FOREIGN EXCHANGE RISK MANAGEMENT RAJESH KUMAR. S

FORWARD MARKET / FUTURES MARKET / OPTIONS MARKET HEDGING AGAINST FOREIGN EXCHANGE EXPOSURE FORWARD MARKET / FUTURES MARKET / OPTIONS MARKET CURRENCY SWAPS INTEREST RATE SWAP CROSS CURRENCY SWAP HEDGING THROUGH CURRENCY OF INVOICING HEDGING THROUGH SELECTION OF SUPPLYING COUNTRY

HEDGING AGAINST FOREIGN EXCHANGE EXPOSURE Currency risk when a firm faces contractual CFs fixed (invoiced) in another currency - receive or pay fixed amount of foreign currency in the future, i.e. any receivable (AR), or payable (AP) in a foreign currency.   Source of currency risk ?    

Example - case of steel An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles three months hence to dealers in the East European market. Suppose that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. Increasing steel prices If steel prices increase, this would result in increase in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding loss in the physical market. But this loss is offset by his gains in the futures market. .

Decreasing steel prices If steel prices decrease, this would result in a decrease in the value of the futures contracts, which the automobile manufacturer has bought. Hence, he makes losses in the futures transaction. But the automobile manufacturer needs to buy steel in the physical market to meet his export obligation. This means that he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract.

FORWARD MARKET A Contract between two parties obligating each to exchange a particular good or instrument at a set price on a future date. It’s an OTC agreement. In forward market hedge , a company that is long in a foreign currency will sell the foreign currency forward whereas a company that is short in foreign currency will buy the currency forward. Perfect , covered , squared Open or uncovered

FUTURES MARKET

OPTIONS MARKET

OPTIONS (PUT & CALL) General rules When the quantity of a foreign currency cash outflow is known , buy the currency forward, when quantity is unknown buy call option. 2.When the quantity of a foreign currency cash inflow is known, sell the currency forward, when the quantity is unknown , buy a put option on the currency. 3. When the quantity of foreign currency cash flow is partially known and partially uncertain , use a forward contract to hedge the known portion and an option to hedge the maximum value of the uncertain remainder. EXPOSURE NETTING Offsetting exposure in one currency with exposure in same or another currency , where exchange rates are expected to move in such way that losses(gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.

CURRENCY SWAPS A currency swap is an exchange of payments in one currency for stream of payments in another currency over given period of time. Benefits : It eliminates all foreign exchange exposure in the currency you are swapping , while creating a cash flow in a currency which would be more acceptable from cash management viewpoint.

Japanese multinational Japanese yen Received from subsidiary Dollars received from ongoing operations Dollar payments Yen payments Japanese multinational US multinational Dollar payments Yen payments Yen payments Dollar payments Japanese multinational Issues yen denominated bonds to investors US multinational Issues dollar Denominated bonds To investors

INTEREST RATE SWAPS A interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. Plain vanilla swap They are typically an exchange of floating rate interest obligations for fixed rate interest obligations

Eg: Consider two companies A and B. Company A wants to obtain medium term four years financing at fixed rate . Company B wants to borrow floating rate dollars. Company A CompanyB Differential Fixed 11.70% 10.75% 95 basis points Floating LIBOR + 3/8 % LIBOR + 1/4 % 12.5 basis points Soln A borrows floating rate funds at LIBOR + 3/8 and sells it to B at LIBOR B borrows fixed rate money at 10.75% and sells it to A at 11.00%

CROSS CURRENCY SWAPS Suppose a manufacturer, XYZ Company, is building a new plant in European country using term fixed rate financing. Suppose further that XYZ, having little access to the european capital markets, concludes that borrowing US Dollars from a domestic bank offers the most cost-effective source of financing. XYZ can fund in US Dollars (USD) and then convert to Euro using a Cross Currency Swap. XYZ will make an initial exchange of USD for Euro at the current spot exchange rate with an agreement to re-exchange at the same rate when the swap terminates in 7 years. In this way, the company is not exposed to exchange rate risk when closing out the swap and paying down the loan. 

HEDGING THROUGH CURRENCY OF INVOICING HEDGING THROUGH INVOICE CURRENCY   Assume that Boeing has a contract to build five 747s for British Airways, and deliver one each year for the next 5 years, and receive pound 10m per plane.  By negotiating and adjusting terms of the invoice, Boeing can shift, share or diversify currency risk. a) If Boeing can invoice in USD, then it has eliminated currency risk for itself and shifted it to British Airways.  Now if S = $1.50/pound , British Airways has a $15m AP and Boeing has a $15m AR.

HEDGING THROUGH MIXED CURRENCY INVOICING b) Boeing could split (share) the currency risk with British Airways by invoicing 50% in USD and 50% in BP: $7.5m + £5m for each plane, and each company shares half the risk.  Invoice in a basket of currencies to diversify and reduce currency risk with a portfolio of currencies: e.g. SDRs ($, ?,?,?,?; weights are 38%, 37%, 13%, 12%) or in the past, ECUs (11 currencies).  Companies can issue bonds denominated in SDRs or ECU (prior to euro) to diversify risk, Egyptian govt. charges in SDRs for passage through the Suez Canal.  Invoicing in currency baskets can be a useful hedging tool when no forward or currency contracts are available

SPEEDING/SLOWING AR AND AP IN FOREIGN CURRENCY General rules: For AR (Accounts Receivable) in foreign currency: Speed up (or lead) collections of depreciating currencies (e.g., peso ARs), and Slow down (or lag) collections of appreciating currencies (e.g., Euro ARs). For AP (Accounts Payable) in foreign currency: Speed up (or lead) payments of appreciating foreign currencies (e.g. Euro APs, when dollar is depreciating), and Slow down (or lag) payments of depreciating currencies (e.g., Mexican peso APs when dollar is appreciating).

HEDGING THROUGH SELECTION OF SUPPLYING COUNTRY Eg Aviva corporation might buy its denim cloth in currencies in which it sells its jeans. Aviva could buy the denim in various currencies in rough proportion to volume of sales in those currencies. i.e total value of jeans that it sells in that market should be netted against its denim purchases.

CAREER IN HEDGE FUNDS