Financial Risk Management

Case 11-2: What Are Our Options?

Hedge accounting is a method of accounting that treats the adjustment entries of a security fair value and its opposing hedge as one. Organizations use hedge accounting to reduce the risk resulting from repeated adjustments to the value of a financial instrument, which is termed fair value accounting. The volatility is reduced by applying both the instrument and the hedge as one entry; this offsets the opposing movement. The main purpose of hedge accounting is to reduce the effects of associated losses, which are attributed to interest rates, exchange rates, or commodity risks. Hedge accounting is not necessarily practiced to generate profit.

The fair value of an option can be categorized into two: intrinsic value and time value. IAS 39 permits the designation of either the entire fair value or only the intrinsic value; however, this usually affects the income statement since changes in the time value of the option are charged to the income statement. The accounting requirements for using purchased options were changed to hedging instruments by IFRS 9. IFRS 9 views the purchase option as similar to purchasing insurance cover, with the time value being the cost associated. If Anthes Enterprises elects to designate only the intrinsic value of the option as the hedging instrument, it must account for the time value changes in investment. The change will be subtracted from the investment and charged to the income statement, which can be either over the hedge period, which is 90 days, or when the hedged transaction impacts the income statements if the hedge is transaction-related (Basher, 2016). As a result, the volatility in the income statement will be reduced for the option-based hedges, as well as eliminating any obstruction to sensible risk management.

Anthes Enterprises should consider that the designation of the intrinsic value of the option will force the enterprise to apply the accounting introduced by the IFRS 9 since it will be mandatory. Additionally, accounting for the initial time value of purchased options is applicable only to the extent that the time value relates to the hedged item; this is referred to as the aligned time value. The firm will have to determine the aligned value where the hedging instrument and the hedged item are fully aligned; this can be done by determining the amount of the time value relating to the hedged item included in the initial time value.

Hedging of Various Risks Faced by Anthes Enterprise

Commodity Price Risk. Sharp fluctuation in the price of commodities results in a significant business challenge, which adversely affects the cost of production, product pricing, earnings, and availability of credits (Salvador, 2014). The company can hedge the prices by using futures markets to protect it against adverse price changes; this can be done by exchanging offer contracts on commodities. Usually, the company is affected if the price of raw materials moves higher, while suppliers will be affected if the price moves lower. The offer contract will enable both the company and suppliers to hedge future production. The use of future exchanges to hedge a future physical sale or purchase exchanges the price risk for the basis risk. Therefore, the company should sell futures contracts which amount to its substitute purchase.

Foreign exchange risk. Forex hedges can be done by using either the cash flow hedge or the fair value hedge. Setting a forex hedge not only prevents the company from being exposed to forex risk but also enables it to forego any profit if currency movements favor it (Lien, 2015). Forex hedging that should be applied is Forward and futures contracts and options. The use of forward contracts will help the company lock in today’s exchange rate at which the transaction currency transaction will occur on a future date. The company can also use a swap contract in hedging.

Hedging of interest rates and stock prices can also be done through forward and futures contracts and options. A stock option gives an investor a right, but not the obligation, to buy or sell a stock. Stock options are of two types: put option and call option. The company can use a put option if it anticipates that the stock price will fall in the future; this will give it the right to sell a specified amount of stock. If the stock prices are expected to fall, the company will use a put option to buy an underlying security at a specified price. It is important to break the valuation of an option into intrinsic value and time value, whereby the intrinsic value of a commodity option can be determined using a spot rate or forward rate, while the time value is any value of the option other than its intrinsic value.

References

Basher, S. A. (2016). Hedging emerging market stock prices with oil, gold, VIX, and bonds: A comparison between DCC, ADCC and GO-GARCH. Energy Economics, 54, 235-247.

Lien, D. L. (2015). Evaluating the effectiveness of futures hedging. Handbook of Financial Econometrics and Statistics, 1891-1908.

Salvador, E. &. (2014). Measuring Hedging Effectiveness of Index Futures Contracts: Do Dynamic Models Outperform Static Models? A Regime‐Switching Approach. Journal of Futures Markets, 34(4), 374-398.

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