Managing Foreign Exchange Exposure with Financial Contracts

1
Managing Foreign Exchange Exposure with Financial
Contracts

• In this lecture we will discuss the various
  financial arrangements which global firms and
  global investors can consider when managing open
  foreign exchange positions

2
Assessing Foreign Exchange Exposure

• All global firms and global investors are faced
  with the need to analyze their foreign exchange
  exposures.
• In some cases, the analysis of foreign exchange
  exposure is fairly straight forward and known.
• For example Transaction exposure.
• There is a fixed (and thus known) contractual
  obligation (in some foreign currency) .
• While in other cases, the analysis of the foreign
  exchange exposure is complex and less certain.
• For example Economic exposure
• There is great uncertainty as to what the firms
  exposures will look like over the long term.
• Specifically when they will take place and what
  the amounts will be.

3
Hedging to Deal with Exposures

• In using a hedge, a firm establishes a situation
  opposite to its initial foreign exchange
  exposure.
• A firm or investor with an open long position in
  a foreign currency will
• Offset the original long position with a short
  position in the same currency.
• A firm with an open short position in a foreign
  currency will
• Offset the original short position with a long
  position in the same currency.
• In essence, the firm is covering (offsetting)
  the original foreign exchange position.
• Since the firm or investor has two opposite
  foreign exchange positions, they will cancel each
  other out.

4
To Hedge or Not to Hedge?

• What are some of the factors that would influence
  a global firm or global investors decision to
  hedge its open foreign exchange exposures?
• Perhaps the assessment of the future strength or
  weakness of the foreign currency the firm or
  investor is exposed in.
• This involves forecasting and how comfortable one
  is with the results of the forecast.
• For example If a firm or investor has a long
  position in what they have forecast will be a
  strong currency they may decide not to hedge, or,
  perhaps, do a partial hedge.
• On the other hand, firms and investors may decide
  not have any currency exposures and simply focus
  on their core business.
• Does Starbucks want to sell coffee overseas or
  speculate on currency moves?
• Obviously, this is different from a company
  managing a hedge fund, or a currency trading
  floor?

5
Hedging Strategies for Firms

• It would appear that most global firms (except
  for those involved in currency-trading) would
  probably prefer to hedge their foreign exchange
  exposures.
• But, how can firms hedge?
• (1) Financial Contracts
• Forward contracts (also futures contracts)
• Options contracts (puts and calls)
• Borrowing or investing in local markets (money
  market hedging)
• (2) Operational Techniques
• Geographic diversification (spreading the risk)

6
Forward Contracts

• Commercial bank generated contracts which allow
  the firm or investor to either buy or sell a
  specified amount of foreign currency on a future
  date (i.e., forward date) at a specified exchange
  rate (i.e., forward exchange rate).
• A forward contract is a firm commitment on the
  part of both parties (i.e., cannot be canceled).
• Open long position Hedged with a forward sale
  of the foreign currency.
• Open short position Hedged with a forward
  purchase of the foreign currency.

7
Use of Forward Contract

• Forward contracts allow the global firm or
  investor to lock in a home currency equivalent of
  an anticipated foreign currency cash flow.
• These forward contracts are used to offset the
  foreign exchange exposure resulting from an
  initial commercial or financial transaction.
• accounts payable (a short position),
• accounts receivable (a long position),
• interest payable (a short position),
• interest receivable (a long position).

8
Example of a Long Position

• Assume U.S. firm has sold a product to a German
  company.
• As a result of this sale, the U.S. firm agrees to
  accept payment of 100,000 in 30 days.
• What type of exposure does the U.S. firm have?
• Answer Open long transaction exposure an
  agreement to receive a fixed amount of foreign
  currency in the future (e.g., an account
  receivable).
• What is the potential problem for the U.S. firm
  if it keeps the position open (i.e., does not to
  cover)?
• The risk that the euro might weaken over this
  period, and in 30 days it will be worth less (in
  terms of U.S. dollars) than it is now.
• This would result in a foreign exchange loss for
  the firm.

9
Hedging with a Forward Contract

• Assume the U.S. firm decides it wants to hedge
  (cover) its open long foreign exchange
  transaction exposure.
• The U.S. firm asks a market maker bank for a 30
  day forward euro quote.
• Assume the market marker bank quotes the
  following EUR/USD 1.2300/1.2400.
• What does this 30 day forward quote mean
• Bid Market maker will buy euros in 30 days for
  1.2300
• Ask Market maker will sell euros in 30 days for
  1.2400
• With the forward contract, the U.S. firm can lock
  in the U.S. dollar equivalent of the sale to the
  German company at the bid price, or 123,000 (and
  will receive this in 30 days).
• Forward contract allows the firm to sell the
  euros (and to do so at the bid price).

10
Example of a Short Position

• Assume a U.S. firm has purchased a product from
  a British company.
• As a result of this purchase, the U.S. firm
  agrees to pay the U.K. company 100,000 in 30
  days.
• What type of exposure does the U.S. firm have?
• Answer Open short transaction exposure an
  agreement to pay a fixed amount of foreign
  currency in the future (e.g., an account
  payable).
• What is the potential problem if the U.S. keeps
  this position open?
• The risk that the pound might strengthen over
  this period, and in 30 days it will take more
  U.S. dollars than now to purchase the required
  pounds.
• This would result in a foreign exchange loss for
  the firm.

11
Hedging with a Forward Contract

• Assume the U.S. firm decides it wants to hedge
  (cover) this open short foreign exchange
  transaction exposure.
• The U.S. firm will ask a market maker bank for a
  30 day forward pound quote.
• Assume the market maker banks quotes the
  following GBP/USD 1.7500/1.7600.
• What do these quotes mean
• Bid Market maker will buy pounds in 30 days for
  1.7500
• Ask Market maker will sell pounds in 30 days for
  1.7600
• With the forward contract, the U.S. firm can lock
  in the U.S. dollar equivalent of its liability to
  the British firm at the ask price, or 176,000
  (and will pay this in 30 days).
• Forward contract allows the firm to buy pounds
  (and to do so at the ask price).

12
Advantages and Disadvantages of the Forward
Contract

• These contracts are written by market maker banks
  to the specifications of the global firm (i.e.,
  they can be tailored to the specific needs of the
  banks clients)
• For some exact amount of a foreign currency.
• For some specific date in the future (forward
  date).
• With no upfront fees, deposits, or commissions.
• Deals done at Bid and Ask prices on forward date.
• And they are easy to understand.
• Global firm or investor knows exactly what the
  home currency equivalent of a fixed amount of
  foreign currency will be in the future.
• However, global firm or investor cannot take
  advantage of a favorable change in the foreign
  exchange spot rate.

13
Upside Potential with Long and Short Positions

• Long position 100,000 to be received in 30
  days.
• Downside risk if the euro weakens.
• Upside potential if the euro strengthens
• Short position 100,000 payable in 30 days.
• Downside risk if the pound strengthens
• Upside potential if the pound weakens.
• Issue Once a forward contract locks in the
  forward spot rate, the upside potential is
  eliminated as a possibility.

14
Foreign Exchange Options Contracts

• A second type of financial contract used to hedge
  foreign exchange exposure is an options contract.
• Definition An options contract offers a global
  firm the right, but not the obligation, to buy (a
  call option) or sell (a put option) a given
  quantity of some foreign exchange, and to do so
• at a specified strike price (i.e., at an
  exchange rate), and
• at a specified date in the future.

15
Foreign Exchange Options Contracts

• Options contracts are either written by global
  banks (market maker banks) or purchased on
  organized exchanges (e.g., the Chicago Mercantile
  Exchange).
• Market maker banks can offer individually
  tailored options contracts, while organized
  exchanges only offer standardized contracts.
• Bank written options contracts provide the global
  firm and investor with
• (1) Insurance (in the form of a floor or
  ceiling exchange rate) against unfavorable
  changes in the exchange rate, and additionally
• (2) the ability to take advantage of a favorable
  change in the exchange rate.
• This latter feature is potentially important and
  it is something a forward contract will not
  allow.
• But the global firm must pay for this right.
• This is the option premium (which is a
  non-refundable up-front fee).

16
A Put Option To Sell Foreign Exchange

• Put Option
• Allows a global firm to sell a (1) specified
  amount of foreign currency on (2) a specified
  future date and at (3) a specified strike price
  (i.e., exchange rate) all of which are set today.
• Put option is used to offset a foreign currency
  long position (e.g., an account receivable or
  interest receivable).
• Provides the firm with an lower limit (floor)
  price for the foreign currency it expects to
  receive in the future.
• If the future spot rate proves to be
  advantageous, the holder will not exercise the
  put option, but instead sell the foreign currency
  in the spot market.
• Firm will not exercised the put option if the
  spot rate is worth more than the options
  contract strike price.

17
Put Option Example

• Recall the example of a U.S. firm which had a 30
  day account receivable in euros (slide 8)
• Firm anticipates receiving 100,000 in 30 days.
• Assume the current spot rate (EUR/USD) is
  1.2500/1.2600
• Thus, at the current spot bid rate the receivable
  is worth 125,000.
• Assume the firm negotiates a put contract with a
  market maker bank at a strike price of 1.2000.
  
• Thus, the U.S. firm has established a lower limit
  exchange rate for these euros at 1.20 (or
  120,000 for the receivable).
• It knows it will not receive less than 1.20 per
  euro.
• Assume the market maker bank charges a
  non-refundable up-front fee of 2,000 for this
  contract to lock in this lower limit at 1.20.
• This is the options premium on this contract.

18
Put Option Example -- Continued

• Assume in 30 days the euro spot rate quote
  (EUR/USD) is 1.1500/1.1700
• Question What has the euro done from the spot
  rate 30 days ago (1.2500/1.2600)
• Euro (bid price) has weakened, by 0.1000 per
  euro.
• Account receivable is now worth 115,000 at this
  spot rate (or 10,000 less than on origination
  date).
• Question What should the U.S. firm do?
• U.S. firm should exercise its put option and sell
  the euros to the market maker bank at the strike
  price of 1.2000.
• Firm will receive 120,000 less the 2,000 up
  front fee, or 118,000

19
Put Option Example -- Continued

• Now assume in 30 days the euro spot rate is
  quoted at 1.3500/1.3700
• Question What has the euro done from the rate 30
  days ago?
• Euro (bid) has strengthened, by 0.1000 per euro.
• Account receivable is now worth 135,000 at this
  spot rate.
• What will the U.S. firm do?
• Firm will not exercise its put option and instead
  will sell the euros in the spot market at 1.3500
• Firm will end up receiving 135,000 (less the
  2,000 up front fee), or 133,000 for the euros.

20
Review of Put Option Example

• We can see from the previous example, that with
  the use of a put option, the firm was able to
  establish (lock in) a lower limit for an open
  long position it has in a foreign currency.
• The firm can also walk away from the put contract
  if the exchange rate moves in its favor.
• Specifically, if the foreign currency
  strengthens.
• This is not a feature of a forward contract.

21
A Call Option To Buy Foreign Exchange

• Call Option
• Allows a global firm to buy a (1) specified
  amount of foreign currency at (2) a specified
  future date and at a (3) specified a price (i.e.,
  at an exchange rate) all of which are set today.
• Call option is used to offset a foreign currency
  short position (e.g., an account payable or
  interest payable).
• Provides the holder with an upper limit
  (ceiling) price for the foreign currency the
  firm needs in the future.
• If spot rate proves to be advantageous, the
  holder will not exercise the call option, but
  instead buy the needed foreign currency in the
  spot market.
• Firm will not exercise if the spot rate is
  cheaper than the options contract strike price.

22
Call Option Example

• Recall the example of the U.S. firm which had the
  30 day account payable in pounds (slide 10).
• Firm knows that it must pay 100,000 in 30 days.
• Assume the current spot rate (GBP/USD) is
  1.7200/1.7400
• Thus the payable will cost 174,000 at the
  current spot ask rate.
• Assume the firm negotiates a call contract with a
  strike price of 1.8000
• Thus, the U.S. firm has established an upper
  limit exchange rate for these pounds at 1.8000
  (or 180,000 for the payable)
• Assume the market maker bank charges a
  non-refundable fee of 3,000 for this contract to
  lock in this upper limit.
• This is the options premium

23
Call Option Example -- Continued

• Assume in 30 days the pound spot rate (GBP/USD)
  quote is 1.8400/1.8600
• What has the pound done from the spot rate 30
  days ago (1.7200/1.7400)?
• Pound (ask) has strengthened, by 0.1200 per
  pound
• Account payable will now require 186,000 at this
  spot ask rate (or 6,000 more than on origination
  date).
• What should the U.S. firm do?
• U.S. firm should exercise its call option and buy
  the pounds at the strike price of 1.8000.
• Firm will pay 180,000 plus the 3,000 up front
  fee, or 183,000, for the pounds

24
Call Option Example -- Continued

• Assume in 30 days the pound spot rate is quoted
  at 1.6500/1.6600
• What has the pound done from the spot rate 30
  days ago (1.7200/1.7400)?
• Pound (ask) has weakened, by .0800 per pound
• Account payable will now require 166,000 at this
  spot rate.
• What will the U.S. firm do?
• U.S. firm will not exercise its call option and
  instead buy the pounds at the current spot rate
  of 1.6600.
• Firm will pay 166,000 plus the 3,000 up front
  fee, or 169,000, for the pounds.

25
Review of Call Option Example

• We can see from the previous example, that with
  the use of a call option, the firm was able to
  establish (lock in) a upper limit for an open
  short position it has in a foreign currency.
• The firm can also walk away from the call
  contract if the exchange rate moves in its favor.
• Specifically, if the foreign currency weakens.
• This is not a feature of a forward contract.

26
Overview of Options Contracts

• Important advantage
• Options provide the global firm with the
  potential to take advantage of a favorable change
  in the spot exchange rate.
• Recall that this is not possible with a forward
  contract.
• Important disadvantage
• Options can be costly
• Firm must pay an upfront non-refundable option
  premium which it loses if it does not exercise
  the option.
• Recall there are no upfront fees with a forward
  contract.
• This fee must be considered in calculating the
  home currency equivalent of the foreign currency.
• This cost can be especially relevant for smaller
  firms and/or those firms with liquidity (i.e.,
  cash flow) issues.
• More difficult to understand (relative to forward
  contracts)

27
Hedging Through Borrowing or Investing in Foreign
Markets

• The third strategy used by global firms to hedge
  open foreign exchange exposure is through the use
  of borrowing or investing in foreign currencies.
• This strategy is commonly referred to as a money
  market hedge (since it involves short term
  financial assets and liabilities).
• Offsetting an open long position Borrowing
  (i.e., taking on a liability) in a foreign
  currency.
• The borrowing produces an offsetting short
  position.
• Offsetting an open short position Investing
  (i.e., acquiring an asset) in a foreign currency.
• The investing produces an offsetting long
  position.

28
Hedging a Long Position

• Assume a U.S. firm expects to receive 1,000,000
  in 1 year as a result of a sale to a British
  company (i.e., an account receivable).
• The U.S. firm could
• Sell the pounds (in 1 year) at the 1 year forward
  bid rate, or
• Purchase a put option on the pounds to sell
  pounds at a strike price in 1 year, or,
• Use a money market hedge strategy
• Using a Money Market Hedge and borrow to offset
  the long position
• (1) Borrow pounds
• (2) Swap out of pounds into dollars at the
  current spot rate.
• (3) In1 year, when the firm receives payment from
  the British company, use those pounds to pay off
  the bank loan.

29
Money Market Hedge Example

• Assume
• (1) an open long position of 1,000,000 (account
  receivable)
• (2) The current pound spot rate is 1.85/1.87
• (3) The U.K. loan rate is 5.25 per annum.
• With a money market hedge
• Borrow 950,000 (Note 49,875 is the interest on
  the loan)
• Swap out of 950,000 pounds into U.S. dollars
• 1,757,500 (at bid quote of 1.85 950,000 x
  1.85)
• In1 year, use the 1,000,000 account receivable
  to pay off the loan.
• Loan payoff 950,000 49,875 999,875
• What did the U.S. firm achieve?
• It has covered against a weakening of the pound
• It received dollars NOW rather than waiting 1
  year.

30
Outcome of Money Market Strategy for a Long
Position

• What has the firm accomplished with this money
  market strategy?
• The firm has effectively offset its initial
  foreign currency long position with the foreign
  currency denominated loan (which is a short
  position).
• The firm as also converted its initial foreign
  currency long position into its home currency and
  has done so before receiving payment.
• The firm has hedged against a weakening of the
  foreign currency.
• However, the firm will not benefit from a
  favorable change in the exchange rate (i.e., if
  the pound strengthens).

31
Hedging a Short Position

• Assume a U.S. firm needs to pay 1,000,000 in 1
  year as a result of a purchase from a British
  company (i.e., an account payable).
• The U.S. firm could
• Buy the pounds (in 1 year) at the 1 year forward
  ask rate, or
• Purchase a call option on the pounds to buy
  pounds at a strike price in 1 year, or,
• Use a money market hedge strategy
• Using a Money Market Hedge and borrow to offset
  the short position
• (1) Borrow U.S. dollars
• (2) Swap out of dollars into pounds at the
  current spot rate.
• (3) Invest in a 1 year pound denominated
  financial asset.
• (4) In1 year, when the pound denominated
  financial asset matures, use the proceeds to pay
  off the 1,000,000 pound account payable.

32
Money Market Hedge Example

• Assume
• (1) A short position of 1,000,000
• (2) The current spot rate is 1.85/1.87
• (3) The U.K. investing rate is 8 per annum.
• With a money market hedge
• The firm needs 926,000 which if invested at 8
  (U.K. interest rate) for a year will equal the
  1,000,000 it needs in 1 year for its short
  position.
• At the ask spot rate, the firm needs to borrow
  1,731,620 from a U.S. bank (926,000 x 1.87).
• Swap out of dollars into pounds
• 926,000 (at ask quote of 1.87)
• Invest 926,000 in a 1 year U.K. financial asset
  at 8.
• Use the maturing U.K. asset (actually equal to
  1,000,080) to meet the account payable in 1
  year.
• What did the U.S. firm achieve?
• It has covered against a strengthening pound.
• It has converted its 1 year pound liability into
  a known U.S. dollar liability.

33
Outcome of Money Market Strategy for a Short
Position

• What has the firm accomplished with this
  strategy?
• The firm has effectively offset its foreign
  currency short exposure with the foreign currency
  denominate asset which is a long position
• The firm has converted its foreign currency
  liability into a home currency liability.
• The firm has hedged against a strengthening of
  the foreign currency.
• However, the firm will not benefit from a
  favorable change in the exchange rate (i.e., if
  the pound weakens).

34
A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure

• Step 1 Determining Specific Foreign Exchange
  Exposures
• What type of exposure are you dealing with?
• By currency and net amounts (i.e., long minus
  short positions)
• Are the net amounts worth hedging? If they are
  go to Step 2.
• Step 2 Forecasting Exchange Rates
• Determining the potential for and possible range
  of currency movements.
• Important to select the appropriate forecasting
  model.
• A range of forecasts is appropriate here (i.e.,
  forecasts under various assumptions)
• How comfortable are you with your forecast? If
  comfortable, go to Step 3. If not, HEDGE.

35
A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure

• Step 3 Assessing the Impact of Forecasted
  Exchange Rates on Companys Home Currency
  Equivalents (What is the Measured Risk?).
• Impact on earnings, cash flow, liabilities
  (positive or negative?)
• Go to Step 4
• Step 4 Deciding Whether to Hedge or Not
• Determine whether the anticipated impact of the
  forecasted exchange rate change merits the need
  to hedge.
• Perhaps the estimated negative impact on home
  currency equivalent is so small as not to be of a
  concern.
• But, if impact is unacceptable, go to Step 5
• Or, perhaps the firm feels it can benefit from
  its exposure.
• If this is the case, go to Step 6

36
A Comprehensive Approach or Assessing and
Managing Foreign Exchange Exposure

• Step 5 Selecting the Appropriate Hedging
  Instruments if Risk is Unacceptable.
• Consider
• Which hedge is appropriate for the type of
  exposure?
• Financial and/or operational
• Firms familiarity and comfort level with types
  of hedging strategies.
• Review the cost involved with different financial
  contracts.
• Step 6 Selecting the Appropriate Strategy to
  Position the Firm to Take Advantage of a
  Favorable Exchange Rate Change.
• Consider
• Partial open position versus complete open
  position.
• Which financial contract will achieve your
  objective?

37
What Hedges are Used?

• 1995 study by Kwok and Folks of Fortune 500
  companies revealed
• Type of Product Heard of Used
• Forwards 100.0 93.1
• Bank (O-T-C) Options 93.5 48.4
• FX Futures 98.8 20.1
• Exchange traded options 96.4 17.3
• Why do you think the first two are preferred over
  the last two?
• Do you think you would see these same results
  today?

38
Preference for Forward Market Contracts

• Why was there a preference for forward contracts?
• Perhaps because they are simple to understand and
  simple to use.
• Forward contract can be tailored to offset known
  contractual agreements.
• They are written by market maker banks for global
  customers on the basis of the customers
  particular needs
• For a particular foreign currency and amount.
• For a particular cash flow (future date).

39
Preference of Bank Options over Exchange Traded
Options and Futures

• As with forwards, bank options can be tailored to
  the specific needs of the global customer.
• And they provide the firm with the flexibility to
  take advantage of a favorable change in exchange
  rates.
• But with a cost, which, in part, explains the
  preference for forwards over options.
• Exchange traded options and foreign exchange
  futures are not over the counter instruments.
• They trade on exchanges
• The contracts are standardized with regard to
  currency itself, the amount, and the maturity
  dates of the product.
• Thus, they may not be appropriate for a global
  firms specific needs.
• Especially with regard to timing and amounts.