Hedging treasury risk with forward foreign exchange contracts

Leslie Šulenta, International Bu siness Strategies, LLC– Example 1: Hedging with forwards – Example 2: Deriving the forward rate  Problems and risks  Accounting for forwards – Example

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Hedging Treasury Risk

with Forward Foreign

Exchange Contracts

Leslie Matthews Šulenta

Director International Business Strategies, LLC, Zagreb

September, 2005 Croatian Association of Corporate Treasurers

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Leslie Šulenta, International Bu siness Strategies, LLC

– Example 1: Hedging with forwards

– Example 2: Deriving the forward rate

 Problems and risks

 Accounting for forwards

– Example 3: Marking to market

 Risk management

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FX Forwards:

Definition, Characteristics and

Features

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 The actual exchange takes place on a

pre-determined date in the future

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 Forwards are entered into “over the counter”

 Deliverable forwards: face amount of currency is

exchanged on settlement date

 Non-deliverable forwards: only the gain or loss is

exchanged

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Characteristics and Features of FX

Forwards

 Contract terms specify:

– forward exchange rate

– term

– amount

– ‘‘value date’’ (the day the forward contract expires)

– locations for payment and delivery

 The date on which the currency is actually exchanged, the ‘‘settlement

date,’’ is generally two days after the value date of the contract

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Characteristics and Features of FX

Forwards

Forward Exchange Rates: “The Iron-Clad Law”

 Forward exchange rates are different from spot rates, but they are

not a prediction of what the spot rate will be when the deal settles!

The difference between the forward exchange rate and the spot exchange rate

is the interest differential between the two currencies

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FX Forwards:

Uses

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Uses of FX Forwards

(1) Hedge foreign currency risk

(2) Arbitrage FX rate discrepancies within and

between markets

(3) Speculate on future market movements

(4) Profit by acting as market maker

 Financial institutions, money managers,

corporations, and traders use these instruments for managing currency risk

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Two Types of Hedging

Corporations engaged in international trade

 Hedge payments and receipts denominated in foreign

currencies

– For example, a Croatian corporation that exports to Germany and expects payment in Euro (EUR) could sell EUR forward to eliminate the risk of a depreciation of the EUR at the time that the payment arrives

 Hedge the translation of foreign earnings for

presentation in financial statements.

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Example 1: Hedging With an FX Forward

Hedged Item

 Company must pay EUR 1,000,000

to a eurozone supplier in 3 months

 Spot rate HRK/EUR: 7.3000.

 Treasurer believes HRK will

depreciate during next 3 months

– Exposure to FX risk:

What will be exchange rate

HRK/EUR in three months??

Hedging Instrument

 Bank buys 1,000,000 EUR

forward at forward rate of 7.3750

– FX risk: Company is protected against large adverse FX rate movements

If FX rate is unfavorable in 3 months (ie, > 7.3750),

Company pays just 7.3750

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Hedged Item

 Company must pay EUR 1,000,000 to

a eurozone supplier in 3 months

 Spot rate HRK/EUR: 7.3000.

 Treasurer believes HRK will

depreciate during next 3 months

Advantages of Hedge:

Company knows its costs and can

plan its finances accordingly

Cost of the hedge is zero

Company is still exposed to FX risk

if the HRK/EUR spot rate is less than 7.3750 in 3 months

Effect of hedge is same as buying EUR today and holding in an interest-bearing

account (Forward FX agreement is NOT a simple speculation)

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 Hedged Company has

already bought EUR forward

– Hedged Company will pay:

7.375 x 1,000,000 = HRK 7,375,000

Money saved by hedging: 7,450,000 –

7,375,000 = HRK 75,000

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Example 2: Deriving the Forward

Exchange Rate

 The spot rate HRK/EUR is 7.3000

 A bank today sells a 3-month HRK/EUR forward to a

company for a forward exchange rate of 7.3371

 How did the bank compute the forward rate?

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 A company with EUR 1 million and a need for HRK in three

months should be indifferent, financially speaking, as to whether

it:

– Invests the EUR 1 million for 3 months at 1% and converts the

euros (plus interest) into HRK at the end of this time, or

– Sells the EUR 1 million spot for HRK, and invests the HRK at 3%

for 3 months

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Example 2: Deriving the Forward

Exchange Rate

Invest EUR 1 million at 1%

for 3 months (91 days)

Interest earned EUR

Interest earned HRK

55,358.33 (7.3 million x 3% x 91/360)

Value after 6 months HRK 7,355,358

Forward Exchange Rate: 7.3371

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FX Forwards:

Problems and Risks

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Problems with FX Forwards

 Finding counterparties who want to take exactly the

opposite position:

– Most companies (potential counterparties) are “in the same boat” (i.e., importers from the eurozone)

– One of the parties to the transaction might want to

trade a different amount, or have a different settlement date

– Transaction costs can be large (bank’s spread)

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 Liquidity risk: A party in a forward contract may find

it difficult to exit the position Alternatives:

– If counterparty agrees, cancel the forward for a fee

– Assign the contract to another party This requires some compensation

– If an exact opposite position can be taken, offset the obligation and suffer only the price differential

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 Default risk: There is an incentive for the

counterparty who lost on the forward contract to

default on the agreement

– Forwards are a zero sum game Each

counterparty that gains is balanced by a

counterparty who loses the same amount.

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FX Forwards: Accounting

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Accounting for FX Forwards

 IAS 39 applies (Accounting for

Financial Instruments – derivatives

accounting)

– The deal has no immediate value

– Off-balance sheet accounts are used

initially to record the deal on the books

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Accounting for Forwards

 Fair value of the forward changes over time with

movements in the foreign exchange rate

 Unrealized gain (loss) is measured by applying today’s

market rates at the forward date

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Example 3: Marking to Market

 After one month’s time, the company has to

mark-to-market a 3-month forward which is

carried in the off-balance sheet accounts

– On the date of the deal, the spot rate was 7.3000

– The forward rate for the deal is 7.3371

– The spot rate HRK/EUR is now 7.4150

 What is the market value of the forward today?

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Example 3: Marking to Market

 The company bought EUR against HRK in 90 days

 Today, the company could buy EUR 1,000,000 at the spot

rate of 7.4150 and pay HRK 7,415,000

 The company is committed to buy EUR 1,000,000 when

the forward matures at 7.3371 and pay only HRK

7,337,100.

 Thus, the deal now has value.

Company records an unrealized GAIN of:

HRK 7,415,000 – HRK 7,337,100 = HRK 77,900

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FX Forwards: Risk Management

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Risk Management

Before using any type of derivatives, companies

should:

 Discuss the potential risks and benefits of derivatives

with Management Board and Supervisory Board

 Develop appropriate internal controls and limits

 Prepare derivatives policy and procedures manual;

tax and accounting manuals

 Host training seminars for management and

employees

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Successful Risk Management

DON’T WORRY,

IT MAY MELT BEFORE WE GET THERE!

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WE CAN DECIDE WHAT

TO DO, IF AND WHEN

WE HIT IT!

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WE NEVER NEEDED TO USE LIFE BOATS

BEFORE!!

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Thank You.

Leslie Matthews Šulenta

+385 98 355 258

Leslie.sulenta@consulting-mps com

www.consulting-mps.com

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