MANAGEMENT OF CURRENCY

Introduction
The foreign exchange markets is the mechanism by which buyers and sellers of currencies are able to meet their foreign currency requirements. Form the interaction of those who supply and demand currencies, exchange rate are established for two types of transactions: (i) (ii) spot exchange (transactions) forward exchange transactions

1. Spot exchange transactions These transactions occur when currencies are traded for delivery within one or two days. For example, a Kenyan importer may need French Francs now to pay for a shipment of perfume that has been received. Of course, the importer exchanges Kshs. For Francs at the spot rate i.e the rate of immediate delivery. 2. Forward exchange transactions These occurs when purchases and sellers contract to buy and sell currencies for delivery at future date They contract for a specific amount of the currency, at a (i) specific rate of exchange and at a (ii) specific future delivery date. They contract for specific amount of the currency, at a (i) specific rate of exchange and at a (ii) specific future delivery date In other words, the forward rate is state the time the parties enter into the contract and remains constant regardless of future exchange rate shifts. Quoting a forward exchange rate A forward exchange rate might be higher or lower than spot rate. If higher, the quoted currency would be cheaper forward than spot (Note we are using indirect quote. For example, assume a foreign currency is quoted against sterling pound as follows Spot rate 3 months forward Required a) Determine the amount of Sterling pound required to buy (banks sells ) 2m foreign currency (i) (ii) currency at spot rate 3 month time under forward 1:F2156-2166 : F2207-2222

b) Compute amount of sterling one would get if he was to sell (Bank buys) 2 million of foreign

(i) (ii) Solution

at spot rate 3 month time under forward exchange contract

Home currency - a) The bank sells F2,000,000 (i) At the spot rate (ii) in 3 months b) the bank buys F2,000,000 (i) At spot rate = 2,000,000 2166 = 923.36 = 900.09 = 2,000,000 2156 = 2,000,000 2207 = 927.64 = 906.21

(ii) In 3 month time = 2,000,000 2222

In both cases the foreign currency is worth less against (cheaper) , in forward contract than at the currency spot rate. This is because it is quoted forward as a cheaper rate or at a discount against (sterling). If forward exchange rate is lower than spot rate then the quoted currency would be more pensive forward than spot. Example Spot 1: DM 3.05-3.06 The 3 month forward 1: DM 3.03-3.04 ) Under such a case, DM is more expensive forward than spot and is said to be quoted at a premium. Forward rate are not quoted independent but as adjustments to spot rates. If forward rate is less expensive than spot rate, it is quoted as a premium to spot rate. The forward rate would be higher than spot rate by amount of premium. Note A discount is added to a spot rte and a premium is subtracted fro a spot rte (indirect quotes). Strategies for Managing Foreign Exchange Risk Recall, exchange risk results from possible changes in the value of one currency relative to another. The change could be either in the positive or negative direction. Accordingly, the elimination of all foreign exchange rate fluctuations appear more likely than looses then it may make sense to bear the exchange rate risk , the retain the exchange risk exposure so that gains may be realized i.e lag Strategic for minimizing eliminating exchange rate risk exist

a) Methods involving third parties (i) (ii) (iii) (iv) (v) i) ii) iii) iv) v) vi) Forward exchange market hedge Financial money market hedge Foreign currency options Future markets Swaps Leading and lagging Matching Netting off Currency cocktail Invoice goods in local currency Bills of exchange

b) Methods of involving 3rd parties

Hedging strategies/methods 1. Forward Exchange contract (forward exchange hedge) It is possible to gain protection against foreign exchange exposure (risk) by making a forward exchange contract with a bank Definition A forward exchange contract is an agreement to exchange currencies of two different countries at a specified rate (i.e the forward rate) on a stipulated future date. NB e.g If spot rate = Sh. 50 and forward rate = Sh. 47, discount = sh. 3 If spot rate = Sh. 50 and forward rate = Sh. 52, premium = Sh. 2 The objective of the forward exchange contract from firms viewpoint is to totally eliminate any risk (uncertainty) regarding the cash flows associated with a transaction. Illustration I (Exposed net assets position) At the time the contract is made, the forward rate normally varies from the spot rate The difference between the two rates is referred to as discount if the forward rate is less than the sport rate If the forward rate is greater than the spot rate, it is referred to as a premium.

1. Assume a Kenyan exporter sells goods to a British importer for 10,000 with payment due in 60 days. 2. Assume the spot rate is Kshs. 50 for one British pound 3. Assume the Kshs. Is expected to appreciate in value relative to the pound (i.e exported net asset position). 4. Assume that in order to minimize the transaction exposure, the Kenyan exporter enters into a forward contract with a commercial bank in town whereby the exporter sells 10,000 for future delivery to the bank in 60 days time. The agreed forward rates Kshs. 49. Required Calculate the value of the receivable to the Kenyan exporters in Kshs. Solution After 60 days, the exporter delivers the 10,000 against he forward exchange contracts and receives Kshs. 490,000 (10,000*49). NB By use of the forward contract, the Kenyan exporters kwon the exact worth of the future cash flow receipt and hence risk is totally eliminated. If the forward exchange transaction had not been entered into, the exporter would have converted the pounds on the 60th day of whatever spot rate existed. Hence, if the spot rate on Sh. 47, the exporter would have relieved only Sh. 470,000 i. 10,000 x Sh. 47). Illustration 2 1. 2. 3. 4. Required The cash liability for the Kenyan company Solution 30 days after the contract, the Kenyan exporter will buy $20,000 from the bank at an agreed price of Sh. 30 (i.e total cost of the transaction equal sh. 600,000 (20,000*30). Accordingly, the forward exchange risk is wiped completely. Financial (money) market hedge strategy Assume a Kenyan exporter buys goods form the Untied States for $20,000 with payment assume the spot rate is Kshs. 28 for one US dollar Assume the Kshs. Is expected to depreciate in value relative to the dollar (i.e Exposed Net Assume that the Kenyan importer enters into a forward contract which stipulates that it can due in 30 days.

Liability Position. buy US dollars after 30 days at kshs. 30 per dollar.

This type of strategy involves borrowing and/or lending in the financial market. Hence a) an exposed asset position is hedged (covered), by creating a liability of the same amount and maturity denominated in the foreign currency. The amounts borrowed are converted in Kshs. At present spot rate and invested locally. b) An exposed liability position is hedged by acquiring assets (lending/deposit) of the same amount and maturity in the foreign currency. The objective of the hedging strategy is to have minimum risk exposure by holding low levels of assets liability in foreign currency. This eliminates (reduces) exchange risk since the loss in the liability is exactly offset by the gain in the value of the asset when the foreign currency appreciates and vice versa. 3. Currency options A major drawback of forward exchange contract is that it is a biding contract that must be performed. Usually an exporter may not be certain about amount of currency they would earn in several months time and would be unable to enter a forward exchange contract without contracting to pay more or less to books. Currency option overcomes this problem. A currency options is an agreement whereby a company buys the rights (but not the obligation) to buy or sell a certain quantity of a specified currency at a stated rate of exchange and as a specified future time. There are two types 1. 2. underlying currency risk. Options are useful to companies in following situations 1. When there is uncertainty about foreign currency receipts or payments either in amount or timing. 2. To support a tender for an overseas contract priced in foreign currency 3. To allow the publication of price lists for goods in a foreign currency 4. To protect the import or export of price sensitive goods. Limitations of currency options 1. The cost is usually high (appropriately 5% of the option value) 2. Options must be paid for as soon as they are bought 3. Traded options are not available in every currency Stranddle Call option gives buyer or option (holder) the right to buy the Put option gives the buyer of option (holder) the right to sell the underlying currency of a fixed exchange rate .

Unlike futures, options can be used to give profits if the trader feels that prices are likely to be related but is uncertain whether they will go up or down . This can be done by buying a call option and a put option for the specific amount. Such a combination is referred to as a straddle. The profitability of such a strategy would depend upon future spot rate. The straddle strategy involves the purchase of two options one call and one put so that two premiums are payable. These can be avoided by arranging a zero cost option. Zero cost option strategy involves simultaneous purchase and sell of two separate option contract so that premium receivable on sell tends to offset premium payable on purchase (low-cost option).

4. Use of future contracts Futures are a form of a forward contract which gives a fixed rate for security prices or exchange rates or interest rates at a future date. It is a standardized contract covering the sale in purchase at a future date of a set of quantity of a commodity, financial investment or cash. Future markets exist for commodities including sugar, gold, silver, wool and coffee. They serve the useful function of permitting suppliers and consumers to plan on the basis of known future prices. Currency futures are contracts to buy or sell quantity of a foreign currency at a future date and so in this respect, they are similar to forward exchange contract. The purchaser of a future contract must deposit assume as a collateral for the contract known as the margin which might take the form of a bank letter or credit treasury bill or cash. The margin varies daily according to changes in value of the contract. Future contracts can be closed out i.e the contract in the market to realize any profit or loss without actually taking delivery of the underlying currency. Differences between future and forward contracts 1. 2. European terms generally 3. 4. Size Trading Futures contracts are standardized and fixed of small amounts while Forward contract are effected by E-mails, telephone and telex forward contracts are individual tailored and of larger amounts. Margins forward market. Quotes Future are quoted in America terms and forward contracts in They are required on all participants in the futures market but not on

communications. Future contracts are traded in formal organized exchanges such a Chicago mercantile exchange (ME), Singapore physical meetings. 5. whose delivery date of contract is specified in advanced. 6. 7. Transaction Future contract cost is a percentage cost commission. For forward contract, its based on difference between buying and selling (spread) Credit risk - This is borne by each party in a forward contract while the exchange clearing house to which a margin is paid incase of a future contract reduces the credit risks substantially. 8. 9. Regulation - Forward contract are self regulating while future contracts are regulated by commodity futures trading commission. Settlement - Forward contracts are settled on a date agreed upon between the customer and the bank while futures contract are settled on daily basis in exchange clearing house. Gains on positions values may be withdrawn and losses colleted daily (marketing to market) 5. Swaps A swamp is an agreement between two or more parties to exchange cash flows related to specific underlying obligations. They are of two types. a) currency swamps (back to back loan) This involves exchanging obligations for conveniences. It is arranged by an intermediary (bank) for two large companies with opposite risks e.g where a Kenyan firm required UK in 3 months and a UK firm requires Kshs. In 3 months time, the Kenyan firm will swap the Kshs. For UK with the UK firm today and place the UK in UK bank until it is required. b) Interest rate swamps Used to hedge against interest rate movement A firm with a stream floating interest rate obligation will swamp with anther firm for a stream of fixed interest rate obligation. The two firms have different borrowing strengths in the capital markets A fixed to floating interest rate swamps involves a lesser credit worthy firms which funds itself virtually unable to obtain long term fixed rate funds. It will thus swamp in obligation to make floating rate payments with a more credit worth institution e.g bank which is better able to gain long term fixed rate financing through the bon market. Reversal Futures contracts can be easily reversed unlike forward contracts International Monetary Exchange (SIMEX) etc

Alternatively, a firm with a fixed rate loan (which believes that interest rate are likely to fall in future) could swamp into a floating interest rate with the attention of taking advantage of anticipated decline in interest rates. Also, to guard against rise in interest rate, a firm could arrange a cap agreement with a swamp in termediary so that if the floating interest rate went above the cap (agreed limit) the firm will on y have to ay interest at the cap level. Benefits of swaps to a company 1. Favourable interest rate 2. Low transaction costs these are limited to legal fees and arrangement fees 3. off-balance sheet financing swamp arrangements are forward contingent agreement/arrangements and are accounted for of the balance sheet. 4. Flexibility swamps can be arranged for any swamp of a ranging time period and reversed by reswampping with other counter parties. 5. Cost foreign currency loans are cheaper if raised by institutions in relevant foreign currency. 6. A currency swamp enables a firm to raise funds in its own currency and swamp this obligation with a foreign firm in the required foreign currency. 7. Access to capital markets for firms which cannot approach the marketer directly for low cost fixed interest funds e.g debentures are only available to large firms. 8. Change in structure of loan obligation. A firm can change the structure of loan obligations without having to redeem the loan e.g if a company has a fixed rate loan and believes interest rates will decline, they can swamp with a floating rate loan. Types of risk associated with swaps 1. Credit risk The risk that the counter party to a swamp will default before the end of swap and fail to carry out the agreed obligation. Such risk is reduced if a reputable bank is sued as an intermediary to the deal. 2. Sovereign risk Risk associated with country in whose currency a swap is considered. It covers political instability or possibility of exchange controls being introduced. 3. Market risk Risk that interest rate or exchange rates would move unfavourably for the company after commitment to a swap.

Methods which do not involve third parties are:

a) Leading and lagging strategies These strategies involve the speeding or delay in payment of a liability on disposal of asset Leading involves (i) (ii) Lagging (i) (ii) delay the collection against an asset when in a currency with a potential to appreciate delay the payment against a liability denominated in weak currency. Expediting the disposal of an asset when dominated in a potentially depreciating currency. Expediting the payment against a liability if denominated in a potentially appreciating currency.

b) Matching receipts and payment e.g 2 months debtors and 2 months creditors The exchange gains are thus offset by exchange losses. This is used by firms with large cash inflows and outflows. c) Netting offsimilar currencies with expectation that they will move in the same direction in foreign market e.g Kshs. And Tsh. Will gain or loose in the market. d) Currency cocktail involves a weighed currency of more than one currency (many currencies) it involves diversification of risk in a portfolio of currencies hence reducing the overall risk effect. e) Invoice goods in a local currency This is passing the risk to the importer since he will pay the fixed amount in local currency. The exporter receives the fixed amount and bears no risk. f) Bills of exchange this is where an exporter drawn up a B.O.E on his foreign customer. The customers bank guarantee to pay up if the customer fails to pay. The exporter then sells the B.O.E to obtain his cash immediately. However, he will receive less than the face value of the B.O.E due to commission paid to the purchaser. Participants of foreign exchange markets Large commercial banks Foreign exchange brokers n interbank markets Commercial customers e.g MNC Central banks which intervene time to time to maintain target exchange rate and smooth rate fluctuation. Participation in forward markets Arbitrageurs they all reduce exchange risk by locking in the exchange rat on future trade or financial operations. Traders the exchange rate on future trade or financial operations Hedgers

Speculators they full expose themselves to currency risk by trying to gain from exchange rate fluctuations.