Forex hedging Flashcards
(24 cards)
Quoting exchange rate
Establish base currency
Foreign currency risk (TET)
Transaction risk - short-term
Economic risk - long-term
Translation risk
Pre-hedging considerations (Za’atar)
Attitude to risk
Shareholders
Portfolio effect
Insolvency risk
Costs
Exposure
Direct risk reduction methods (goal)
Leading/lagging
Invoice currency
Match assets / liabilities
Match receipts / payments
No hedge receipt
Amount due / ask spot price on date of transfer
Forwards
An agreement to buy or sell an amount of a currency in the future for a set price in another currency
Receipt = amount due / forward rate
Forward rate = current ask spot price + forward discount
Forwards pros and cons
Lock in a price to hedge downside risk
Tailored to the investor (OTC)
vs
Loss of upside potential
Difficult to unwind
Interest rate parity
After accounting for the difference in interest rates, an investor should expect the same return on an investment no matter what currency they invest in
Interest parity holding calculations
Average forward rate = average spot rate * (1 + pro-rated average interest rate 1 ) / (1 + pro-rated average interest rate 2)
Average spot rate rise = average forward rate - average spot rate rise
Average premium on spot rate = average exchange rate discount
Purchasing power parity
After applying the exchange rate, goods in one country will cost the same no matter where they are traded
Implications of late payment by customer
Forward = Obliged to exchange on time
Company - borrow/buy to fulfil contract
M-M hedge = Depends on loan terms
Currency option - Does not matter
FX futures
Standardised contracts to buy a set amount of a currency at a set rate at a set date in the future
1. Number of contracts = amount due / futures price 1 / standard contract size
2. Rate difference = futures price 2 - futures price 1
3. Total gain/loss = number of contracts * rate difference * standard contract size
4. Receipt = (amount due + total gain/loss) / ask spot price on date of transfer
FX futures pros and cons
Lock in a price to hedge downside risk
Can close out position at any time
vs
Loss of upside potential
Standardised contracts = over/under hedging
Basis risk if maturity date ≠ transaction date
Must post margin to exchange as collateral
Currency options pros and cons
Protect from downside risk
Allows buyer to gain from upside potential
vs
Expensive
Paid upfront
Standardised = over/under hedge (traded)
Not available in all currencies (if traded)
Forwards > futures
Contracts tailored to user’s requirements = less hedge inefficiencies = less basis risk
Unlimited currencies available
Less complex to use
Futures > forwards
Lower transaction costs
Exact date of receipt / payment of currency does not have to be known
Problems presented by using crypto for international transactions
Exchangeability
Price volatility
Money market hedges
- Borrow foreign currency at pro-rated (1+borrowing rate)
- Convert foreign currency into domestic currency immediately at spot rate
- Deposit domestic currency at pro-rated (1+depositing rate) and settle foreign currency loan upon receipt
Money market hedges pros and cons
Lock in a price to hedge downside risk
Tailored to the investor
vs
Loss of upside potential
Difficult to unwind
More expensive / effort
Currency options (Traded)
- Calculate number of contracts
= receipt / exercise price / standard contract size - Calculate premium paid
= contracts x standard contract size x June call premium (convert at bid spot rate)
3a. Exercise option if spot rate higher than exercise price
3b. Let option lapse if spot rate lower than exercise price
3c. Gain = (ask spot price on exercise date - exercise price) * number of contracts * standard contract size - Net receipt =
Amount due / spot rate
Gain on hedge / spot rate
(Premium)
Currency options (OTC)
- Decide to use put / call options
- Premium = amount due * premium
3a. Exercise option if spot rate higher than exercise price
3b. Let option lapse if spot rate lower than exercise price
Receipt= amount due/ put price - premium
Post-hedging considerations
Compare value of payment / receipt at earlier / current / future spot spot rates
Compare results of different hedging options
Evaluate the forward rate implications
- e.g. $ receipt expected and $ trading at discount in the forward market
= Weakening of $? Cause to hedge?
Overseas trading risks
Physical
Credit
Trade
Liquidity
Hedging economic exposure
Diversify global operations / production
Weigh benefits of operating in each market vs economic risk
Product management
Pricing
