Currency Risk Management Solutions

1
Currency Risk Management Solutions
STEP Hedging Workshop October 29, 2008 Mark
Frey Vice President FX Trading
2
Todays discussion points

• The basic hedging process
• Forward contracts and forward points
• Swaps
• The basic principles of vanilla options
• The various options products available in the
  marketplace and their use

3
Currency Risk Management and Hedging Programs

4
Forward Contracts future dated settlement

• Benefits Flexibility in all but one sense.
• Nearly every currency pair.
• Can be both deliverable and non-deliverable
  draw down at any time.
• Dates are flexible, not fixed. Can pick any
  specific date.
• Amounts are not fixed, can cover to the exact
  penny.
• Extremely liquid based from FX spot market
  which is largest financial market in the world.
• No upfront costs or fees.
• CH offers forwards for a total of 75 currencies.
• Note Nearly all of these benefits can be
  realized via currency options as well

5
Forward Contracts

• Payoff is completely linear.
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500

6
Forward Contracts

• Drawbacks
• A forward is a commitment to buy or sell a
  foreign currency as opposed to an option.
• Does not allow for participation in any
  favourable market moves.
• Once a forward position is initiated, it must be
  delivered or closed out at or before maturity
  with a resulting paper gain or loss.

7
Forward Points Simplified

• Forward points are always ADDED to a the spot
  rate to determine the forward contract price.
• Derived from the interest rate differential
  between the two currencies
• If you are selling the currency with the HIGHER
  interest rate, you will do so at a DISCOUNT.
• If you are selling the currency with the LOWER
  interest rate, you will do so at a PREMIUM.

8
How to Derive Forward Points

• Assume a Canadian-based importer needs to buy USD
  to pay for her widgets in 6 months time (100K
  CAD).
• Spot of 1.0100 and 6M forward points on offer at
  40 Forward at 1.0140
• Current CAD 6M interest rate 4.10
• Current USD 6M interest rate 3.30
• Book a forward at 1.0140 or
• Borrow CAD for 6 months (100,000 1.0205
  102,050 CAD)
• Convert at spot and invest in USD GIC for 6
  months (99,009.90 1.0165 100,643.56 USD)
• Effective forward rate 102,050 / 100,643.56
  1.013974466

9
Forward Contract Types

• Open Contract
• An Open contract means that the forward points
  are only applied when it is in the sellers
  interest to do so.
• The purchaser sacrifices any potential benefits
  from the forward points in return for being able
  to exercise the contract at any time.
• The contract rate is never adjusted regardless of
  when the contract is drawn down.

10
Forward Contract Types

• Closed Contract (Fixed Dated)
• A Closed contract means that the forward
  points, whether discount or premium (in the
  clients favor or not) are always priced into the
  contract from the transaction date to the
  maturity date.
• The contract rate will be adjusted for the
  remaining points when the contract is
  pre-delivered.

11
Forward Contract Types

• Window Contract (Option Dated)
• A Window contract means that the contract is
  initially closed for a period and thereafter open
  for the remainder of the term.
• The forward points are applied up to the end of
  the closed period if in the clients favor, to the
  end of the open period if in the sellers favor.
• The contract rate is adjusted on pre-deliveries
  while the contract is closed.

12
Swaps An Invaluable Tool

• Two parties sell each other a currency with a
  commitment to re-exchange the principal amount at
  the maturity of the deal
• Essentially two forwards where you both buy and
  sell after having removed the bid-ask spread
• All thats left is the interest rate differential
  or the forward points
• It is important to note that the far date of the
  swap is essentially just a forward contract

13
When to Employ a Swap

• When one has foreign receivables but payables in
  both local and foreign currencies a cash
  smoothing tool
• When one is sitting on a positive cash balance in
  a foreign currency with payables in local but
  doesnt want to convert because of an
  unfavourable spot rate avoid being forced to
  exchange
• A swap can be employed both to close out a
  non-deliverable hedge to realize the MTM
  gain/loss while simultaneously re-initiating the
  hedge for the customer

14
Plain Vanilla Option

• An option gives the buyer the right, but not the
  obligation, to buy or sell a predetermined amount
  of one currency for another at a pre-specified
  rate at or before an agreed upon point in the
  future.
• An option gives the seller the obligation to
  perform the terms of the option should the buyer
  decide to exercise the option.
• This is fundamentally, and importantly different
  from a forward contract.

15
Plain Vanilla Option

• Provides you with full protection from adverse
  market moves
• A pre-determined exchange rate is set your Worst
  Case Rate
• You have unlimited participation in the market to
  take advantage of favourable market moves
• Unable to pre-deliver
• Premium payable upfront / or deferred until
  maturity
• Can be rolled into a Forward Exchange Contract

16
Plain Vanilla Option
Spot 1.0490 FEC Pts 0.0010 Outright
1.0500 WCR 1.0200 Cost 1980.00 USD
17
Corporate Hedging of Foreign Exchange

• A corporate with foreign currency exposure could
  do nothing, and wait to buy or sell in the spot
  market when the underlying transaction occurs,
  but that would leave them exposed to spot market
  price movements.
• The company could eliminate price risk by buying
  or selling the currency forward, but this would
  eliminate any potential gains from their position
  a forward obligates them to deal at the hedge
  rate.
• A company that likes its currency position or
  exposure, yet requires downside protection could
  be a good candidate for employing currency
  options. Why?
• Also, a corporate that has contingent obligations
  (i.e. bidding on a contract), is also a good
  candidate. Why?

18
Application of Options

• Using simple purchased currency option strategies
  to hedge currency risk is analogous to purchasing
  insurance you only benefit from the insurance
  if the adverse event occurs.
• Paying option premiums up-front may seem onerous
  at first, but it is well worth it when a
  catastrophic event occurs that would otherwise
  cause serious financial loss if the insurance
  were not present.
• The optimal outcome occurs when the option
  (insurance) expires unexercised due to a large,
  favorable market movement (fundamentally
  different than a forward).

19
Application of Options

• Risk vs. Reward Trade-off
• For purchased options, there is a large
  probability of realizing a small loss and a small
  probability of realizing a large gain (remember
  to breakeven, the gain must be big enough to
  compensate for the premium).
• This risk vs. reward relationship can be adjusted
  by selecting options of different strike prices,
  further OTM option structures reduce the cost,
  but have a higher probability of expiring OTM.

20
Risk vs. Reward Buying OTM Options

• Reduces the premium expense, and therefore
  increases profitability if the market moves
  favorably.
• Provides less protection in the event the market
  moves unfavorably by way of the less attractive
  hedge or strike rate.
• Is similar to high deductible insurance (ATM or
  ITM options would be low deductible but more
  expensive in terms of premiums.
• There is an increased chance of the a larger loss
  (on the underlying exposure) but also a large
  probability (range of potential outcomes) whereby
  the OTM option will outperform the ATM option

21
Exotic Options Range Forward

• Provides you with a known Worst Case Rate
• Allows you to participate in favourable exchange
  rate moves up to a Best Case Rate
• Not obligated if market settles between Worst and
  Best Case Rates
• Its essentially a forward with a variable rate.
• Unable to pre-deliver
• Minimum face value 100,000 USD
• Can be structured as a zero cost structure with
  no premium
• Can roll exercised option into a Forward Exchange
  Contract

22
Exotic Options Range Forward

• Scenario 1
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0200
• BCR 1.0820
• Deal at 1.0200

23
Exotic Options Range Forward

• Scenario 2
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0200
• BCR 1.0820
• Deal at spot (1.0740)

24
Exotic Options Range Forward

• Scenario 3
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0200
• BCR 1.0820
• Deal at 1.0820

25
Exotic Options Participating Forward

• Provides you with a known Worst Case Rate
• Allows you to participate in part of any
  appreciation in the exchange rate
• Unable to pre-deliver
• Minimum face value 100,000 USD
• Can be structured as a zero cost structure
• Can roll expired option into a Forward Exchange
  Contract
• In exchange for accepting a worse than current
  market forward rate at initiation, you are able
  to participate in favourable market moves at a
  rate of 50.

26
Exotic Options Participating Forward

• Scenario 1
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0250
• 50 Participation
• Deal at 1.0250

27
Exotic Options Participating Forward

• Scenario 2
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0250
• 50 Participation
• Deal 50 1.0250
• 50 1.0550
• (Spot)

28
Exotic Options Forward Extra

• Provides you with a known Worst Case Rate
• Allows you to participate in favourable exchange
  rate moves up to a preset Trigger Rate
• Not obligated if market settles between Worst
  Case Rate and Trigger Rate
• Obligated to deal at the Worse Case Rate if your
  trigger is touched at any stage throughout the
  contracts life
• Unable to pre-deliver
• Minimum face value 100,000 USD
• Can be structured as a zero cost structure
• Can roll expired option into a Forward Exchange
  Contract

29
Exotic Options Forward Extra

• Scenario 1
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0200
• Trigger 1.1300
• Deal at 1.0200

30
Exotic Options Forward Extra

• Scenario 1
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0200
• Trigger 1.1300
• Deal at spot (1.0900)

31
Exotic Options Forward Extra

• Scenario 1
• Spot 1.0490
• FEC Pts 0.0010
• Outright 1.0500
• WCR 1.0200
• Trigger 1.1300
• Deal at 1.0200

32
Exotic Options Bonus Forward

• Provides you with a known Worst Case Rate
• Allows you to participate in favourable exchange
  rate moves up to a preset Trigger Rate
• Not obligated if market settles between Worst
  Case Rate and Trigger Rate
• Obligated to deal at the Bonus Rate if your
  trigger is touched at any stage throughout the
  contracts life
• Unable to pre-deliver
• Minimum face value 100,000 USD
• Can be structured as a zero cost structure
• Can roll expired option into a Forward Exchange
  Contract

33
Exotic Options Bonus Forward

• Scenario 1
• Spot 1.0390
• FEC Pts 0.0010
• Outright 1.0400
• WCR 1.0200
• Trigger 1.1200
• Bonus 1.0450
• Deal at 1.0200

34
Exotic Options Bonus Forward

• Scenario 2
• Spot 1.0390
• FEC Pts 0.0010
• Outright 1.0400
• WCR 1.0200
• Trigger 1.1200
• Bonus 1.0450
• Deal at spot (1.0900)

35
Exotic Options Bonus Forward

• Scenario 3
• Spot 1.0390
• FEC Pts 0.0010
• Outright 1.0400
• WCR 1.0200
• Trigger 1.1200
• Bonus 1.0450
• Deal at 1.0450

36
Recommendations

• What do you want to achieve? Align your
  business goals with your hedging strategy and
  tools employed
• Balanced portfolio forwards combined with
  options?
• Ensure your budgeted rate is protected
• Participate in any potential gains, at least to a
  degree
• Combined with forecast exporters should be
  looking to participate whereas importers should
  be worried about protecting
• Any Questions? ?