On-Balance Sheet hedging

blackjack21
Good Student
Posts: 20
Joined: Thu May 03, 2012 9:56 pm

On-Balance Sheet hedging

Postby blackjack21 » Thu May 10, 2012 2:24 am

Hi

In On-balance sheet hedging we see that we can lock in profits for an exchange rate movement in either direction. This is the case with any kind of hedging.

What is the risk involved in such a type of hedging except credit/default risk?

Obviously these are not riskless profits else they would be an arbitrage trade. Kindly throw some light on this.

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content.pristine
Finance Junkie
Posts: 356
Joined: Wed Apr 11, 2012 11:26 am

Re: On-Balance Sheet hedging

Postby content.pristine » Fri May 11, 2012 7:55 pm

Hi Blackjack,

The "profits" realized here are NOT risk free, just as you have said in your post.
For example, if you are expecting to sell a commodity at some point in the future, lets say the current spot is at $50 and you are planning to get into a hedge. Lets say that you were able to lock into a hedge to sell at a future price $55. Then that $5 spread is not arbitrage. No matter how the markets move, even if prices drop to $40, we lock into our $5 profit.
To answer your question, this type of trade does involve market risk, as in the fluctuation of market prices. Whether you would be lucky enough to get this rate.

I hope this answers your question 8-)

content.pristine
Finance Junkie
Posts: 356
Joined: Wed Apr 11, 2012 11:26 am

Re: On-Balance Sheet hedging

Postby content.pristine » Sat May 12, 2012 10:11 pm

One of our instructors, Pradeep, had something to add to the discussion:
"On Balance sheet hedging:
Let us just recapitulate what is on balance sheet hedging...its a technique where in u manage ur assets and liabilities for their foreign exchange risk ...when u have an exposure in euro on assets side u take corresponding exposure on the liabilities side (ie u raise deposits in euros to lend in euros) this way u eliminate the foreign currency risk. because of this inherent hedging available in your operations you are able to gain profits or foreign currency risk is not affecting you. this is an advantage one can exploit ..here one is able to generate returns without taking any risk...but there is a catch here...one shd be in a position to raise assets in a particular currency and deploy them...consider the case of bank in india...its ability to raise funds in USD is limited until it opens up a branch in US or have very good remittance portfolio....in this situation the bank is not in a position to exploit the advantage of on balance sheet hedging...so on balance sheet hedging doesn't come free of cost .... it has got its own risks and barriers of entry...and for other hedging techniques you are willing to sacrifice your upside potential (in case of forwards) or lose certain premium (in the case of options).....hope this clarifies....pls let me know if you need clarifications....."

blackjack21
Good Student
Posts: 20
Joined: Thu May 03, 2012 9:56 pm

Re: On-Balance Sheet hedging

Postby blackjack21 » Thu May 17, 2012 11:32 pm

Excellent explanation! 8-)

Hats off for the Bank of India example!


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