Foreign Exchange Risk Management (1)
1 Introduction
Globalisation has served to increase the amount of foreign trade which has in turn increased the amount of foreign currency transactions that companies have. Any dealing in foreign currency presents the problem of the risk of changes in exchange rates. The adoption in most of Europe (but notably not the UK) of a single currency – the euro – has removed the problem for companies trading within Europe, but for trading with companies in other countries an important role of the financial manager is to look for ways of removing or reducing this risk.
This chapter and the next chapter look in detail at the different ways available for the removal or reduction of the risk of changes in exchange rates.
2 Types of risk
Transaction risk
This is the risk that a transaction in a foreign currency at one exchange rate is settled at another rate (because the rate has changed). It is this risk that the financial manager may attempt to manage and forms most of the work in the rest of this chapter.
Translation (or accounting) risk
This relates to the exchange profits or losses that result from converting foreign currency balances for the purposes of preparing the accounts.
These are of less relevance to the financial manager, because they are book entries as opposed to actual cash flows.
Economic risk
This refers to the change in the present value of future cash flows due to unexpected movements in foreign exchange rates. E.g. raw material imports increasing in cost.
3 The foreign exchange market
The foreign exchange market is known as FOREX. The biggest centre is the London FOREX market, although since the market is very competitive virtually no differences exist between one FOREX market and another.
4 Exchange rates
The exchange rate on a given day is known as the spot rate and two prices are quoted, depending on whether we are buying or selling the currency – the difference is known as the spread.
In the examination, the way exchange rates are quoted is always the amount of the first mentioned currency that is equal to one of the second mentioned currency.
For example, suppose we are given an exchange rate as follows:
$/£ 1.6250 – 1.6310
In this quote, the first number (1.6250) is the exchange rate if we are buying the first mentioned currency ($’s), and (1.6310) is the rate if we are selling the first mentioned currency ($’s).
(Alternatively, if you prefer, the first number is the rate at which the bank will sell us $’s and the second number the rate at which the bank will buy $’s from us. It is up to you how you choose to remember it, but it is vital that you get the arithmetic correct!)
A plc receives $100,000 from a customer in the US.
The exchange rate is $/£ 1.6250 – 1.6310.
How many £’s will A plc receive?
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Usually the questions in the examination relate to real currencies (such as dollars and euros). However, occasionally the examiner invents currencies which makes the answer a little less obvious – it becomes even more important that you know the rules.
Jimjam is a company based in India, where the currency is the Indian Rupee (IR). They owe money to a supplier in Ruritania, where the currency is Ruritanian Dollars (R$). The amount owing is R$ 240,000.
The current exchange rate is IR/R$ 8.6380 – 9.2530
How many Indian Rupees will Jimjam have to pay?
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5 Methods of hedging transaction exposure
In the above examples, our answers are (hopefully!) correct provided that we convert the money at the spot rate. The problem is that if the transaction is not going to take place until some time in the future, the exchange rate stands to change. We obviously have no idea what the rate will be – it may change to our advantage or to our disadvantage – and therefore there is risk.
The following methods of removing or reducing this risk are the methods of which you must be aware for the examination:
Invoicing in home currency
Leading and lagging
Netting
Matching
The above methods do not require any special techniques, but in addition you must have knowledge (and be able to perform detailed calculations) of the following:
forward contracts
money market hedges
currency futures
currency options
currency swaps
It is these last five methods that we will go through in this and the following chapters.
6 Forward contracts
If a company wishes to buy or sell foreign currency at some date in the future, then they can obtain a quote from the bank today which will apply on a fixed date in the future. Once the quote has been accepted, that rate is then fixed (on the date, and on the amount specified) and what happens to the actual (or spot) rate on the date of the transaction is then irrelevant.
An alternative way in which you might see forward rates quoted is as follows:
$/£ 1.2845 ± 0.0015
This means that the forward rates are: $/£ 1.2830 – 1.2860
X is due to pay $200,000 in 1 months time.
Spot | $/£ 1.4820 – 1.4905 |
1 month forward | $/£ 1.4910 – 1.4970 |
If X contracts 1 month forward, how much will he have to pay in 1 months time (in £’s)?
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More often, forward rates are quoted as difference from spot. The difference is expressed in the smaller units of currency (e.g. cents, in the case of the US), and is expressed as a premium or a discount depending on whether we should deduct or add the discount to the spot rate.
Y is due to receive $150,000 in 3 months time.
Spot | $/£ | 1.5326 – 1.5385 |
3m forward | 0.62 – 0.51 c pm |
How much will Y receive?
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Z is due to pay $200,000 in 2 months time.
Spot | $/£ | 1.6582 – 1.6623 |
2m forward | 0.83 – 0.92 dis |
How much will Z pay?
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Advantages and disadvantages of using forward contracts:
7 Money market hedging
This approach involves converting the foreign currency at the current spot, which therefore makes future changes in the exchange rate irrelevant. However, if we are (for example) not going to receive the foreign currency for 3 months, then how can we convert the money today? The answer is that we borrow foreign currency now at fixed interest, on the strength of the future receipt.
P is due to receive $5M in 3 months time.
Spot: | $/£ 1.5384 – 1.5426 |
Current 3 month interest rates: | US prime 5.2% – 5.8% |
UK LIBOR 3.6% – 3.9% |
Show how P can use the money markets to hedge the risk.
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Q is due to pay $8M in 3 months time.
Spot: | $/£ 1.6201 – 1.6283 |
Current 3 month interest rates: | US prime 6.4% – 6.9% |
UK LIBOR 9.2% – 9.9% |
Show how Q can use the money markets to hedge the risk.
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Advantages and disadvantages of using the money markets:
8 Currency futures
If we buy a sterling futures contact it is a binding contract to buy pounds at a fixed rate on a fixed date. This is similar to a forward rate, but there are two major differences:
delivery dates for futures contracts occur only on 4 dates a year – the ends of March, June, September and December.
futures contracts are traded and can be bought and sold from / to others during the period up to the delivery date.
For these two reasons, most futures contracts are sold before the delivery date – speculators use them as a way of gambling on exchange rates. They buy at one price and sell later – hopefully at a higher price. To buy futures does not involve paying the full price – the speculator gives a deposit (called the margin) and later when the future is sold the margin is returned plus any profit on the deal or less and loss. The deal must be completed by the delivery date at the latest. In this way it is possible to gamble on an increase in the exchange rate. However, it is also possible to make a profit if the exchange rate falls! To do this the speculator will sell a future at today’s price (even though he has nothing to sell) and then buy back later at a (hopefully) lower price. Again, at the start of the deal he has to put forward a margin which is returned at the end of the deal plus any profit and less any loss.
The role of the financial manager is not to speculate with the company’s cash, but he can make use of a futures deal in order to ‘cancel’ (or hedge against) the risk of a commercial transaction.
Here is a simple example (note that there are more limitations that are ignored in this example but will be explained later – this example is just to illustrate the basic principle.).
R is in the US and needs £800,000 on 10 August.
Spot today (12 June) is: | $/£ 1.5526 – 1.5631 |
September $/£ futures are available. The price today (12 June) is 1.5580.
Show the outcome of using a futures hedge (assuming that the spot and the futures prices both increase by 0.02).
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Note:
the futures price on any day is not the same as the spot exchange rate on that date. They are two different things and the futures prices are quoted on the futures exchanges – in London this is known as LIFFE (the London International Financial Futures Exchange). More importantly, the movement in the futures price over a period is unlikely to be exactly the same as the movement in the actual exchange rate. The futures market is efficient and prices do move very much in line with exchange rates, but the movements are not the same (unlike in the simple example above). We will illustrate the effect of this shortly.
In practice any deal in futures must be in units of a fixed size (you will be given the size in the examination). It is therefore not always possible to enter into a deal of precisely the same amount as the underlying transaction whose risk we are trying to hedge against.
It is 10 September 2004.
T plc expects to receive $1,200,000, on 12 November 2004
The spot rate (on 10 September) is | $/£ 1.5020 – 1.5110 |
Futures prices (on 10 September) are:
$/£ (£62,500) contracts. | |
September | 1.5035 |
December | 1.5045 |
March | 1.5054 |
On 12 November 2004:
Spot: | $/£ 1.5100 – 1.5190 |
December futures: 1.5120
Show the outcome of the futures hedge.
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Notes:
When deciding whether to ‘buy’ or to ‘sell’ futures, look at the underlying transaction. If the underlying transaction involves buying the contract currency, then we need to buy futures. If the underlying transaction involves selling the contract currency, then we need to sell futures. The contract currency is the currency in which the contract size is quoted.
The fact that the movement in the futures price does not exactly equal the movement in the exchange rate does leave us exposed to a little risk. This risk is known as the basis risk. We will investigate this more shortly.
The hedge instruction earns marks of its own, so set it out before the outcome, as the answers to Examples 9 and 11 do: whether futures are bought or sold, using the rule above; which delivery month, normally the first after the transaction date; and how many contracts, rounded to a whole number because only whole contracts can be dealt. Going straight to the net receipt or payment without these loses marks even when the figure is right.
8.1 Estimating futures prices
Unless you are told otherwise in the examination, we assume that the difference between the futures price and the mid-market spot rate (the basis risk), falls linearly to zero over the life of the future.
On 1 July:
Spot | $/£ 1.5050 – 1.5150 |
September $/£ futures: 1.4900.
On 31 August:
Spot | $/£ 1.5250 – 1.5370 |
What will be the futures price on 31 August?
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Now let us look at a full example with everything included!
It is 20 June 2004.
S plc owes an American supplier $500,000 payable on 12 September.
Spot rate on 20 June | $/£ 1.4821 – 1.4896 |
Futures prices on 20 June:
$/£ (£62,500 contracts) | |
June | 1.4800 |
September | 1.4840 |
December | 1.4860 |
On 12 September, spot rate is | $/£ 1.4791 – 1.4812 |
Show the outcome of using a futures hedge.
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8.2 Ticks
In the previous examples we have calculated the profit on futures by looking at the change in the futures price, and multiplying this by the amount of the futures deal.
In practice, the movement is expressed slightly differently (although the resulting figures will be exactly the same).
Instead of referring to a change in futures price of (for example) 0.0135, it is referred to in practice as a change of 135 ticks. 1 tick = 0.0001, which is the smallest possible movement.
We can use this to calculate the profit or loss on futures as we will illustrate by repeating part of example 11.
In example 11 re-calculate the profit making use of ticks.
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8.3 Lock-in rate
In the previous examples, we were told the spot rate on the date of the transaction and therefore we were able to calculate what the futures price would be. In practice we obviously would not know in advance what the spot rate would be on the future date., but we would be in a position to calculate in advance what the net effect would be of using futures because we know what will happen to the basis.
The lock-in rate is a rate that we can calculate in advance, that when applied to the contract amount will give us the net result on the date of the transaction, whatever actually happens to the spot rate.
It is calculated as either the current futures price as adjusted by the unexpired basis on the date of the transaction, or as the current spot rate as adjusted by the change in the basis between ‘now’ and the date of the transaction (both approaches result in the same answer).
Now is 1 January.
A transaction is due to take place in 2 months time and March futures are to be used to hedge the risk.
The current spot rate is $/£ 1.20, and the current futures price is $/£ 1.16.
Calculate the lock-in rate applicable to this transaction.
8.4 Under or Over hedging
As previously explained, futures can only be dealt in fixed-size contracts. As a result it is unlikely that the exact amount of the transaction can be hedged using futures and that there will be an amount ‘missing’. This over or under hedge has therefore to be converted at whatever the spot rate turns out to be, which means that there is risk attached. However, since we know in advance how much the over or under hedge will be, we can eliminate the risk by the used of forward rates on the amount.
Advantages and disadvantages of using futures