Hedging Treasury Risk with Forward Foreign Exchange Contracts Leslie Matthews Šulenta Director International Business Strategies, LLC, Zagreb September, 2005 Croatian Association of Corporate Treasurers

Leslie Šulenta, International Business Strategies, LLC 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 Leslie Šulenta, International Business Strategies, LLC

FX Forwards: Definition, Characteristics and Features

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 Leslie Šulenta, International Business Strategies, LLC

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 Leslie Šulenta, International Business Strategies, LLC 5

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. Leslie Šulenta, International Business Strategies, LLC 5

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 Leslie Šulenta, International Business Strategies, LLC

FX Forwards: Uses

Leslie Šulenta, International Business Strategies, LLC 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 Leslie Šulenta, International Business Strategies, LLC

Leslie Šulenta, International Business Strategies, LLC 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. Leslie Šulenta, International Business Strategies, LLC

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, > 7.3750), Company pays just 7.3750

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)

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 The unhedged bank has to buy $ spot at 5.6. The cost of the hedge is the price paid for insurance. And what if exchange rate is 5.3 on 31.12.2005? Bank pays 5.3 x 11,000,000 = 58,300,000 + 189,000 cost of hedge = 58,489,000 Yes, bank had to “eat” the cost of the hedge, but it still paid less than it would have paid if it somehow could have locked in the spot rate on the date of the borrowing without paying a premium (5.4 x 11,000,000 = 59,400,000). Money saved by hedging: 7,450,000 – 7,375,000 = HRK 75,000

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? Leslie Šulenta, International Business Strategies, LLC

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 Leslie Šulenta, International Business Strategies, LLC

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

FX Forwards: Problems and Risks

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 (bank’s spread) Leslie Šulenta, International Business Strategies, LLC

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 Leslie Šulenta, International Business Strategies, LLC

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. Leslie Šulenta, International Business Strategies, LLC

FX Forwards: Accounting STARTING HERE: SKIP THE REST OF THE SLIDES TO SAVE TIME?

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 Leslie Šulenta, International Business Strategies, LLC

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 today’s market rates at the forward date Leslie Šulenta, International Business Strategies, LLC

Example 3: Marking to Market After one month’s 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? Leslie Šulenta, International Business Strategies, LLC

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 Leslie Šulenta, International Business Strategies, LLC

FX Forwards: Risk Management

Leslie Šulenta, International Business Strategies, LLC 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 Leslie Šulenta, International Business Strategies, LLC

Successful Risk Management DON’T WORRY, IT MAY MELT BEFORE WE GET THERE! Leslie Šulenta, International Business Strategies, LLC

Successful Risk Management WE CAN DECIDE WHAT TO DO, IF AND WHEN WE HIT IT! Leslie Šulenta, International Business Strategies, LLC

Successful Risk Management WE NEVER NEEDED TO USE LIFE BOATS BEFORE!! Leslie Šulenta, International Business Strategies, LLC

Leslie Matthews Šulenta Thank You. Leslie Matthews Šulenta +385 98 355 258 Leslie.sulenta@consulting-mps.com www.consulting-mps.com Thank you for your kind attention, and enjoy the remainder of your stay in Zagreb.