1. Lecture 11: Managing Foreign Exchange Exposure with Financial Contracts A discussion of the various financial arrangements which global firms and global investors can use when managing open foreign exchange positions

2. Where is this Financial Center?

3. 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 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.

4. The Concept of Hedging In using a financial hedge, a firm negotiates a financial contract which establishes a situation opposite to the foreign exchange exposure it wishes to hedge.  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 can cancel each other out.

5. 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?  (1) The assessment of the future strength or weakness of the foreign currency the firm or investor is exposed in. For example: If a firm or investor has a long position (short position) in what they forecast will be a strong (weak) currency they may decide not to hedge, or, perhaps, do a partial hedge.  (2) How comfortable one is with the results of the above forecast. The less comfortable, the more likely to 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 firm managing a hedge fund, or a currency trading floor?

6. Hedging Strategies for Firms Assumption: Given the downside risk associated with an open FX position, we can assume that most global firms and investors would probably prefer to hedge (fully or partially) their foreign exchange exposures. Question: how can firms hedge?  (1) Financial Contracts Forward contracts (also futures contracts) Options contracts (puts and calls) Money market hedges, specifically borrowing or investing in local financial markets.  (2) Operational Hedges Geographic diversification (spreading the risk). Contract manufacturing (e.g., Nike).

7. Commercial Bank Forward Contracts Contracts which allow the firm or investor to (1) either buy or sell a specified amount of foreign currency on (2) a future date (i.e., forward date) at (3) an exchange rate specified today (i.e., at a forward exchange rate).  A forward contract is a firm commitment on the part of both parties (i.e., cannot be canceled).  For an open long FX position: Hedge with a forward sale of the foreign currency.  For an open short FX position: Hedge with a forward purchase of the foreign currency. Forward contracts allow the global firm or investor to lock in the home currency equivalent of an anticipated foreign currency cash flow.

8. Example of a Long Position Assume: U.S. firm has sold a product to a German company and 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; resulting from an agreement to receive a fixed amount of foreign currency in the future.  What is the potential problem for the U.S. firm if it does not hedge the position long open? The risk that the euro will weaken over this period, and in 30 days the euro will be worth less (in terms of U.S. dollars) than it is at today’s spot rate. 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 (i.e., cover) its open long foreign exchange transaction exposure (of €100,000).  The U.S. firm asks a market maker bank for a 30 day forward euro quote and receives 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 a forward contract to sell euros, the U.S. firm can lock in the U.S. dollar equivalent of the long position at the bid price, or $123,000.

10. Example of a Short Position Assume: a U.S. firm has purchased a product from a British company and the U.S. firm agrees to pay £100,000 in 30 days.  What type of exposure does the U.S. firm have? Answer: Open short transaction exposure; resulting from an agreement to pay a fixed amount of foreign currency in the future.  What is the potential problem if the U.S. dos not hedge this position short open? The risk that the pound will strengthen over this period, and in 30 days it will take more U.S. dollars (than at today’s spot rate) 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 (of £100,000).  The U.S. firm asks a market maker bank for a 30 day forward pound quote and receives 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 to buy pounds, 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 amount in 30 days).

12. Advantages of a Forward Contract These contracts are written by market maker banks to the “specifications” of the global firm or global investor (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. Contracts offered 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.

13. Upside Potential of an Open Position Assume an open long position: €100,000 to be received in 30 days.  Upside potential: if the euro strengthens, the euro is worth more in U.S. dollars. Assume an open short position: £100,000 payable in 30 days.  Upside potential: if the pound weakens, it takes fewer U.S. dollars to buy pounds. Disadvantage of a Forward Contract: Since a forward contract locks in a specific forward spot rate, the upside potential from an open position is eliminated.

14. Foreign Exchange Options Contracts The second type of financial contract used to hedge foreign exchange exposure is an options contract. An options contract offers the hedging firm the right, but not the obligation, to either (1) buy (referred to as a “call” option) or to (2) sell (referred to as 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. Recall a forward contract is an obligation.

15. Foreign Exchange Options Contracts Options contracts allow the hedging firm to take advantage of a favorable change in the exchange rate (i.e., the upside potential), while providing “Insurance” against unfavorable changes in the exchange rate. However, the hedging firm pays for this right in the form of an option’s premium (which is a non-refundable up-front fee).  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 offer individually tailored options contracts, while organized exchanges only offer standardized contracts.

16. An FX Put Option Put options allow a hedging 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 three of which are set today.  Put option is used to offset a foreign currency long position  Put options 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 (i.e., the foreign currency strengthens), the option holder will not exercise the put option, but instead sell the foreign currency in the spot market.

17. Put Option Example Recall the example of a U.S. firm which had a 30 day account receivable in euros (see 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).  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 option’s 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 (1.2500/1.2700)? Euro 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 quote (EUR/USD) is 1.3500/1.3700  Question: What has the euro done from the rate 30 days ago (1.2500/1.2700)? Euro has strengthened by $0.1000 per euro.  Account receivable is now worth $135,000 at this spot rate.  What should the U.S. firm do? Firm should not exercise its put option and instead 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 hedging firm was able to establish (“lock in”) a lower limit for its open long FX position. The hedging firm can also walk away from the put contract if the exchange rate moves in its favor (i.e., take advantage of the upside potential if the foreign currency strengthens). This was not possible with a forward contract.

21. An FX Call Option Call options allow a hedging 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 three of which are set today.  Call option is used to offset a foreign currency short position.  Call options provides the holder with an upper limit (“ceiling’) price for the foreign currency the firm needs in the future.  If the future spot rate proves to be advantageous (i.e., the foreign currency weakens), the option holder will not exercise the call option, but instead buy the foreign currency in the spot market.

22. Call Option Example Recall the example of the U.S. firm which had the 30 day account payable in pounds (see 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 option’s 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 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 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 Now assume in 30 days the pound spot rate (GBP/USD) quote is: 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 should the U.S. firm do? U.S. firm should not exercise its call option and instead buy 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 hedging firm was able to establish (“lock in”) a upper limit for its open short FX position. The firm can also walk away from the call contract if the exchange rate moves in its favor (i.e., take advantage of the upside potential if the foreign currency weakens). This was not possible with 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. Important disadvantages:  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. Factors Affecting Options’ Premiums ParameterCall PremiumPut Premium Strike PriceAs strike price increases (relative to the spot) the call premium decreases As strike price decreases (relative to the spot) the put premium decreases Time to maturityAs time to maturity increases, the likelihood of the option being exercised increases, thus the premium increases. VolatilityAs volatility increases there is high degree of potential movement about the spot rate of the currency. Thus the greater the volatility, thus the premium increases. Volatility is without a doubt the most important factor of the options’ pricing factors.

28. 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 financial markets (i.e., 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.

29. 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. 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, Or, use a Money Market Hedge:  (1) Borrow pounds now.  (2) Swap out of pounds into dollars at the current spot rate.  (3) In 1 year, when the firm receives payment from the British company, use those pounds to pay off the bank loan. Note: The loan (from the borrowing) produces a short FX position which offsets the original long FX position.

30. Money Market Hedge Example Assume:  (1) a U.S. firm has a 1 year open long position of £1,000,000 (resulting from an account receivable)  (2) The current pound spot rate (GBP/USD) is: $1.85/$1.87  (3) The U.K. 1 year loan rate is 5.26% per annum. With a money market hedge:  ( 1) Borrow £950,000 (Note: at 5.26%, £49,970 is the interest on a £950,000 loan). Thus total loan payback in I year = £999,970.  (2) Swap out of £950,000 into U.S. dollars (sell £s at spot) Receive $1,757,500 (at bid quote of $1.85; £950,000 x $1.85)  (3) In 1 year, use the £1,000,000 account receivable to pay off the loan. Loan payoff = £950,000 + £49,970 = £999,970

31. 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 received its home currency now (before receiving payment).  The firm has hedged against a weakening of the foreign currency.  However, the firm cannot benefit from a favorable change in the exchange rate (i.e., if the pound strengthens).

32. 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. 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:  (1) Borrow U.S. dollars now  (2) Swap out of dollars into pounds at the current spot rate.  (3) Invest in a 1 year pound denominated financial asset.  (4) In 1 year, when the pound denominated financial asset matures, use the proceeds to pay off the £1,000,000 account payable. Note: The financial asset (i.e., from the investment) produced a long FX position which offsets the original short FX position.

33. Money Market Hedge Example Assume:  (1) A 1 year short position of £1,000,000  (2) The current spot rate (GBP/USD) is: $1.85/$1.87  (3) The U.K. 1 year investing rate is 8%. With a money market hedge:  The U.S. firm needs £926,000 today, which if invested at 8% (U.K. interest rate) for a year will approximate the £1,000,000 it needs in 1 year for its short position. £926,000 x 1.08 = £1,000,080.00  (1) Borrow $1,731,620. At the ask spot rate, this is the amount of dollars the firm needs to acquire £926,000 (£926,000 x $1.87 = $1,731,620).  (2) Swap out of dollars into pounds: Receive £926,000 (at ask quote of $1.87; $1,731,620/$1.87 = £926,000)  (3) Invest £926,000 in a 1 year U.K. financial asset at 8%.  (4) Use the maturing U.K. asset (actually equal to £1,000,080) to meet the account payable in 1 year.

34. 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 cannot benefit from a favorable change in the exchange rate (i.e., if the pound weakens).

35. What Hedges are Used? 1995 study by Kwok and Folks of Fortune 500 companies revealed: Type of ProductHeard of Used  Forwards100.0%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 forwards were preferred over the others? Why do you think bank options were preferred over exchange traded options? Do you think you would see these same results today?

36. Explaining The Findings (1) Why was there a use preference for forward contracts over others?  Perhaps because they are simple to understand and simple to use.  Forward contract can be tailored to specific needs of hedging firms.  There is no upfront cost. (2) Why was there a use preference for bank options over exchange options?  Again, tailored to specific needs of hedging firms.  Exchange traded options are “standardized” with regard to currency, the amount, and the maturity dates of the contract.