Hedging Foreign Exchange Exposures

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Hedging Foreign Exchange

Exposures

BYMRINMOY

1121610


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Hedging Strategies

Recall that most firms (except for those involved incurrency-trading) would prefer to hedge their foreignexchange exposures.

But, how can firms hedge?

(1) Financial Contracts Forward contracts (also futures contracts)

See Appendix 1 for a discussion of forwardcontracts.

Options contracts (puts and calls) Borrowing or investing in local markets.

(2) Operational Techniques

Geographic diversification (spreading the risk)


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Forward Contracts These are foreign exchange contracts offered by market

maker banks.

They will sell foreign currency forward, and

They will buy foreign currency forward

Market maker banks will quote exchange rates today at which

they will carry out these forward agreements.

These forward contracts allow the global firm to lock in a

home currency equivalentof some fixed contractual

foreign currency cash flow.

These contracts are used to offset the foreign exchange

exposure resulting from an initial commercial or financial

transaction.


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Example # 1: The Need to Hedge U.S. firm has sold a manufactured product to a

German company.

And as a result of this sale, the U.S. firm agrees toaccept payment of100,000 in 30 days.

What type of exposure does the U.S. firm have? Answer: Transaction exposure; an agreement to receive a

fixed amount of foreign currency in the future.

What is the potential problem for the U.S. firm if itdecides not hedge (i.e., not to cover)?

Problem for the U.S. firm is in assuming the risk that theeuro might weaken over this period, and in 30 days it will beworth less (in terms of U.S. dollars) than it is now.

This would result in a foreign exchange loss for the firm.


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Hedging Example #1 with a Forward

So the U.S. firm decides it wants to hedge(cover) this foreign exchange transactionexposure. It goes to a market maker bank and requests a 30

day forward quote on the euro. The market marker bank quotes the U.S. firm a bid

and ask price for 30 day euros, as follows:

EUR/USD 1.2300/1.2400.

What do these quotes mean: Market maker will buy euros in 30 days for $1.2300

Market maker will sell euros in 30 days for $1.2400


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Example #2: The Need to Hedge

U.S. firm has purchased a product from a British company. And as a result of this purchase, the U.S. firm agrees to pay the

U.K. company 100,000 in 30 days.

What type of exposure is this for the U.S. firm?

Answer: Transaction exposure; an agreement to pay a fixed amount

of foreign currency in the future.

What is the potential problem if the firm does not hedge?

Problem for the U.S. firm is in assuming the risk that the pound might

strengthen over this period, and in 30 days it take more U.S. dollars

than now to purchase the required pounds. This would result in a foreign exchange loss for the firm.


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Hedging Example #2 with a Forward

So the U.S. firm decides it wants to hedge(cover) this foreign exchange transactionexposure.

It goes to a market maker bank and requests a 30

day forward quote on pounds. The market maker quotes the U.S. firm a bid and ask

price for 30 day pounds as follows:

GBP/USD 1.7500/1.7600.

What do these quotes mean:

Market maker will buy pounds in 30 days for $1.7500

Market maker will sell pounds in 30 days for $1.7600


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So What will the Firm Accomplished with the

Forward Contract?

Example #1: The firm with the long position in euros: Can lock in the U.S. dollar equivalent of the sale to the

German company.

It knows it can receive $123,000

At the forward bid: $1.2300/$1.2400 Example #2: The firm with the short position in

pounds:

Can lock in the U.S. dollar equivalent of its liability to the

British firm: It knows it will cost $176,000

At the forward ask price: $1.7500/$1.7600


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Advantages and Disadvantages of the

Forward Contract

Contracts written by market maker banks to thespecifications of the global firm.

For some exact amount of a foreign currency.

For some specific date in the future.

No upfront fees or commissions. Bid and Ask spreads produce round transaction profits.

Global firm knows exactly what the home currencyequivalent of a fixed amount of foreign currency will be

in the future. However, global firm cannot take advantage of a

favorable change in the foreign exchange spot rate.


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Foreign Exchange Options Contracts One type of financial contract used to hedge

foreign exchange exposure is an optionscontract.

Definition: An options contract offers a global

firm the right, but not the obligation, to buy (acall option) or sell (a put option) a givenquantity of some foreign exchange, and to doso:

at a specified price (i.e., exchange rate), and

at some date in the future.


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Foreign Exchange Options Contracts Options contracts are either written by global banks

(market maker banks) or purchased on organizedexchanges (e.g., the Chicago Mercantile Exchange).

Options contracts provide the global firm with:

(1) Insurance (floor or ceiling exchange rate) against

unfavorable changes in the exchange rate, and additionally (2) the ability to take advantage of a favorable change in the

exchange rate.

This latter feature is potentially important as it is

something a forward contract will not allow the firm todo.

But the global firm must pay for this right.

This is the option premium (which is a non-refundable fee).


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A Put Option: To Sell Foreign Exchange Put Option:

Allows a global firm to sell a (1) specified amountof foreign currency at (2) a specified future dateand at (3) a specified price (i.e., exchange rate) allof which are set today.

Put option is used to offset a foreign currency longposition (e.g., an account receivable).

Provides the firm with an lower limit(floor) price forthe foreign currency it expects to receive in the future.

If spot rate proves to be advantageous, the holder willnot exercise the put option, but instead sell the foreigncurrency in the spot market.

Firm will not exercised if the spot rate is worth more.


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A Call Option: To Buy Foreign Exchange

Call Option: Allows a global firm to buy a (1) specified amount

of foreign currency at (2) a specified future dateand at a (3) specified a price (i.e., at an exchangerate) all of which are set today. Call option is used to offset a foreign currency short

position (e.g., an account payable).

Provides the holder with an upper limit(ceiling) pricefor the foreign currency the firm needs in the future.

If spot rate proves to be advantageous, the holder willnot exercise the call option, but instead buy the neededforeign currency in the spot market.

Firm will not exercise if the spot rate is cheaper.


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Overview of Options Contracts Important advantage:

Options provide the global firm which the potential to take

advantage of a favorable change in the spot exchange rate.

Recall that this is not possible with a forward contract.

Important disadvantage:

Options can be costly:

Firm must pay an upfront non-refundable option premium which it

loses if it does not exercise the option.

Recall there are no upfront fees with a forward contract.

This fee must be considered in calculating the home currency

equivalent of the foreign currency.

This cost can be especially relevant for smaller firms and/or those

firms with liquidity issues.

See Appendix 2 for a further discussion of options contracts.


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Hedging Through Borrowing or Investing in

Foreign Markets

Another strategy used to hedge foreignexchange exposure is through the use ofborrowing or investing in foreign currencies.

Global firms can borrow or invest in foreigncurrencies as a means of offsetting foreignexchange exposure.

Borrowing in a foreign currency is done to offset a

long position. Investing in a foreign currency is done to offset a

short position.


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Specific Strategy for a Long Position Global firm expecting to receive foreign currency in the

future (long position): Will take out a loan (i.e., borrow) in the foreign currency equal

to the amount of the long position.

Will convert the foreign currency loan amount into its home

currency at the spot exchange rate.

And eventually use the long position to pay off the foreign

currency denominated loan.

What has the firm accomplished?

Has effectively offset its foreign currency long position (with the

foreign currency loan, which is a short position).

Plus, immediate conversion of its foreign currency long position

into its home currency.


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Specific Strategy for a Short Position Global firm needing to pay out foreign currency in the

future (short position). Will borrow in its home currency (an amount equal to its short

position at the current spot rate).

Will convert the home currency loan into the foreign currency atthe spot rate.

Will invest in a foreign currency denominated asset

And eventually use the proceeds from the maturing financialasset to pay off the short position.

Global firm has: Offset its foreign currency short exposure (with the foreign

currency denominate asset which is a long position)

Plus immediate conversion of its foreign currency liability into ahome currency liability.

See Appendix 3 for more discussion of this borrowingand lending strategy.


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Hedging Unknown Cash Flows

Up to this point, the hedging techniques we have

covered (forwards, options, borrowing and investing)

have been most appropriate for covering transaction

exposure.

Why? Because transaction exposures have known

foreign currency cash flows and thus they are easy

to hedge with financial contracts

However, economic foreign exchange exposures do

not provide the firm with this known cash flow

information.


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Dealing with Economic Exposure Recall that economic exposure is long term

and involves unknown future cash flows. So this type of exposure is difficult to hedge with

the financial contracts we have discussed thus far.

What can the firm do to manage this economic

exposure? Firm can employ an operational hedge.

This strategy involves global diversification ofproduction and/or sales markets to produce naturalhedges for the firms unknown foreign exchange

exposures. As long as exchange rates with respect to these

different markets do not move in the same direction,the firm can stabilize its overall cash flow.


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A Comprehensive Approach for Assessing and

Managing Foreign Exchange Exposure

Step 1: Determining Specific Foreign

Exchange Exposures.

By currency and amounts (where possible)

Step 2: Exchange Rate Forecasting

Determining the likelihood of adverse currency

movements.

Important to select the appropriate forecasting model.

Perhaps a range of forecasts is appropriate here (i.e.,

forecasts under various assumptions)


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A Comprehensive Approach for Assessing and


Step 3: Assessing the Impact of the Forecasted ExchangeRates on Companys Home Currency Equivalents

Impact on earnings, cash flow, liabilities

Step 4: Deciding Whether to Hedge or Not

Determine whether the anticipated impact of the forecastedexchange rate change merits the need to hedge.

Perhaps the estimated impact is so small as not to be of

a concern.

Or, perhaps the firm is convinced it can benefit from itsexposure.


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A Comprehensive Approach or Assessing and


Step 5: Selecting the Appropriate Hedging

Instruments. What is important here are:

Firms desire for flexibility.

Cost involved with financial contracts.

The type of exposure the firm is dealing with.

Documents

Hedging Foreign Exchange Exposures