Hedging Foreign Exchange Exposures

BY MRINMOY 1121610

Hedging Strategies
Recall that most firms (except for those involved in currency-trading) would prefer to hedge their foreign exchange exposures. But, how can firms hedge?
(1) Financial Contracts Forward contracts (also futures contracts) See Appendix 1 for a discussion of forward contracts. Options contracts (puts and calls) Borrowing or investing in local markets. (2) Operational Techniques Geographic diversification (spreading the risk)

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 equivalent of 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.

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 to accept payment of 100,000 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 it decides not hedge (i.e., not to cover)?
Problem for the U.S. firm is in assuming the risk that the euro might weaken over this period, and in 30 days it will be worth less (in terms of U.S. dollars) than it is now. This would result in a foreign exchange loss for the firm.

Hedging Example #1 with a Forward

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

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.

Hedging Example #2 with a Forward

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

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

Advantages and Disadvantages of the Forward Contract

Contracts written by market maker banks to the specifications 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 currency equivalent 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.

Foreign Exchange Options Contracts

One type of financial contract used to hedge foreign exchange exposure is an options contract. Definition: An options contract offers a global firm the right, but not the obligation, to buy (a call option) or sell (a put option) a given quantity of some foreign exchange, and to do so:
at a specified price (i.e., exchange rate), and at some date in the future.

 Options contracts are either written by global banks (market maker banks) or purchased on organized exchanges (e.g., the Chicago Mercantile Exchange). Options contracts provide the global firm with:

Foreign Exchange Options Contracts

(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 to do.

But the global firm must pay for this right.

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

 Put Option:

A Put Option: To Sell Foreign Exchange

Allows a global firm to sell a (1) specified amount of foreign currency at (2) a specified future date and at (3) a specified price (i.e., exchange rate) all of which are set today.
Put option is used to offset a foreign currency long position (e.g., an account receivable). Provides the firm with an lower limit (floor) price for the foreign currency it expects to receive in the future. If spot rate proves to be advantageous, the holder will not exercise the put option, but instead sell the foreign currency in the spot market.
Firm will not exercised if the spot rate is worth more.

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 date and at a (3) specified a price (i.e., at an exchange rate) 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) price for the foreign currency the firm needs in the future. If spot rate proves to be advantageous, the holder will not exercise the call option, but instead buy the needed foreign currency in the spot market.
Firm will not exercise if the spot rate is cheaper.

 Important advantage:

Overview of Options Contracts

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.

Hedging Through Borrowing or Investing in Foreign Markets

Another strategy used to hedge foreign exchange exposure is through the use of borrowing or investing in foreign currencies.
Global firms can borrow or invest in foreign currencies as a means of offsetting foreign exchange 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.

 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.

Specific Strategy for a Long Position

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.

Specific Strategy for foreign currency in the Global firm needing to pay out a Short Position 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 at the spot rate. Will invest in a foreign currency denominated asset And eventually use the proceeds from the maturing financial asset 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 a home currency liability.

See Appendix 3 for more discussion of this borrowing and lending strategy.

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.

 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 of production and/or sales markets to produce natural hedges 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.

Dealing with Economic Exposure

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)

A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure

Step 3: Assessing the Impact of the Forecasted Exchange Rates 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 forecasted exchange 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 its exposure.

A Comprehensive Approach or Assessing and Managing Foreign Exchange Exposure

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.