OVERVIEW
Objective
¾
To explain the causes of exchange rate fluctuations.¾
To apply hedging techniques for foreign currency risk.¾
To apply hedging techniques for interest rate risk.INTEREST RATE RISK CURRENCY
RISK
RISK MANAGEMENT
¾ Forecasting exchange rates ¾ Types of exchange rate risk ¾ External hedging of
transaction risk
¾ Types of interest rate risk ¾ External hedging of interest
1
FORECASTING EXCHANGE RATES
¾
The key models for forecasting future exchange rates focus either on inflation rate differences, or interest rate differences.¾
The relationships between these macro-economic variables can be summarised in the “four-way equivalence model” shown belowDifferences in
interest rates Expected difference in inflation rates
Interest rate parity
Fisher effect
International
Fisher effect Purchasing power party
Expectations theory Difference between spot
and forward exchange rate
Expected change in spot exchange rate
¾
Spot exchange rate - the market exchange rate for buying/selling the currency for immediate delivery.¾
Forward exchange rate – the exchange rate for buying or selling the currency at a specific date in the future.1.1
Purchasing Power Parity (PPP)
¾
Absolute PPP states that the exchange rate simply reflects the different cost of living in two countries. For example if a representative basket of goods and services costs $1, 700 in the US and £1,000 in the UK, the exchange rate should be $1.70 to £1.¾
While absolute PPP exchange rates may represent the long-run equilibrium rate between two currencies, they are of limited practical use in financial management.¾
The formula for relative PPP is as follows:s1 = s0 x
(
(
)
)
b c h 1h 1
+ +
where:
s1 = expected spot exchange rate after one year s0 = today’s spot exchange rate
hc = foreign inflation rate (as a decimal) hb = domestic inflation rate
¾
Spot rates should be put into the formula is the format: Units of foreign currency/units of domestic currencyExample 1
Spot rate 1 January 19X6 = $1.90 per £1 Predicted inflation rates for 19X6:
US 2%
UK 3%
Required:
What is the predicted exchange rate at 31 December 19X6?
1.2
Interest Rate Parity (IRP)
¾
IRP states that the forward exchange rate is based upon the spot rate and .the interest rate differential between the two currencies:Forward rate = spot rate × (1+overseas interest rate/1+ domestic interest rate)
¾
f0 = s0 x(
(
)
)
b c i 1i 1
+ +
where:
f0 = forward exchange rate s0 = spot exchange rate ic = overseas interest rate ib = domestic interest rate
Example 2
If spot $ per £ = 1.78 and the dollar and sterling one year interest rates are 3.25% and 4.5% respectively, what is the one year forward exchange rate?
Solution
¾
If this theory did not hold it would be possible for investors to make a risk-free profit using a process referred to as covered interest rate arbitrage.1.3
Fisher effect
¾
Countries with a higher rate of inflation have higher nominal interest rates in order to offer the same real return as countries with low inflation(1+i) = (1+r) (1+h)
Where i = nominal interest rate r = real interest rate h = inflation rate
1.4
International Fisher effect
¾
States that the spot exchange rate will change to offset interest rate differences between countries.¾
The calculations are basically as per Interest Rate Parity theory.1.5
Expectations theory
¾
Differences between forward and spot rates reflect the expected change in spot rates.1.6
Other factors influencing exchange rates
¾
Current and prospective government policies.¾
Balance of payments surpluses/deficits.¾
Actions of speculators.2
TYPES OF EXCHANGE RATE RISK
There are three types of exchange rate risk to consider – translation risk, economic risk and transaction risk.
2.1
Translation risk
¾
This occurs where a parent company holds an overseas subsidiary.¾
In order to consolidate the subsidiary’s financial statements into the group accounts, they must first be translated into the reporting currency of the parent company. The exact method for doing this depends on the relevant financial reporting standards.¾
In particular translating the statement of financial position of overseas subsidiaries can lead to significant translation gains/losses.¾
If the home currency has appreciated against the foreign currency, it is likely to produce a translation loss when converting the value of overseas net assets.¾
Although such gains/losses can be significant in size, they do not represent actual cash gains/losses for the group – they are simply caused by financial accounting methods for consolidating overseas subsidiaries.¾
As long as users of financial statements understand that translation differences do not represent cash flows, they should not affect the value of the group.¾
Therefore the financial manager should ensure that the nature of translation gains/losses is clearly explained e.g. in the annual report, at shareholder meetings.¾
However the financial manager does not need to hedge translation risk, because it is not a cash flow.2.2
Economic risk
¾
Economic risk is the risk that cash flows will be affected by long-term exchange rate movements.¾
As the value of a firm is the present value of its future cash flows, economic risk is a significant issue for the financial manager. Unfortunately it is difficult to hedge against.¾
For example, take a UK company which exports to the US and therefore has dollar export earnings. Suppose that, over time, sterling becomes stronger against the dollar. The sterling value of export earnings will fall, damaging the cash flow and the value of the company. What can the company do to reduce this risk? Increase the dollar price of the exports – however this may not be practical, particularly when exporting to a competitive market.
Diversify exports into other markets – in the hope that sterling will fall against some currencies while rising against the dollar.
Use hedging techniques such as forward contracts – however, in the long run this will not give effective protection. As sterling rises over time in the spot markets it also rises in the forward markets – and the value of exports still falls.
Attempt to convert the cost base into dollars - for example by importing materials from the US or setting up operations in the US. However these may not be practical options for many companies.
2.3
Transaction Risk
¾
Transaction risk is the short-term version of economic risk.¾
It is the risk that the exchange rate changes between the date of a specific export/import and the related receipt/payment of foreign currency.¾
Like economic risk this affects cash flows and hence affects the value of the firm. It is therefore a significant issue for financial management.¾
Transaction risk can be effectively managed using both internal and external techniques.2.4
Internal management of exchange rate risk:
¾
Invoicing in the domestic currency – an exporter could denominate sales invoices in its domestic currency, effectively transferring the transaction risk to the customer.However this may lead to lost sales.
¾
“Leading and lagging” - paying overseas suppliers earlier (“leading”) if the home currency is expected to fall, or later (“lagging”) if the home currency is expected to appreciate.¾
Netting - where there are both sales and purchases in a foreign currency offset the receivables and payables and only consider an external hedge on the net difference.¾
Matching - consider using foreign currency loans to finance overseas subsidiaries. Overseas earnings can be used to pay the loan interest and repay principal, reducing the net foreign currency cash flow exposed to risk upon repatriation to the parent company. This may be effective as a longer-term hedge against economic risk.¾
Asset and Liability Management – if overseas subsidiaries borrow locally rather than receiving finance from the parent company this reduces the net assets of the subsidiary. This can also be referred to as a “balance sheet hedge” and reduces exposure totranslation risk upon consolidation of the subsidiaries’ net assets into the group accounts (although, as mentioned above, translation risk should not affect the value of the group).
3
EXTERNAL HEDGING OF TRANSACTION RISK
3.1
Forward exchange contracts
¾
Forward contract – a legally binding agreement to buy or sell: a specified quantity of a specified currency
on an agreed future date (“delivery date”) at an exchange rate fixed today
¾
Forward contracts are not bought, they are entered into. Therefore no premium needs to be paid to set up a forward hedge (unlike options).¾
Forward contracts do not require any margin to be posted i.e. no deposit of cash is required when setting up a forward hedge (unlike futures contracts). However there will usually be a small arrangement fee to set up a forward contract.¾
The major disadvantage of forward contracts is that physical delivery must occur i.e. if a company signs a forward contract to buy/sell foreign currency then it must physically exchange currency on the agreed date at the agreed rate, even if that rate has become unattractive compared to the spot rate.¾
Therefore forward contracts are not a flexible method of hedging.Example 3
Today is 1 January 19X1. A UK-based company is expecting dividend income of $200,000 to be received from its US subsidiary on 31 March 19X1.
Spot rate 1 January 19X1 ($ per £) = 1.5123–1.5245
Three month forward = 2.00–2.14 cents discount (c dis)
Required:
(a) How much sterling will be received if forward cover is taken out?
(b) How much sterling would be received if no forward cover is taken out and the actual spot rate on 31 March 19X1 = 1.5247–1.5361?
3.2
Money Market Hedges
¾
Money market hedges involve either borrowing or investing foreign currency in order to protect against transaction risk. Whether to borrow or invest depends on whether the company is exporting or importing.¾
Suppose a UK company has dollar export earnings. A money market hedge could be set up as follows:1.
Today borrow dollars.2.
Exchange these dollars into sterling, which can then be invested.3.
Use the dollar export earnings to repay the dollar loan.Example 4
A UK-based company expects to receive $300,000 in 3 months.
Spot rate ($ per £): 1.7820 ± 0.0002
One year sterling interest rates: 4.9%(borrowing) 4.6% (investing) One year dollar interest rate: 5.4% (borrowing) 5.1% (investing)
Required:
Set up a money market hedge.
3.3
Currency Options
¾
If a company wants a more flexible hedge it may consider buying a currency option.¾
Options are an example of derivatives – a financial instrument based upon an underlyingasset. In the case of currency options the underlying asset is a currency.
¾
The purchaser of a currency option has the right, but not the obligation, to buy or sell: a specified quantity of a specified currency
on or before a specified date (expiry date)
at an exchange rate agreed today (exercise price/strike price)
¾
The owner of the option can either: exercise their right or
allow it to lapse i.e. not exercise it.
¾
However the owner of an option must pay for this flexibility. The cost of an option is known as its premium¾
Premiums are paid at the date the option is bought and are non-refundable.¾
A company may buy options on: a derivatives market, or
directly from a bank – known as OTC (Over The Counter)
¾
A call option gives its owner the right to buy the underlying asset.¾
A put option gives its owner the right to sell the underlying asset.¾
European style options can only be exercised on the expiry date.¾
American style options can be exercised at any time until the expiry date.3.4
Currency Futures Contracts
¾
Futures are simply traded forward contracts.¾
When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin. If losses are incurred (as exchange rates and hence the prices of currency futures contracts change), the buyer or seller may be called on to deposit additional funds (variation margin) with theexchange.
¾
Any profits are credited to the margin account on a daily basis as the contract is “marked to market”.¾
Although the definition of a futures contract is basically the same as a forward contact, there is a significant practical difference between hedging with forwards and futures: With forward contracts there is always physical delivery i.e. a company that signs a forward contract will physically buy or sell the underlying currency when the contract reaches its delivery date.
However most currency futures contracts are “closed out” before their delivery dates. The company simply executes the opposite transaction to the initial futures position e.g. if buying currency futures was the initial transaction, it is later closed out by selling currency futures.
¾
If a futures hedge is correctly performed any gain made on the futures transactions will offset a loss made on the spot currency markets (and vice versa).Illustration 1
Today is 1 February. A UK exporter expects to receive $300,000 in three months’ time and is considering the use of sterling futures to protect against transaction risk.
The company is worried that sterling will appreciate, leading to a loss on the spot market sale of dollars in 3 months.
It therefore needs to set up a futures position that would produce a gain on a rise in sterling.
On 1 February it should buy sterling futures contracts. It needs to hedge until 1 May and hence June contracts should be used (March contacts would only hedge until the end of March)
On 1 May the company should:
¾
sell June sterling futures¾
sell the $300,000 export receipts on the spot market3.5
Currency Swaps
¾
A currency swap is a formal agreement between two parties to exchange principal and interest payments in different currencies over a stated time period.¾
Currency swaps can be used to eliminate transaction risk on foreign currency loans.¾
The steps are as follows: On commencement of the swap; an exchange of agreed principal amounts, usually at the prevailing spot rate.
Over the life of the swap; an exchange of interest payments.
At the end of the swap; a re-exchange of principals, usually at the original spot rate (thereby removing foreign currency risk).
4
INTEREST RATE RISK
4.1
Types of interest rate risk
¾
Exposure to rising interest rates – there are two main situations where a company may fear rising interest rates: If a company has a significant proportion of floating interest rate debt it will fear a rise in interest rates as this obviously leads to lower profits. However higher
interest expense also leads to higher financial risk i.e. more volatile future profits due to a larger block of committed interest expense to be covered. An extreme interest rate rise could even cause financial distress risk i.e. bankruptcy.
If a company has a significant amount of surplus cash invested in fixed interest rate securities e.g. government bonds.
¾
Exposure to falling interest rates – there are two main situations where a company may fear falling interest rates: a company which has a significant proportion of fixed interest rate debt and therefore does not participate in the benefits of falling rates (unlike its competitors for example).
a company with significant floating rate investments e.g. money market investments.
¾
Basis Risk – even if a company has floating rate assets and floating rate liabilities of4.2
Internal Management of Interest Rate Risk
¾
Smoothing – maintaining a balance between fixed rate and floating rate borrowing.¾
Matching – attempting to have a common interest rate for both assets and liabilities.This is more practical for financial institutions than for industrial companies.
5
EXTERNAL HEDGING OF INTEREST RATE RISK
5.1
Forward rate Agreements (FRAs)
¾
FRAs allow companies to fix, in advance, either a future borrowing rate or a future deposit rate, based on a notional principal amount, over a given period.¾
FRAs are cash settled in advance, based upon the present value of the difference on settlement date between: The fixed contract rate
The reference interest rate e.g. LIBOR
¾
The maximum maturity period for an FRA is usually around two years.¾
Customised agreement with a bank i.e. OTC¾
No premium is paid for the FRA and no margin needs to be posted.Illustration 2
A company plans to borrow $20 million in 3 months time for a period of 6 months and wishes to pay 7% interest no matter what happens to interest rates during the next 3 months.
It can enter into an FRA with a bank at an agreed rate of 7% on a notional principal amount of $20 million, starting in 3 months and lasting for 6 months. This is known as a 3v9 FRA.
¾
if actual interest rates are higher than 7% in 3 month’s time then the bank pays the company the difference between 7% and the actual rate i.e. cash settlement is made at the start of the FRA period. The compensation would be calculated as the present value of the interest rate difference on a $20m 6 month loan (discounted a the actual interest rate)¾
if actual interest rates are lower than 7% then the company pays the bank the difference.No matter what the actual interest rate the company will pay interest at a rate of 7% on the underlying $20 million loan.
5.2
Interest Rate Options
Various OTC interest rate options can be purchased from financial institutions and tailor-made to meet company requirements. The major types are:
¾
Cap - if the reference interest rate rises above a pre-determined level, the financial institution pays the difference to the company, based upon an agreed notional principal and time period. This puts a cap or ceiling on the interest rate paid by the company. If the reference rate stays below the pre-determined rate the cap will not be exercised.¾
Floor - if the reference interest rate falls below a pre-determined level, the financial institution pays the difference to the company. This would be relevant for a company with floating rate investment income that wishes to guarantee a minimum return.¾
Collar – combination of a cap and a floor and therefore keeps an interest rate between an upper and lower limit. This is a cheaper hedge than just using a cap or floor.5.3
Interest Rate Futures
¾
The most common futures contract to use for interest rate hedging is a “three-month” contract. This contract is referenced to short-term interest rates e.g. three month LIBOR.¾
Interest rate futures contacts are priced at 100 minus the implied interest rate. Therefore if interest rates rise, the price of interest rate futures falls.¾
If a company wishes to hedge against rising interest rates it should use futures as follows: Today sell interest rate futures Wait for interest rates to rise
If interest rates rise, the price of futures must fall
“Close out” the futures position by buying the same contracts that were originally sold.
There should be a gain on futures (as we sold high and bought low) to offset higher interest expense on company debts.
5.4
Interest Rate Swaps
¾
Interest rate swap - an exchange between two parties of interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period of time.¾
Interest rate swaps are a flexible method for companies to change the interest rate profile of their underlying loans or investments.¾
The most common is a plain vanilla swap where fixed interest payments based on a notional principal are wapped for floating interest payments based upon the same notional principal.Key points
³
Risk management is a topic that is introduced in this paper and taken to a higher level in the Advanced Financial Management syllabus.³
It is important to understand the various types of foreign exchange and interest rate risk.³
Calculations will focus on forecasting exchange rates and performing relatively simple hedges such as forward contracts, money market hedges or FRA’s for interest rate management.³
An appreciation of more complex derivatives such as futures, options and swaps should be sufficient.FOCUS
You should now be able to:
¾
forecast exchange rates using purchasing power parity and interest rate parity;¾
discuss the various types of exchange rate risk and interest rate risk;EXAMPLE SOLUTIONS
This is a predicted fall in the value of sterling.
Solution 2
Sterling is weaker in the forward market than the spot market
Solution 3
Expected receipt after 3 months = $300,000
Dollar interest rate over three months = 5.4/ 4 = 1.35%
