DERIVATIVES AND HEDGING TECHNIQUES Flashcards
Why is there a need to manage foreign exchange risk?
-Reduce risk of future earnings
-Protect the MNC against adverse price movements (for a specified time period)
- Protecting profitability
Strategic tool in order to adjust future transactions in times of adverse price movements.
FOREX RISK
Transaction risk
What are the approaches to managing exchange rate risk?
- Do nothing
- Invoicing in the home currency
- Identifying net transaction exposure (matching and netting)
- Leading and lagging
- Money market hedging
- Forward exchange contracts
Foreign currency derivatives
- Currency futures
- Currency options
- Currency swaps
DOING NOTHING
-Passive strategy - very risky
-Active strategy
Equilibrium / average position lead to a neutral impact
No transaction costs
Low frequency/ low value transactions
INVOICING IN THE HOME CURRENCY
Require customers and suppliers to use your home currency to pay bills in the home currency.
- Almost eliminates foreign currency risk
- May be unacceptable to trading partners.
LEADING AND LAGGING
Adjusting the timing of a payment request or disbursement to reflect expectations about future currency movements.
- Lead payments - payments in advance
- Lagged payments - delaying payments beyond their due date
MATCHING
This concept focuses on “matching” receipts and payments in the same currency
NETTING
An approach that is used to settle inter-company balances.
MONEY MARKET HEDGING
Approach to hedge against foreign exchange risk.
-Assume we have a future payment to make, the idea is to avoid future exchange rate uncertainty by making the exchange at today’s spot rate.
e.g. borrow in home currency today and immediately convert to foreign currency and place the money in a deposit account. Receive interest and pay creditor in future from foreign bank account.
Repay loan in home currency.
Assume we are an exporter and will receive a known payment in foreign currency in the future. The idea is to avoid future exchange rate uncertainty by making the exchange at today’s spot rate
Money market hedging example:
A UK firm owes HK$3.5m in three months time. The exchange rate is HK$
7.5509 – 7.5548. The company can borrow in GBP for 3 months at 8.6%
p. a. and can deposit HK$ for 3 months at 10% p. a. What is the cost in
GBP with a money market hedge and what effect forward rate would this
represent?
Step 1: Determine the amount of HK$ required in 3 months’ time.
Step 2: Evaluate how much the required amount of HK$ will cost in GBP.
Step 3: Calculate the amount that will have to be repaid
Step 4: Calculate the effective rate of exchange
What is the effective exchange rate?
Interest rate for 3 months:
3/12 * 8.6% = 2.15% (to borrow in GBP)
3/12 * 10% = 2.5% (to borrow in HKD)
Need to deposit enough HKD so that the total plus interest will be our liability (HK$3.5m)
Deposit:
3,500,000 / (1+0.025) = HK$3,414,634 - what we need in HK$ for interest rate
How much will this cost in GBP?
Exchange rate = 7.5509
3,414,634/7.5509 = £452.215 - equivalent in GBP
£452,215 (1.0215) = £461,938
The creditor will be paid from the HK$ account and the company will pay £461,938 in £.
FORWARD
A forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (forward rate) at a specified date in the future.
Can buy and sell foreign currency.
Example of a forward contract:
Freeze PLC is based in Birmingham and will need 1mil Singapore
dollars in 90 days to purchase imports. Spot rate: £0.35 per
Singapore dollar (S$).
Doesn’t have S$ at present.
Arrange a forward to lock in the price of S$1mil 90 days from now
to avoid exchange rate exposure.
Risk has been completely removed.
Forward agreement - terms £0.38 : S$1
At the spot rate: £0.35:S$1
S1$mil * 0.35 = £350,000
Liability occurs in 90 days so risk is we have some movement in the exchange rate.
S$1million * 0.38 = £380,000 - locked this rate
Example of a forward contract 2:
This can sometimes lead to an opportunity cost:
Freeze PLC again
If original agreement was £0.38 to S$1 in 90 days
= S$1mil * 0.38 per S$ = £380,000.
If spot price in 90 days = £0.37 to S$1
= S$1mil * 0.37 per S$ = £370,000
£10,000 opportunity cost
DERIVATIVES
Derivatives are financial instruments whose returns are derived from those of another financial instrument.
CASH/SPOT MARKETS
The sale is made, the payment is remitted and the good or security is usually remitted immediately or shortly after.
DERIVATIVE MARKETS
Contractual instrument returns depend on the performance of the underlying asset.
FUTURES
A futures contract between two parties to buy or sell an asset at a particular price agreed today, for delivery at some point in the future.
Currency futures contracts specify a standard volume of a particular instrument to be exchanged on a specific settle date at a specific exchange rate.
Can be to buy or sell foreign currency.
Used by MNCs to hedge foreign currency positions
Traded by speculators
FUTURE CONTRACTS
Exchange traded
Buyers and sellers do not transact directly with each other
Trading made possible by the standardised nature of the contracts.
SHORT POSITION
A trader takes a short position when selling a futures contract, which corresponds to selling the currency forward.
LONG POSITION
A trader takes a long position when buying a futures contract, which corresponds to buying the currency forward.
Advantages of futures
- Transaction costs should be lower than other hedging methods.
- Futures are tradable on a secondary market -> leading to price transparency.
- The exact date of receipt or payment doesn’t need to be known.
Disadvantages of futures
- Contract cannot be tailored
- Hedge inefficiencies -> due to whole number of contracts
- Limited currencies have currency futures
- Cannot take advantage in favourable exchange rate movements
CURRENCY OPTIONS
Provide the right but not the obligation to purchase or sell currencies at specified (strike) prices. They are classified as calls (right to buy a currency) or puts (right to sell a currency).
Customised options offered by brokerage firms and commercial banks are traded in the over-the-counter market.
What can option owners do?
Sell or exercise their options, or let their options expire.
What can firms do (options)?
May purchase currency call options to hedge payable, project bidding, or target bidding.
May purchase currency put options to hedge receivables, interest earned or sales of assets.
STRIKE PRICE
The specified price is called the exercise or strike price within a specified period of time.
PREMIUM
The fee attached to granting the right to put or call.
A call that is IN THE MONEY
if a claim can be made
A call option is AT THE MONEY
if currency price = strike price
A call option is OUT OF THE MONEY
if a claim cannot be made
EUROPEAN OPTIONS
European options can only be exercised on maturity date
AMERICAN OPTIONS
Americans can be exercised anytime
How to value a call option?
Common approach is to use Black-Scholes (1973) formula.
How to value a put option?
Similar to the call option, based on put-call parity.
SPECULATION
- Help set prices
- If foreign currency will appreciate could purchase a call option in that currency
- If foreign currency is expected to depreciate then will want to sell a currency call option
INTEREST RATE RISK
Interest rate risk is faced by companies with floating and fixed rate debt.
Can arise from gap exposure and basis risk.
SMOOTHING
A simple approach to hedge against interest rate risk movement for loans or deposits.
Firms will borrow some at fixed rate and some at floating rate.
Increase in interest rates -> floating rate will rise, but limited by fixed.
Decrease in interest rates -> floating rate will decrease, but limited by fixed.
ASSET AND LIABILITY MANAGEMENT
This relates to the periods or duration for which loans (liabilities) and deposits (assets) last.
Match loans to lease periods
MATCHING
Internal approach used by the banking sector to manage changes in interest rates.
Interest rates on assets are matched with interest rates on liabilities.
FORWARD RATE AGREEMENTS
A company can enter into an agreement now to fix the rate of interest for borrowing.
Delivery: at a certain time in the future.
Method: OTC contract
Units: Tailored to requirements
INTEREST RATE DERIVATIVES
Interest rate futures
Interest rate options
Interest rate swaps
Interest rate caps, floors and collars
INTEREST RATE FUTURES
Used to hedge against changes in the rate of interest between now and date in the future.
Fixed term deposit, generally for the period of three months.
Buyer of an interest rate future is buying the (theoretical) right to deposit money at a particular interest rate for three months.
Borrowers: sell futures = hedge against interest rate rises
Lenders: buy futures = hedge against interest rate falls.
INTEREST RATE OPTIONS
An interest rate option grants the buyer, the right (but not the obligation) to a deal at an agreed interest rate (strike rate) at a future maturity date.
Interest rate options offer more flexibility and are more expensive than FRAs
INTEREST RATE SWAPS
When two parties agree to exchange interest payments on an agreed notional amount for an agreed period of time.
Swaps are used to hedge against adverse interest rate movements.
INTEREST RATE CAP
Contract that gives the purchaser the right to set a maximum level for the interest rates payable.
Compensation is paid to the purchaser if interest rates rise above this level.
Advantage of interest rate cap?
Limits exposure to increase in interest rates.
Company can benefit from interest rate decreases.
INTEREST RATE FLOOR
Contract that gives the purchaser the right to set a minimum level for interest rates payable.
Compensation is paid to the purchaser if interest rates drop below this level.
Advantages of interest rate floor?
Protects against decreasing interest rate.
Company benefit with interest rate increases.
INTEREST RATE COLLAR
Contract that gives the purchaser protection from interest rate rises (above a certain level) and interest rate declines (below a certain level).
Compensation paid if interest rate drops below this floor level or above cap level.
Advantages of interest rate collar?
Collar reduces the cost of interest rate protection.
Provides protection in times of higher rates.
Collar can easily be sold back to the bank at any time.
Disadvantage of interest rate collar?
User cannot benefit from large drops/increases in interest rates.
