Hedging Policy and Instruments

Running head: HEDGING POLICY
Hedging Policy
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Table of Contents
Hedging Instruments:.................................................................................................................2
References:.................................................................................................................................4

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Hedging Instruments:
Energy is the primary requirement for an economy, as all the industries, households
and businesses depend on its availability to flourish. Thus the initial energy requirement
which was provided from the use of fossil fuels or nuclear power plants have a lot of
drawbacks in the environmental front, is being substituted with the use of renewable energy.
In the case of traditional sources of energy, the inputs were variably depend on the market
factors and hedging was possible with the use of various strategies. Thus if the price of fossil
fuels is rising the hedge could be implemented by the purchase of futures or forwards at the
today price and contracted for 3 months or 6 months. Thus if the expectation is of rise in
prices the hedge would be to go long and if the price are expected to fall the hedge is to go
short on the contracts. Thus this provides a price at which the company can procure the raw
materials and thus has a stable cost of inputs. The benefit of traditional sources of energy is
the accuracy of the output which can be generated and thus the cash flows being easily
determined by the investors (Awudu, Asare and Asa 2019).
However, in the case of renewable energy this is not possible as it all depends on the
environment to determine the level of output being able to generate. Thus the raising of funds
is a difficult task as investors cannot determine the value of a renewable source of energy.
Thus the concept of hybrid bonds with the waterfall scheme provides a sense of security to
the investors for the money being invested. This is because if the project fails to provide the
payments, the tranch which assumes the most risk will bear the loss. Thus the senior or the
secured bonds will be safe until the subordinate levels bear the risk (Balcılar, Demirer,
Hammoudeh and Nguyen 2016).
However, to hedge the credit risk of a renewable energy project a hedge can be
undertaken by taking a credit default swap. Thus, all the tranches of the bond are secured by

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the purchase of a credit default swap. Thus in this arrangement the buyer of the bonds or the
lender to the company will enter into a contract with an institution which will reimburse the
holder of the bonds. Thus the reimbursement will only take place when the hybrid bond fails
on any of the coupon payment or the principal payment during the tenure of the contract. The
lender would require to pay upfront premium to the seller of the credit default swap. This for
better understanding an example is provided below (D’errico, Battiston, Peltonen and
Scheicher 2018).
Thus if the value of the hybrid bond is $100 million, covering all the tranches the
lender would make an arrangement with the seller of the CDS to secure the $100 million
investment. The lender would be required to pay say 0.2% of $100 million which is 0.2
million to the seller every year. Thus if the project defaults in a coupon payment or principal
payment, the seller of the CDS will pay to the bond holders. (Hong, Lobo and Ryou 2019).
Hence the credit risk of the hybrid bond is secured, with the risk of the investment
being reduced by the purchase of a credit default swap or by going long in the CDS.

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References:
A Hong, H., Lobo, G.J. and Ryou, J.W., 2019. Financial market development and firm
investment in tax avoidance: Evidence from credit default swap market. Journal of Banking
& Finance, 107(C), pp.1-1.
Awudu, I., Asare, A., Asa, E., Osmani, A., Gonela, V. and Afful-Dadzie, A., 2019.
Maximizing Profits in an Ethanol Supply Chain with Hedging Strategies. Journal of Supply
Chain and Operations Management, 17(2), p.221.
Balcılar, M., Demirer, R., Hammoudeh, S. and Nguyen, D.K., 2016. Risk spillovers across
the energy and carbon markets and hedging strategies for carbon risk. Energy Economics, 54,
pp.159-172.
D’errico, M., Battiston, S., Peltonen, T. and Scheicher, M., 2018. How does risk flow in the
credit default swap market?. Journal of Financial Stability, 35, pp.53-74.