Chapter 13

Chapter 13
Foreign Exchange Risk Management
Objectives
To explain why there is concern about FX risk
To illustrate how to manage transaction, economic
and translation exposure
Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-2
Hedging
Hedging, which is the core risk management
operation, is a process whereby a firm can protect
itself from unanticipated changes in exchange rates
and other sources of risk
(cont.)
13-3
Hedging (cont.)
The decision to hedge or not to hedge an uncovered
or open foreign currency position is basically a
speculative decision
It all depends on the expected exchange rate or the
movement of the exchange rate between the point in
time when the decision is taken and when its effect
materialises

13-4
Why is there no need to worry about FX risk?

If international parity conditions hold, FX risk will not
arise
If it is possible to forecast exchange rates accurately,
FX risk can be controlled
Shareholders are naturally hedged though
diversification

13-5
Why worry about FX risk?

International parity conditions do not hold
Forecasting exchange rates is rather difficult
Hedging produces a more stable income stream

13-6
Benefits of hedging
Hedging has a positive effect on the value of the firm
It produces a more stable corporate income stream

13-7
Managing short-term transaction exposure

(financial hedging)
Forward hedging
Money market hedging
Futures hedging
Option hedging

13-8
Financial hedging
By taking an affecting position on a hedging
instrument (forward, etc), the profit/loss on the
unhedged position is offset by the loss/profit on the
hedging instrument

13-9
Forward hedging
Forward hedging entails locking in the exchange rate
at which payables and receivables are converted
from the domestic currency into a foreign currency,
and vice versa
(cont.)
13-10
Forward hedging (cont.)

V
KS1 (no-hedge)
KS0 (hedge)
S0
S1
13-11
Offsetting profit/loss on payables

+
Long forward
S0
S1
F0
Payables
(a) F0 S0 (par)

(cont.)
13-12
Offsetting profit/loss on payables (cont.)

+
Long forward
S0
F0
S1
Payables
(b) F0 S0 (premium)

(cont.)
13-13
Offsetting profit/loss on payables (cont.)

+
Long forward
F0
S1
S0
Payables
(c) F0 S0 (discount)

13-14
Introducing the bid-offer spread
Hedge
No-Hedge
Payables
KFa 0
KS a1
Receivable
s
KFb 0
KSb1

13-15
Futures hedging
Futures hedging results may differ quantitatively from
those of forward hedging
Because of the standardisation of contracts, it may
not be possible to hedge the exact amount
(cont.)
13-16
Futures hedging (cont.)

The due date may not coincide with the settlement
date
Marking-to-market introduces some variation

13-17
Money market hedging

A money market hedge amounts to taking a money
market position to cover expected payables or
receivables
By borrowing and lending, a synthetic forward
contract is created

13-18
K
S
0
(
1
i
)
K
(
1
i)K
S
(
1
i
)
0
S
(
1
i)
0
Money market hedging of payables
P
a
y
a
b
le
s
(
K
)
B
o
r
o
w
i
n
g
d
m
e
s
t
c
c
u
rn
c
y
C
n
v
e
n
g
a
to
s
p
o
trtia
te
L
o
a
n
R
e
p
a
y
m
e
n
t
I
v
tin
g
t
fn
o
re
is
g
r
a
ta
e
K
Im
p
lic
itfo
rw
a
rd
ra
te

13-19
(1
iK
)
S
0
(
1
i
)
K
S
(1
i)S
0
(1
i)
0
Money market hedging of receivables
R
e
c
e
iK
v
a
b
le
s
(
)
B
o
r
o
w
i
n
g
fc
e
i
g
n
u
rc
y
C
n
v
e
n
g
a
to
s
p
o
trtia
te
L
o
a
n
R
e
p
a
y
m
e
n
t
Id
n
v
e
sts
itn
g
te
o
m
ic
ra
K
Im
p
lic
itfo
rw
a
rd
ra
te

13-20
K
S
a
0
(1
iK
)
b
(1
ib)K
S
(
1
i
)
a
0
a
b
S
(1
ia)
a
0
Money market hedging of payables with

bid-offer spreads
P
ay
ab
les
(
K
)
B
o
r
o
w
i
n
g
d
m
e
s
t
c
cu
rn
cy
C
v
e
n
g
ato
sn
p
o
trtia
te
L
o
n
R
ea
p
ay
m
en
t
Ifn
v
tin
t
o
re
isg
rg
ata
e
K
Im
p
licitfo
rw
ardrate

13-21
Money market hedging as a pricing

mechanism
When the banker quotes a forward rate for a future
delivery of a particular currency, the banker will be
exposed to the risk arising from possible
appreciation of the underlying currency
(cont.)
13-22

mechanism (cont.)
The banker can protect himself by hedging the
forward position in the money market, so that he
receives the amount of the underlying currency to be
delivered on the maturity date
(cont.)
13-23

mechanism (cont.)
The minimum forward rate that the banker can
quote, therefore, is the cost of money market
hedging, which is the forward rate implicit in the
synthetic forward contract created by the hedge
(cont.)
13-24

mechanism (cont.)
The bid and offer forward rates quoted by the banker
are
1 ib
Fb S b 0
*
1 ia
1 ia
Fa S a 0
*
1 ib
13-25
Option hedging
The outcome of option hedging is not known with
certainty, since it depends on whether or not the
option is exercised

13-26
Hedging with a call option
H
edge
D
ecision
N
o-hedge
S
V
K
(S
R
)
1
0
1
S
K
(
S
R
)
1
0
0
S
V
K
S
1
0
1
S
V
K
S
1
0
1

13-27
Hedging with a put option
H
edge
D
ecision
N
o-hedge
S
V
K
(S
R
)
1
0
0
S
K
(
S
R
)
1
0
1
S
V
K
S
1
0
1
S
V
K
S
1
0
1

13-28
Contingent exposure
A contingent exposure arises only if a certain
outcome materialises, such as winning a contract

13-29
Contract is won Firm receives KF0
Hedging
a contingent
long exposure
Forward
Contract is not won Firm loses K ( S1 F0 )

S1 S 0 Firm receives K ( S0 R )
Contract is won
S1 S 0 Firm loses KR
Put Option
S1 S 0 Firm receives K ( S 0 S1 R )
Contract is not won
S1 S 0 Firm loses KR

13-30
Managing long-term transaction exposure
Long-term forward contracts

Currency swaps
Parallel loans
Leading and lagging
Cross hedging
Currency diversification
Exposure netting
Price variation and currency of invoicing
(cont.)
13-31
Managing long-term transaction exposure

(cont.)
Risk sharing arrangement
Currency collars

13-32
Long-term forward contracts

Commercial banks do provide forward contracts in
major currencies with long maturities (for example,
five or ten years)
Because of the risk involved, banks only offer these
contracts to the most creditworthy customers

13-33
Currency swaps
Two parties exchanging cash flows denominated in
two different currencies

13-34
Parallel loans
Parallel loans are the origin of currency swaps. They
can be used to exchange cash flows

13-35
Leading and lagging

If the foreign currency is expected to appreciate,
foreign currency dues are paid sooner rather than
later: this is called leading
If, on the other hand, the foreign currency is
expected to depreciate, payables are met later rather
than sooner: this is called lagging

13-36
Cross hedging
Hedging a position on one currency with a position
on another currency
Correlation between the exchange rates against the
base currency is important

13-37
Currency diversification
Depending on correlation of the exchange rates
against the base currency, currency diversification
reduces risk

13-38
Exposure netting
A natural hedge would arise when the firm has
payables and receivables in the same currency, in
which case only net exposure should be covered

13-39

The foreign currency price of a product can be
adjusted by varying its domestic currency price
Exposure to FX risk can be eliminated completely by
using the domestic currency as the currency of
invoicing

13-40
Risk sharing and currency collars

Risk-sharing arrangements and currency collars
involve the use of various values of the exchange
rate to convert cash flows

13-41
AUD value of receivables with and without

risk-sharing arrangement
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
13-42
AUD value of receivables with and 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
13-43
Economic exposure
Economic exposure arises because revenues and
costs vary with changes in the real exchange rate

13-44
The effects of real appreciation

Assuming elastic demand, real appreciation of the
foreign currency leads to:
an increase in domestic sales revenue
an increase in foreign sales revenue
an increase in the costs of imported raw materials
and foreign borrowing

13-45
The effects of real depreciation

Assuming elastic demand, real depreciation of the
foreign currency leads to:
a decrease in domestic sales revenue
a decrease in foreign sales revenue
a decrease in the costs of imported raw materials and
foreign borrowing

13-46
Hedging economic exposure

Reducing economic exposure requires:
changing sales in new or existing foreign markets
changing dependence on foreign supply of raw
materials
establishing or eliminating production facilities abroad
changing the level of foreign debt

13-47
Why worry about translation exposure?

Translation exposure does not affect the economic
value of the firm
Different translation methods affect reported
earnings per share and other financial indicators

13-48
Hedging translation exposure

Fund adjustment
Forward contracts
Exposure netting and balance sheet hedging

13-49
Fund adjustment
Fund adjustment involves altering the amounts
and/or currencies of the planned cash flows of the
firm or its subsidiaries to reduce exposure to the
currency of the subsidiary (the local currency)

13-50
Forward contracts
If the base currency of a foreign subsidiary is
expected to depreciate against the parent firms base
currency, then translation exposure exists

13-51
Exposure netting and balance sheet hedging

Exposure netting can be used by multinational firms
with offsetting positions in more than one foreign
currency
A balance sheet hedge eliminates the mismatch
between assets and liabilities in the same currency

13-52

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Chapter 13

Foreign Exchange Risk Management

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Why is there no need to worry about FX risk?

Copyright 2010 McGraw-Hill Australia Pty Ltd

Why worry about FX risk?

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Managing short-term transaction exposure

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Forward hedging (cont.)

Offsetting profit/loss on payables

Copyright 2010 McGraw-Hill Australia Pty Ltd

Offsetting profit/loss on payables (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Offsetting profit/loss on payables (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Introducing the bid-offer spread

Copyright 2010 McGraw-Hill Australia Pty Ltd

Futures hedging (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Money market hedging

Copyright 2010 McGraw-Hill Australia Pty Ltd

Money market hedging of payables

Copyright 2010 McGraw-Hill Australia Pty Ltd

Money market hedging of receivables

Copyright 2010 McGraw-Hill Australia Pty Ltd

Money market hedging of payables with

Copyright 2010 McGraw-Hill Australia Pty Ltd

Money market hedging as a pricing

Money market hedging as a pricing

Money market hedging as a pricing

Money market hedging as a pricing

Copyright 2010 McGraw-Hill Australia Pty Ltd

Hedging with a call option

Copyright 2010 McGraw-Hill Australia Pty Ltd

Hedging with a put option

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Contract is won Firm receives KF0

Contract is not won Firm loses K ( S1 F0 )

Contract is not won

Copyright 2010 McGraw-Hill Australia Pty Ltd

Managing long-term transaction exposure

Long-term forward contracts

Managing long-term transaction exposure

Copyright 2010 McGraw-Hill Australia Pty Ltd

Long-term forward contracts

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Leading and lagging

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Price variation and currency of invoicing

Copyright 2010 McGraw-Hill Australia Pty Ltd

Risk sharing and currency collars

Copyright 2010 McGraw-Hill Australia Pty Ltd

AUD value of receivables with and without

Copyright 2010 McGraw-Hill Australia Pty Ltd