E2. The use of financial derivatives to hedge against forex risk Flashcards
(33 cards)
Types of foreign currency risk
- 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.
Spot rate and spreads.
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.
Options to manage these foreign currency risks (internal)
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.
Options to manage these foreign currency risks
Do nothing.
In the long run, the company would ‘win some, lose some’. This method:
• Works for small occasional transactions
• Saves in transaction costs
• Is dangerous!
Options to manage these foreign currency risks
Invoicing in domestic currency.
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
Options to manage these foreign currency risks
Leading.
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.
Options to manage these foreign currency risks
Lagging.
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!
Options to manage these foreign currency risks
Matching payments and receipts.
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.
Options to manage these foreign currency risks
Netting.
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
Forward contracts.
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.
Close-out of forward contracts.
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
Forward contracts adv vs disadv
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
Money market hedging.
Hedging a receipt.
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)
Money market hedging.
Hedging a payment.
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.
Synthetic foreign exchange agreements (SAFEs)
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.
Futures (derivative).
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.
Futures features.
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.
Advantages of futures.
- 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.
Disadvantages of futures.
- 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.
Steps in a future hedge
• 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.
Currency swaps.
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.
Currency swaps enable a company to:
• 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).
Currency swaps process
Process (same as interest swap):
• Assess potential for gain from swap
• Swap, variable rate at LIBOR, designed to split gain 50:50
Advantages of currency swaps.
- 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.
