Tuesday 25 June 2013

Hedging Exchange Rate Risk

Hedging Exchange Rate Risk

1. Introduction. 4
     3.2 Currency Forward contracts. 6
     3.3 Currency Future contracts. 7
     3.4 Currency Option contracts. 7
     3.5 Hedging through Money Market 8
4. Calculations of three chosen approaches 8
    4.2 Currency Forward contracts. 9
5. Forward exchange fixed V/S forward exchange option contracts 11
    5.1 Option but not obligation 11
    5.2 Premium.. 12
    5.3 Trading 12
    5.4 Execution Time 12


Executive Summary:
Exchange rate risk is one of the most important factors managers should consider while dealing in outside the country in foreign currency. To reduce the volatility in future cash flows and to protect from losses due to change in currency rates stimulates the firm to go for a hedging strategy to cater currency risk problem. Billing in home currency, Forwards, Futures, Options and hedging through money markets are the potential strategies firm can adopt to hedge their currency risk. Giving right to purchase or sale not the obligation, paying premium at the time of contract and to some extent the flexibility in exercising the contract are the potential factors that discriminate Currency forward options with currency forward fixed contracts. The right to buy or sale allows the firm to minimize the risk and maximize the profits as compared to option contract at the cost of premium paid at the time of contract. In the case of firm it was found that the selecting forward contract is the best hedging strategy as company can get maximum proceeds in dollars from this strategy as compared to billing in US dollars or money market hedge. Company can earn 33306022.4 dollars from forward contract which is 744399.5 dollars more than billing in US dollar strategy and 342602.6 dollars more than money market strategy.

  1. Introduction:
Today this is a world of globalization where firms are broadening their activities across the boundaries and not restricted themselves for local operations only. Access to new markets, raw materials, new technology, to seek production efficiency, diversification and to avoid political and regulatory risks are the potential factors that stimulate the firms to go global (Brigham and Houston, 2008:747).
While dealing in across the border a number of factors like exchange rate risk, political risk, regulatory risk, cultural and language differences can affect the decision making of managers. Exchange rate risk is one of the most important factors in this respect. Exchange rate is the specified units of a given currency that are equal to the one unit of another currency. So whenever international financial managers are dealing in foreign currency instead of their local currency, an analysis of exchange rate risk should make to assess the real value of transaction.
2. Why hedging Exchange Rate risk:
Exchange rate risk management becomes more critical for the firms dealing in import and export where change in currency rate can lead to a volatile cash flow. It was Adler and Dumas who have explain the exchange rate exposure phenomena as the volatility in cash flows because of unexpected increase or decrease in foreign exchange rate (1984).
As a key source of uncertainty for companies exchange rates evidenced a volatility of ten times of inflation rate and four times of interest rate all over the world (Jorion, 1990).  Froot et al. have found that volatility in the cash flows due to change in exchange rates can lead to a shortage of finance and as a result direct the company for costly external financing (1993). Though researchers found a small economical and significant effect between firm’s value and the change in exchange risk (Griffin and Stutz, 2001) but still it increases opportunity cost and the uncertainty about the future cash flows. So hedging exchange rate risk is very important to avoid this uncertainty of losses. As the firm is expecting to receive 500 million Mexican pesos in next 6 months while those Pesos will be used in home country. So after receiving those pesos they have to convert into dollars to use in US. Today if company receives those 500 Poses and converted it on spot bid rate (rate at which you can buy Dollars in exchange of other specified currency at the spot) then firm will receive 500000000 / 15.3555 = 32561622.9 dollars. But firm will get these Pesos in next 6 month and what will happen if the spot bid rate does change? Now suppose if the Mexican Pesos depreciated after 6 month and spot bid rate changes from 15.3555 to 15.5 Poses/Dollar and firm converted those Poses into Dollar then the firm will receive 500000000 / 15.5 = 32258064.5 Dollars which is 303558.4 (32561622.9 - 32258064.5 = 303558.4) less than today amount of Dollars if converted. So it is very important to manage this risk arises due to change in exchange rate and hedging exchange rate risk to avoid future cash flow volatility.
3. Techniques of hedging Exchange Rate risk:
Above illustration shows the importance of hedging exchange rate risk especially when foreign currency is expected to appreciate for an importer or depreciation in foreign currency for an exporter while payments or receipts are made in foreign currency. Firms use derivative instruments to hedge their exchange rate risk and to avoid the volatility in their cash flows all over the world (Froot et al., 1993). Following are techniques to hedge exchange rate in this respect.

3.1 Billing in home currency:
While dealing in foreign exchange currencies in their operations one can deal in three different currencies
  1. Home Currency
  2. Counter party’s home currency
  3. Third country currency
Dealing with home currency transaction is the easiest way to hedge the currency risk as whenever the payment is paid you will receive in home currency and no need to convert it with other currency that can lead to volatile cash flows, but this holds true if home currency is stronger and expected to appreciate with respect to that currency (Grath, 2008:98). While if foreign currency is expected to appreciate i.e. forward rate is less than spot rate then you can hedge yourself through forward contracts with more returns.
3.2 Currency Forwards:
It is an obligatory sale or purchase agreement of a specified number of units of a currency with a specified exchange rate in replace of another currency at a future date. The agreed rate can be different from spot rate but it did not assure that on that future date spot price of that currency will be same as this forward rate. This forward rate is been determined according to interest rates and to market situation plus bank commission (Grath, 2008:98). These are over the counter contracts and time period of the transaction should be more than 2 days after transaction and in the foreign exchange market nearly 10 percent of all transactions are forward contracts (Homaifar, 2004:41). It is an obligation on both the parties and at the maturity of contract one party has to sale and other has to purchase that specified numbers of units at that agreed price. In these contracts one can hedge his exchange rate risk by transferring it to the counter party. Currency forward contracts allows a firm to hedge its exchange rate risk by locking the price to be paid against foreign currency as the value of that currency may appreciate over time (Madura, 2006). For example as firm is expected to receive 500 million Pesos whose spot rate is 15.3555 and we made a 6 month forward contract whose rate is 15.0123 and hedge our risk. Now whatever the spot price will be after 6 months bank is obligatory to exchange those Pesos at 15.0123 exchange rates and risk has been transferred to bank. If the spot rate at that time is more than forward rate then bank will enjoy premium and if the exchange rate falls than forward rate than risk bank will bear losses. Though currency rate risk is been catered in forwards with customized options but as these are over the counter contracts usually made by bank, so the risk of default of that bank is associated and on the other hand liquidity before maturity of these contracts are also been an issue to be considered.
3.3 Futures Contract
Having all features of forward contracts but standardized features along with trading in exchange makes it different from forwards. As Futures are traded on exchange, so the risk of default is guaranteed by that exchange. Unlike forwards these are standardized contracts where you just have to choose your contract.
3.4 Currency Options:
These are the contracts in which the buyer of option has the right, but not the compulsion to sale or buy a specified number of units of a currency at a agreed rate during some future date (Grath, 2008:101). Unlike forward or futures it did not create obligations to the party to execute the contract but it provides the right to the option holder whether to execute the contract or not at the time of maturity. A call option provides to its owner the right to purchase while a put option gives the right to sell a specified number of foreign currency in exchange of home currency at a particular price (also called strike price), on or before some specified expiration date (Marcus, 2004:656). Option holder has to pay some premium at the time of contract but at the withdrawal option holder will loss that premium. Both options at over the counter and tradable options are available. Suppose you buy a put option to sell 5oo million Mexican Poses after 6 month with a premium of $1000 at the rate of 15.2 Poses / Dollar and today spot price is 15.3555 Poses / Dollar. Now after 6 months total value of option will be $32893736.8 (500000000 / 15.2 - $1000). You will exercise the put option if the spot rate at that time will be at least 15.2004 poses / dollars (500000000 / 32893736.8) as at this level there is no profit and no loss. So decrease in spot rate at that time from this level will increase the profitability in dollars while any increase from this level will lead to withdraw from option as it will increase the loss.
3.5 Hedging through Money Market:
It is a process by which one can borrow and deposits different currencies in different countries having different interest rates to eliminate the currency risk. Here the logic is different interest rates in different countries and we try to cater our currency risk through those interest rate differentials.
4. Calculations of three chosen approaches:
                                                            Bid Rate         Ask Rate
Spot rate (Peso/USD)                         15.3555           15.3561
Six months forward (Peso/USD)        15.0123           15.0134
Six months interest rates                   U.S                  Mexico
Deposit                                               3.1% p.a.         1.6% p.a.
Borrowing                                          5.1% p.a.         2.6% p.a.
4.1 Billing in US Dollars:
As firm is expecting 500 million Mexican poses in next 6 months. Now if firm contracted with its customer to pay in US dollars then today he will fix dollar amount to be paid after 6 months according to current spot rate as given.
                        Dollars to be paid = 500000000 / 15.3555 = 32561622.9 US Dollars
Now after 6 months company will receive 32561622.9 dollars from its customer and company has hedged himself to this amount of dollars. Now whatever the exchange rate will be after 6 months company will receive 32561622.9 dollars.
4.2 Currency Forward Contract:
Another option that can be used to hedge currency risk is forward contract. After entering a six month forward contract company can lock the exchange price of 15.0123 poses per dollar. Now whatever the price will be after 6 month company can exchange those 500 million poses into dollars at 15.0123 poses per dollar. So after 6 month company will receive following amounts.
Receipts from customers                     = 500000000 poses
Covert to Dollar at Forward rate    = 500000000 / 15.0123                                                                                                           = 33306022.4 Dollars
So after entering forward contract company has locked the conversion price at 15.0123 and can convert those 500 million poses into 33306022.4 Dollars after 6 months.

4.3 Money Market Hedge:
Company can also go for a money market hedge where firm can borrow from Mexican money market for 6 months against some interest rate to be paid and convert this amount into Dollars. Then deposit this amount in home country money market for 6 months for some interest. When receive those 500 million poses from its customer, return the loan borrowed from Mexican money market and also receive money deposited in home country money market with interest. This all process is completed in following way
 Step 1                                                                                 
Borrow required Poses from Mexican market = 500000000 / [1 + (0.026 * 6/12)]
                                                                                      = 500000000 / 1.013                                                                                                               = 493583416 poses
Step 2
Covert these Poses into Dollars at current spot rate     = 493583416 / 15.3555                                                                                                           = 32143754.1 Dollars
Step 3
Deposit these Dollars into home money market at 5.1% p.a.
Step 4
Now after 6 months firm’s repayment of loan (Principle + interest) from Mexican market becomes due
                      Amount due to Mexican money market = Principle + Interest                                                                                      = 493583416 + 6416584                                                                       = 500000000 Poses
Company will repay its 500000000 Poses loan after receiving from its customer. Company also will receive his deposited 32143754.1 Dollars along with 5.1% p.a. interest rate.
Amount Receive from Home money market = Principle + Interest                                                                                                   = 32143754.1 + (32143754.1 * 0.051 * 6/12)                                                                        = 32143754.1 + 819665.73                                                                                                        = 32963419.8 Dollars
So after 6 months company will receive a total of 32963419.8 Dollars.
4.4 Recommended approach:
Company should go for forward contract to hedge its currency rate risk as company will receive maximum amount of dollars after 6 month in this approach. If company goes for billing in US dollars then it will receive 32561622.9 dollars which is not a good option as the forward rate is less than spot rate and company can gain 33306022.4 Dollars through forward contract even more than the proceeds will receive from money market hedge approach. In exercising the forward contract company can hedge his currency risk and also will earn 744399.5 (33306022.4 - 32561622.9) dollars more than billing n US dollar option and 342602.6 (33306022.4 - 32963419.8) more than the money market option.
5. Forward exchange fixed V/S forward exchange option contracts:
Following are the critical features that distinguish these two Forward exchange fixed and forward exchange option contracts.
5.1 Option but not obligation:
The main feature that differentiate forward option contract with forward fixed contract is the right to execute the contract and not the obligation. In option contract option holder can cancel the contracts while loosing his premium amount (Grath, 2008:101). This feature of option provides option holder more flexible risk management as he can cancel the deal if observing low proceeds of amount and also can got high profits if the exchange spot rate increases as compared to strike price (option exchange rate). While in forward you make a 100% hedge and lack at one price.
 5.2 Premium:
No premium is required to enter in a forward contract while for a forward option contract premium is required which act as insurance premium determined and varying according to interest rate level, market condition, time period of contract and expected fluctuations in currency Grath, 2008:102). This feature of options can make it costly as compared to forwards. But on the other hand it can also provide an opportunity for high profits. Unlike options there is no such premium required to enter in a forward contract but a little margin or commission.
5.3 Trading:
Forwards are available in over the counter market while options can be accessed through both traditional and over the counter market. So both tailor made and standardized option contracts are available.
5.4 Exercise Time:
As it is very difficult for an importer to figure out the exact time of payment or proceeds will receive in foreign currency, so option contract also can provide this kind of flexibility. For example if today (1 April) you but an option for 6 months at a strike rate of 15.43 Poses / Dollars and in agreement it is given that you can exercise this agreement from 1st September to 30th September. Now you have more flexibility in exercising the contract according to your need during the month of September. But in the case of forward contract you fix a future date and the contract will be exercised on that particular date.

 References:
Adler, M., and B. Dumas (1984), ‘Exposure to Currency Risk: Definition and Measurement’, Financial Management, 13: 41-50

Brigham and Houston (2008), ‘Fundamentals of financial management’, (10th Ed)

Froot, K.A., D.S. Scharfstein, and J.C. Stein (1993), ‘Risk Management: Coordinating Corporate In-vestment and Financing Policies’, Journal of Finance, 48: 1629-1658

Grath, A (2008), ‘The hand book of International Trade and Finance’, US: Kogan Page Limited

Griffin, J.M., and R.M. Stutz (2001), ‘International Competition and Exchange Rate Shocks: A Cross-Country Industry Analysis of Stock Returns’, Review of Financial Studies, 14: 215-241

Homaifar G.A. (2004), ‘Managing Global Financial and Foreign Exchange Rate Risk’,
John Wiley & Sons, Inc

Jorion, P. (1990), ‘The Exchange Rate Exposures of US Multinationals’, Journal of
Business, 63, 331-345

Madura, J. (2006), ‘Financial Markets and Institutions’, Ohio: Thomson South Western
  





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