Hedging Treasury

Risk with
Forward Foreign
Exchange Contracts
 Overview
 FX forwards: definition,
characteristics and features
 Uses of FX forwards
 Example 1: Hedging with forwards
 Example 2: Deriving the forward
rate
 Problems and risks
 Risk management
 Forward Foreign
Exchange Contract
Definition:
An agreement to exchange one currency for another,
where
 The exchange rate is fixed on the day of the contract,
but
 The actual exchange takes place on a pre-determined
date in the future
 Characteristics and
Features of FX Forwards
 Available daily in major currencies in 30-, 90-,
and 180-day maturities
 Forwards are entered into “over the counter”
 Deliverable forwards: face amount of
currency is exchanged on settlement date
 Non-deliverable forwards: only the gain or
loss is exchanged
 Characteristics and
Features of FX Forwards
 Contract terms specify:
 forward exchange rate
 term
 amount
 ‘‘value date’’ (the day the forward contract expires)
 locations for payment and delivery.

 The date on which the currency is actually exchanged, the

‘‘settlement date,’’ is generally two days after the value date of
the contract.
 Characteristics and
Features of FX Forwards
Forward Exchange Rates: “The Iron-Clad Law”
 Forward exchange rates are different from spot rates, but they are
not a prediction of what the spot rate will be when the deal settles!

The difference between the

forward exchange rate and the spot exchange rate
is the interest differential
between the two currencies
 Uses of FX Forwards
(1) Hedge foreign currency risk
(2) Arbitrage FX rate discrepancies within and
between markets
(3) Speculate on future market movements
(4) Profit by acting as market maker

 Financial institutions, money managers,

corporations, and traders use these
instruments for managing currency risk
 Two Types of Hedging
Corporations engaged in international
trade

 Hedge payments and receipts denominated in

foreign currencies.
 For example, a Croatian corporation that exports to
Germany and expects payment in Euro (EUR)
could sell EUR forward to eliminate the risk of a
depreciation of the EUR at the time that the
payment arrives.

 Hedge the translation of foreign earnings for

presentation in financial statements.
 Example 1: Hedging
With an FX Forward
Hedged Item Hedging Instrument
 Company must pay EUR  Bank buys 1,000,000 EUR
1,000,000 to a eurozone forward at forward rate of 7.3750
supplier in 3 months
 Spot rate HRK/EUR: 7.3000.
 Treasurer believes HRK will
depreciate during next 3
months
 FX risk: Company is
protected against large
adverse FX rate movements
 Exposure to FX risk: If FX rate is unfavorable in 3
What will be exchange rate months (ie, > 7.3750),
HRK/EUR in three Company pays just 7.3750
months??
Example 2: Deriving the
Forward Exchange Rate
 Three month interest rates are:

 1% on the euro
 3% on the kuna

 A company with EUR 1 million and a need for HRK in three

months should be indifferent, financially speaking, as to whether it:

 Invests the EUR 1 million for 3 months at 1% and converts the euros
(plus interest) into HRK at the end of this time, or
 Sells the EUR 1 million spot for HRK, and invests the HRK at 3% for 3
months
 Example 1: Hedging
With an FX Forward
Hedged Item
 Company must pay EUR 1,000,000
to a eurozone supplier in 3 months
 Spot rate HRK/EUR: 7.3000.
 Treasurer believes HRK will
depreciate during next 3 months
Advantages of Hedge:
Company knows its costs and can
plan its finances accordingly
Cost of the hedge is zero --
 No money is exchanged at
inception of the forward FX
agreement
Hedging Instrument
 Bank buys 1,000,000 EUR forward at
forward rate of 7.3750
Disadvantage of Hedge:
Company is still exposed to FX
risk if the HRK/EUR spot rate is
less than 7.3750 in 3 months
 Effect of hedge is same as
buying EUR today and holding in
an interest-bearing account
 (Forward FX agreement is NOT
a simple speculation)
 Example 1: Hedging
With an FX Forward
Unhedged Company Effect of Hedging
 If in 3 months, spot rate is  Hedged Company has
7.4500… already bought EUR forward

 Hedged Company will pay:

 Unhedged Company must 7.375 x 1,000,000 = HRK
pay: 7,375,000
7.45 x 1,000,000 =
HRK 7,450,000

 Money saved by hedging:

7,450,000 – 7,375,000 =
 HRK 75,000
Example 2: Deriving the
Forward Exchange Rate
 The spot rate HRK/EUR is 7.3000

 A bank today sells a 3-month HRK/EUR

forward to a company for a forward
exchange rate of 7.3371

 How did the bank compute the forward

rate?
Example 2: Deriving the
Forward Exchange Rate
OPTION 1
 Invest EUR 1 million at 1%
for 3 months (91 days)
 Interest earned EUR
2,493.15
 Value after 3 months
EUR 1,002,493
OPTION 2
 Sell EUR 1 million spot at 7.30
Buy HRK 7.3 million
Invest HRK for 3 months at 3%
 Interest earned HRK
55,358.33
(7.3 million x 3% x 91/360)
 Value after 6 months
HRK 7,355,358
 Forward Exchange
Rate: 7.3371
Problems with FX Forwards

 Finding counterparties who want to take

exactly the opposite position:
 Most companies (potential counterparties) are “in
the same boat” (i.e., importers from the eurozone)
 One of the parties to the transaction might want to
trade a different amount, or have a different
settlement date
 Transaction costs can be large (bank’s spread)
 Problems with FX
Forwards
 Liquidity risk: A party in a forward contract
may find it difficult to exit the position.
Alternatives:
 If counterparty agrees, cancel the forward for a fee
 Assign the contract to another party. This requires
some compensation
 If an exact opposite position can be taken, offset the
obligation and suffer only the price differential
 Problems with FX
Forwards
 Default risk: There is an incentive for
the counterparty who lost on the
forward contract to default on the
agreement
 Forwards are a zero sum game. Each
counterparty that gains is balanced by a
counterparty who loses the same amount.
 Risk Management
Before using any type of derivatives, companies
should:
 Discuss the potential risks and benefits of
derivatives with Management Board and
Supervisory Board
 Develop appropriate internal controls and limits
 Prepare derivatives policy and procedures manual;
tax and accounting manuals
 Host training seminars for management and
employees
Successful Risk
Management
DON’T WORRY, IT
MAY MELT
BEFORE WE GET
THERE!
Successful Risk
Management
WE CAN DECIDE
WHAT TO DO, IF
AND WHEN WE
HIT IT!
Successful Risk
Management

WE NEVER
NEEDED TO USE
LIFE BOATS
BEFORE!!