5 FOREX Risk Management

Foreign
Exchange Risk Management
Why Is There No Need To Worry About
y y
FX Risk?
• If international parity conditions hold, FX risk
will not arise.
ill t i
• If it is possible to forecast exchange rates
If it is possible to forecast exchange rates
accurately, FX risk can be controlled.
• Shareholders are naturally hedged though
diversification.
diversification
Copyright 2004 McGraw‐Hill
Australia Pty Ltd
PPTs t/a International Finance:
2
An Analytical Approach 2e by
Wh W
Why Worry About FX Risk?
Ab t FX Ri k?
• Parity conditions do not hold.
• Forecasting exchange rates is rather difficult.
• Hedging produces a more stable income
Hedging produces a more stable income
stream.
Australia Pty Ltd
3
Why is a Stable Income Stream
y
Desirable?
• If a progressive tax rate is in operation, more
stable before‐tax income
t bl b f t i produces higher
d hi h
after‐tax income.
• It is more conducive to sales.
• Volatile earnings may imply lack of job
security.
security
Australia Pty Ltd
4
Managing Short‐Term Transaction
g g
Exposure
• Forward hedging
• Money market hedging
• Futures hedging
Futures hedging
• p g g
Option hedging
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F
Forward Hedging
dH d i
• Forward hedging entails locking in the
exchange rate at which payables and
h t t hi h bl d
receivables are converted from the domestic
currency into a foreign currency, and vice
versa.
versa
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F
Forward Hedging
dH d i
V
KS1 (no‐hedge)
KS0 (hedge)
S1
S0
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Fi
Financial Hedging
i lH d i
• By taking an affecting position on a hedging
i t
instrument (forward), the profit/loss on the
t (f d) th fit/l th
g p y /p
unhedged position is offset by the loss/profit
on the hedging instrument.
Australia Pty Ltd
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Off tti P fit/L
Offsetting Profit/Loss on Payables
P bl
+
Long forward
S0
S1
F0
Payables
F0 = S0
–
(a) (par)
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g / y
(cont.)
+
Long forward
Long forward
S0 F0
S1
Payables
F0 > S0
–
(b) (premium)
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g / y
(cont.)
+
Long forward
Long forward
S1
F0 S0
Payables
F0 < S0
–
(c) (discount)
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I t d i th Bid Off S
Introducing the Bid‐Offer Spread
d
H N‐H
P bl
Payables KFa 0 KS a1
R i bl
Receivables KFb 0 KSb1
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F t
Futures H d i
Hedging
• Futures hedging results may differ
quantitatively from those of forward hedging.
tit ti l f th ff dh d i
• Because of the standardisation of contracts, it
Because of the standardisation of contracts it
may not be possible to hedge the exact
amount.
Australia Pty Ltd
13
F t
Futures H d i ( t)
Hedging (cont.)
• The due date may not coincide with the
settlement date.
ttl td t
• Marking
Marking‐to‐market
to market introduces some variation.
introduces some variation
Australia Pty Ltd
14
M
Money Market Hedging
M k tH d i
• A money market hedge amounts to taking a
money market position to cover expected
k t iti t t d
p y
payables or receivables.
• By borrowing and lending, a synthetic forward
contract is created.
d
Australia Pty Ltd
15
Payables
Money Market Borrowing

(K)
Hedging of domestic
currency
KS0
(1 + i ∗ )
Payables
Converting
at spot rate
Loan
Repayment
K
(1 + i ∗ )
Investing at
foreign rate
KS 0 (1 + i )
(1 + i ∗ )
K
Implicit forward rate
S0 (1 + i )
(1 + i ∗ )
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Receivables

(K)
Hedging of foreign
currency
K
(1 + i ∗ )
Receivables
Converting
at spot rate
Loan
Repayment
KS 0
(1 + i ∗ )
Investing at
domestic rate
KS 0 (1 + i )
(1 + i ∗ )
K
S 0 (1 + i )
(1 + i ∗ )
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Payables
(K)

domestic
currency
Hedging of KS a 0
(1 + ib∗ )
Payables with Converting

at spot rate
Bid-Offer Loan
Repayment
p
Spreads K
(1 + ib∗ )
Investing at
foreign rate
K KS a 0 (1 + ia )
(1 + ib∗ )
S a 0 (1 + ia )
(1 + ib∗ )
Australia Pty Ltd
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Money Market
Receivables
(K)
Borrowing
H d i off
Hedging foreign
currency
K
(1 + ia∗ )
Receivables
with Bid-Offer Converting
at spot rate
Spreads KSb 0
(1 + ia∗ )
Loan
Repayment
Investing at
domestic rate
KSb 0 (1 + ib ) K
(1 + ia∗ )
Sb 0 (1 + ib )
(1 + ia∗ )
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O ti H d i
Option Hedging
• The outcome of option hedging is not known
with certainty, since it depends on whether or
ith t i t i it d d h th
p
not the option is exercised.
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Hedging with
edg g t aa Call Option
Ca Opt o
S1 < S0 → V = K ( S1 + R )
Hedge
S1 > S 0 → V = K ((S
S0 + R)
Decision
S1 < S 0 → V = KS1
N h d
No-hedge
S1 > S 0 → V = KS1
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Hedging with a Put Option
Hedging with a Put Option
S1 < S0 → V = K ( S0 − R )
H d
Hedge
S1 > S 0 → V = K ( S1 − R )
Decision
S1 < S0 → V = KS1
No-hedge
S1 > S0 → V = KS1
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C ti
Contingent Exposure
tE
• A contingent exposure arises only if a certain
outcome materialises, such as winning a
t t i li h i i
contract.
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Contract is won → Firm receives KF0 Hedging
Forward a Contingent
C ti t
Contract is not won → Firm loses K ( S1 − F0 ) Long Exposure
Long Exposure
S1 < S0 → Firm receives K ( S0 − R )
Contract is won
S1 > S0 → Firm loses KR
Option put
S1 < S0 → Firm receives K ( S0 − S1 − R )
Contract is not won
S1 > S0 → Firm loses KR
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Managing Long‐Term Transaction
g g g
Exposure
• Long‐term forward contracts
• Currency swaps
• Parallel loans
Parallel loans
• Leading and lagging
g gg g
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g g g
Exposure (cont.)
• Cross hedging
• Currency diversification
• Exposure netting
Exposure netting
• Price variation and currency of invoicing
y g
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g g g
Exposure (cont.)
• Risk‐sharing arrangements
• Currency collars
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AUD Value of Receivables With and
AUD Value of Receivables With and
Without Risk‐Sharing Arrangement
g g
60000
50000
Hedge
40000
30000
20000
0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30
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AUD Value of Receivables With
AUD Value of Receivables With
and Without Currency Collar
Without Currency Collar
60000
50000
Hedge
40000
30000
20000
0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30
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E
Economic Exposure
i E
• Economic exposure arises because revenues
and costs vary with changes in the real
d t ith h i th l
g
exchange rate.
Australia Pty Ltd
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Th Eff t f R l A
The Effect of Real Appreciation
i ti
• Assuming elastic demand, real appreciation of
th f i
the foreign currency leads to:
l d t
– Increase in domestic sales revenue
– Increase in foreign sales revenue
– Increase in the costs of imported raw materials
and foreign borrowing
Australia Pty Ltd
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Th Eff t f R l D
The Effect of Real Depreciation
i ti
• Assuming elastic demand, real depreciation of
th f i
the foreign currency leads to:
l d t
– Decrease in domestic sales revenue
– Decrease in foreign sales revenue
– Decrease in the costs of imported raw materials
and foreign borrowing
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H d i E
Hedging Economic Exposure
i E
• Reducing economic exposure requires:
– Changing sales in new or existing foreign markets
– Changing dependence
Changing dependence on foreign supply of raw
on foreign supply of raw
materials
– Establishing or eliminating production facilities
E t bli hi li i ti d ti f iliti
abroad
– Changing the level of foreign debt
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Why Worry About Translation
y y
Exposure?
• Translation exposure does not affect the
economic value of the firm.
i l f th fi
• Different translation methods affect reported
Different translation methods affect reported
earnings per share and other financial
indicators.
d
Australia Pty Ltd
34
H d i T
Hedging Translation Exposure
l ti E
• Fund adjustment
• Forward contracts
• Exposure netting and balance sheet hedging
Exposure netting and balance sheet hedging
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35

5 FOREX Risk Management

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5 FOREX Risk Management

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Foreign

Money Market Borrowing

Implicit forward rate

Money Market Borrowing

Implicit forward rate

Money Market Borrowing

Payables with Converting

S1 > S0 → Firm loses KR

S1 < S0 → Firm receives K ( S0 − S1 − R )

Contract is not won

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