Ian H. Giddy
6.7 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE RISK. In this section we consider the relative merits of several different tools for
corrected. Any predictable, economically meaningful bias would be corrected by the transactions of profit-seeking transactors.
The importance of market-based forecasts for a determination of the foreign ex- change exposure of the firm is that of a benchmark against which the economic con- sequences of deviations must be measured. This can be put in the form of a concrete question: How will the expected net cash flow of the firm behave if the future spot exchange rate is not equal to the rate predicted by the market when commitments are made? The making of this kind of forecast is completely different from trying to out- guess the foreign exchange markets.
6.7 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE
First, there are different tools that serve effectively the same purpose. Most cur- rency management instruments enable the firm to take a long or short position to hedge an opposite short or long position. Thus, one can hedge a yen payment using a forward exchange contract, or debt in yen, or futures or perhaps a currency swap.
In equilibrium the cost of each will be the same, according to the fundamental rela- tionships of the international money market as illustrated in Exhibit 6.1. They differ in details like default risk or transactions costs, or if there is some fundamental mar- ket imperfection.
Second, tools differ in that they hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge contingent cash flows: options may be better suited for the latter.
(a) Foreign Exchange Forwards. Foreign exchange is, of course, the exchange of one currency for another. Trading or “dealing” in each pair of currencies consists of two parts, the spot market, where payment (delivery) is made right away (in prac- tice this means usually the second business day), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract.
Forward contracts are the most common means of hedging transactions in foreign currencies, as the example in Exhibit 6.10 illustrates. The trouble with forward con- tracts, however, is that they require future performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, some- times at great cost to the hedger. This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure. For such situations, futures may be more suitable.
(b) Currency Futures. Outside of the interbank forward market, the best-developed market hedging exchange rate risk is the currency futures market. In principle, cur- rency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price. In practice, they differ from forward contracts in important ways.
One difference between forwards and futures is standardization. Forwards are for
Janet Fredericks, Foreign Exchange Manager at Murray Chemical, was informed that Murray was selling 25,000 tons of naphtha to Canada for a total price of C$11,500,000, to be paid upon delivery in two months' time. To protect her company, she arranged to sell 11.5 million Canadian dollars forward to the Royal Bank of Montreal. The two-month forward contract price was US$0.6785 per Canadian dollar. Two months and two days later, Fredericks re- ceived US$7,802,750 from RBM and paid RBM C$11,500,000, the amount received from Murray's customer.
Exhibit 6.10. Hedging with a Forward Contract.
any amount, as long as it’s big enough to be worth the dealer’s time, while futures are for standard amounts, each contract being far smaller than the average forward transaction. Futures are also standardized in terms of delivery date. The normal cur- rency futures delivery dates are March, June, September, and December, while for- wards are private agreements that can specify any delivery date that the parties choose. Both of these features allow the future contract to be tradable.
Another difference is that forwards are traded by phone and telex and are com- pletely independent of location or time. Futures, on the other hand, are traded in or- ganized exchanges such as the LIFFE in London, SIMEX in Singapore, and the IMM in Chicago.
The most important feature of the futures contract is not its standardization or trad- ing organization but the time pattern of the cash flows between parties to the trans- action. In a forward contract, whether it involves full delivery of the two currencies or just compensation of the net value the transfer of funds takes place once: at matu- rity. With futures, cash changes hands every day during the life of the contract, or at least every day that has seen a change in the price of the contract. This daily cash compensation feature largely eliminates default risk.
Thus, forwards and futures serve similar purposes, and tend to have identical rates, but differ in their applicability. Most big companies use forwards; futures tend to be used whenever credit risk may be a problem.
(c) Foreign Currency Debt. Debt, borrowing in the currency to which the firm is ex- posed or investing in interest-bearing assets to offset a foreign currency payment, is a widely used hedging tool that serves much the same purpose as forward contracts.
Consider an example.
In Exhibit 6.10, Fredericks sold Canadian dollars forward. Alternatively, she could have used the Eurocurrency market to achieve the same objective. She would borrow Canadian dollars, which she would then change into francs in the spot mar- ket, and hold them in a U.S. dollar deposit for two months. When payment in Cana- dian dollars was received from the customer, she would use the proceeds to pay down the Canadian dollar debt. Such a transaction is termed a “money market hedge.”
The nominal (not the expected) cost of this money market hedge is the difference between the Canadian dollar interest rate paid and the U.S. dollar interest rate earned. According to the Interest Rate Parity Theorem, the interest differential equals the forward exchange premium, the percentage by which the forward rate differs from the spot exchange rate. So the cost of the money market hedge should be the same as the forward or futures market hedge, unless the firm has some advantage in one market or the other. Indeed, in an efficient market, one would expect even the anticipated cost of hedging to be zero. This follows from the unbiased forward rate theory.
The money market hedge suits many companies because they have to borrow any- way, so it simply is a matter of denominating the company’s debt in the currency to which it is exposed. That is logical but if money market hedge is to be done for its own sake, as in the example just given, the firm ends up borrowing from one bank and lending to another, thus losing on the spread. This is costly, so the forward hedge would probably be more advantageous except where the firm had to borrow for on- going purposes anyway.
(d) Currency Options. Many companies, banks, and governments have extensive experience in the use of forward exchange contracts, whereas currency options—or option contracts in general— are still used far less frequently. However, as market participants have developed a better understanding of option pricing, trading, and hedging of options positions over the last couple of years, the use of options has be- come more frequent. But when comparing options with forwards and futures, one has to be aware of the fact that these types or categories of financial instruments have very different characteristics and hence serve very different purposes.
With a forward contract, one can lock in an exchange rate for the future. There are a number of circumstances, though, where it may be desirable to have more flexibil- ity than a forward contract provides. For example, a computer manufacturer in Cali- fornia may have sales priced in U.S. dollars or in euros in Europe. Depending on the relative strength of the two currencies, revenues may be realized in either euros or dollars. In such a situation, the use of forward and futures would be inappropriate:
There is no point in hedging a position that does not exist. What is needed in this sit- uation is a foreign exchange option that represents the right to exchange currency at a predetermined rate.
A foreign exchange option is a contract for future delivery of a currency in ex- change for another, where the holder of the option has the right, but not the obliga- tion to buy (or sell) the currency at an agreed price, the strike or exercise price. The right to buy is a call; the right to sell is a put. For such a right the option buyer pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his option. In some option contracts, the instrument being delivered is the currency it- self; in others, a futures contract on the currency. American options permit the holder to exercise at any time before the expiration date; European options only on the expiration date; Asian options have an exercise price that represents an average rate.
Futures and forwards are contracts in which two parties oblige themselves to ex- change an asset under specified conditions in the future, which makes them useful to hedge or to convert known currency or interest rate exposures. An option, in contrast, offers flexibility in that its holder can decide at any point in time whether he wants to exercise the option now or later, sell it, or let it expire without exercise. Options are often compared to insurance because of their asymmetric payoff structure that
“keeps the upside potential while eliminating downside risk.” This view, however, represents a misconception of the true nature of this type of financial instrument. Op- tions can be properly used for hedging purposes, that is, for risk reduction, only if the exposure the firm faces has been an option-type character, too. In the above example, the computer manufacturer has effectively granted a currency option to his European customers, giving them the choice to pay in U.S. dollars or euros. Therefore, he can offset his exposure to unanticipated changes in the exchange rate by an equivalent currency option.
In the presence of currency exposures, however, for example, caused by foreign currency receivables or liabilities, the use of options has to be regarded as position taking, that is, speculating. Although there may be nothing wrong about speculating per se, it should not, but often is, done under the guise of hedging. Speculating means taking a position against the market; thus, a person who speculates puts money at risk under the premise that he or she has superior information than professional market
makers. In contrast to linear instruments like futures and forwards, the value of an option does not depend on the price of the underlying instrument alone, but also on its volatility and the remaining time to expiration. As a consequence, using currency options in the absence of a matching exposure means speculation with respect to one or more of these determinants. Therefore, just having a view on the currency’s di- rection that is different from the forward rate would simply suggest taking a position via the forward or futures market. But if one’s expectation of volatility deviates from the market, futures do not work any more, but options are needed. Indeed, currency options provide the only convenient means of hedging or positioning “volatility risk,” as their price is directly influenced by the outlook for a currency’s volatility:
the more volatile, the higher the price of the option.
Corporate uses of currency options vary widely. Some multinational companies use options to hedge transaction exposures, that is, currency risk from transactions that have already been booked as payables or receivables. Others use them as a shield against currency risk of future transactions (economic exposure). If companies bid for overseas contracts, they face what is called “contingent exposures,” a risk with respect to unexpected currency changes that arises only in case the company wins the contract. Still other companies try to bet against the market by taking a position with respect to the direction of currency changes or the expectation of volatility. A general obstacle to the use of options might still be the fact that the purchase of an option—
as opposed to futures and forwards which are just mutual agreements—has to be paid for, thus drawing management’s attention to the employment of this financial instru- ment and requiring justification of its usefulness. An attempt to hide or avoid outlays for such option premiums leads treasury departments to adopt more risky strategies that involve the simultaneous sale of an option—with the concomitant downside risks.
6.8 CONCLUSION. This chapter offers the reader an introduction to the complex subject of the measurement and management of foreign exchange risk. We began by noting some problems with interpretation of the concept, and entered the debate as to whether and why companies should devote active managerial resources to something that is so difficult to define and measure.
Accountants’ efforts to put an objective value on a firm involved in international business has led many to focus on the translated balance sheet as a target for hedg- ing exposure. As was demonstrated, however, there are numerous realistic situations where the economic effects of exchange differ from those predicted by the various measures of translation exposure. In particular, we emphasized the distinctions be- tween the currency of recording, the currency of denomination, and the currency of determination of a business.
After giving some guidelines for the management of economic exposure, the chap- ter addressed the thorny question of how to approach currency forecasting. We sug- gested a market-based approach to international financial planning, and cast doubt on the ability of the corporation’s treasury department to outperform the forward ex- change rate.
The chapter then turned to the tools and techniques of hedging, contrasting the ap- plications that require forwards, futures, money market hedging, and currency op- tions. In Exhibit 6.11, we present a sketch of how a company may approach the ex- change management task, based on the principles laid out in this chapter.
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