Currency Risk Management

1 Introduction

Any entity that buys, sells, borrows, lends or owns assets in a currency other than the one it reports in is exposed to movements in exchange rates. This chapter deals with that exposure: how exchange rates are quoted, how they can be forecast, what forms the risk takes, and every instrument and technique the syllabus requires for managing it.

Exchange rates move for many reasons — the relative strength of the two economies, the demand for each currency, political events, speculation, and the actions of central banks. Most of that is unpredictable. Three relationships, however, can be used to work out what a rate should be, and they are the subject of section 3.

2 Reading an exchange rate quotation

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More marks are lost on the quotation convention than on any of the arithmetic in this chapter, so it is worth being exact about it.

Two further points follow from the convention.

• A rising number means the base currency is strengthening. If $/£ moves from 1.50 to 1.60, one pound buys more dollars: sterling has strengthened and the dollar has weakened. There is no such thing as one currency moving on its own — if one strengthens, the other has weakened by exactly the same amount.

• A strengthening currency helps importers and hurts exporters. An entity buying in dollars and reporting in sterling pays less for the same goods when sterling strengthens; an entity selling in dollars receives less.

2.1 The spread, and which side of it you get

A bank quotes two rates, not one. Written as a pair, for example:

A quotation is sometimes given as a mid-rate with a margin — "€/£ 1.2025 ± 0.0003" is the same pair as the first line of the table. It is a shorthand for the spread, nothing more.

3 Forecasting exchange rates

The syllabus requires three relationships: purchasing power parity, interest rate parity and the international Fisher effect. All three are written the same way round, and one convention governs all of them.

3.1 Purchasing power parity

Purchasing power parity predicts the future spot rate. It starts from the proposition that money is worth what it will buy, so if the same good can be bought in two countries its price in the two currencies must imply the exchange rate between them.

Rather than re-price a basket every time, the same answer comes directly from the rates of inflation:

S₁ = S₀ × (1 + h_c) ÷ (1 + h_b)

where S₀ is the current spot rate, S₁ the expected spot rate in one year, h(c) the inflation rate in the counter currency and h(b) the inflation rate in the base currency. Checking it against the illustration: 1.20 × 1.03 ÷ 1.05 = 1.177.

For a forecast n years ahead, raise both factors to the power of n — or, equivalently, apply the formula year by year, which is the safer method when the inflation rates are not the same in each year.

S_n = S₀ × [(1 + h_c) ÷ (1 + h_b)]ⁿ

3.2 Interest rate parity

Interest rate parity predicts the forward rate — the rate that can be fixed today for an exchange at a future date. It rests on a much harder argument than purchasing power parity: if the forward rate were anything else, money could be made risk-free, and dealers would trade until it was not.

Suppose the one-year interest rate is 4% in the sterling market and 6% in the US dollar market, and the spot rate is $/£ 1.40. An investor might see a 2% margin in borrowing sterling and depositing dollars — but the profit is only real if the rate at which the dollars come back is known today. So:

The forward rate must be the rate at which those two exactly cancel — otherwise the trade makes money out of nothing:

F = $1,484 ÷ £1,040 = $/£ 1.427

which is the general formula, written to the same convention as before:

F = S₀ × (1 + i_c) ÷ (1 + i_b)

where i(c) and i(b) are the interest rates in the counter and base currencies. Over three years the interest accrues for three years on both sides:

F₃ = 1.40 × (1.06 ÷ 1.04)³ = $/£ 1.482

3.3 The international Fisher effect

The international Fisher effect links the other two. It says that the real rate of interest is the same in every country, and that the interest rate quoted on a deposit — the nominal or money rate — is that real rate combined with expected inflation:

(1 + i) = (1 + r)(1 + h)

where i is the nominal rate, r the real rate and h the rate of inflation. Suppose one economy has inflation of 2.5% and a nominal interest rate of 5%. The real rate implied is:

1 + r = 1.05 ÷ 1.025 = 1.02439, so r = 2.439%

If a second economy has inflation of 6%, its nominal rate is predicted to be:

(1 + i) = 1.02439 × 1.06 = 1.08585, so i = 8.585%

The nominal rate is higher where inflation is higher because money on deposit has to grow by the rate of inflation simply to stand still; investors then require a real return on top of that.

3.4 How the three fit together

Because the international Fisher effect makes interest rate differences reflect inflation differences, and interest rate parity makes forward rates reflect interest rate differences, the three relationships describe one system.

3.5 The limitations

An exam answer that quotes a parity forecast without a caveat is incomplete. The main ones:

• Purchasing power parity assumes the goods are identical and freely traded. Transport costs, tariffs, taxes, differing consumer tastes, and the large part of any economy that is not traded across borders at all — housing, most services — all break the link between prices and rates.

• Governments intervene. A managed or pegged rate will not move to parity, and capital controls stop the arbitrage that would otherwise force it there.

• The forecast is only as good as the inflation forecast. Two uncertain numbers go into the formula and one uncertain number comes out.

• Short-run rates are driven by capital flows, not by goods. Speculation, interest rate expectations and political events move rates far more, and far faster, than relative inflation does.

• Interest rate parity predicts the forward rate, not the spot rate that will actually prevail. Locking in a forward rate removes uncertainty; it does not guarantee a good outcome.

3.6 Cross rates

A cross rate is the rate between two currencies worked out from each one's rate against a third. Suppose the published rates are:

To find €/US$, write down what is wanted and build it out of what is known:

EUR ÷ USD = (EUR ÷ GBP) × (GBP ÷ USD) = 1.26 × (1 ÷ 1.45) = 0.87

The units cancel exactly as they would in any other piece of algebra, which is the check to apply if the direction is ever in doubt.

4 The three currency risks

Chapter 8 introduced the three categories. This section takes each one further, because the response to each is different.

4.1 Transaction risk

Transaction risk arises whenever an entity buys or sells in a foreign currency. If the rate moves between agreeing the contract and settling the cash, the amount in the entity's own currency changes, and until it is settled the cash flow cannot be forecast.

For example, in June an exporter agrees to sell goods for 100,000 Australian dollars, payable in three months. The rate at the date of the contract is AUD/£ 1.80, so it expects to receive:

AUD 100,000 ÷ 1.80 = £55,556

If the Australian dollar weakens over the three months to AUD/£ 2.00, the receipt is worth only £50,000. If it strengthens to AUD/£ 1.70, the receipt is worth £58,824. The exporter does not know which, and that — not the loss — is the problem. Sections 5 to 10 are all about removing it.

4.2 Translation risk

Translation risk affects entities with foreign subsidiaries, branches or assets. If the currency of the subsidiary weakens, its assets are worth less when restated for the purposes of the consolidated financial statements.

This usually matters least of the three, because it produces no cash flow. It begins to matter when the parent wants to sell the subsidiary and remit the proceeds, when the subsidiary pays a dividend, or when reported gearing is what a covenant is written on.

It can be reduced by funding the foreign operation in its own currency, so that a foreign currency liability sits against the foreign currency assets and only the net position is exposed. Compare a subsidiary funded wholly by equity from the parent with the same subsidiary funded half by a local-currency loan:

Only the net assets are exposed. If the rate moves from $/£ 1.60 to $/£ 2.00 over the year, the sterling value of the parent's investment falls as follows:

The exposure has halved, because half of the dollar assets are now matched by a dollar liability that falls in sterling terms at exactly the same rate. (The split of the $2.0 million between non-current and current assets is illustrative; only the totals matter to the point being made.)

4.3 Economic risk

Economic risk is the effect of exchange rate movements on the entity's competitive position, and so on the present value of its future cash flows. It is the hardest of the three to measure and the only one that cannot be hedged with a contract.

Take an exporter that prices in sterling and sells into the euro area. If the euro weakens from €/£ 1.10 to €/£ 1.30, goods with a sterling price of £100 now cost a euro-area buyer €130 instead of €110. Nothing has changed about the goods; they have simply become 18% more expensive to that buyer, and less competitive against locally made substitutes.

The mirror image is that goods imported from the euro area become cheaper in sterling and more competitive in the exporter's home market.

5 Internal hedging techniques

The syllabus names internal hedging techniques as a topic in their own right, and they should be considered first: they cost no premium, involve no counterparty and create no new position to be monitored.

5.1 Invoicing in the entity's own currency

If the contract and the invoice are denominated in the entity's own currency, the whole exchange risk moves to the other party. Whether that can be achieved is a matter of negotiation alongside price and payment terms: an entity keen to win a foreign customer may have to invoice in the customer's currency, and where it does, the risk it takes on is part of the price of the sale.

5.2 Netting

Where the same currency flows both in and out of a group, only the net amount is exposed. If an entity owes a Japanese supplier ¥1,000,000 and another group company is owed ¥1,100,000 by a Japanese customer, netting the two leaves an exposure of ¥100,000.

• Bilateral netting — two companies in the same group offset flows between themselves.

• Multilateral netting — every group company reports its foreign currency flows to a central treasury, which nets them across the whole group and hedges only the residual.

Netting works where there are many transactions in the same currency at similar dates. It cannot help where the flows are months apart.

5.3 Matching

Matching applies the same idea to third-party flows. An entity expecting to receive $2 million from a customer on 1 November and to pay $1.9 million to a supplier on 15 November can hold a US dollar bank account, deposit the receipt in it and pay the supplier out of it. Only $0.1 million is ever exposed.

As with netting, this depends on the flows being close together. Few entities can leave money sitting in a foreign currency account from November until the following May.

5.4 Leading and lagging

Leading is settling a foreign currency obligation early, and lagging is delaying it, in each case because of a view about which way the rate will move.

5.5 Which internal technique answers which problem

6 Forward exchange contracts

A forward exchange contract is a binding agreement to buy or sell an agreed amount of currency at an agreed date in the future, at a rate fixed today (the forward rate). It is arranged individually with a bank — an "over the counter" arrangement — and can be for any amount and any date.

Take a manufacturer that reports in euros and has agreed a sale worth £500,000, to be received in three months. Using the rates from section 2.1, it will be converting sterling into euros in three months, so it takes the three-month rate that leaves it worse off, €/£ 1.2014, and contracts to deliver £500,000 in exchange for:

£500,000 × 1.2014 = EUR 600,700

That figure is now certain whatever the spot rate turns out to be. If sterling strengthens to €/£ 1.50, the manufacturer will have forgone €149,300 — but income maximisation was never the point: €600,700 can be put into the cash flow forecast today with confidence.

6.1 Forward rates quoted as a margin

Forward rates are sometimes quoted not directly but as an adjustment to the spot rate. For example:

6.2 Closing out

The contract is binding, and that is its one real drawback. If the underlying sale falls through, the entity still has to deliver the £500,000 it promised. What it does then is buy sterling on the spot market, deliver it under the forward contract and receive its €600,700 — a process called closing out. Depending on the spot rate at the time, closing out produces a gain or a loss, and the entity has no choice about incurring it.

That risk is the reason for options (section 9): where the underlying cash flow is uncertain — a contract bid, for instance — a binding forward contract can create the very exposure it was meant to remove.

7 Money market hedges

A money market hedge produces the same certainty as a forward contract using only a deposit, a loan and today's spot rate. It works by creating an equal and opposite foreign currency balance, so that the two cancel.

7.1 Hedging a future receipt

An exporter that reports in sterling is due to receive $2 million in three months. It would have no exposure at all if it also had a $2 million liability falling due then — so it creates one, by borrowing dollars now and repaying them out of the receipt.

The amount to borrow is the amount that will grow to $2 million with three months' interest. Dollar three-month interest rates are quoted as a pair, say 0.54% – 0.66%, and although they are described as three-month rates they are always quoted as annual rates. The entity is borrowing, so it pays the higher of the two:

X × (1 + 0.66% ÷ 4) = $2,000,000, so X = $1,996,705

Converted now at the spot rate of, say, $/£ 1.4701, that gives:

$1,996,705 ÷ 1.4701 = £1,358,210

The sterling is in hand today and no future exchange rate can change it. The dollar loan accrues quietly in the background and is repaid in three months by the $2 million from the customer. The hedge is complete.

7.2 Comparing a money market hedge with a forward contract

The two produce cash at different dates, so the amounts cannot be compared as they stand: money received today is worth more than money received in three months. To compare them, roll the money market proceeds forward at the sterling deposit rate. At a sterling three-month deposit rate of 1.2% a year:

£1,358,210 × (1 + 1.2% ÷ 4) = £1,362,285

It is that figure, not £1,358,210, that is compared with the proceeds of a forward contract. Failing to bring both methods to a common date is the commonest error in a money market hedge question.

7.3 Hedging a future payment

The mirror image. An entity that must pay $2 million in three months buys dollars now and deposits them, so that the deposit grows to exactly $2 million by the payment date. Because the currency is bought today at today's spot rate, the cost in sterling is fixed today.

Using a dollar deposit rate of 0.54% a year, the amount to deposit now is:

$2,000,000 ÷ (1 + 0.54% ÷ 4) = $1,997,302

bought at the spot rate of $/£ 1.4701 for £1,358,617. If that sterling has itself to be borrowed for three months at 1.8% a year, the cost in three months' time is £1,358,617 × 1.0045 = £1,364,731, and that is the figure to set against a forward contract.

Money market hedging, like a forward contract, is an over-the-counter operation.

8 Currency futures

A currency future is a standardised, exchange-traded contract for the sale or purchase of a set quantity of currency at a set future date. It is bought and sold like any other traded instrument, and its price follows the exchange rate closely.

The point of a future is not to take delivery of the currency. It is that a profit made on the futures position offsets the loss made on the underlying transaction, and vice versa.

8.1 How futures are traded

• Contracts are for standard sizes — for example £62,500, €125,000 or ¥12,500,000 — and only whole contracts can be dealt.

• Contracts have standard maturity dates, so the entity chooses the first expiry date after the date of its transaction.

• Currency futures are priced in US dollars per unit of the other currency.

• A tick is the smallest price movement, 0.0001 of the contract, so the value of one tick is 0.0001 × the contract size (on a £62,500 contract, $6.25).

• An initial margin is paid up front when the position is opened, and further margin is called if the position moves against the holder.

9 Currency options

An option is different in kind from everything above it. It gives the holder the right, but not the obligation, to buy or sell an agreed amount of currency at a fixed rate (the exercise or strike price) on or before an agreed date. A forward contract binds; an option does not.

• The right to sell a currency at a set rate is a put option — think of putting something up for sale.

• The right to buy a currency at a set rate is a call option.

Suppose an exporter that reports in sterling expects to be paid $1 million in 90 days. If sterling strengthens it receives fewer pounds; if sterling weakens it receives more. The current rate is $/£ 1.40 and the exporter becomes concerned beyond $/£ 1.50. It buys sterling call options at an exercise price of $/£ 1.50, giving it the right to buy sterling at that rate.

The exporter is protected against the bad outcome and keeps the good one. There is nothing free in finance, and what pays for it is a premium, payable up front and not returnable whether the option is used or not.

9.1 What an option costs: intrinsic value and time value

The premium has two components.

So a put option allowing an asset to be sold at $5 when the asset is worth $4 has an intrinsic value of $1; a call option to buy at $7 when the asset is worth $10 has an intrinsic value of $3. Both are said to be in the money. A put option to sell at $6 when the asset is worth $7 is out of the money and has no intrinsic value — but it still has a premium, and that premium is entirely time value.

Time value increases with:

• the length of time the option has left to run — more time means more chance of a favourable move;

• the volatility of the underlying rate — the more it moves, the more protection the option is providing.

The same reasoning explains a smaller point: the value of a call option rises when interest rates rise, because the call lets the holder defer paying for the currency and keep the money earning interest for longer.

9.2 Over-the-counter and traded options

Options come in the same two forms as everything else in this chapter: over the counter, arranged with a bank for any amount and any date, and exchange traded, in standard contract sizes and standard expiry dates. Traded options are cheaper and can be closed out at any time; over-the-counter options fit the exposure exactly.

10 Currency swaps

A currency swap is an agreement between two parties to exchange principal and interest payments in two different currencies, and to re-exchange the principal at the end of the agreed term at the rate fixed at the outset.

It differs from the interest rate swap of chapter 10 in one important respect: because the two legs are in different currencies, the principal is actually exchanged, at the beginning and again at the end. In an interest rate swap it never is.

Entities use currency swaps to:

• obtain a currency they cannot borrow cheaply themselves, by borrowing the one they can and swapping — each party borrows where it is best known and lends that advantage to the other;

• hedge a long-term exposure, of five or ten years, for which forward contracts are expensive or unobtainable;

• create a foreign currency liability to sit against a foreign currency asset, which hedges the translation exposure on a net investment in a foreign operation (section 4.2);

• avoid the withholding taxes, exchange controls or issue costs that would apply to borrowing directly in the other currency.

11 Managing economic risk

None of sections 5 to 10 helps with economic risk, because there is no transaction and no date to hedge. The responses are operational and strategic.

• Diversify the currency exposure. Buy from, and sell into, more than one currency zone, so that the movements do not all fall the same way at the same time. Over a single quarter one pair may move by close to 20% while another moves by 8%; an entity exposed to both is hurt less than one exposed to either alone.

• Match the currency of costs to the currency of revenues. Manufacture, or buy raw materials, in the country the goods are sold in. Wages, rent and local services are then incurred in the currency the revenue arrives in and the margin is protected however the rate moves.

• Borrow in the currency the revenue arrives in. The interest payments then fall with the revenue rather than against it.

• Keep the ability to move production. Capacity in more than one currency zone is expensive, and it buys the option to shift output to wherever the rate currently favours it.

• Price flexibly where the market allows it. Whether a currency movement can be passed on to customers depends on how competitive the market is — which is why economic risk is a commercial question before it is a treasury one.

12 Choosing between the hedges

Where more than one instrument would work, the choice is made by comparing the certain outcome each one produces — all brought to the same date — and then by the qualitative factors below.

13 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.