Hedging Transaction Exposure

Forward Contracts Forward contracts are purchases/sales of currencies to be delivered at a specific forward date (30,90,180, or 360 days) Forward contracts are purchases/sales of currencies to be delivered at a specific forward date (30,90,180, or 360 days) Example Example CAD/USD month months months months.7525 Forward contracts are individualized agreements between the bank and the customer

Futures Contracts Forward contracts are written on an individual basis. Futures are standardized, traded commodities (Chicago Mercantile Exchange) Forward contracts are written on an individual basis. Futures are standardized, traded commodities (Chicago Mercantile Exchange) JPY: 12,500,000 Yen JPY: 12,500,000 Yen GBP: 62,500 Pounds GBP: 62,500 Pounds Euro: 125,000 Euro Euro: 125,000 Euro CAD: 100,000 Canadian Dollars CAD: 100,000 Canadian Dollars

To hedge or not to hedge….that is the question” Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate: $ Day Forward: $1.85 (-1.6%) If you were to “lock in” your price with the forward/futures contract, you would pay $185,000 for the goods (with certainty)

Suppose you have the following forecast for the percentage change in the British pound over the upcoming 90 days % Change in e ($/GBP) Mean: -1.6% Std. Dev: 2% %Change e -1.6% [ -3.6%, 0.4%] [ -5.6%,2.4%] [ -7.6%, 4.4%]

Given a standard deviation, we can approximate a distribution for the exchange rate in 90 days. Standard Deviations Percentage Change Exchange Rate Probability $1.741% $1.774%-3.6$1.8125% 0-1.6$1.8540% 1.4%$1.8925% 22.4%$1.934% 34.4%$1.961% Current Spot Rate: $1.88

Given the distribution of exchange rates, we can estimate the expected cost of the hedge Exchange Rate Probability Cost w/out hedge Cost w/hedge Value of Hedge $1.741%$174,000$185,000-$11,000 $1.774%$177,000$185,000-$8,000 $1.8125%$181,000$185,000$-4,000 $1.8540%$185,000$185,000$0 $1.8925%$189,000$185,000$4,000 $1.934%$193,000$185,000$8,000 $1.961%$196,000$185,000$11,000 Current Spot Rate: $1.88 Expected Value: $0

From the previous table, we can show the distribution of gains from the hedge If forward rates are unbiased, most of the weight will be at zero!

Money Market Hedges Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate = $1.88 British 90 Day Interest Rate = 2.6% US 90 Day interest rate = 1%

Money Market Hedges Spot Rate = $1.88 British 90 Day Interest Rate = 2.6% US 90 Day interest rate = 1% Today90 Days GBP 100, Present Value of 100,000 in 90 days $1.88= $183,236 (1.01) = $185,000  Borrow 1% for 90 Days  Convert to $1.88  Invest in 90 Day British 2.6%  Collect GBP 100,000 to pay for imports  Pay of loan + interest = $185,000

Money Market Hedges VS. Forward/Futures Hedge Recall Covered Interest Parity e = (1+i) (1+i*)F Forward Rate Spot Rate If covered interest parity holds (and it does!), then the forward rate reflects the interest differential and the money market hedge is identical to the forward/future hedge!

Currency Options With options, you have the right to buy/sell currency, but not the requirement With options, you have the right to buy/sell currency, but not the requirement Call: The right to buy at a specific “strike price” Call: The right to buy at a specific “strike price” Put: The right to sell at a specific “strike price” Put: The right to sell at a specific “strike price” The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option. The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option. The buyer must pay an up front price for the contract The buyer must pay an up front price for the contract

Payout from a Call Suppose you buy a 30 day call on 125,000 Euros at a strike price of $1.20 For spot rates less than $1.20, the option is worthless (“out of the money”) If the spot rate is $1.25, your profit is ($.05)*($125,000) = $6,250

Payout from a Put Suppose you buy a put on 125,000 Euros at a strike price of $1.20 Suppose you buy a put on 125,000 Euros at a strike price of $1.20 For spot rates greater than $1.20, the option is worthless (“out of the money”) For spot rates greater than $1.20, the option is worthless (“out of the money”) For example, if the spot rate is $1.15, your profit is For example, if the spot rate is $1.15, your profit is ($.05)*($125,000) = $6,250

Hedging with Options Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate: $ Month Call w/strike price of $1.85 is selling at a premium of $.05 (GBP 100,000) You pay $.05(100,000) = $5,000 today. Your cost of GBP in 90 days = MIN [ spot rate, $1.85]

Remember, you pay (.05)*100,000 = $5,000 Today! Exchange Rate Probability Cost w/out hedge Cost w/hedge Value of Hedge $1.741%$174,000$179,000-$5,000 $1.774%$177,000$182,000 $1.8125%$181,000$186,000 $1.8540%$185,000$190,000 $1.8925%$189,000$190,000$1,000 $1.934%$193,000$190,000$3,000 $1.961%$196,000$190,000$6,000 Current Spot Rate: $1.88 Expected Value: -$3,070

Option Hedge The option hedge is more expensive on average, but protects you from large negative outcomes!

Hedging Techniques Type of Exposure Forward/Futures Money Market Options Payables (Cash Outflow) Long Position Borrow Domestically/Lend Abroad Call Option Receivables (Cash Inflow) Short Position Lend Domestically/Borrow Abroad Put Option

Cross Hedging Suppose that you have entered an agreement to buy PLN 100,000 (Polish Zloty) worth of imports. ($1 = 3.17PLN). Zloty futures are not traded. What do you do? You notice that the Zloty is highly correlated with the Euro (E 1 = 4.09 PLN) Act as if you are hedging (100,000/4.09) = E 24,454

Some more advanced hedging strategies… Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. You are in the process of negotiating a deal to sell GBP 200,000 worth of goods to Britain. Case #1: The export deal falls through and you will need to buy GBP 100,000 in one 90 days Case #2: The export deal succeeds and you will need to sell GBP 100,000 in one 90 days How do you hedge this?

A currency straddle is a combination of a put (the right to sell) and a call (the right to buy) e ($/L) Value 1.85 e ($/L) Value 1.85 e ($/L) Value 1.85 Cost = $0.06/L Cost = $0.12/L(L 100,000) = $12,000

Currency Straddles: Four Possibilities NCF = L100,000, e > $1.85  Let Put Expire  Buy $ in Spot Market  Buy GPB with Call  Sell GBP in Spot Market NCF = L100,000, e < $1.85  Let Call Expire  Use Put to sell GBP NCF = - L100,000, e > $1.85  Let Put Expire  Use Call to Buy GBP NCF = - L100,000, e < $1.85  Let Call Expire  Buy GBP in Spot Market  Sell GBP with Put

e ($/L) Value 1.89 e ($/L) Value 1.84 e ($/L) Value 1.84 Cost = $0.03/LCost = $0.04/L Cost = $0.07/L(L 100,000) = $7,000 Straddles hedge your exposure under all circumstances, but are very expensive (in this case, $12,000 in premium costs) 1.89 Un-hedged Region

Another way to save money is to only hedge particular ranges (i.e. a 95% confidence interval!) Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. e ($/L) Value 1.85 e ($/L) Value 1.89 Cost = $0.08/LCost = $0.05/L

You could hedge the range from $1.85 to $1.89 by selling a call w/ a strike price of $1.85 and using the proceeds to buy a call with a strike price of $1.89 e ($/L) Value 1.85 e ($/L) Value 1.89 Cost = $0.08/LCost = $0.05/L Value 1.85 Cost = $ $0.05 = $0.03 e ($/L) 1.89

Hedging…the possibilities are endless! There are many different types of hedges available. Each hedge has a cost and a level of protection. Its your choice to decide what coverage you need and how much you are willing to pay for it!!