“Hedging allows the commercial banks to manage foreign exchange risk but
hedging itself poses additional risk to bank.” (Gandhi G. S., 2006)
Financial risks are part of the normal life of any Bank. In order to remain competitive, you
might choose to manage those risks through the use of one or more techniques.
As the name suggests, "derivatives" are products derived from standard transactions on
underlying instruments. The underlying instrument may be an interest rate, currency,
equity or bond. The price of a derivative varies amongst others according to the price of
the underlying instrument.
ING is able to offer tailor-made products through the OTC (over-the-counter) market. An
organized market invariably offers standard products (standard duration, strike price,
number of options per contract, etc.) whereas on the OTC market you can determine
almost all the parameters/procedures for the derivatives concerned, according to your
needs. However, the models used to determine the price are the same as those used by the
Hedge your Interest Rate risk
Corporates are more and more aware of the value of hedging their Interest Rate risks
actively. Also the number of products and strategies available has grown considerably
over the last few years.
Hedge your Foreign Exchange risk
When dealing in foreign currencies, your commercial profitability might be affected by a
disadvantageous evolution of the exchange rate. Several techniques exist to hedge this
risk. Some are common (Forward Foreign Exchange Agreement, Call/Put
options) while some are more complex but allow you to generate more benefits than the
market if your view on the evolution is revealed to be right.
Hedge your Equity risk
As a Corporate you are exposed to merger and acquisitions or you may want to organize a
stock option plan for your employees. Using equity derivatives will help you to manage
the risks linked to these operations.
Hedge your Inflation risk
As a pension fund, insurance company or corporate subject to indexation, you are exposed
to unexpected moves of the inflation rate. This risk can be managed through the use of
inflation linked instruments. You may also use inflation linked bonds to diversify your
investment portfolio and so to improve its risk-return profile. ING has always been one of
the frontrunners with respect to the inflation market.
Hedging using Derivatives
A commercial bank uses foreign currency derivatives to hedge foreign exchange risk.
Foreign currency derivatives are:
a. Foreign Currency Futures
b. Foreign Currency Swap
c. Foreign Currency Options
d. Foreign Currency Forward Contracts
The most popular amongst all others as mentioned above are FX forward Contracts.
Instead of matching FX asset-liability bank enters into a forward contract having the same
maturity. For example in above examples bank does not need to advance loans in the same
currency rather it uses forward contracts to insulate FX risk. An important feature of such
contracts is that they do not appear on the balance sheet of the bank instead it appears
under the head of Contingencies & Commitments and hence are off-balance sheet items.
Dealers typically hedge a forward foreign-exchange commitment with a spot plus “FX
Swap”: spot sale plus forward purchase of a foreign currency. The FX swap rate is
determined by the interest differential.
Types of Hedging:
Money market hedging: match currency of assets and liabilities
Forwards: Agreement to exchange currencies at certain exchange rate in the future .
Futures: Exchange-traded contracts for notional future delivery, minimizing default
risk via marking to market.
Currency swap: match payments on foreign-currency debt.
Interest-rate swap: change floating cost to fix.
Policies and Schemes from Insurance Companies about Risks
A risk policy specifies which risks a company will be willing to assume and which risks it
will not. The risk policy of an insurance company focuses on:
creating and protecting shareholders’ value from the volatility of its financial
containing the impact of this volatility on the cost of its capital and thus also, the
cost of its risk capacity
Types of Risks
With regards insurability, there are basically two categories of risks;
1. speculative or dynamic risk; and
2. pure or static risk
Speculative or Dynamic Risk
Speculative (dynamic) risk is a situation in which either profit OR loss is possible.
Examples of speculative risks are betting on a horse race, investing in stocks/bonds and
Pure or Static Risk
The second category of risk is known as pure or static risk. Pure (static) risk is a situation
in which there are only the possibilities of loss or no loss, as oppose to loss or profit with
Types of Pure (Static) Risk
The major types of pure risk that are associated with great economic and financial
1. Personal risks,
2. Property risks,
3. Liability risks.
Fundamental Risks and Particular Risks
Fundamental risks affect the entire economy or large numbers of people or groups within
the economy. Examples of fundamental risks are high inflation, unemployment, war, and
natural disasters such as earthquakes, hurricanes, tornadoes, and floods.
Particular risks are risks that affect only individuals and not the
entire community. Examples of particular risks are burglary, theft, auto accident,
dwelling fires. With particular risks, only individuals experience losses, and the rest of the
community are left unaffected.
Insurance risk policy
To develop its insurance risk policy, a company needs to takes into account its ability to
establish and sustain a competitive advantage by leveraging superior capabilities (e.g.
underwriting expertise, claim management, risk management, etc.). It must evaluate the
attractiveness of individual insurance markets based on analysis and assessment of key
factors that shape business strategy, including:
Market structure and characteristics (size in premium revenue, number of accounts,
distribution of exposures by location, industry, etc.)
Revenue growth potential
Business acquisition and underwriting expenses
Changes in customer needs and value perceptions
Assessment of relative competitive positions
Loss frequency and severity, and expected loss ratio
Correlations with macro-economic factors (e.g., inflation and GDP growth rates),
and other markets served by the company.
Systemic insurance risk
Availability, cost and anticipated use of reinsurance
Investment risk policy
The investment risk policy needs to address the following two effects of investment value
volatility that might cause:
The absolute market value of invested assets to fall in a given time period, thereby
reducing available capital and risk capacity.
Changes in the market value of invested assets relative to the value of liabilities
that increase the volatility of the company’s capital position, thereby also
increasing the probability of downgrading, or of intervention by regulators in
Type of Insurance
1. Life Insurance.
2. Health Insurance.
3. Long-Term Disability Coverage.
4. Auto Insurance.
5. Agriculture Insurance.