E2. The use of financial derivatives to hedge against forex risk

Question 1

Types of foreign currency risk

Answer 1

• Translation. Risk that there will be losses when a subsidiary is translated into the parent company currency when doing consolidated accounts
• Economic. Long term cashflow risk caused by exchange rate movements. For example, a UK exporter would struggle if sterling appreciated against the euro. It is like a long-term transaction risk.
• Transaction. The risk that changes in the exchange rate adversely affect the value of foreign exchange transactions.

Question 2

Spot rate and spreads.

Answer 2

A spot rate is the rate available if buying or selling a currency immediately. By offering a different exchange rate to exporters and importers, a bank can make a profit on the spread (ie the difference). Exchange rates are therefore often quoted as a spread.
1.9612-1.9618 A$ to the £
• A lower ‘bid’ price (selling price), so importer will receive 1.9612 A$ for every £ it sells to the bank
• A higher ‘offer’ price (buying price), so exporter will pay 1.9618 A$ for every £ it buys from the bank.
If in doubt, work out which rate most favours the bank (as could be inverted and then it becomes opposites.

Question 3

Options to manage these foreign currency risks (internal)

Answer 3

Options to manage these risks
• Only deal in home currency (commercially acceptable?)
• Do nothing (saves transaction costs but is risky)
• Leading - Receive early (offer discount) - expecting rate to depreciate
• Lagging - Pay later if currency is depreciating
• Matching - Use foreign currency bank account - so matching receipts with payments then risk is against the net balance
• Another way of managing the risk is using (external techniques): Hedging, options, futures, swaps and forward rates.
Internal hedging techniques are cheaper than external and should be considered first.

Question 4

Options to manage these foreign currency risks

Do nothing.

Answer 4

In the long run, the company would ‘win some, lose some’. This method:
• Works for small occasional transactions
• Saves in transaction costs
• Is dangerous!

Question 5

Options to manage these foreign currency risks

Invoicing in domestic currency.

Answer 5

One way of avoiding exchange risk is for exporters to invoice overseas customer in their domestic currency, or for importers to arrange with its overseas supplier to be invoiced in their home currency. However, only importer or exporter can avoid the transaction risk, the other party to the transaction will bear the full risk.
This method:
• Transfers risk to the other party
• May not be commercially acceptable

Question 6

Options to manage these foreign currency risks

Leading.

Answer 6

Involves accelerating payments to avoid potential additional costs due to currency rate movements. Receipts – If an exporter expects that the currency it is due to receive will depreciate over the next few months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.

Question 7

Options to manage these foreign currency risks

Lagging.

Answer 7

It is the practice of delaying payments if currency rate movements are expected to make the later payment cheaper. Payments – If an importer expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.

Note: If the importer expects that the currency will in fact appreciate, then it should settle the liability as soon as possible (leading). Or, if an exporter expects the currency to appreciate, it may try to delay the receipt of payment by offering longer credit terms (lagging).
NB Strictly this is not hedging – it is speculation – the company only benefits if it correctly anticipates the exchange rate movement!

Question 8

Options to manage these foreign currency risks

Matching payments and receipts.

Answer 8

A company can reduce or eliminate its transaction risk exposure by matching receipts and payments. If a company expects to make a payment and have receipts in the same foreign currency should plan to offset its payments against its receipts in that currency. The process of matching is made simpler by having foreign currency accounts with a bank. It will be cheaper than arranging forward contracts. Any difference between amount receivable and payable may be covered by a forward contract.

Question 9

Options to manage these foreign currency risks

Netting.

Answer 9

Unlike matching, netting is not technically a method of managing transaction risk. The objective is simply to save transaction costs by netting off intercompany balances before arranging payment

Question 10

Forward contracts.

Answer 10

A contract with a bank covering a specific amount of foreign currency for delivery on a specific future date at an exchange rate agreed now. The purpose of a forward contract is to fix an exchange rate now for settlement of a transaction at a future date. This removes uncertainty about what the exchange rate will be at the future date.

Question 11

Close-out of forward contracts.

Answer 11

If importer (exporter) cannot fulfil the forward contract agreed (maybe because he didn’t receive the goods) the bank will sell the importer the currency at the forward exchange rate (spot rate) and then buy it back again at the current spot rate (forward exchange contract). This closes out the forward contract

Question 12

Forward contracts adv vs disadv

Answer 12

Advantages include:
• Flexibility with regard to the amount to be covered
• Relatively straightforward both to comprehend and to organise
Disadvantages include:
• It is a contractual commitment which must be completed on the due date.
• No opportunity to benefit from favourable exchange movements

Question 13

Money market hedging.

Hedging a receipt.

Answer 13

Borrowing in the foreign currency allows an exporter to take to take their foreign currency revenue now, at todays spot rate and thereby avoiding exchange rate risk. The foreign currency revenue will be used to repay the loan when it is received.
• Borrow the present value of the foreign currency amount today
• The foreign loan accrues interest until the transaction date
• The loan is then repaid with the foreign currency receipt
Steps:
• Calculate how much foreign currency needed (discount @ foreign borrowing rate)
• Convert that to home currency
• Deposit that amount of home currency
• The receipt will be the amount converted plus interest on that (home currency deposit rate)

Question 14

Money market hedging.

Hedging a payment.

Answer 14

Transferring an amount of money into an overseas bank account, at todays spot rate, that is sufficient to repay the amount owed to the supplier in future allows an importer avoid exchange rate risk.
• Buy the present value of the foreign currency amount today at the spot rate:
• The foreign currency purchased is placed on deposit and accrues interest until the transaction date.
• The deposit is then used to make the foreign currency payment
Steps:
• Calculate how much foreign currency needed (discount @ foreign deposit rate)
• Convert that to home currency
• Borrow that amount of home currency
• The cost will be the amount borrowed plus interest on that (home currency borrowing rate)
The effect is exactly the same as using a forward contract and will usually cost almost exactly the same amount.

Question 15

Synthetic foreign exchange agreements (SAFEs)

Answer 15

In order to reduce the volatility of their exchange rates, some governments have banned foreign currency trading (Russia, India and Philippine). In such markets, synthetic foreign exchange agreements (SAFEs) -also known as non-deliverable forwards - are used. These instruments resemble forward contracts, but no currency is actually delivered. Instead the two counterparties settle the profit or loss (calculated as the difference between the agreed SAFE rate and spot rate) on a notional amount of currency (SAFE’s face value). At no time is there any intention on the part of either party to exchange this notional amount.

Question 16

Futures (derivative).

Answer 16

A currency futures contract is a standardized contract for buying or selling of a specified quantity of foreign currency at a set date and is traded on a futures exchange (so basically market traded forward contract). The futures contract is separate from the actual transactions and operates in such a way that is losses are made on the spot market, the profits are expected in the futures market and vice versa. The gain or loss on a future contract derives from future exchange rate movements – so futures are a derivative.
When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin. If losses are incurred as exchange rates and hence the prices of currency futures contracts change, the buyer or seller may be called on to deposit additional funds (variation margin) with the exchange. Equally, profits are credited to the margin account daily as the contract is ‘marked to market’. Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the initial futures transaction, i.e. if buying currency futures was the initial transaction, it is closed out by selling currency futures. A gain made on the futures transactions will offset a loss made on the currency markets and vice versa.

Question 17

Futures features.

Answer 17

Features:
• Each contract fixes the exchange rate on a large, standard amount of currency
• Contracts normally expire at the end of each quarter (March, June, September or December) but can be used on any date up to the expiry date
• Smaller range of currencies are traded on the futures market compared to those available on forward market.
• They fix the exchange rate for a set amount of currency for a specified period of time.

Question 18

Advantages of futures.

Answer 18

• Transaction costs should be lower than other hedging methods
• Futures are tradeable and can be bought and sold on a secondary market so there is pricing transparency, unlike forward contracts where prices are set by financial institutions.
• The exact date of receipt or payment of the currency does not have to be known, because the futures contract does not have to be closed out until cash receipt or payment is made.

Question 19

Disadvantages of futures.

Answer 19

• The contracts cannot be tailored to the user’s exact requirements.
• Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis risk.
• Only a limited number of currencies are the subject of futures contracts.
• Unlike options, they do not allow a company to take advantage of favourable currency movements.
• Margin payments, so has liquidity implications.

Question 20

Steps in a future hedge

Answer 20

• Step 1 Now. Contracts should be set in terms of buying or selling the futures contract currency – choosing the closest standardised futures date after the transaction date
• Step 2: In the future. Complete the actual transaction on the spot market
• Step 3: at the same time as Step 2. Close out the futures contract by doing the opposite of what was done in Step 1.
• Calculate net outcome.
Quicker method. Effective futures rate = opening future’s rate (so when we buy or sell) - closing basis (futures rate less spot rate on closing). This is multiplied by amount of receipt or payment and should give overall outcome of hedge.

Question 21

Currency swaps.

Answer 21

A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate. During the length of the swap each party pays the interest on the swapped principal loan amount. At the end of the swap the principal amounts are swapped back at either the prevailing spot rate, or at a pre-agreed rate such as the rate of the original exchange of principals. Using the original rate would remove transaction risk on the swap.
Currency swaps are used to obtain foreign currency loans at a better interest rate than a company could obtain by borrowing directly in a foreign market or as a method of hedging transaction risk on foreign currency loans which it has already taken out.

Question 22

Currency swaps enable a company to:

Answer 22

• Manage currency risk – by swapping some of its existing or new domestic debt into foreign currency debt a company can match foreign currency cash inflows and assets to costs/liabilities in the same currency.
• Reduce borrowing costs -by taking out a loan in a domestic market where they have a comparative interest rate advantage.
Currency swaps are similar to interest rate swaps but normally involve the actual transfer of the funds that have been borrowed (the initial capital is swapped at the start and then back at the end to repay the original loans).

Question 23

Currency swaps process

Answer 23

Process (same as interest swap):
• Assess potential for gain from swap
• Swap, variable rate at LIBOR, designed to split gain 50:50

Question 24

Advantages of currency swaps.

Answer 24

• Swaps are easy to arrange and are flexible since they can be arranged in any size.
• Transaction costs are low, only amounting to legal fees, since there is no commission or premium to be paid.
• The parties can obtain the currency they require without subjecting themselves to the uncertainties of the spot foreign exchange markets.
• The company can gain access to debt finance in another country and currency where it is little known. It can therefore take advantage of lower interest rates than it could obtain if it arranged the currency loan itself.

Question 25

Swaption

Answer 25

Swaption is an option to enter into a swap in return for an up-front premium (if there is uncertainty).

Question 26

FOREX swap:

Answer 26

FOREX swap: a short term swap made up of a spot transaction and a forward transaction which allows a company to obtain foreign currency for a short-term period (usually within a week) and then to swap back into the domestic currency a short time later at a known (forward) rate.
A FOREX swap is useful for hedging because it allows companies to shift temporarily into or out of one currency in exchange for a second currency without incurring the exchange rate risk of holding an open position in the currency they temporarily hold.

Question 27

Currency options (derivative).

Answer 27

Currency options (derivative). Contracts giving the holder the right, but not the obligation, to buy (call) or sell (put) a fixed amount of currency at a fixed rate in return for an upfront fee or premium. So unlike forwards or futures, currency options protect against adverse exchange movements but still allow a company to take advantage of favourable exchange rate movements. A company can therefore:
• Exercise the option if it is in its interests to do so
• Let it lapse if:
o the spot rate is more favourable
o there is no longer a need to exchange currency

Question 28

Currency options: OTC and exchange traded

Answer 28

Currency options can be purchased directly (over the counter) from a merchant bank; these options are normally fixed date options (European options) which means that they can only be exercised on a specific date. Currency options are also available from the US exchanges markets.
Advantages of exchange traded options vs OTC options.
• Exchange traded options cover a period of time (American options); OTC options are fixed date (European options).
• Exchange traded options are tradeable – so if they are not needed, they can be sold on.
Disadvantages of exchange traded options vs OTC options.
• Exchange traded options are normally offered up to two years ahead; OTC options can be agreed for longer periods
• Exchange traded options are in standard contract sizes.
Exchange trade quotations. The prices of exchanges traded options are normally quoted as a price per unit (in cents, so divide by 100) of the contract currency.

Question 29

Steps in exchange traded options hedge.

Answer 29

• Step 1: Now. Contracts should be selected in terms of buying or selling the options contract currency – choosing the closest standardised options date after the transactions date and a logical exercise price (e.g. cheapest or closest to current spot rate). Assess any shortfall or surplus if option exercised (this can be covered with forward contract). Calculate the premium, this must be paid immediately.
• Step 2: In the future. Calculate the outcome if the option is exercised (or whether the spot rate is better). If unsure assume the option is exercised (this giver a worst-case scenario since if the option is not exercised it means that the spot rate is better).
• Step 3: In the future. Calculate the net position, taking into account the premium (step 1), and the outcome (step 2, including any surplus or shortage if the option is exercised).

Question 30

Advantages of currency options.

Answer 30

• Currency options do not need to be exercised if it is disadvantageous for the holder to do so.
• Holders of currency options can take advantage of favourable exchange rate movements in the cash market and allow their options to lapse. The initial fee paid for the options will still have been incurred, however.

Question 31

Disadvantages of currency options.

Answer 31

• The have a cost (premium).
• Options must be paid for as soon as they are bought
• Tailor-made options lack negotiability
• Traded options are not available in every currency

Question 32

Netting

Answer 32

Netting is setting the debtors and creditors in the group resulting in the net amount either paid or received. There are two types of netting:
• Bilateral Netting. In the case of bilateral netting, only two companies are involved. The lower balance is netted against the higher balance and the difference is the amount remaining to be paid.
• Multilateral Netting. Multilateral netting is a more complex procedure in which the debts of more than two group companies are netted off against each other. Multilateral netting involves minimising the number of transactions taking place through each country’s banks. This would limit the fees that these banks would receive for undertaking the transactions.
Disadvantages may include:
• The central treasury may have difficulties in exercising control that the procedure demands.
• Subsidiary company’s result may be distorted if the base currency is weakened in the sustained period.

Question 33

Matching.

Answer 33

Matching. This is the use of receipts in a particular currency to match payment in that same currency. Wherever possible, a company that expects to make payments and have receipts in the same foreign currency should plan to of set it payments against its receipts in that currency. Since the company is offsetting foreign payment and receipt in the same currency, it does not matter whether that currency strengthens or weakens against the company’s domestic currency because there will be no purchase or sale of the currency. The process of matching is made simply by having a foreign currency account, whereby receipts and payments in the currency are credited and debited to the account respectively. Probably, the only exchange risk will be limited to conversion of the net account balance into the domestic currency. This account can be opened in the domestic country or as a deposit account in oversees country.