IntroductionThis report is to check the hedging strategy that was used and lead to the huge loss of CITIC Pacific Limited and point out the importance of managing foreign exchange exposure through select appropriate hedging strategies. The huge loss of CITIC Pacific Limited and its cause is discussed in the first part. The importance of hedging and the tools of hedging are respectively reviewed in part two and part three. Finally, suggestions are given out on how to design proper hedging strategies for different enterprises.
The huge loss of CITIC Pacific LimitedOn October 2008 21st, shares in CITIC Pacific (Listed in the HKEx) halved (http://news.bbc.co.uk/1/hi/business/7683160.stm) after the news of huge loss of foreign exchange was released. The next day, the share price fell sharply by 24.69%.
The transaction is a 25-year long magnetite investment project with total value of about 42 billion U.S. dollars. It is a normal course of business involved in large amount of money.
The risk of exchange rate is obvious in such a long period and it's common to enter into foreign exchange forward contracts. However, CITIC Pacific has chosen Accumulator contract with Australian dollar as target. That is to say, CITIC Pacific has the right to purchase Australian dollar with a discount when it's appreciating but there is an upper limit; if Australian dollar depreciates in the period stipulated in the contract, CITIC Pacific has to buy it in double amount at the negotiated price and there is no lower limit. With the outbreak of the global financial crisis (http://www.eurotopics.net/en/magazin/magazin_aktuell/finanzkrise-2008/debatte-kapitalismus-11-2008/), the Australian dollar devaluated more than 10.8 percent in a period of time as short as one month, which directly lead to the huge loss of CITIC Pacific.
It's supposed to select simple and traditional financial derivatives to deal with the foreign exchange risk...