Lecture International finance: An analytical approach (3/e): Chapter 13 - Imad A. Moosa

Chapter 13 - Foreign exchange risk management. The objectives of this chapter are: To explain why there is concern about foreign exchange risk; to illustrate how to manage short-term transaction exposure using forward hedging, futures hedging, money market hedging and option hedging; to illustrate other techniques of managing short-term and longterm transaction exposure;…

Chapter 13

Foreign Exchange Risk

Management

Objectives

• To explain why there is concern about FX risk

• To illustrate how to manage transaction, economic

and translation exposure

• Hedging, which is the core risk management

operation, is a process whereby a firm can protect

itself from unanticipated changes in exchange rates

and other sources of risk

(cont.

Hedging (cont.)

• The decision to hedge or not to hedge an uncovered

or open foreign currency position is basically a

speculative decision

• It all depends on the expected exchange rate or the movement of the exchange rate between the point in time when the decision is taken and when its effect materialises

Why is there no need to worry

about FX risk?

• If international parity conditions hold, FX risk will not arise

• If it is possible to forecast exchange rates accurately,

FX risk can be controlled

• Shareholders are naturally hedged though

diversification

Why worry about FX risk?

• International parity conditions do not hold

• Forecasting exchange rates is rather difficult

• Hedging produces a more stable income stream

Benefits of hedging

• Hedging has a positive effect on the value of the firm

• It produces a more stable corporate income stream

Managing short-term transaction exposure (financial hedging)

• Forward hedging

• Money market hedging

• Futures hedging

• Option hedging

Financial hedging

• By taking an affecting position on a hedging

instrument (forward, etc), the profit/loss on the

unhedged position is offset by the loss/profit on the hedging instrument

Forward hedging

• Forward hedging entails locking in the exchange rate

at which payables and receivables are converted

from the domestic currency into a foreign currency,

and vice versa

(cont.

Introducing the bid-offer spread

Futures hedging

• Futures hedging results may differ quantitatively from those of forward hedging

• Because of the standardisation of contracts, it may

not be possible to hedge the exact amount

(cont.

Futures hedging (cont.)

• The due date may not coincide with the settlement

date

• Marking-to-market introduces some variation

Money market hedging

• A money market hedge amounts to taking a money market position to cover expected payables or

receivables

• By borrowing and lending, a synthetic forward

contract is created

Money market hedging of payables

  Payables 

(K) 

Borrowing  domestic  currency 

Converting 

at spot rate 

Investing at  foreign rate 

K   

Loan  Repayment 

Implicit forward rate 

) 1 (

0

i KS

) 1 ( i K

) 1 ( ) 1 ( 0

i i S

) 1 (

) 1 ( 0

i i KS

Money market hedging of

receivables

(K) 

Borrowing  foreign  currency 

Converting 

at spot rate 

Investing at  domestic rate 

K   

Loan  Repayment 

Implicit forward rate 

) 1

K

) 1 (

0

i KS

) 1 ( ) 1 ( 0

i i S

) 1 ( ) 1 ( 0

i i KS

Money market hedging of payables with bid-offer spreads

  Payables 

(K) 

Borrowing  domestic  currency 

Converting 

at spot rate 

Investing at  foreign rate 

K   

Loan  Repayment 

Implicit forward rate 

) 1 ( a i b0KS

) 1 ( i b K

) 1 ( ) 1 (

0

b a a

i i S

) 1 ( ) 1 (

0

b a a

i i KS

Money market hedging as a pricing mechanism

• When the banker quotes a forward rate for a future

delivery of a particular currency, the banker will be

exposed to the risk arising from possible

appreciation of the underlying currency

(cont.

Money market hedging as a pricing mechanism (cont.)

• The banker can protect himself by hedging the

forward position in the money market, so that he

receives the amount of the underlying currency to be delivered on the maturity date

(cont.

Money market hedging as a pricing mechanism (cont.)

• The minimum forward rate that the banker can

quote, therefore, is the cost of money market

hedging, which is the forward rate implicit in the

synthetic forward contract created by the hedge

(cont.

Money market hedging as a pricing mechanism (cont.)

• The bid and offer forward rates quoted by the banker are

* 0

1

1

a

b b

b

i

i S

F

* 0

1

1

b

a a

a

i

i S

F

Option hedging

• The outcome of option hedging is not known with

certainty, since it depends on whether or not the

option is exercised

Hedging with a call option

Decision 

)( 1

0

1 0

1 0

Hedge 

Hedging with a put option

)( 10

1 0

1 0

Decision 

Contingent exposure

• A contingent exposure arises only if a certain

outcome materialises, such as winning a contract

Managing long-term transaction

Managing long-term transaction

exposure (cont.)

• Price variation and currency of invoicing

• Risk sharing arrangement

• Currency collars

Long-term forward contracts

• Commercial banks do provide forward contracts in

major currencies with long maturities (for example,

five or ten years)

• Because of the risk involved, banks only offer these contracts to the most creditworthy customers

Currency swaps

• Two parties exchanging cash flows denominated in two different currencies

Parallel loans

• Parallel loans are the origin of currency swaps They can be used to exchange cash flows

Leading and lagging

• If the foreign currency is expected to appreciate,

foreign currency dues are paid sooner rather than

later: this is called leading

• If, on the other hand, the foreign currency is

expected to depreciate, payables are met later rather than sooner: this is called lagging

Currency diversification

• Depending on correlation of the exchange rates

against the base currency, currency diversification

reduces risk

Exposure netting

• A natural hedge would arise when the firm has

payables and receivables in the same currency, in

which case only net exposure should be covered

Price variation and currency of

invoicing

• The foreign currency price of a product can be

adjusted by varying its domestic currency price

• Exposure to FX risk can be eliminated completely by using the domestic currency as the currency of

invoicing

Risk sharing and currency collars

• Risk-sharing arrangements and currency collars

involve the use of various values of the exchange

rate to convert cash flows

Economic exposure

• Economic exposure arises because revenues and

costs vary with changes in the real exchange rate

The effects of real appreciation

• Assuming elastic demand, real appreciation of the

foreign currency leads to:

and foreign borrowing

The effects of real depreciation

• Assuming elastic demand, real depreciation of the

foreign currency leads to:

foreign borrowing

Hedging economic exposure

• Reducing economic exposure requires:

materials

Why worry about translation

exposure?

• Translation exposure does not affect the economic

value of the firm

• Different translation methods affect reported

earnings per share and other financial indicators

Hedging translation exposure

• Fund adjustment

• Forward contracts

• Exposure netting and balance sheet hedging

Fund adjustment

• Fund adjustment involves altering the amounts

and/or currencies of the planned cash flows of the

firm or its subsidiaries to reduce exposure to the

currency of the subsidiary (the local currency)

Forward contracts

• If the base currency of a foreign subsidiary is

expected to depreciate against the parent firm’s base currency, then translation exposure exists

Exposure netting and balance sheet hedging

• Exposure netting can be used by multinational firms with offsetting positions in more than one foreign

currency

• A balance sheet hedge eliminates the mismatch

between assets and liabilities in the same currency