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Lecture 9 Managing Foreign Exchange Exposure Further tools

Learning Objectives

Learn how different types of exposure are measured

Gain knowledge of approaches to hedging transaction exposure

Understand and be able to apply further risk management instruments and techniques

Forward hedge

Futures hedge

Money market hedge

Option hedge

Analyse and compare the advantages and disadvantages of different approaches under different circumstances

Reading: Madura and Fox, Ch 11

Wang, Peijie, Ch 15-16

Management of transaction exposure

Is to control and reduce the risk

Of exchange rate fluctuations

Involved in these contractual transactions

Managing transaction exposure

Tools employed to manage exposure

To hedge the risks firms might use the tools we have largely discussed already

Forward hedge

Futures hedge

Money market hedge

Option hedge

Forward or futures contract

Recall that these contracts

Agree to exchange a specific amount of foreign currency

At a specific exchange rate

At a specified future point in time.

Note also that both parties

Are obliged to exchange

So both face downside risks

Though these may be offset by gains elsewhere

Features of a Forward/Futures Hedge

Advantages/disadvantages

Forward market gains offset spot market losses exactly;

Spot market gains may also be offset by forward market losses

Cash inflows/ receivables	Cash outflows/ payables	Features
Short position on the foreign currency	Long position on the foreign currency	Right and obligations

Example of Forward Hedge

Suppose a British importer of home electric appliances

Has made orders for the coming year.

Payment of €10 million in Euros is due in twelve months.

If the current prevailing exchange rate of £0.6757/€.

The cash outflow in pounds would be £6.757 million

But if the exchange rate is increased to £0.7246/€,

The payment in pounds would be £7.2464 million,

An increase of £0.4894 million (=7.2464 – 6.757)

Or 7.24% more than the payment if the exchange rate were kept unchanged

Example Forward Hedge

Therefore, the importer

Decides to enter into a forward contract

With a forward exchange rate being £0.6934/€

The importer has effectively fixed

The amount of payables or cash outflows in sterling

At £6.934m = €10m * £0.6934/€

No matter what the exchange rate will be in twelve months

The forward hedge gain is (S1-F0,1)€10m,

Where S1 is the spot exchange rate at the end of the contract period, F0,1 is the forward exchange rate contracted at the beginning of the period for delivery at the end of the period

Forward Hedge Example

£/€

0.6934

Gain/loss in £m

0.6250

0.7692

0.758

-0.684

Forward hedge for payables – gains and losses

(S1-F0,1)  €10m =(0.6250-0.6934)*10m =-0.684

(S1-F0,1)  €10m =(0.7692-0.6934)*10m =0.758

Forward Hedge Example

If the spot rate in 12 months is £0.7692/€,

the forward gain is (£0.7692/€ – £0.6934/€)  €10m

= £0.758m

If the spot exchange rate in twelve months is £0.6250/€,

then the forward loss is (£0.6250/€ – £0.6934/€)  €10m

= – £0.684m

Forward Hedge Example

If the importer does not enter into a forward contract

the spot gain is derived as (F0,1–S1)€10m

exactly the opposite to that of the forward gain

To, briefly repeat the example from before

If the spot exchange rate in twelve months is £0.7692/€

the spot loss is (£0.6934/€ – £0.7692/€)  €10

= – £0.758m

If the spot exchange rate in twelve months is £0.6250/€

the spot gain is (£0.6934/€ – £0.6250/€)  €10

= £0.684m

Forward Hedge Example

£/€

0.6934

Gain/loss in £m

0.6250

0.7692

-0.758

0.684

Un-hedged position of payables – gains and losses

Forward Hedge Example

The gain in the forward (spot) market

is exactly offset by the loss in the spot (forward) market

We have discussed this already

Explained as covered interest rate parity

And since the gains / losses off-set

There is no arbitrage possible

Futures Hedge

A futures hedge works in the same way as a forward hedge,

To lock in the future exchange rate

At which the firm will buy or sell a currency

When the futures contract/product is held

Until maturity/expiry

A futures hedge works exactly the same as a forward hedge over the same period

So again this relates to covered interest rate parity

Without arbitrage

Money Market Hedge

This does not involve the use of a derivative

But (un)covered interest rate parity is related to the approach

Involves borrowing in domestic / foreign country

And then saving in the other country

By an amount equivalent to the amount receivable / payable

For example (simplified)

Expect to receive US$10000 in three months

So borrow this amount now

Convert to £ and invest for three months

Use $US receipt in three months to pay back loan

Features of a Money Market Hedge

Advantages/disadvantages

Simple and works exactly the same if IRP holds;

IRP may not hold and there can be shortfall or excess in payables or receivables but that is not the case with a money market hedge

Cash inflows/ receivables	Cash outflows/ payables	Features
Borrow the foreign currency	Borrow the domestic currency	Borrow, save and repay

Money Market Hedge

This does not make use of the derivatives we have already discussed

However a money market hedge is related to covered interest rate parity

When CIRP holds in absence of transaction costs,

A money market hedge

Will yield the same result as forward hedge

Money Market Hedge

To hedge future foreign currency inflows/ receivables, a firm may

Step 1: Borrow the foreign currency

Step 2: Sell the foreign currency for the domestic currency now

Step 3: Let it grow at the domestic interest rate

Step 4: Repay the borrowed foreign money plus interest

Money Market Hedge

To hedge future foreign currency outflows/ payables, a firm may:

Step 1: Borrow the domestic currency in the domestic money market.

Step 2: Convert the borrowed domestic currency into the foreign currency now

Step 3: Let the money grow at the foreign interest rate

Step 4: Repay the borrowed domestic currency plus interest

Money Market Hedge Example

Using the same example as in the forward hedge case, plus additional information:

Forward rate F0,1 = £0.6934/€

Spot rate S0 = £0.6757/€

r€ = 1.50%, r£ = 4.15% (effective in one year)

Spot rate S1 = £0.7692/€

Money Market Hedge Example

Step 1: The PV of €10 million payable in one year

is €10m/(1+0.015) = €9.8522m.

Given the current exchange rate of £0.6757/€

the importer needs to borrow €9.8522m * £0.6757/€

= £6.6571m in the domestic currency

Step 2: Convert the borrowed domestic currency into the foreign currency now:

£6.6571m  €9.8522m

Step 3: Let the money grow at the foreign interest rate: €9.8522m(1+0.015)

= €10m = payables

Money Market Hedge Example

Step 4: The domestic currency borrowing incurs interest

so the amount of repayment in twelve months

is the principal plus the interest,

being £6.6571m (1+0.0415) =£6.9334m.

This is the same amount the importer would pay with the forward hedge

Forward/Futures Hedge v. Money Market Hedge

The results of money market hedge

can be compared with the results of forward or futures hedge

to determine which type of hedging is preferred

When CIRP holds in the absence of transaction costs,

A money market hedge will yield the same result as a forward hedge

Forward/Futures Hedge v. Money Market Hedge

When CIRP does not hold

Forward/Futures hedge is preferred in hedging receivables if:

Forward/Futures hedge is superior in hedging payables if:

Forward/Futures Hedge v. Money Market Hedge

When CIRP does not hold	Cash inflows/receivables	Cash outflows/payables
	Forward/Futures Hedge Money Market Hedge	Money Market Hedge Forward/Futures Hedge

Options contracts

As for forwards and futures these contracts

Agree to exchange a specific amount of foreign currency

At a specific exchange rate

At (or until) a specified future point in time.

However in contrast

Only one party is obliged to exchange

So the buyer of an option

Does not face downside risks beyond the cost of buying the option

Option Hedge

Advantages/disadvantages

No contractual obligation to exercise,

Only (small) part of the spot market gain may be offset by the option loss

Cash inflows/ receivables	Cash outflows/ payables	Features
Long in put on the foreign currency	Long in call on the foreign currency	Right but no obligations

Currency Option Hedge

A currency option hedge

Involves the use of currency call or put options

To hedge transaction exposure

Since options do not involve obligations to exercise

Firms will be insulated from adverse exchange rate movements,

While still benefitting from favorable movements

However, firms must assess

Whether the option premium paid is worthwhile

Example of a Currency Option Hedge

Using the same information as in the forward hedge and money market hedge examples, plus additional information:

The exercise price X is £0.6934/€

The option premium/price c0 is £0.02 per euro

The cost of option at maturity, r£ = 4.15%

Is £0.02(1+0.0415) = £0.02083 per euro

Or £0.2083m for €10m

Taking the diagram that we used for payoffs for an option

We can see what the gains or losses might be

Currency Option Hedge Example

If the spot rate in 12 months is £0.7692/€,

The option will be exercised

The net option payoff is

(£0.7692/€ – £0.6934/€)€10m – £0.2083m = £0.5507m

If the future spot exchange rate in twelve months

Is £0.6934/€ or lower,

The currency option will not exercised,

The option payoff is –£0.2083m (the cost of buying it)

Currency Option Hedge Example

£/€

0.6934

Gain/loss in £m

0.6250

0.7692

0.5507

Option hedge for payables – gains and losses

0.2083

Option payoff

Spot market payoff

Net gain / loss

0.4757

Should Firms Hedge?

In general, hedging policies vary with the MNC management’s

Degree of risk aversion

And exchange rate forecasts

The hedging policy of an MNC

May be to hedge most of its exposure

None of its exposure,

Or to selectively hedge its exposure

Should Firms Hedge?

Some currency inflows and outflows offset each other

And so need not be hedged individually and totally

Only the net flows need be hedged

Currency diversification.

When an MNC’s currency “portfolio” is more diversified

There is less need to hedge exposure with derivatives.

Some of them can hedge each other

Conclusion

This session has brought together

The concept of transactions exposure that we discussed earlier

Together with the different financial instruments that we examined earlier

We have noted that

The use of forward or futures contracts

Might be matched by the use of a money market hedge

Options contracts may be used to hedge

But the absence of downside risk means a cost

Next time we will discuss the management of

Economic Exposure

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