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

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 firm’s exposures will look like over the long term. Specifically when they will take place and what the amounts will be.

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.

To Hedge or Not to Hedge? What are some of the factors that would influence a global firm or global investor’s 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 Starbuck’s 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?

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)

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.

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).

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.

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).

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.

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).

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 bank’s 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.

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.

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.

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).

A Put Option: To Sell Foreign Exchange 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.

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.

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

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.

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.

A Call Option: To Buy Foreign Exchange 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.

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

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

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.

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.

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)

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.

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.

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.

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).

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.

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.

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).

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.

A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure Step 3: Assessing the Impact of Forecasted Exchange Rates on Company’s 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

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 Firm’s 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. Partial “open” position versus complete “open” position. Which financial contract will achieve your objective?

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?

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).

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 firm’s specific needs. Especially with regard to timing and amounts.