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Hedging Risk

Hedging Risk Definition

Hedging is a strategy for reducing exposure to investment risk. An investor can hedge the risk of one investment by taking an offsetting position in another investment. The values of the offsetting investments should be inversely correlated.

Hedge Your Bet

When an investor buys a stock, he will profit if that stock goes up in value. However, the investor doesn’t know if the stock’s value will go up or go down. If the stock’s value goes down, he could incur a loss.

In order to protect against potential losses, the investor may want to hedge the risk. He could do this by investing in a financial instrument that will profit if the stock he owns, or a related security, decreases in value. Once the investment is hedged, the investor’s exposure to the risk of incurring a loss is reduced.

Hedging is similar to insurance. A homeowner might purchase fire insurance to hedge against the risk of losing his home in a fire.

Hedging Investments

Investors can use various techniques and financial instruments to hedge investments, including options contracts, futures contracts, short selling, investing in currencies, investing in commodities, and investing in other assets or derivatives.

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hedging risk

See Also:
Currency Exchange Rates
Currency Swap
Transaction Exposure
Exchange Traded Funds
Translation Exposure
Covariance
Hedge Funds
Put Option
ROCE (Return on Capital Employed)

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Delivered Duty Unpaid

See Also:
Delivered Duty Paid (DDP)
Freight on Board (FOB)
Delivery Order
Ex Works (EXW)
Cost of Goods Sold (COGS)

Delivered Duty Unpaid

Delivered Duty Unpaid or DDU is the contract assuming that a vendor or seller will assume transportation costs associated with an international or overseas sale. Furthermore, the buyer will assume all of the import/export fees or duty fees.

Delivered Duties Unpaid (DDU) Meaning

Delivered Duties Unpaid means that a seller will assume liabilities and costs associated with delivering goods to a country. However, the buyer assumes the duty fees or costs to bring the product into the country. Unless specified in the DDU contract the buyer will also assume all liability once the product has entered the desired country. This is something that is often negotiated between companies. DDU talks are often decided in association with the riskiness of that particular country.

For example, if a U.S. firm is selling to a company that is centered in a high risk or war plagued country, then there is little chance the U.S. firm would want to assume the responsibility of delivery within the country. Negotiations for delivered duties unpaid are not that different from the negotiations that take place domestically. DDU is essentially the same type of negotiation that occurs for Ex Works and Freight on Board.

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Currency Swap

See Also:
Currency Exchange Rates
Transaction Exposure
Exchange Traded Funds
Translation Exposure
Hedge Funds

Currency Swap Definition

Currency swaps are used to manage exchange rate risk. In a currency swap, two counterparties exchange the interest and principal payments on loans in different currencies. The counterparties agree to a set exchange rate, a set maturity, and a set schedule to pay interest and principal. By fixing the exchange rate for the transaction, both counterparties hedge the risk of unfavorable exchange rate fluctuations.

Currency Swap Example

For example, a British company may need to borrow US dollars. But the only rate it can get on a dollar loan is too high. At the same time, a US company needs to borrow pounds, but the only rate it can get on a loan in pounds is too high.

The British company, however, can borrow pounds at an attractive interest rate and the US company can borrow dollars at an attractive interest rate. So the two companies decide to enter into a currency swap agreement.

The US company borrows dollars cheaply and then lends them to the British company. Meanwhile, the British company borrows pounds cheaply and lends them to the US company. Through the swap agreement, both companies end up benefiting from the other company’s attractive home-currency borrowing rate. It is a win-win situation.

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Credit Letter

See Also:
Letter of Credit
Credit Memorandum (memo)
Debit Memorandum
Trade Credit
Proforma Invoice
5 C’s of Credit (5 C’s of Banking)

Credit Letter Definition

credit letter, defined as a letter written by a bank which declares that the account holder has enough funds to pay for something, is most commonly used during importation.

Credit Letter Explanation

A credit letter, explained as a two sided protection for both buyers and sellers, is a valuable tool for minimizing risk. With a credit letter of reference, the concerns of companies selling across boarders are put to ease. This letter serves two functions: proving that a company has the funds to pay for a shipment of products and protecting the purchasing company from loosing money. In this scenario, the bank protects the account holder by transferring funds only when it receives a document which proves that the products have been shipped.

Example

Ivan is both a Russian and American citizen. He has earned his place in the business world by relying on the experience he has gained. He now imports and exports products both to and from both nations. Ivan has a successful business and is trying to move ahead.

Ivan wants to purchase some products from Russia. Despite this, he is not able to visit the supplier. He wants to receive these products while protecting himself from the risks of international trade. To do this Ivan will use a credit letter of explanation.

Ivan talks with his bank to have a line of credit letter made. Then, he sends the letter to the supplier. After having the letter for a few weeks the company attempts to use the letter of credit without sending a shipment notice. Luckily, Ivan is protected by his bank. They refuse to transfer the payment until they received a shipment confirmation.

Ivan appreciates that his bank protected him. He could have lost a large sum of money without the line of credit letter of credit. Ivan thanks his account manager the next time he sees her.

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Collateralized Debt Obligations

See Also:
Letter of Credit
Investment Banks
Double Entry Bookkeeping
Current Expenditures
Accounts Payable

Collateralized Debt Obligations Definition

A collateralized debt obligation derivative, or CDO, is an investment grade debt instrument backed by collateral consisting of loans or other debt instruments. The collateral typically consists of bonds with varying degrees of credit quality and risk.

You can also call collateralized debt obligations collateralized bond obligations or CBOs. Rank them with different levels of credit quality depending on the quality of the underlying debt instruments used as collateral. Call the different levels of credit quality tiers or tranches.

Collateralized Debt Obligation Tranches

Underwriters pool the collateral according to risk and credit quality. The highest quality collateral backs the top tranche CDOs. Those collateralized debt obligation derivatives offer the lowest returns to the investor. In comparison, use medium credit quality collateral to back middle tier CDOs. These collateralized debt obligations offer returns above the top tier CDOs but below the bottom tier CDOs. The lowest quality collateral backs the bottom tier CDOs. These collateralized debt obligations are the riskiest. They may pay the highest returns to the investor, or they may pay nothing. It all depends on whether the underlying collateral debt instruments default. In the event of default, you must pay all higher ranking CDOS in full or in part. As a result, the bottom tier CDOs may not pay yields.

Collateralized Debt Obligation Example

Assume the underwriters of a CDO are going to divide the pool of debt collateral into the following 3 tranches:

  • A top tranche
  • A middle tranche
  • A bottom tranche.

Divide the tranches according to risk. The corresponding collateralized debt instruments will then offer returns reflecting the degree of risk in the underlying collateral.

If the top tier CDOs, or the collateralized debt obligation derivatives, with the least risk that are backed by the collateral that has the lowest chances of default, then it offers a yield of 5%.

The middle tier CDOs, or the collateralized debt obligation instruments with medium risk that are backed by the collateral that has mediocre chances of default, then it would offer the investor a slightly higher return to compensate for the slightly higher risk. So these middle tier CDOs might offer a yield of 7.5%.

And finally the bottom tranche CDOs – the collateralized debt instruments with the highest risk, backed by the collateral with the highest chances of default – might offer the investor a yield of 10%. As a result, expect this higher yield to compensate the investor for the higher risk of default associated with the bottom tier CDOs.

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Bankruptcy Information

See Also:

Chapter 7 Bankruptcy
Chapter 11 Bankruptcy
Bankruptcy Code
Chapter 13 Bankruptcy
Bankruptcy Costs
Chapter 12 Bankruptcy
Courts – Bankruptcy

Bankruptcy Information

Bankruptcy is the legal condition of being unable to repay debts. It can apply to individuals or organizations. There are two types of bankruptcy: voluntary and involuntary.

Voluntary bankruptcy occurs when the debtor, the party that owes money, files for bankruptcy. Involuntary bankruptcy occurs when the creditor – the party owed money – files a petition for bankruptcy against the debtor. Voluntary bankruptcy is more common than involuntary bankruptcy.

The idea is to settle the debtor’s debts in an orderly manner that forgives the debt and at least partially repays the creditors. When an entity files for bankruptcy, the creditor values the assets. Then they make arrangements to pay off all or some of the entity’s outstanding debt. After successfully completing the bankruptcy proceedings, the debtor is relieved of its prior debt obligations. This allows them to resume operations.

Bankruptcy laws are stated in the chapters of the Bankruptcy Code. These proceedings take place in Bankruptcy Court.

Bankruptcy Pros & Cons

There are advantages and disadvantages of bankruptcy proceedings. First, filing for bankruptcy allows an entity facing financial distress to settle its debts and essentially start over again. Second, bankruptcy regulations allow creditors to collect at least a portion of what is owed to them. Also, bankruptcy regulations are a sort of safety net, encouraging entrepreneurial individuals and businesses to take risks.

On the other hand, bankruptcy proceedings are expensive for the debtor. An entity filing for bankruptcy may incur legal costs, operational inefficiencies, asset write-downs and liquidation losses, and a higher cost of capital. Also, in bankruptcy proceedings, creditors rarely recoup the full amount owed to them.

Although bankruptcy can be great option for a company with no end in sight, we need to start looking at the valuation aspect. Download the Top 10 Destroyers of Value to maximize the value of your company.

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Bankruptcy Costs

See Also:
Chapter 7 Bankruptcy
Chapter 13 Bankruptcy
Bankruptcy Courts
Chapter 11 Bankruptcy
Bankruptcy Code
Bankruptcy Information
Chapter 12 Bankruptcy

Bankruptcy Costs

The more debt a company takes on, the more it risks being unable to meet its financial obligations to creditors. A highly leveraged firm is more vulnerable to a decrease in profitability. Therefore a highly levered firm has a higher risk of bankruptcy.

Bankruptcy costs vary for different types of firms, but they typically include the following:

  • Legal fees
  • Losses incurred from selling assets at distressed fire-sale prices
  • Increased borrowing costs due to poorer credit
  • The departure of valuable human capital

Bankruptcy costs can also affect intangible assets and include indirect costs. For example, bankruptcy could tarnish a company’s reputation and brand equity, causing it to lose market share and competitive positioning. It can also cause suppliers to tighten trade credit terms and cause the loss of customers.

The way to measure bankruptcy cost is to multiply the probability of bankruptcy by the expected cost of bankruptcy. A company should consider the expected cost of bankruptcy when deciding how much debt to take on.

Debt can destroy a company, but it can be managed. If you’re looking at bankruptcy, then click here to download the Top 10 Destroyers of Value to maximize the value of your company.

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