Before I take on the BR piece on hedging, let me do a Derivatives102 thread.

This was Derivatives101 https://twitter.com/2paisay/status/1260075432415821824?s=20

Consider interest rate swap (IRS). IRS allows you to swap one interest rate with another. Say I borrow $1M from MCB for one year at 1Month LIBOR +2% repriced at 15th of every month. This is how your monthly interest payments are expected to be if libor turns out like as shown.

You are worried that LIBOR is volatile. You approach Standard Chartered (SCB) for IRS. SCB will do an IRS fixing Libor at 1.5% for notional $1M. You can replace LIBOR 1.5% thus your total interest cost will be 3.5% $2,917 (see May 20) every month regardless of what LIBOR does.

Your arrangement with MCB will not change. You will continue paying as above. You will settle the difference between 1M Libor and 1.5% with SCB as shown below.
Your net cost will be 1.5% + 2% every month. No volatility.

This is example of floating to fixed IRS.

As the IRS was a separate transaction from the loan, if you want to play "satta" on interest rates, you can engage in such an IRS without having any loan. For example, by just doing an IRS with SCB without any loan you made a profit of $1,583.

If hedging, things to note:

-Date:
Date at which SCB calculates the difference should be the same as MCB calculation date. MCB shouldn't be using LIBOR of 30th whereas SCB is calculating the difference between swap rate and LIBOR one day later i.e. 1st of every month.

- Reference
If MCB is using the average of opening and closing LIBOR for that day, SCB should be using the same. Not the mid-day, not the opening or closing.

These things are important if hedging. If speculating, doesn't matter. Do as you please.

Let's replace it with oil. Pakistan buys oil from Saudi on monthly basis at market price. And say partially hedges it by entering a commodity swap arrangement with SCB at $40 per barrel against Brent market price.

Mistake is obvious as reference is wrong. As Brent and Arabian gulf can vary significantly, this is not a perfect hedge even for half the amount. This is called basis risk.

If it was Arabian Gulf on both sides, need to know price at which date will Saudi use to raise invoice ie 1st of the month or the date the oil shipped or the date it landed. As oil price is volatile, the hedge with SCB should be using the same date/price. Not average. Not other

Now to give you an example of how the Citi/SCB etc market derivatives to "sophisticated" customers. This is the email a few of us received from a Nigerian friend in 2009. This is a term sheet for fixed to (not exactly) floating IRS.

Upon signing the IRS, the client will receive fixed 21.50% every quarter and pay either 17.5% or 28.50% based on how the 3m LIBOR behaves. Bank has shrewdly diverted the client's attention to LIBOR barriers. If libor is between barrier client pays 17.5% otherwise 28.5%.

The client instead of asking WTF? what do I know about LIBOR forecasting? How would I know what Libor will be every quarter? How can I get it right between when the difference between upper and lower limit is just 0.75bps, why the fuck will I be charged 28.5% -->

--> he is focusing his energy on this impossible task that if he somehow gets this right, he will pay 17%. But he can get it easily get it wrong as the difference is just 0.75% and he gets screwed even if libor is low if it is outside barrier.

But these bankers give you all the charts and excels and historical data to make you feel smart and sophisticated and not ask the obvious question: "if I am borrowing in Nigerian Niara, what the fuck has it to do with GBP 3m LIBOR and why am I forecasting it sitting in Nigeria".

SCB nay Internation Industries Limited to ko barriers say hi aisa choona lagaya tha ke IIL nay hamesha k liay derivatives say tauba kar li. Whenever, we go there, the discussion used to revolved around what should be the barriers for their SCB deal.

This is what I replied to him k bhai kin chakkaron mein phans raha hai. This is 2009

Interest rate trader jumped into the thread saying aap ka bhai is wrong (though I believe I got the gist of it right) and bombarded with jargon

Another colleague jumped in the thread defending aap ka bhai that this definitely is a risky transaction. The interest rate trader brought out the big guns. And people complain that I use jargons.

Years later, I asked the Nigerian friend how did the trade go. He replied that after my email, he didn't do the deal (at least thats what he told me). Interest rate trader can take his volatility shtick and shove it up where the sun don't shine.

Since I am into shameless self promotion, got these two emails in response to my email. In 2009 and in 2011.

A german lawyer giving me a copyright. I will take that as a compliment.