Hedging Treasury Risk

with
Forward Foreign
Exchange Contracts

Leslie Matthews Šulenta

Director
International Business Strategies, LLC, Zagreb

September, 2005
Croatian Association of Corporate Treasurers
 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
 Accounting for forwards
– Example 3: Marking to market
 Risk management
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 FX Forwards:
Definition,
Characteristics and
Features
 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

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 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

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 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.

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 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
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FX Forwards:
Uses
 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
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 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.

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 Example 1: Hedging
With an FX Forward
Hedged Item Hedging Instrument
 Company must pay EUR 1,000,000  Bank buys 1,000,000 EUR
to a eurozone supplier in 3 months forward at forward rate of 7.3750
 Spot rate HRK/EUR: 7.3000.
 Treasurer believes HRK will
depreciate during next 3 months

– Exposure to FX risk:
What will be exchange rate
HRK/EUR in three months??
– FX risk: Company is
protected against large
adverse FX rate movements
If FX rate is unfavorable in 3
months (ie, > 7.3750),
Company pays just 7.3750
 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  Hedged Company has
already bought EUR
is 7.4500…
forward

– Hedged Company will pay:

– Unhedged Company 7.375 x 1,000,000 = HRK
must pay: 7,375,000

7.45 x 1,000,000 = Money saved by

HRK 7,450,000 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?

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 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
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 Example 2: Deriving the Forward
Exchange Rate
OPTION 1 OPTION 2
Sell EUR 1 million spot at 7.30
Invest EUR 1 million at 1%
Buy HRK 7.3 million
for 3 months (91 days)
Invest HRK for 3 months at 3%

Interest earned HRK

Interest earned EUR
55,358.33
2,493.15
(7.3 million x 3% x 91/360)

Value after 3 months Value after 6 months

EUR 1,002,493 HRK 7,355,358

Forward Exchange Rate: 7.3371

 FX Forwards:
Problems and Risks
 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)
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 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
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 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.

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FX Forwards:
Accounting
 Accounting for FX Forwards
 IAS 39 applies (Accounting for
Financial Instruments – derivatives
accounting)
– The deal has no immediate value
– Off-balance sheet accounts are used
initially to record the deal on the books
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 Accounting for Forwards
 Fair value of the forward changes over
time with movements in the foreign
exchange rate

 Unrealized gain (loss) is measured by

applying today’s market rates at the
forward date

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Example 3: Marking to Market
 After one month’s time, the company has to
mark-to-market a 3-month forward which is
carried in the off-balance sheet accounts

– On the date of the deal, the spot rate was 7.3000

– The forward rate for the deal is 7.3371
– The spot rate HRK/EUR is now 7.4150

 What is the market value of the forward today?

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Example 3: Marking to Market
 The company bought EUR against HRK in 90 days.
 Today, the company could buy EUR 1,000,000 at the
spot rate of 7.4150 and pay HRK 7,415,000.
 The company is committed to buy EUR 1,000,000 when
the forward matures at 7.3371 and pay only HRK
7,337,100.
 Thus, the deal now has value.

Company records an unrealized GAIN of:

HRK 7,415,000 – HRK 7,337,100 = HRK 77,900

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 FX Forwards:
Risk Management
 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

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Successful Risk Management
DON’T WORRY, IT
MAY MELT
BEFORE WE GET
THERE!

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Successful Risk Management
WE CAN DECIDE
WHAT TO DO, IF
AND WHEN WE
HIT IT!

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Successful Risk Management

WE NEVER
NEEDED TO USE
LIFE BOATS
BEFORE!!

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 Thank You.
Leslie Matthews Šulenta
+385 98 355 258
Leslie.sulenta@consulting-mps.c
om
www.consulting-mps.com