P3 Risk Management Module: 11 Currency Hedging Techniques 1. Hedging and transaction risk Managing Transaction risk External hedging is one of the key methods of dealing with transaction risk – as a reminder, transaction risk is the risk that between the point of contract and the point of receiving or paying the funds in a foreign currency, the exchange rate will have changed, and we will have to pay more or receive less than expected. We've already covered various ways of dealing with transaction risk using internal hedging techniques - can you remember these? Let's remind you quickly... Matching - receipts in one foreign currency are matched against payments made in the same currency, reducing the total amount that needs to be converted back into the home currency. Lagging – paying amounts due later to match against funds to be received in that currency or in anticipation of favourable exchange rate movements. Leading – paying amounts due early using funds already received in that currency or in anticipation of unfavourable exchange rate movements. Invoicing (or paying) in home currency – therefore no currency risk is taken, although care should be taken since this effectively passes the risk on to customers, who may see this unfavourably. Counter-trading – where customers are also suppliers’ payment could be made in goods and services. Netting inter-company transactions – a centralised treasury department can offset payments made between divisions or subsidiaries in different countries (and hence using different currencies) to keep the total amounts exchanged to a minimum. External Hedging Let's look at a formal definition.... A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. Let's break the definition down – here are the constituents: Companion investment – this is the main transaction you are wishing to hedge against, such as purchasing something expensive in a foreign currency. Investment position – undertaking some other transaction or investment in addition to the main transaction. Offset potential losses – should we make a loss on the main transaction, the 1 'investment position' will counteract that loss. It can also be useful to see this in diagrammatic form to understand how it works: There are 5 key techniques for hedging currency risk: In this chapter we'll look at these techniques. 2 2. Forwards What is a forward contract? A forward contract is a non-standardised contract between two parties to buy or sell a fixed amount of foreign currency at a specified future time at a price agreed upon today. The forward price of such a contract is commonly contrasted with the spot price, which is the current exchange rate. The difference between the spot and the forward price is the forward premium or forward discount. How a forward contract works Generic example of forwards (non-currency) Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000. Andy and Bob have entered into a forward contract. Bob has now fixed the amount he will pay for this house, ensuring he never has to pay any more than $104,000. This helps him to manage his cash flows and reduce his exposure to fluctuations in the property market. Currency example of forwards A similar situation works for currency forwards, where one party opens a forward contract to buy or sell a currency (for example a contract to buy Euros) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. 3 Let's say Bob lives in Germany and wants to avoid paying more or less than the agreed $104,000 in one year's time. He goes to his bank and agrees the rate he will pay to convert from Euros to US dollars now. He has entered into a forward foreign currency exchange transaction. Combining these two examples, Bob has removed two risks, firstly he knows what he will pay for the house in US$ and secondly he knows how many Euros that will cost him. He has reduced his risk significantly. Forwards are popular, as they are simple and flexible. Other characteristics include: Legally binding contract (so it must be completed even If the need for the foreign currency or amount changes) You set any date for exercising, but once agreed that date can not be changed. It is flexible in terms of amounts – any amount can be agreed. Offered by banks – makes it simple and easy for anyone to do. Numerical example The current forward price quoted for the €/$ in 6 months time is 1.5 - 1.52. If a US company needs €1m for a contract to be paid in 6 months. Firstly we need to work out which of the two values in the spread is the relevant one here. Remember – the bank always wins. One rate would cost them $1.5m and the second $1.52m. The worst for the company and best for the bank is the second option, so that’s the relevant forward rate, and that’s the amount payable in 6 months time. 4 3. Money market hedge What is a money market hedge? There are two types of money market hedge: Paying in a foreign currency in the future The home currency is converted at the spot rate, and monies held in a foreign currency bank account until required for payment in the future. The exchange rate used was the rate now, and hence the risk of rates changing by the payment date is removed. Note that the amount you need to exchange 'today' is a little less than the amount you'll need in the future as you hope to gain some interest on that amount in the intervening period. So for example, if Bob needs $104,000 in 1 year's time and the US interest rate is 4%, he only needs to buy $100,000 today. Receiving money in a foreign currency in the future A loan is taken out in a foreign currency, which is then converted into the domestic currency at the current spot rate and kept in an account. When the monies are received in the foreign currency they are used to pay off the foreign currency loan. Again note that the exchange rate used was the rate now, and hence the risk of rates changing by the receipt date is removed. Note that the amount you should borrow 'today' is a little less than the amount you'll receive in the future as you will have to pay interest in the intervening period. So for example, if John is receiving needs $105,000 in 1 year's time and the US interest rate is 5%, he should borrow $100,000 today so that in 1 year's time he can pay off the loan and the year's interest 5 Example question Banana Ltd will be required to make a $2m payment in 8 months time to MacroSoft Inc. The current exchange rate is €1 = $2. The exchange rate for the $ is highly volatile. The company’s banks are willing to undertake a forward contract at a rate of €1 = $1.9. A € loan would incur rates of interest are 10% per annum, while a $ deposit would secure a return of 13% per annum. Compare the costs of leading (paying now), with using a forward or money market hedge. Example Solution Payment now – Amount payable = $2m = €1m 2 Forward rates – Amount payable = $2m = €1,052,632m 1.9 Money market hedge Steps 1 – Borrow now and convert to the currency of payment Banana Ltd will (Step 1 in the diagram) borrow money now in €, convert this at the spot rate to $ (Step 2 in the diagram). Don't worry about the exact amounts for the moment, we'll show you how they are worked out shortly. Step 2 – Invest the overseas currency This will then earn interest for 8 months so that the total amount in the bank account is $2m, when the payment can be made. Step 3 – Make the payment After 8 months there is now $2m in the bank account and MacroSoft can be paid. 6 Take a quick look at the diagram to see how this works from steps 1 to 3. Note that the end effect here is that Banana Ltd has undertaken an exchange rate transaction at the spot rate (the rate now) and so has not taken any exchange rate risk. MacroSoft has received their money when they wanted it in $ so they're happy too! So, how do you work out the exact numbers? Now, when you are doing your calculation, you actually do the steps in a slightly different order from the way the actual transaction is done. Yes, a bit strange, but if you learn the calculation order and practise it it's easy enough to get the hang of! To do the full calculation you have to start with final amount Step 3, then work out amount in Step 2, then Step 1 and finally Step 4. We start at Step 3 as that's the amount we know we need, in this case $2m. Then we go back to Step 2 by taking off the interest for 8 months. The interest rate is 13% x 8/12 (it is normal to ignore compounding in these calculations) which is 8.66%.