Foreign exchange risk is the probability of loss occurring due to adverse movements in the foreign exchange rates. We can put in this way that the exchange rate risk on a foreign currency will move against the position of the investor such that the value of the investment is reduced. The exposure to foreign exchange rate is common to all who conduct international business or do trading. If someone buying or selling goods or services which are denominated in foreign currencies can immediately expose to foreign exchange rate risk. International commerce has rapidly increased as the internet and communication media has provided new and more transparent marketplace for individuals and entities alike to conduct international business and trading activities.
The pressure to monitor and manage foreign currency risks has led many companies to develop sophisticated computer based systems to keep track of their foreign exchange exposure and aid in managing that exposure. Economists handles these exposures in different ways where as the accountants favour other approaches for measuring and managing these exposures.
Management of accounting exposure which includes both translation and transaction exposure centers on the idea of hedging.
2.0 Hedging Foreign Exchange Risk:
Hedging in foreign exchange risk is a method of reducing risk in those situations where you can make or get higher returns on foreign exchange investments with bearing minimum risks. Hedging a particular currency exposure means establishing an offsetting currency position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange loss or gain on the currency hedge.
3.0 Purpose of Hedging Foreign Exchange Risk:
Hedging foreign exchange risk helps you to reduce your level of risk and increase the ability to leverage your position. The usefulness of a particular hedging strategy depends on both acceptability and quality. Acceptability refers to approval by those in the organization who will implement the strategy and quality refers to the ability to provide better decisions. Different companies hold different reasons to hedge foreign exchange risk. The most common reasons behind foreign exchange hedge are
Foreign Exchange Rate Risk Exposure
Interest Rate Risk Exposure
Foreign Investment/ Stock Exposure
Hedging Speculative Positions
This and other explanations for hedging all relate to the idea that there is likely to be an inverse relation between total risk and shareholder value. Given this view the main purpose of hedging is to reduce exchange risk where exchange risk is defined as that element of cash flow variability attributable to currency fluctuations. Many firms follow a selective hedging policy designed to protect against anticipated currency movements. A selective hedging policy is especially prevalent among those firms that organize their treasury department as profit centres. In such a firms the desire to reduce the expected costs of hedging and thereby increase profits often leads to taking higher risks by hedging only when a currency change is expected and going unhedged otherwise.
4.0 Hedging Techniques
The most common hedging techniques are
Forward Exchange Contracts (Forward Market Hedge)
Futures
Options
Swap
Money Market Hedge
All of the above mentioned hedging techniques are well famous and companies select one or more techniques which are align to their strategy for minimizing foreign exchange risk. All of these techniques differ from each other and involve different processes.
4.1 Forward Exchange Contract
Forward contract is a contract between two parties in which a buyer agrees to sell a sum of money or product on a future date in exchange for something in return and the parties reach their agreement without the involvement of a future exchange or clearinghouse. Unlike other hedging techniques the contract can contain non- standard terms and conditions, such as unusual quantities or expiration dates.
The contract basically relying on the creditability of both parties and the forward contract must agree to assume the credit risk of the other party. Because of these features, forward contracts are generally not designed to be tradable and there is no secondary market for them.
Forward contracts are customized agreements between two parties to fix the exchange rate for a future transaction. Forward contracts are somewhat less familiar, probably there exit no formal trading facilities, building or even regulating bodies.
How does it work?
Suppose gold is currently selling at Rs.11500/- per 10 grams. Based on the perception of the movement of gold prices, A & B enter into a contract where A takes a short position and thereby agrees to deliver 10 gms of gold to B on 31st Dec of the year at a price of Rs. 12000/- and B agrees to take the delivery and pay the agreed price. Now, if there is a spurt in market price of gold, it would make investor B happy since an increase in spot price would also cause the price expected in future to increase. If the price increase does stay at the date of the maturity of contract, the buyer would stand to gain and the seller to lose from it
4.2 Future Contracts
A future contract is an agreement between two parties where a buyer and a seller
buys or sells a particular currency at a future date at particular exchange rate that is fixed or agreed upon today. In fact the future contract is similar to the forward contract but is much more liquid and the reason for its liquidity is that it is traded in an organized exchange the future market just like the stock market.
Future contracts are standardized contracts and therefore they can bought and sold just like the normal shares on the stock market. As for hedging with futures, if the risk is an appreciation of value one needs to buy futures and in case if the risk is depreciation then one needs to sell futures. The profits and losses of futures contracts are paid over every day at the end of trading, a practice called marking to market.
This daily settlement reduces the default risk of futures contracts relative to forward contracts. In case of future contracts, futures investors must pay over any losses or receive any gains from the day's price movements. These losses or gains are generally added to or subtracted from the investor's account.
4.3 Options
An option is a financial instrument that gives the holder the right but not the obligation to sell (put) or buy (call) another financial instrument at a set price and expiration date. The seller of the put option or call option must fulfil the contract if the buyer so desires it.
There are two types of options:
• Call options - gives the buyer the right to buy a specified currency at a specified
exchange rate, at or before a specified date.
• Put options - gives the buyer the right to sell a specified currency at a specified
exchange rate, at or before a specified date.
Of course the seller of the option needs to be compensated for giving such a right.
The compensation is called the price or the premium of the option. Since the seller
of the option is being compensated with the premium for giving the right, the seller
thus has an obligation in the event the right is exercised by the buyer.
An option that would be profitable to exercise at the current exchange rate is said to be in -the -money conversely an out- of- the- money option is one that would not be profitable to exercise at the current exchange rate. The price at which the option is exercise is called the exercise price or strike price. An option whose exercise price is the same as the spot exchange rate is termed at- the-money.
4.4 Swaps
If we talk about the simplest form title a plain swap, you are offering a set of cash
flows for another set of cash flows of equivalent market value at the time of the
swap. Currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency.
The counterparties to a currency swap will be concerned about their all in cost that is effective interest rate on the money they have raised. Currency swaps contain the right of offset, which gives each party the right to offset any non-payment of principal or interest with a comparable non-payment. The most common swaps are US$ followed Japanese yen, sterling .The typical uses of a currency swap is conversion from a liability in one currency to a liability in another currency and conversion from an investment in one currency to an investment in another currency.
4.5 Money Market Hedge
Money market hedge is an alternative forward market hedge is to use a money market hedge. A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow.
How does it work?
To understand how money market hedge works let say a UK company with a 1 year receivable of $1,000,000. If the spot foreign exchange is 2.00 and US interest rates were 4% and UK interest rates were 5%. The company would borrow money in dollars equivalent to its receivable which is $1,000,000.00 discounted by 4% ($1,000,000.00/1.04)= $961,538.46 and then convert it into sterling at spot rate 2.00 which will be £480,769.23. The sterling then would be deposited @5% and after 1 year we would have (£480,769.23*1.05= £504,807.69). In one year's time the company receives the expected $1,000,000 and repays the sterling equivalent for the full. In this case the company has hedged the foreign exposure and has enjoyed the sterling equivalent for the full period. The formula for calculation of effective Foreign Exchange Forward outright is $1,000,000/£504,807.69 = 1.98
In reality there are transaction costs associated with hedging, the bid- ask spread on the forward contract and the difference between borrowing and lending rates. These transactions costs must be factored in when comparing a forward contract hedge with a money market hedge.
5.0 Calculation of Expected proceeds in US$
The expected proceeds from each of the 3 methods are calculated as
5.1 Billing in US$
The company will use the rate 15.3555 (Peso/USD) to bill the other party in US dollars. The expected proceeds will be calculated as follows:
Expected proceeds in US $ in six months=500M /15.3555= $ 32.56162287M
5.2 Six Month Forward Rate Contract
If the company engage in 6 month forward rate contract then the expected proceeds will be calculated as
Expected proceeds in US $ in six months= 500M/15.0134= $33.30358213M
(Using Forward Rate Contract)
5.3 Money Market Hedge
If the company is interested in money market hedge the expected proceeds will calculated using these steps:
The company first borrow peso @ 1.3% (for 6 month borrowing rate in Mexico) which is [500M/(1.013)]= 493.5834156M Peso
The company will convert US dollars @ 15.3561 exchange rate which will result into 493.5834156M/15.3561= $ 32.14249813M
Now deposit $32.14249813M in US bank @ (1.55% for 6 months) which will result into
$32.14249813M *1.0155= $ 32.64070685.
After a year the company will receive its 500M peso and will adjust its loan of 500m peso
with the Mexican bank.
