Hedging Exchange Rate Risk
1. Introduction
5.2 Premium
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
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
- Home Currency
- Counter party’s home currency
- 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
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
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
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