day 31 DM 208,333 investment mature
Interest = 0.13 x 208,333 x 1/12 +210,590
= 2,257

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 $ 100,000 borrowing mature
Interest = 0.15 x 100,000 x 1/l 2 -101,250
-=1,250 .
Deliver on forward contract +101,336 -210,590
from day 1
Net cash flows + 86 0

KASUS 4:
Currency Rp SGD MR US$ AUD
Rp 1 6,200 2,500 10,120 5,300
SGD ? ? ? ? ?
MR ? ? ? ? ?
US$ ? ? ? ? ?
AUD ? ? ? ? ?

KASUS 5 :
New York Zurich Paris Frankfurt Amsterdam
$ 0,5963/SwF SwF 1,6769/$ FF 4,3772/$ DM 1.1223/SwF Hfl 2.1I85/$
$ 0,504/Hfl SwF 0,4238/FF FF 2,4340/DM DM 0.4348/FF Hfl 1.0899/DM
$ 0,5410/DM SwF 0,9289/DM FF 2,5340/SwF DM 1.8550/$ Hfl 1.2054/SwF
$ 0,224/FF SwF 0,8550?Hfl FF 2,1394/Hfl DM 0.9160/Hfl Hfl 0.4696/FF

Diminta: Bagaimana transaksi seharusnya dilakukan terhadap valas di masing-masing kota

besar dunia tersebut ?

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