Hedging Treasury Risk with Forward Foreign Exchange Contracts

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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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Overview

• FX forwards definition, characteristics and
  features
• Uses of FX forwards
• 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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Forward Foreign Exchange Contract

• Definition
• An agreement to exchange one currency for
  another, where
• The exchange rate is fixed on the day of the
  contract, but
• The actual exchange takes place on a
  pre-determined date in the future

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Characteristics and Features of FX Forwards

• Available daily in major currencies in 30-, 90-,
  and 180-day maturities
• 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, gt
  7.3750), Company pays just 7.3750

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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
• Advantages of Hedge
• Company knows its costs and can plan its finances
  accordingly
• Cost of the hedge is zero --
• No money is exchanged at inception of the forward
  FX agreement

• Hedging Instrument
• Bank buys 1,000,000 EUR forward at forward rate
  of 7.3750
• Disadvantage of Hedge
• 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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Example 1 Hedging With an FX Forward

• Unhedged Company
• If in 3 months, spot rate is 7.4500
• Unhedged Company must pay
• 7.45 x 1,000,000
• HRK 7,450,000

• Effect of Hedging
• 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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Example 2 Deriving the Forward Exchange Rate

• Three month interest rates are
• 1 on the euro
• 3 on the kuna
• 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
OPTION 1
OPTION 2
Sell EUR 1 million spot at 7.30 Buy HRK 7.3
million Invest HRK for 3 months at 3
Invest EUR 1 million at 1 for 3 months (91 days)
Interest earned HRK 55,358.33 (7.3 million x 3 x
91/360)
Interest earned EUR 2,493.15
Value after 3 months EUR 1,002,493
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 (banks spread)

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Problems with FX Forwards

• 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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Problems with FX Forwards

• 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
  todays market rates at the forward date

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Example 3 Marking to Market

• After one months 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
DONT WORRY, IT MAY MELT BEFORE WE GET THERE!
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Successful Risk Management
WE CAN DECIDE WHAT TO DO, IF AND WHEN WE HIT IT!
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Successful Risk Management
WE NEVER NEEDED TO USE LIFE BOATS BEFORE!!
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• Thank You.
• Leslie Matthews Šulenta
• 385 98 355 258
• Leslie.sulenta_at_consulting-mps.com
• www.consulting-mps.com