Chapter 11: Foreign exchange risk

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the meaning and causes of translation risk
• explain the meaning and causes of transaction risk
• explain the meaning and causes of economic risk
• describe how the balance of payments can cause exchange rate fluctuations
• explain the impact of purchasing power parity on exchange rate fluctuations
• explain the impact of interest rate parity on exchange rate fluctuations
• use purchasing power parity theory (PPPT) to forecast exchange rates
• use interest rate parity theory (IRPT) to forecast exchange rates
• explain the principle of four-way equivalence and the impact on exchange rate fluctuations
• explain the significance of the currency of an invoice on foreign currency risk management
• discuss and apply netting and matching as a form of foreign currency risk management
• discuss and apply leading and lagging as a form of foreign currency risk management
• define a forward exchange contract
• calculate the outcome of a forward exchange contract
• define money market hedging
• calculate the outcome of a money market hedge used by an exporter
• calculate the outcome of a money market hedge used by an importer
• explain the significance of asset and liability management on foreign currency risk management
• compare and evaluate traditional methods of foreign currency risk management
• define the main types of foreign currency derivates and explain how they can be used to hedge foreign currency risk.

1 Foreign currency risk

Unlike when trading domestically, foreign currency risk arises for companies that trade internationally.

In a floating exchange rate system:

• the authorities allow the forces of supply and demand to continuously change the exchange rates without intervention
• the future value of a currency vis-à-vis other currency is uncertain
• the value of foreign trades will be affected.

Depreciation and appreciation of a foreign currency

If a foreign currency depreciates it is now worth less in our home currency.

• Receipt – adverse movement – will receive less in your home currency.
• Payment – favourable movement – will end up paying less in your home currency.

If a foreign currency appreciates it is simply worth more in our home currency.

• Receipt – favourable movement – will receive more in your home currency.
• Payment – adverse movement – will end up paying more in your home currency.

An example

Let's say the current exchange rate between the US dollar and theUK pound is $1.60 / £. This means that a $10m cash flow would equate to£6.25m.

Now let's say the exchange rate moves to $1.50 / £. In this case, the $ has appreciated(you would have to sell fewer $s to get one pound). The same $10m cashflow now equates to £6.67m. If you are a UK company receiving $10m,this is obviously good news. However, if you are needing to pay $10m,this will not cost you more.

A movement in the opposite direction, to say $1.70 / £ reflects a depreciationin the US dollar (you would need to sell more $s to get one pound). The$10m cash flow now equates to £5.88m. For a UK company, this would bebad news if you were receiving the money but good news if you weremaking a payment.

The currency blues

If a currency appreciates, companies complain that they cannot selltheir goods abroad and workers agitate about losing their jobs.

If a currency depreciates, consumers are unhappy because inflationis imported and their money travels less far when they go abroad.'

Additional question - Foreign currency implications

What would a strong pound mean for companies in the UK pricing transactions in foreign currency if they were a:

• UK exporter?
• UK importer?

What would a weak Euro mean for companies in the Eurozone pricing transactions in foreign currency if they were a:

• European exporter?
• European importer?

The answer to this question can be found after the chapter summary diagram at the end of this chapter.

Exchange rate systems

The world's leading currencies such as:

• US dollar
• Japanese yen
• British pound
• European euro

float against each other. However only a minority of currencies use this system.

Other systems include.

• Fixed exchange rates
• Freely floating exchange rates
• Managed floating exchange rates.

Exchange rate systems

Although the world's leading trading currencies, like the USdollar, Japanese yen, British pound and European Euro are floatingagainst the other currencies, a minority of countries use floatingexchange rates. The main exchange rate systems include:

(a)Fixed exchange rates

This involves publishing the target parity against a singlecurrency (or a basket of currencies), and a commitment to use monetarypolicy (interest rates) and official reserves of foreign exchange tohold the actual spot rate within some trading band around this target.

Fixed against a single currency

This is where a country fixes its exchange rate against thecurrency of another country's currency. More than 50 countries fix theirrates in this way, mostly against the US dollar. Fixed rates are notpermanently fixed and periodic revaluations and devaluations occur whenthe economic fundamentals of the country concerned strongly diverge(e.g. inflation rates).

Fixed against a basket of currencies

Using a basket of currencies is aimed at fixing the exchange rateagainst a more stable currency base than would occur with a singlecurrency fix. The basket is often devised to reflect the major tradinglinks of the country concerned.

Historical perspective: British pound previously used a fixed rate system

The pound was fixed against the US dollar from 1945 to 1972, andmore recently was part of the European Exchange Rate Mechanism (ERM)between 1990 and 1992. The rules of the ERM were complicated, UKmembership of the ERM involved a target rate of 2.95 DM against the £with a +/– 6% trading band: in other words, a minimum spot rate ofaround 2.77DM. To hold sterling above this rate in 1992, the governmentused a significant amount of the UK's foreign currency reserves and ahigh interest rate policy. Following its failure to defend the poundwithin the system, the UK left the ERM in September 1992.

(b)Freely floating exchange rates (sometimes called a ‘clean float’)

A genuine free float would involve leaving exchange rates entirelyto the vagaries of supply and demand on the foreign exchange markets,and neither intervening on the market using official reserves of foreignexchange nor taking exchange rates into account when making interestrate decisions. The Monetary Policy Committee of the Bank of Englandclearly takes account of the external value of sterling in itsdecision-making process, so that although the pound is no longer in afixed exchange rate system, it would not be correct to argue that it ison a genuinely free float.

(c)Managed floating exchange rates (sometimes called a ‘dirty float’)

The central bank of countries using a managed float will attempt tokeep currency relationships within a predetermined range of values (notusually publicly announced), and will often intervene in the foreignexchange markets by buying or selling their currency to remain withinthe range.

2 Types of foreign currency risk

Since firms regularly trade with firms operating in countries withdifferent currencies, and may operate internationally themselves, it isessential to understand the impact that foreign exchange rate changescan have on the business.

Transaction risk

Transaction risk is the risk of an exchange rate changing between thetransaction date and the subsequent settlement date, i.e. it is the gainor loss arising on conversion.

It arises on any future transaction involving conversion betweentwo currencies (for example, if a UK company were to invest in USDbonds, the interest receipts would be subject to transcation risk). Themost common area where transaction risk is experienced relates toimports and exports.

Test your understanding 1 – Transaction risk

On 1 January a UK firm enters into a contract to buy a piece ofequipment from the US for $300,000. The invoice is to be settled on 31March.

The exchange rate on 1 January is $1.6/£ (i.e. $1.6 = £1).

However by 31 March, the pound may have

(1)strengthened to $1.75/£ or

(2)depreciated to $1.45/£.

Explain the risk faced by the UK firm.

A firm may decide to hedge – take action to minimise – the risk, if it is:

• a material amount
• over a material time period
• thought likely exchange rates will change significantly.

We will see more on hedging later in this chapter.

Economic risk

Economic risk is the variation in the value of the business (i.e.the present value of future cash flows) due to unexpected changes inexchange rates. It is the long-term version of transaction risk.

For an export company it could occur because:

• the home currency strengthens against the currency in which it trades
• a competitor's home currency weakens against the currency in which it trades.

A favoured but long-term solution is to diversify all aspects ofthe business internationally so the company is not overexposed to anyone economy in particular.

Test your understanding 2 – Economic risk

A US exporter sells one product in Europe on a cost plus basis.

The selling price is based on a US price of $16 to cover costs and provide a profit margin.

The current exchange rate is €1.26/$.

What would be the effect on the exporter's business if the dollar strengthened to €1.31/$?

Economic risk

Transaction exposure focuses on relatively short-term cash flowseffects; economic exposure encompasses these, plus the longer-termeffects of changes in exchange rates on the market value of a company.Basically this means a change in the present value of the futureafter-tax cash flows due to changes in exchange rates.

There are two ways in which a company is exposed to economic risk

Directly: If your firm's home currency strengthens then foreigncompetitors are able to gain sales at your expense because your productshave become more expensive (or you have reduced your margins) in theeyes of customers both abroad and at home.

Indirectly: Even if your home currency does not move vis-à-visyour customer's currency, you may lose competitive position. For examplesuppose a South African firm is selling into Hong Kong SAR and its maincompetitor is a New Zealand firm. If the New Zealand dollar weakensagainst the Hong Kong SAR dollar the South African firm has lost somecompetitive position.

Economic risk is difficult to quantify but a favoured strategy isto diversify internationally, in terms of sales, location of productionfacilities, raw materials and financing. Such diversification is likelyto significantly reduce the impact of economic exposure relative to apurely domestic company, and provide much greater flexibility to reactto real exchange rate changes.

Translation risk

Where the reported performance of an overseas subsidiary in home-basedcurrency terms is distorted in consolidated financial statements becauseof a change in exchange rates.

NB. This is an accounting risk rather than a cash-based one.

Translation risk

The financial statements of overseas subsidiaries are usuallytranslated into the home currency in order that they can be consolidatedinto the group's financial statements. Note that this is purely apaper-based exercise – it is the translation not the conversion ofreal money from one currency to another.

The reported performance of an overseas subsidiary in home-basedcurrency terms can be severely distorted if there has been a significantforeign exchange movement.

'If initially the exchange rate is given by $1/£ and an Americansubsidiary is worth $500,000, then the UK parent company will anticipatea balance sheet value of £500,000 for the subsidiary. A depreciationof the US dollar to $2/£ would result in only £250,000 beingtranslated.'

Unless managers believe that the company's share price will fall asa result of showing a translation exposure loss in the company'saccounts, translation exposure will not normally be hedged. Thecompany's share price, in an efficient market, should only react toexposure that is likely to have an impact on cash flows.

Make sure you are able to distinguish between the three types of foreign currency risk: transaction, economic and translation.

3 Trading in currencies

The foreign exchange market

The foreign exchange or forex market is an international market innational currencies. It is highly competitive and virtually nodifference exists between the prices in one market (e.g. New York) andanother (e.g. London).

Bid and offer prices

Banks dealing in foreign currency quote two prices for an exchange rate:

• a lower 'bid' price
• a higher 'offer' price.

For example, a dealer might quote a price for US$/£ of 1.340 – 1.345:

• The lower rate, 1.340, is the rate at which the dealer will sell the variable currency (US$) in exchange for the base currency (sterling).
• The higher rate, 1.345, is the rate at which the dealer will buy the variable currency (US$) in exchange for the base currency (sterling).

This quote might also be written as a mid price with an adjustment, for example:

US$/£ 1.3425 ± 0.0025

This tells you to add $0.0025 to get the buying rate ($1.3425 +$0.0025 = $1.345) or subtract $0.0025 to get the selling rate ($1.3425 -$0.0025 = $1.340).

To remember which of the two prices is relevant to any particularforeign exchange (FX) transaction, remember the bank will always tradeat the rate that is more favourable to itself.

If in doubt, work out which rate most favours the bank or remember the rules:

Test your understanding 3 – Bid and offer prices

The US$ rate per £ is quoted as 1.4325 - 1.4330.

Company A wants to buy $100,000 in exchange for sterling.

Company B wants to sell $200,000 in exchange for sterling.

What rate will the bank offer each company?

The spot market

The spot market is where you can buy and sell a currency now (immediate delivery), i.e. the spot rate of exchange.

The forward market

The forward market is where you can buy and sell a currency, at a fixedfuture date for a predetermined rate, by entering into a forwardexchange contract.

Why exchange rates fluctuate

Changes in exchange rates result from changes in the demand for andsupply of the currency. These changes may occur for a variety ofreasons, e.g. due to changes in international trade or capital flowsbetween economies.

Balance of payments

Since currencies are required to finance international trade,changes in trade may lead to changes in exchange rates. In principle:

• demand for imports in the US represents a demand for foreign currency or a supply of dollars
• overseas demand for US exports represents a demand for dollars or a supply of the currency.

Thus a country with a current account deficit where imports exceedexports may expect to see its exchange rate depreciate, since the supplyof the currency (imports) will exceed the demand for the currency(exports).

Any factors which are likely to alter the state of the currentaccount of the balance of payments may ultimately affect the exchangerate.

Capital movements between economies

There are also capital movements between economies. Thesetransactions are effectively switching bank deposits from one currencyto another. These flows are now more important than the volume of tradein goods and services.

Thus supply/demand for a currency may reflect events on the capitalaccount. Several factors may lead to inflows or outflows of capital:

• changes in interest rates: rising (falling) interest rates will attract a capital inflow (outflow) and a demand (supply) for the currency
• inflation: asset holders will not wish to hold financial assets in a currency whose value is falling because of inflation.

These forces which affect the demand and supply of currencies andhence exchange rates have been incorporated into a number of formalmodels.

4 The causes of exchange rate fluctuations

Purchasing Power Parity Theory (PPPT)

PPPT claims that the rate of exchange between two currencies depends onthe relative inflation rates within the respective countries.

PPPT is based on:

In equilibrium, identical goods must cost the same, regardless of the currency in which they are sold.

Illustration 1 – PPPT

An item costs $3,000 in the US.

Assume that sterling and the US dollar are at PPPT equilibrium, atthe current spot rate of $1.50/£, i.e. the sterling price x currentspot rate of $1.50 = dollar price.

The spot rate is the rate at which currency can be exchanged today.

The 'law of one price' states that the item must always cost the same. Therefore in one year:

$3,150 must equal £2,060

and so the expected future spot rate can be calculated:

$3,150/2,060 = $1.5291

 Rule: PPPT predicts that the country with the higher inflation will be subject to a depreciation of its currency.

If you need to estimate the expected future spot rates, simply apply the following formula:

Where:

S₀ = Current spot

S₁ = Expected future spot

h_b = Inflation rate in country for which the spot is quoted (base currency)

h_c = Inflation rate in the other country. (counter currency)

This formula is given to you in the exam.

Test your understanding 4 – PPPT

The dollar and sterling are currently trading at $1.72/£.

Inflation in the US is expected to grow at 3% pa, but at 4% pa in the UK.

Predict the future spot rate in a year's time.

PPPT can be used as our best predictor of future spot rates; however it suffers from the following major limitations:

• the future inflation rates are only estimates
• the market is dominated by speculative transactions (98%) as opposed to trade transactions; therefore purchasing power theory breaks down
• government intervention: governments may manage exchange rates, thus defying the forces pressing towards PPPT.

PPPT

The main function of an exchange rate is to provide a means oftranslating prices expressed in one currency into another currency. Theimplication is that the exchange will be determined in some way by therelationship between these prices. This arises from the law of oneprice.

The law of one price states that in a free market with no barriersto trade and no transport or transactions costs, the competitive processwill ensure that there will only be one price for any given good. Ifprice differences occurred they would be removed by arbitrage;entrepreneurs would buy in the low market and resell in the high market.This would eradicate the price difference.

If this law is applied to international transactions, it suggeststhat exchange rates will always adjust to ensure that only one priceexists between countries where there is relatively free trade.

Thus if a typical set of goods cost $1,000 in the USA and the sameset cost £500 in the UK, free trade would produce an exchange rate of£1 to $2.

How does this result come about?

Let us suppose that the rate of exchange was $1.5 to £1: the sequence of events would be:

• US purchasers could buy UK goods more cheaply (£500 at $1.5 to £1 is $750).
• There would be a flow of UK exports to the US: this would represent demand for sterling.
• The sterling exchange rate would rise.
• When the exchange rate reached $2 to £1, there would be no extra US demand for UK exports since prices would have been equalised: purchasing power parity would have been established.

The clear prediction of the purchasing power parity model ofexchange rate determination is that if a country experiences a fasterrate of inflation than its trading partners, it will experience adepreciation in its exchange rate. It follows that if inflation ratescan be predicted, so can movements in exchange rates.

In practice the purchasing power parity model has shown someweaknesses and is a poor predictor of short-term changes in exchangerates.

• It ignores the effects of capital movements on the exchange rate.
• Trade and therefore exchange rates will only reflect the prices of goods which enter into international trade and not the general price level since this includes non-tradeables (e.g. inland transport).
• Governments may 'manage' exchange rates, e.g. by interest rate policy.
• It is likely that the purchasing power parity model may be more useful for predicting long-run changes in exchange rates since these are more likely to be determined by the underlying competitiveness of economies, as measured by the model.

Interest Rate Parity Theory (IRPT)

The IRPT claims that the difference between the spot and the forwardexchange rates is equal to the differential between interest ratesavailable in the two currencies.

The forward rate is a future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future date.

Illustration 2 – IRPT

UK investor invests in a one-year US bond with a 9.2% interest rateas this compares well with similar risk UK bonds offering 7.12%. Thecurrent spot rate is $1.5/£.

When the investment matures and the dollars are converted intosterling, IRPT states that the investor will have achieved the samereturn as if the money had been invested in UK government bonds.

In 1 year, £1.0712 million must equate to $1.638 million so whatyou gain in extra interest, you lose on an adverse movement in exchangerates.

Any attempt to 'fix' the future exchange rate by locking into anagreed rate now (for example by buying a forward (see section 5 of thischapter for details)), will also fail.

The forward rates moves to bring about interest rate parity amongst different currencies:

Rule: IRPT predicts that the country with the higher interestrate will see the forward rate for its currency subject to adepreciation.

If you need to calculate the forward rate in one year's time:

Where:

F₀ = Forward rate

i_b = interest rate for base currency

i_c = interest rate for counter currency

You are provided with this formula in the exam.

The IRPT generally holds true in practice. There are no bargaininterest rates to be had on loans/deposits in one currency rather thananother.

However it suffers from the following limitations:

• government controls on capital markets
• controls on currency trading
• intervention in foreign exchange markets.

Test your understanding 5 – IRPT

A treasurer can borrow in Swiss francs at a rate of 3% pa or in theUK at a rate of 7% pa. The current rate of exchange is 10SF/£.

What is the likely rate of exchange in a year's time?

IRPT

The interest rate parity model shows that it may be possible topredict exchange rate movements by referring to differences in nominalinterest rates. If the forward exchange rate for sterling against thedollar was no higher than the spot rate but US nominal interest rateswere higher, the following would happen:

• UK investors would shift funds to the US in order to secure the higher interest rates, since they would suffer no exchange losses when they converted $ back into £.
• the flow of capital from the UK to the US would raise UK interest rates and force up the spot rate for the US$.

Four way equivalence

The Fisher Effect

The Fisher Effect was covered in chapter 4 to look at therelationship between interest rates and expected rates of inflation. Itis expressed by the formula:

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

This states that the money or nominal rate of interest is made upof two parts, the underlying required rate of return (real interestrate) and a premium to allow for inflation.

Countries with high rates of inflation will be expected to havenominal rates of interest in order to ensure investors can obtain a highenough real return.

The International Fisher Effect

The International Fisher Effect claims that the interest ratedifferentials between two countries provide an unbiased predictor offuture changes in the spot rate of exchange.

• The International Fisher Effect assumes that all countries will have the same real interest rate, although nominal or money rates may differ due to expected inflation rates.
• Thus the interest rate differential between two countries should be equal to the expected inflation differential.
• Therefore, countries with higher expected inflation rates will have higher nominal interest rates, and vice versa.

In practice interest rate differentials are a poor unbiased predictor of future exchange rates.

Factors other than interest differentials influence exchange rates such as government intervention in foreign exchange markets.

Expectations theory

The expectations theory claims that the current forward rate is anunbiased predictor of the spot rate at that point in the future.

If a trader takes the view that the forward rate is lower than theexpected future spot price, there is an incentive to buy forward. Thebuying pressure on the forward raises the price, until the forward priceequals the market consensus view on the expected future spot price.

In practice, it is a poor unbiased predictor – sometimes it iswide of the mark in one direction and sometimes wide of the mark in theother.

Four-way equivalence

The four theories can be pulled together to show the overallrelationship between spot rates, interest rates, inflation rates and theforward and expected future spot rates. As shown above, theserelationships can be used to forecast exchange rates.

5 Managing foreign currency risk

When currency risk is significant for a company, it should do something to either eliminate it or reduce it.

Taking measures to eliminate or reduce a risk is called:

• hedging the risk or
• hedging the exposure.

Practical approaches

Practical approaches to managing foreign currency risk include:

• Dealing in your home currency
• Doing nothing
• Leading
• Lagging
• Matching receipts and payments
• Foreign currency bank accounts
• Matching assets and liabilities

Practical approaches to managing risk

Practical approaches

Deal in home currency

Insist all customers pay in your own home currency and pay for all imports in home currency.

This method:

• transfers risk to the other party
• may not be commercially acceptable.

Do nothing

In the long run, the company would 'win some, lose some'.

This method:

• works for small occasional transactions
• saves in transaction costs
• is dangerous!

Leading

Receipts – If an exporter expects that the currency it is due toreceive will depreciate over the next few months it may try to obtainpayment immediately.

This may be achieved by offering a discount for immediate payment.

Lagging

Payments – If an importer expects that the currency it is due to pay will depreciate, it may attempt to delay payment.

This may be achieved by agreement or by exceeding credit terms.

Note: If the importer expects that the currency will in factappreciate, then it should settle the liability as soon as possible(leading). Or, if an exporter expects the currency to appreciate, it maytry to delay the receipt of payment by offering longer credit terms(lagging).

NB Strictly this is not hedging – it is speculation – thecompany only benefits if it correctly anticipates the exchange ratemovement!

Matching payments and receipts

When a company has receipts and payments in the same foreigncurrency due at the same time, it can simply match them against eachother. It is then only necessary to deal on the foreign exchange (forex)markets for the unmatched portion of the total transactions.

Suppose that ABC plc has the following receipts and payments in three months time:

Foreign currency bank accounts

Where a firm has regular receipts and payments in the same currency, it may choose to operate a foreign currency bank account.

This operates as a permanent matching process.

The exposure to exchange risk is limited to the net balance on the account.

Matching assets and liabilities (asset and liability management)

A company which expects to receive a significant amount of incomein a foreign currency will want to hedge against the risk of thiscurrency weakening. It can do this by borrowing in the foreign currencyand using the foreign receipts to repay the loan. For example, Euroreceivables can be hedged by taking out a Euro overdraft. In the sameway, Euro trade payables can be matched against a Euro bank accountwhich is used to pay the suppliers.

A company which has a long-term foreign investment, for example anoverseas subsidiary, will similarly try to match its foreign assets(property, plant etc) by a long-term loan in the foreign currency.

Hedging with forward exchange contracts

Although other forms of hedging are available, forward exchangecontacts represent the most frequently employed method of hedging.

Illustration 3 – Forward exchange contract

It is now 1 January and Y plc will receive $10 million on 30 April.

It enters into a forward exchange contract to sell this amount onthe forward date at a rate of $1.60 / £. On 30 April the company isguaranteed £6.25 million.

The risk has been completely removed.

In practice, the forward rate is quoted as a margin on the spot rate. In the exam you will be given the forward rate.

Test your understanding 6 – Hedging with forwards

The current spot rate for US dollars against UK sterling is 1.4525– 1.4535 $/£ and the one-month forward rate is quoted as 1.4550 –1.4565.

A UK exporter expects to receive $400,000 in one month.

If a forward exchange contract is used, how much will be received in sterling?

Advantages and disadvantages of forward exchange contracts

Forward exchange contracts are used extensively for hedging currency transaction exposures.

Advantages include:

• flexibility with regard to the amount to be covered
• relatively straightforward both to comprehend and to organise.

Disadvantages include:

• contractual commitment that must be completed on the due date (option date forward contract can be used if uncertain)
• no opportunity to benefit from favourable movements in exchange rates.

Disadvantages of a forward exchange contract

It is a contractual commitment which must be completed on the due date.

This means that if a payment from the overseas customer is late,the company receiving the payment and wishing to convert it using itsforward exchange contract will have a problem. The existing forwardexchange contract must be settled, although the bank will arrange a newforward exchange contract for the new date when the currency cash flowis due.

To help overcome this problem an 'option date' forward exchangecontract can be arranged. This is a forward exchange contract thatallows the company to settle a forward contract at an agreed fixed rateof exchange, but at any time between two specified dates. If thecurrency cash flow occurs between these two dates, the forward exchangecontract can be settled at the agreed fixed rate.

Inflexible

It eliminates the downside risk of an adverse movement in the spotrate, but also prevents any participation in upside potential of anyfavourable movement in the spot rate. Whatever happens to the actualexchange rate, the forward contract must be honoured, even if it wouldbe beneficial to exchange currencies at the spot rate prevailing at thattime.

A money market hedge

 Themoney markets are markets for wholesale (large-scale) lending andborrowing, or trading in short-term financial instruments. Manycompanies are able to borrow or deposit funds through their bank in themoney markets.

Instead of hedging a currency exposure with a forward contract, acompany could use the money markets to lend or borrow, and achieve asimilar result.

Since forward exchange rates are derived from spot rates and moneymarket interest rates, the end result from hedging should be roughly thesame by either method.

NB Money market hedges are more complex to set up than the equivalent forward.

Hedging a payment

If you are hedging a future payment:

• buy the present value of the foreign currency amount today at the spot rate:
  • this is, in effect, an immediate payment in sterling
  • and may involve borrowing the funds to pay earlier than the settlement date
• the foreign currency purchased is placed on deposit and accrues interest until the transaction date.
• the deposit is then used to make the foreign currency payment.

Test your understanding 7 – Hedging a payment

Liverpool plc must make a payment of US $450,000 in 3 months' time. The company treasurer has determined the following:

Spot rate $1.7000 – $1.7040

3-months forward $1.6902 – $1.6944
6-months forward $1.6764 – $1.6809

Decide whether a forward contract hedge or a money market hedge should be undertaken.

Note: Money market rates vary according to the length of time the funds are borrowed or lent (see chapter on interest rate risk).

Here the rates quoted are annual rates. Don't forget to adjustthese for the period of the loan or deposit (i.e. by dividing by 4 toget a 3 month rate).

Additional question – Hedginga payment

Bolton, a UK company, must make a payment of US$230,000 in threemonths' time. The company treasurer has determined the following:

Dollar: Sterling Spot rate $1.8250 – $1.8361.

3-months forward $1.8338 – $1.8452

Ascertain the cost of the payment using a forward contract hedge and a money market hedge.

The answer to this question can be found after the chapter summary diagram at the end of this chapter.

Hedging a receipt

If you are hedging a receipt:

• borrow the present value of the foreign currency amount today:
  • sell it at the spot rate
  • this results in an immediate receipt in sterling
  • this can be invested until the date it was due
• the foreign loan accrues interest until the transaction date
• the loan is then repaid with the foreign currency receipt.

Test your understanding 8 – Hedging a receipt

Liverpool plc is now expecting a receipt of US$900,000 in six months' time. The company treasurer has determined the following:

Spot rate $1.7000 – $1.7040.
3-months forward $1.6902 – $1.6944
6-months forward $1.6764 – $1.6809

Decide whether a forward contract hedge or a money market hedge should be undertaken.

Note: Money market rates vary according to the length of time the funds are borrowed or lent (see chapter on interest rate risk).

Here the rates quoted are annual rates. Don't forget to adjustthese for the period of the loan or deposit (i.e. by dividing by 2 toget a 6 month rate).

Additional question – Hedging a receipt

Bolton is now to receive US$400,000 in 3 months' time. The company treasurer has determined the following:

Spot rate $1.8250 – $1.8361

3-months forward 1.8338 – 1.8452

Decide whether a forward contract hedge or a money market hedge should be undertaken.

The answer to this question can be found after the chapter summary diagram at the end of this chapter.

Balance sheet hedging

All the above techniques are used to hedge transaction risk.

Sometimes transaction risk can be brought about by attempts to manage translation risk.

Translation exposure:

• arises because the financial statements of foreign subsidiaries must be restated in the parent's reporting currency, for the firm to prepare its consolidated financial statements
• is the potential for an increase or decrease in the parent's net worth and reported income caused by a change in exchange rates since the last transaction.

A balance sheet hedge involves matching the exposed foreigncurrency assets on the consolidated balance sheet with an equal amountof exposed liabilities, i.e.:

• a loan denominated in the same currency as the exposed assets and for the same amount is taken out
• a change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities.

This method eliminates the mismatch between net assets and netliabilities denominated in the same currency, but may create transactionexposure.

As a general matter, firms seeking to reduce both types of exposuretypically reduce transaction exposure first. They then recalculatetranslation exposure and decide if any residual translation exposure canbe reduced, without creating more transaction exposure.

Foreign currency derivatives

Foreign currency risk can also be managed by using derivatives:

Futures

Futures are like a forward contract in that:

• the company's position is fixed by the rate of exchange in the futures contract
• it is a binding contract.

A futures contract differs from a forward contract in the following ways:

• Futures can be traded on futures exchanges. The contract which guarantees the price (known as the futures contract) is separated from the transaction itself, allowing the contracts to be easily traded.
• Settlement takes place in three-monthly cycles (March, June, September or December). i.e. a company can buy or sell September futures, December futures and so on
• Futures are standardised contracts for standardised amounts. For example, the Chicago Mercantile Exchange (CME) trades sterling futures contracts with a standard size of £62,500. Only whole number multiples of this amount can be bought or sold
• The price of a currency futures contract is the exchange rate for the currencies specified in the contract.

Because each contract is for a standard amount and with a fixedmaturity date, they rarely cover the exact foreign currency exposure.

Futures

When a currency futures contact is bought or sold, the buyer orseller is required to deposit a sum of money with the exchange, calledinitial margin. If losses are incurred as exchange rates and hence theprices of currency futures contracts changes, the buyer or seller may becalled on to deposit additional funds (variation margin) with theexchange. Equally, profits are credited to the margin account on a dailybasis as the contract is 'marked to market'.

Most currency futures contracts are closed out before theirsettlement dates by undertaking the opposite transaction to the initialfutures transaction, i.e. if buying currency futures was the initialtransaction, it is closed out by selling currency futures.

Effectively a future works like a bet. If a company expects a US$receipt in 3 month's time, it will lose out if the US$ depreciatesrelative to sterling. Using a futures contract, the company 'bets' thatthe US$ will depreciate. If it does, the win on the bet cancels out theloss on the transaction. If the US$ strengthens, the gain on thetransaction covers the loss on the bet.

Ultimately futures ensure a virtual no win/no loss position.

Illustration 4 – Futures

It is currently February and a US exporter expects to receive £500,000 in June.

The US exporter uses futures to hedge its currency risk by selling Sterling futures.

In June, the company receives £500,000

Show the outcome of the futures hedge.

Solution

Number of contracts = £500,000 ÷ £62,500 = 8

Exporter needs to sell futures (sell £s)

In February – the hedge is set up by:

Selling (8 contracts × £62,500) = £500,000 for June delivery at $1.65

In June – the futures position is closed

Buying (8 contracts × £62,500) = £500,000 for June delivery at $1.70

Summary of futures position:

Loss on futures position = $0.05 £ / × (62,500 × 8 contracts) = $25,000

The £500,000 received by the US exporter is then sold in June at the prevailing spot rate

£500,000 @ $1.70 = $850,000

Notice that sterling appreciated (the dollar depreciated) in thespot rate over the period, causing an increase in the value of thesterling as follows:

Summary

Thus the futures hedge removes risk – both upside potential (as above) and downside risk.

Note: This example shows a perfect hedge. In reality this isunlikely to happen, due to basis risk (see chapter on interest raterisk) and the standardised nature of futures contracts.

Currency options

Options are similar to forwards but with one key difference.

They give the right but not the obligation to buy or sell currency at some point in the future at a predetermined rate.

A company can therefore:

• exercise the option if it is in its interests to do so
• let it lapse if:
  • the spot rate is more favourable
  • there is no longer a need to exchange currency.

The downside risk is eliminated by exercising the option, but there is still upside potential from letting the option lapse

Options are most useful when there is uncertainty about the timing of the transaction or when exchange rates are very volatile.

Options may be:

Two types of option are available – over the counter options frombanks (tailored to the specific wants of the customer and can be usedby small and medium sized companies) and exchange traded options (tradedon the same exchanges as futures and which can be used by largercompanies)

The catch:

The additional flexibility comes at a price – a premium must be paid to purchase an option, whether or not it is ever used.

Illustration 5 – Options

A UK exporter is due to receive $25m in 3 months time. Its bankoffers a 3 month put option on $25m at an exercise price of $1.50 / £at a premium cost of £30,000.

Required

Show the net £ receipt if the future spot is either $1.60 or $1.40

Solution

Dividing by the smallest $/£ rate gives the highest £ receipt –the premium is paid no matter what so should be ignored for thepurposes of determining whether to exercise the option.

Future spot $1.60 – exercise the option. $25m / $1.50 = £16.67m less£30,000 premium gives a net receipt of £16.37m

Future spot $1.40 – abandon the option. $25m / $1.40 = £17.86m less £30,000 premium gives a net receipt of £17.56m

Chapter summary

Answer to additional question - Foreigncurrency implications

A strong pound

The pound has appreciated – therefore other foreign currencies have depreciated relative to the pound:

• UK exporters: Bad news; receipts in currencies that are depreciating; receive fewer pounds.
• UK importers: Good news; payments in currencies that are depreciating; pay fewer pounds.

Note: the alternative for the UK exporter is to put the price up in the foreign currency, but exports then become uncompetitive.

A weak euro

The euro has depreciated – therefore other foreign currencies have appreciated relative to the euro.

• European exporters: Good news; receipts in currencies that are appreciating; receive more euros.
• European importers: Bad news – payments in currencies that are appreciating – pay more euros.

Answer to additional question - Hedging a payment

Answer to additional question - Hedging a receipt

Test your understanding answers

Test your understanding 1 – Transaction risk

The UK firm faces uncertainty over the amount of sterling they will need to use to settle the US dollar invoice.

However on settlement, the cost may be:

This uncertainty is the transaction risk.

Test your understanding 2 – Economic risk

The product was previously selling at $16 × 1.26 = €20.16. Afterthe movement in exchange rates the exporter has an unhappy choice:

Either they must

• raise the price of the product to maintain their profits: 16 × 1.31 = €20.96 but risk losing sales as the product is more expensive and less competitive, or

The exporter is facing economic risk.

Test your understanding 3 – Bid and offer prices

Company A wants to buy $100,000 in exchange for sterling (so that the bank will be selling dollars):

• If we used the lower rate of 1.4325, the bank would sell them for £69,808
• If we used the higher rate of 1.4330, the bank would sell them for £69,784.

Clearly the bank would be better off selling them at the lower rate

RULE=> Bank sells lower (remember – this sounds like HELLO!).

Company B wants to sell $200,000 in exchange for sterling (so the bank would be buying dollars):

• If we used the lower rate of 1.4325, the bank would buy them for £139,616
• If we used the higher rate of 1.4330, the bank would buy them for £139,567

The bank will make more money buy at the higher rate:

RULE =>Bank buys high (remember – this sounds like BYE BYE!).

Test your understanding 4 – PPPT

Test your understanding 5 – IRPT

Test your understanding 6 – Hedging with forwards

The exporter will be selling his dollars to the bank and the bank buys high at 1.4565.

The exporter will therefore receive = 400,000 ÷ 1.4565 = £274,631.

Test your understanding 7 – Hedging a payment

Money market hedge:

(1)Create an equal and oppositeasset to match the $ liability. Calculate the amount the company needsto deposit now, so that with interest it will generate $450,000 to makethe payment in three months' time.

If annual interest rate for a three-month $ deposit is 5%, theninterest for three months is 5 × 3 ÷ 12 = 1.25%. The company will wantto put 450,000 ÷ 1.0125 = $444,444 on deposit now, so that it willmature to match the payment in three months' time.

(2)The company needs to purchase the required amount of dollars now, at the spot rate, at a cost of $444,444 ÷ $1.70 = £261,438.

(3)In order to compare the moneymarket hedge (MMH) with a forward contract we assume that the companywill borrow this money today and repay it in three months' time, withinterest.

If annual interest rate for a three-month £ borrowing is 7.5%,then interest for three months is 7.5 × 3 ÷ 12 = 1.875%. So thecompany will have to repay £261,438 × 1.01875 = £266,340 in threemonths' time.

Overall result: Liverpool knows today that it will cost £266,340 to settle the $ liability in three month's time.

The cost of a forward contract is marginally cheaper though this islargely due to rounding differences. In practice because of IRPT, theresult should be very similar.

Note that:

• as the payment has been made today, all forex risk is eliminated
• the method presupposes the company can borrow funds today.

Test your understanding 8 – Hedging a receipt

Money market hedge:

(1)Create a liability to match thereceipt: borrow an amount now, ($900,000 ÷ 1.0325 = $871,671) so thatwith interest, $900,000 is owing in 6 months' time.

(2)Convert the $871,671 borrowedinto sterling immediately to remove the exchange risk ($871,671 ÷1.7040) and deposit the £511,544.

(3)In 3 months the $ loan is paidoff by the $ received from the customer and Liverpool plc realises the£526,890 deposit (£511,544 × 1.03).

Overall result: Liverpool knows today that it will effectively exchange the $900,000 received for £526,890 in 6 months' time.

The forward hedge is the recommended hedging strategy.

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