Hedging Foreign Exchange Exposures

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Hedging Foreign Exchange Exposures
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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)

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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.

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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.

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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

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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.

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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

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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

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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.

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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.

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Foreign Exchange Options Contracts

• 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
• (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).

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A Put Option To Sell Foreign Exchange

• Put Option
• 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.

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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.

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Overview of Options Contracts

• Important advantage
• 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.

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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.

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Specific Strategy for a Long 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.
• 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.

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Specific Strategy for a Short Position

• Global firm needing to pay out foreign currency
  in the 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.

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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.

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Dealing with Economic Exposure

• 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.

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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)

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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.

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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.