[Session 9 & 10]
Dec 2015
Education Course Notes
ACCA P4
Advanced Financial Management
Education Class 5
Patrick Lui
hklui2007@yahoo.com.hk
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Session 9 and 10
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[Session 9 & 10]
Chapter 14 Hedging Foreign Exchange Risk
LEARNING OBJECTIVES
1.
2.
3.
4.
Discuss the operation of the derivatives market, including:
(a) The relative advantages and disadvantages of exchange traded versus OTC
agreements
(b) Key features, such as standard contracts, tick sizes, margin requirements and
margin trading
(c) The source of basis risk and how it can be minimised
Assess the impact on an organization to exposure in translation, transaction and
economic risks and how these can be managed.
Evaluate, for a given hedging requirement, which of the following is the most
appropriate strategy, given the nature of the underlying position and the risk exposure:
(a) The use of the forward exchange market and the creation of a money market
hedge
(b) Synthetic foreign exchange agreements (SAFE’s)
(c) Exchange-traded currency futures contracts
(d) Currency swaps
(e) FOREX swaps
(f) Currency options
Advise on the use of bilateral and multilateral netting and matching as tools for
minimizing FOREX transactions costs and the management of market barriers to the
free movement of capital and other remittances.
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[Session 9 & 10]
Hedging Foreign
Exchange Risk
Exchange
Rates
Internal Hedging
Techniques
Forward
Contracts
Money Market
Hedge
Currency
Futures
Currency
Options
Currency
Swap
Direct and
Indirect Quotes
Invoice in
Home Currency
Characteristics
Principle
Features
Principles
Swap
Procedures
Bid and
Offer Prices
Do Nothing
Synthetic Foreign
Exchange
Agreement
(SAFEs)
For Foreign
Currency
Payment
Ticks
Options Hedging
Calculations
Advantages and
Disadvantages
Spread
Leading and
Lagging
For Foreign
Currency
Receipt
Basis
Risk
Advantages and
Disadvantages
Matching
Choosing
Hedging Method
Hedging
Calculations
Netting
FOREX
Swaps
Hedge
Efficiency
Margins and
Marking to Market
Advantages and
Disadvantages
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1.
Exchange Rates
1.1
Direct and indirect currency quotes
1.1.1 A direct quote is the amount of domestic currency which is equal to one foreign
currency unit.
1.1.2 An indirect quote is the amount of foreign currency which is equal to one domestic
currency unit.
1.1.3 In the UK, indirect quotes are invariably used but, in most countries, direct quotes are
more common.
1.2
Bid and offer prices
1.2.1 The bid price is the rate at which the bank is willing to buy the currency.
1.2.2 The offer (or ask) price is the rate at which the bank is willing to sell the currency.
Example 1 – Bid and offer prices
Calculate how many dollars an exporter would receive or how many dollars an importer
would pay, ignoring the bank’s commission, in each of the following situations, if they were
to exchange currency at the spot rate.
(a)
(b)
A US exporter receives a payment from a Danish customer of 150,000 kroner
A US importer buys goods from a Japanese supplier and pays 1 million yen
Spot rates are as follows.
Bank sells (offer)
Bank buys (bid)
Danish Kr/$
9.4340
9.5380
Japanese Yen/$
203.650
205.781
Solution:
(a)
The bank is being asked to buy the Danish kroners and will give the exporter:
150,000
 $15,726.57
9.5380
(b)
The bank is being asked to sell the yen to the importer and will charge for the currency
1,000,000
 $4,910.39
203.650
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1.3
[Session 9 & 10]
Spread
1.3.1 The difference between bid price and the offer price, covering dealers’ costs and profit,
is called the spread. The spread can be quoted in different ways.
£/$0.6500 +/– 0.0005 or £/$0.6495 – 0.6505
Example 2 – Spread
ABC Inc, a US based company, is engaged in both import and export activities. During a
particular month, ABC sells goods to Posh plc, a UK company, and receives £5 million. In
the same month, ABC imports goods from a UK supplier, which cost £5 million.
If the exchange rates were £/$0.5075 +/– 0.0003, calculate the dollar values of the sterling
receipt and payment.
(a)
As an exporter, ABC will pay a high rate to buy dollars (sell pounds) – that is, they
will be quoted a rate of 0.5075 + 0.0003 = 0.5078. Pratt will therefore receive
£5 million/0.5078 = $9,846,396
(b)
As an importer, ABC will receive a low rate to sell dollars (buy pounds) – that is, a
rate of 0.5075 – 0.0003 = 0.5072. Pratt will therefore pay £5 million/0.5072 =
$9,858,044
2.
Internal Hedging Techniques
2.1
Invoice in home currency
2.1.1 One easy way is to insist that all foreign customers pay in your home currency and
that your company pays for all imports in your home currency.
2.1.2 However the exchange rate risk has not gone away, it has just been passed onto the
customer. Your customer may not be too happy with your strategy and simply look for
an alternative supplier.
2.1.3 Achievable if you are in a monopoly position, however in a competitive environment
this is an unrealistic approach.
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2.2
[Session 9 & 10]
Do nothing
2.2.1 In the long run, the company would “win some, lose some”. This method
(a)
(b)
(c)
2.3
works for small occasional transactions
saves in transaction costs
is dangerous.
Leading and lagging
2.3.1 Leading involves accelerating payments to avoid potential additional costs due to
currency rate movements.
2.3.2 Lagging is the practice of delaying payments if currency rate movements are expected
to make the later payment cheaper.
Example 3 – Leading and lagging
Williams Inc – a company based in the US – imports goods from the UK. The company is
due to make a payment of £500,000 to a UK supplier in one month’s time. The current
exchange rate is as follows:
£0.6450 = $1
(a)
(b)
If the dollar is expected to appreciate against sterling by 2% in the next month and by
a further 1% in the second month what would be Williams Inc’s strategy in terms of
leading and lagging and by how much would the company benefit from this strategy?
If the dollar was to depreciate against sterling by 2% in the next month and by a
further 1% in the second month, how would Williams Inc’s strategy probably change
and what would the resulting benefit be?
Solution:
(a)
Dollar appreciating against sterling
If the dollar appreciates against sterling, this means that the dollar value of payments will be
smaller in two months’ time than if payment was made when due. Williams Inc will
therefore adopt a ‘lagging’ approach to its payment – that is it will delay payment by an
extra month to reduce the dollar cost.
Payment to UK supplier
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One month’s time
Two month’s time
Exchange rate
£0.6450 × 1.02 = £0.6579
£0.6579 × 1.01 = £0.6645
$ value of payment
£500,000/0.6579 = $759,994
£500,000/0.6645 = $752,445
By delaying the payment by an extra month Williams Inc will save $7,549.
(b)
Dollar depreciating against sterling
The opposite strategy should now be adopted. As the dollar depreciates, there is an incentive
for Williams Inc to pay as soon as possible. The dollar value of sterling payments will
increase as the dollar depreciates therefore to save money the company will want to pay on
time.
Payment to UK supplier
One month’s time
Two month’s time
Exchange rate
£0.6450 × 0.98 = £0.6321
£0.6321 × 0.99 = £0.6258
$ value of payment
£500,000/0.6321 = $791,014
£500,000/0.6258 = $798,977
By paying on time Williams Inc will save $7,963.
Companies should be aware of the potential finance costs associated with paying early.
This is the interest cost on the money used to make the payment, but early settlement
discounts may be available. Before deciding on a strategy of making advanced payments,
the company should compare how much they save in terms of currency with the finance
costs of making early payment.
By delaying payments there may be a loss of goodwill from the supplier which may result
in tighter credit terms in the future. Whilst savings may have been made by paying late, the
company must compare these savings with potential future costs resulting from, for
example, withdrawal of favourable credit terms or early settlement discounts.
2.4
Matching
2.4.1 When a company has receipts and payments in the same foreign currency due at the
same time, it can simply match them against each other. It is then only necessary to
deal on the foreign exchange (forex) markets for the unmatched portion of the total
transactions.
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[Session 9 & 10]
Suppose that ABC Co has the following receipts and payments in three months time:
2.5
Netting
(Jun 13)
2.5.1 The terms netting and matching are often used interchangeably but strictly speaking
they are different:
(a)
Netting refers to netting off group receipts and payments.
(b)
Matching extends this concept to include third parties such as external
suppliers and customers.
2.5.2 In the case of bilateral netting, only two companies are involved. The lower balance
is netted off against the higher balance and the difference is the amount remaining to
be paid.
2.5.3 Multilateral netting is a more complex procedure in which the debts of more than
two group companies are netted off against each other. The arrangement might be
coordinated by the company’s central treasury or alternatively by the company’s
bankers.
2.5.4 Multilateral netting involves minimizing the number of transactions taking place
through each country’s banks. This limits the fees that these banks receive for
undertaking the transactions and therefore some governments do not allow
multilateral netting in order to maximize the fees their local banks receive.
2.5.5 On the other hand, some other governments allow multilateral netting in the belief
that this will be make companies more willing to operate from those countries and
any banking fees lost will be more than compensated by the extra business these
companies and their subsidiaries bring into the country.
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[Session 9 & 10]
2.5.6 Tabular method (transaction matrix)
Step 1: Set up a table with the name of each company down the side and across the
top.
Step 2: Input all the amounts owing from one company to another into the table and
convert them into a common (base) currency (at spot rate).
Step 3: By adding across and down the table, identify the total amount payable and
the total amount receivable by each company.
Step 4: Compute the net payable or receivable, and convert back into the original
currency.
Example 4 – Multilateral netting
P is the parent company of a group that contains 3 subsidiaries: Q (based in Europe), R
(based in the USA) and S based in Canada. The following cash flows are due in 2 months’
time between P and its subsidiaries:
Owed by
Owed to
Amount
P
S
CAN$ 3 million
P
R
US$ 5 million
Q
R
US$ 4 million
Q
S
CAN$ 7 million
R
S
CAN$ 2 million
R
P
US$ 6 million
S
Q
EUR 12 million
S
P
CAN$ 5 million
Mid rate exchange rates in two months’ time are expected to be:
£1 = US$1.60
£1 = EUR 1.20
£1 = CAN$ 1.50
Required:
Calculate, using a tabular format (transaction matrix), the impact of undertaking
multilateral netting by P and its three subsidiary companies for the cash flows due in
two months.
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Solution:
Note that all foreign currency amounts have been translated into £ using the given mid rates.
In £ million
Paid to
P
Q
R
S
Paid by
P
Q
3.125
2.000
2.500
4.667
1.333
Total payment
(5.125)
(7.167)
(5.083)
(13.333)
Total receipt
7.083
10.000
5.625
8.000
Net receipt/(payment)
1.958
2.833
0.542
(5.333)
R
3.750
S
3.333
10.000
Total
7.083
10.000
5.625
8.000
So overall, S needs to pay amounts equivalent to the above figures to each of P, Q and R in
two months’ time.
Question 1
X, Y and Z are three companies within the same UK based international group. W is a
company outside of the group. The following liabilities have been identified for the
forthcoming year:
Owed by
Owed to
Amount (millions)
X
Y
€39
Y
X
£10
Y
W
Z
X
$20
￥200
Z
Y
€15
W
X
W
Z
$15
￥100
Mid-market spot rates are:
£1 = $2.00
£1 = €1.50
£1 = ￥250
Required:
Establish the net indebtedness that would require external hedging.
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3.
[Session 9 & 10]
Managing Transaction Risk – Forward Contracts
(Jun 11, Dec 12, Jun 13, Jun 14)
3.1
Characteristics of forward contracts
3.1.1 A forward contract allows a business to buy or sell a currency on a fixed future date at
a predetermined rate, i.e. the forward rate of exchange.
3.1.2 A forward exchange contract is:
(a)
An immediately firm and binding contract, e.g. between a bank and its
customer.
(b)
For the purchase or sale of a specified quantity of a stated foreign currency.
(c)
At a rate of exchange fixed at the time the contract is made.
(d)
For performance (delivery of the currency and payment for it) at a future time
which is agreed when making the contract (this future time will be either a
specified date, or any time between two specified dates).
3.1.3 The rule for adding or subtracting discounts and premiums
Forward rate cheaper => Quoted at discount => added to the spot rate
Forward rate more expensive => Quoted at premium => subtracted from the spot rate
3.1.4 Quotation of forward rates
Banks will quote a spread based on the forward bid and offer prices. For example the
$/€ 3-month forward rate might be quoted as:
$1.3495 – $1.3525 / € or 1.3510 ± 0.0015 / €
Example 5 – Forward contract
An Australian firm has just bought some machinery from a US supplier for US$250,000
with payment due in 3 months time. Exchange rates are quoted as follows:
Spot (US$/A$)
3 months forward
0.7785 – 0.7891
0.21 – 0.18 cents premium
Required:
Calculate the amount payable if a forward contract is used.
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Solution:
Step 1: Get the appropriate spot rate from the spread (remember the bank always win):
0.7785
Step 2: Adjust to get the forward rate (remember to add discounts and deduct premium)
0.7785 – 0.0021 = 0.7764
Step 3: Payment in three months’ time = 250,000 ÷ 0.7764 = A$322,000
3.1.5 Advantages and disadvantages:
Advantages


Disadvantages
Flexibility with regard to the amount to 
be covered.
Relatively straightforward both to 
comprehend and to organize.

3.2
Contractual commitment that must be
completed on the due date.
No opportunity to benefit from
favourable movements in exchange
rates.
Only major currencies, such as $, £,
Yen or Euro, have the forward markets
Synthetic foreign exchange agreements (SAFEs)
3.2.1 In order to reduce the volatility of their exchange rates, some governments have
banned foreign currency trading.
3.2.2 Examples of affected currencies include:
(a)
Brazilian Reals
(b)
Philippine Peso
(c)
Indian Rupee
(d)
Taiwan Dollars
(e)
Korean Won
(f)
Russian Ruble
(g)
Chinese Renminbi (or Yuan)
3.2.3 In such markets the use of non-deliverable forwards (NDFs) has developed.
3.2.4 These are like forward contracts, except no currency is delivered. Instead the
profit or loss (i.e. the difference between actual and NDF rates) on a notional
amount of currency (the face value of the NDF) is settled between the two counter
parties.
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[Session 9 & 10]
3.2.5 It is important to remember that settlement of SAFEs will always be in dollars as the
counterparty will be unable to settle in the alternative currency (as it is not
traded).
Example 6 – SAFEs
Let the spot rate between the US$ and the Brazilian Real be 1.6983 Reals to $1 and suppose
ABC Co agree a 3 month NDF to buy $1 million worth of Reals at 1.7000.
Case 1
If the spot rate moves to 1.6800 in 3 months, then the counter-party (e.g. bank) will have to
pay ABC Co = 1 million × (1.7000 – 1.6800) = 20,000 Reals.
This will be settled in US$, so the actual receipt will be 20,000 ÷ 1.6800 = $11,905.
Case 2
If the spot rate moves to 1.7010 in 3 months, then ABC Co will have to pay the
counter-party = 1 million × (1.7010 – 1.7000) = 1,000 reals
Again, this will be settled in US$, so the actual payment will be 1,000 ÷ 1.7010 = $588.
4.
Money Market Hedge
(Jun 08, Jun 13)
4.1
4.1.1
Principle of money market hedge
Money Market Hedge
Money market hedge involves borrowing in one currency, converting the money
borrowed into another currency and putting the money on deposit until the
time the transaction is completed, hoping to take advantage of favourable interest
rate movements.
4.2
Setting up a money market hedge for a foreign currency payment
4.2.1 Suppose a British company needs to pay a Swiss creditor in Swiss francs in three
months time. It does not have enough cash to pay now, but will have sufficient in
three months time. Instead of negotiating a forward contract, the company could:
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Step 1: Borrow the appropriate amount in pounds now
Step 2: Convert the pounds to francs immediately
Step 3: Put the francs on deposit in a Swiss franc bank account
Step 4: When time comes to pay the company:
(a) pay the creditor out of the franc bank account
(b) repays the pound loan account
Example 7 – Money market hedge for payment
A UK company owes a Danish creditor Kr3,500,000 in three months time. The spot
exchange rate is Kr/£ 7.5509 – 7.5548. The company can borrow in Sterling for 3 months at
8.60% per annum and can deposit kroners for 3 months at 10% per annum. What is the cost
in pounds with a money market hedge and what effective forward rate would this represent?
Solution:
The interest rates for 3 months are 2.15% to borrow in pounds and 2.5% to deposit in
kroners. The company needs to deposit enough kroners now so that the total including
interest will be Kr3,500,000 in three months’ time. This means depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634.
These kroners will cost £452,215 (spot rate 7.5509). The company must borrow this amount
and, with three months interest of 2.15%, will have to repay:
£452,215 x (1 + 0.0215) = £461,938.
Thus, in three months, the Danish creditor will be paid out of the Danish bank account and
the company will effectively be paying £461,938 to satisfy this debt. The effective forward
rate which the company has manufactured is 3,500,000/461,938 = 7.5768. This effective
forward rate shows the kroner at a discount to the pound because the kroner interest
rate is higher than the sterling rate.
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[Session 9 & 10]
Convert
7.5509
£
Now:
Kr
Borrow
£452,215
Deposit
Kr3,414,634
Interest
paid: 2.15%
Interest
earned: 2.5%
3 months' time: £461,938
4.3
Kr3,500,000
Setting up a money market hedge for a foreign currency receipt
4.3.1 A similar technique can be used to cover a foreign currency receipt from a debtor. To
manufacture a forward exchange rate, follow the steps below.
Step 1: Borrow the appropriate amount in foreign currency today
Step 2: Convert it immediately to home currency
Step 3: Place it on deposit in the home currency
Step 4: When the debtor’s cash is received:
(a) Repay the foreign currency loan
(b)
Take the cash from the home currency deposit account
Example 8 – Money market hedge for receipts
A UK company is owed SFr 2,500,000 in three months time by a Swiss company. The spot
exchange rate is SFr/£ 2.2498 – 2.2510. The company can deposit in Sterling for 3 months
at 8.00% per annum and can borrow Swiss Francs for 3 months at 7.00% per annum. What
is the receipt in pounds with a money market hedge and what effective forward rate would
this represent?
Solution:
The interest rates for 3 months are 2.00% to deposit in pounds and 1.75% to borrow in
Swiss francs. The company needs to borrow SFr2,500,000/1.0175 = SFr2,457,003 today.
These Swiss francs will be converted to £ at 2,457,003/2.2510 = £1,091,516. The company
must deposit this amount and, with three months interest of 2.00%, will have earned
£1,091,516 x (1 + 0.02) = £1,113,346
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Thus, in three months, the loan will be paid out of the proceeds from the debtor and the
company will receive £1,113,346. The effective forward rate which the company has
manufactured is 2,500,000/1,113,346 = 2.2455. This effective forward rate shows the
Swiss franc at a premium to the pound because the Swiss franc interest rate is lower
than the sterling rate.
S Fr
Now:
Convert
2.251
Borrow
SFr2,457,003
£
Deposit
£1,091,516
Interest
paid: 1.75%
Interest
earned: 2.0%
3 months' time:SFr2,500,000
4.4
£1,113,546
Choosing the hedging method
(Jun 11)
4.4.1 The choice between forward and money markets is generally made on the basis of
which method is cheaper, with other factors being of limited significance.
4.4.2 When a company expects to receive or pay a sum of foreign currency in the next few
months, it can choose between using the forward exchange market and the money
market to hedge against the foreign exchange risk. Other methods may also be
possible, such as making lead payments. The cheapest method available is the one
that ought to be chosen.
Example 9
ABC Co has bought goods from a US supplier, and must pay $4,000,000 for them in three
months time. The company’s finance director wishes to hedge against the foreign exchange
risk, and the three methods which the company usually considers are:
(a)
(b)
(c)
Using forward exchange contracts
Using money market borrowing or lending
Making lead payments
The following annual interest rates and exchange rates are currently available.
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[Session 9 & 10]
US dollar
Sterling
Deposit rate
Borrowing rate
Deposit rate
Borrowing rate
%
%
%
%
1 month
7
10.25
10.75
14.00
3 months
7
10.75
11.00
14.25
Spot
1 month forward
3 months forward
$/£ exchange rate ($ = £1)
1.8625 – 1.8635
1.8565 – 1.8577
1.8455 – 1.8460
Which is the cheapest method for ABC Co? Ignore commission costs (the bank charges for
arranging a forward contract or a loan).
Solution:
The three choices must be compared on a similar basis, which means working out the cost
of each to ABC Co either now or in three months time. In the following paragraphs, the cost
to ABC Co now will be determined.
Choice 1: the forward exchange market
ABC Co must buy dollars in order to pay the US supplier. The exchange rate in a forward
exchange contract to buy $4,000,000 in three months time (bank sells) is 1.8445.
The cost of the $4,000,000 to ABC Co in three months time will be:
$4,000,000
= £2,168,609.38
1.8445
This is the cost in three months. To work out the cost now, we could say that by deferring
payment for three months, we assume that the company needs to borrow the money for the
payment.
At an annual interest rate of 14.25% the rate for three months is 14.25/4 = 3.5625%. The
present cost of £2,168,609.38 in three months time is:
£2,168,609.38 / 1.035625 = £2,094,010.26
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Choice 2: the money markets
Using the money market involves
(a) Borrowing in the foreign currency, if the company will eventually receive the
currency
(b) Lending in the foreign currency, if the company will eventually pay the currency.
Here, ABC Co will pay $4,000,000 and so it would lend US dollars.
It would lend enough US dollars for three months, so that the principal repaid in three
months time plus interest will amount to the payment due of $4,000,000.
(a) Since the US dollar deposit rate is 7%, the rate for three months is approximately 7/4
(b)
= 1.75%.
To earn $4,000,000 in three months time at 1.75% interest, ABC Co would have to
lend now:
$4,000,000
 $3,931,203.93
1.0175
These dollars would have to be purchased now at the spot rate of $1.8625. The cost would
be:
$3,931,203.93
= £2,110,713,52
1.8625
By lending US dollars for three months, ABC Co is matching eventual receipts and
payments in US dollars, and so has hedged against foreign exchange risk.
Choice 3: lead payments
Lead payments should be considered when the currency of payment is expected to
strengthen over time, and is quoted forward at a premium on the foreign exchange market.
Here, the cost of a lead payment (paying $4,000,000 now) would be $4,000,000 / 1.8625 =
£2,147,651.01.
Summary
£
2,094,010.26
2,110,713.52
2,147,651.01
Forward exchange contract (cheapest)
Currency lending
Lead payment
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5.
[Session 9 & 10]
Currency Futures
(Jun 11, Jun 14)
5.1
Features of currency futures
5.1.1 Currency futures are standardized contracts for the sale or purchase at a set future
date of a set quantity of currency.
5.1.2 Futures contracts are exchange-based instruments traded on a regulated exchange.
The buyer and seller of a contract do not transact with each other directly.
5.1.3 Futures are generally more liquid and have less credit risk than forward contracts as
organized exchanges have clearing house that guarantee that all trades in the futures
market will honour their obligations.
5.1.4 Futures contracts are assumed to mature at the end of either March, June, September
or December.
5.1.5 Buying the futures contract means receiving the contract currency. Selling the
futures contract means supplying the contract currency.
5.2
Ticks
5.2.1 The price of a currency futures moves in tick. A tick is the smallest movement in the
exchange rate and is normally four decimal places.
Tick value = size of futures contract × tick size
5.2.2 For example, if a futures contract is for £62,500 and the tick size is $0.0001, the tick
value is $6.25. Note that the tick size and tick value are always quoted in US
dollars.
5.2.3 What this means is that for every $0.0001 movement in the price, the company will
make a profit or loss of $6.25. If the exchange rate moves by $0.004 in the company’s
favour – which is 40 ticks (0.004/0.0001) – the profit made will be 40 × $6.25 = $250
per contract.
5.2.4 Examples of futures contract specifications – including tick size and tick value – are
given below.
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5.3
[Session 9 & 10]
Basis risk
5.3.1 Basis is the difference between the spot rate and the futures price.
5.3.2 Basis risk is the risk that the price of a futures contract will vary from the spot
rates as expiry of the contract approaches. There is no basis risk when a contract
is held to maturity.
5.3.3 In order to manage basis risk it is important to choose a currency futures with the
closest maturity date to the actual transaction.
Example 10
A US company trades in Europe and will need to pay €5 million in five months’ time. It is
now 1 March and futures contracts mature at the relevant month end. The current spot rate
is $1.2500/€1. The following futures contracts are available ($ per €1).
September
December
1.2456
1.2382
If September contracts are used, there will be two months of unexpired basis. If December
contracts are used there will be five months. If basis is assumed to decline at a constant rate,
the unexpired basis on 1 August under each contract would be as follows:
Spot rate now
Futures price
Difference (basis now)
Months until contract matures
Unexpired portion of contract on 1 August
Unexpired basis
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September
December
1.2500
1.2456
0.0044
7
2/7
0.0013
1.2500
1.2382
0.0118
10
5/10
0.0059
Copyright @ Kaplan Financial 2015
Education Course Notes
[Session 9 & 10]
The September contracts have the lower unexpired basis. Given the shorter time
horizon there is less risk of significant between the predicted futures price and the
actual futures prices on 1 August when the contracts are settled.
In this case however, the September contracts are closed two months before expiry and there
is no guarantee that the price of the futures contract will be the same as the predicted price
calculated by basis at that date. It is assumed that the expired basis above is 0.0013 but it
could be either more or less.
This creates a problem in that the futures contract, which in theory give a fixed interest cost,
may vary and therefore the amount of interest is not fixed or predictable. Typically, this risk
is much smaller than the risk of remaining unhedged and therefore the impact of this risk
is smaller and preferable to not hedging at all.
5.4
Futures hedging calculations
5.4.1 Steps for futures hedging
Step 1:
Determine buy or sell futures
Step 2:
Determine the number of contracts
Step 3:
Determine the expiry date which should be chosen
Step 4:
Calculate profit or loss in the futures market by closing out the
futures contracts, and calculate the value of the transaction using the
spot rate on the transaction date.
Example 11
A US company buys goods worth €720,000 from a German company payable in 30 days.
The US company wants to hedge against the € strengthening against the dollar.
Current spot is 0.9215 – 0.9221 $/€ and the € futures rate is 0.9245 $/€.
The standard size of a 3 month € futures contract is €125,000.
In 30 days time the spot is 0.9345 – 0.9351 $/€.
Closing futures price will be 0.9367.
Evaluate the hedge.
Solution:
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[Session 9 & 10]
Step 1: We need to buy € or sell $. As the futures contract is in €, we need to buy futures.
720,000
Step 2: No. of contracts = 5.76, say 6 contracts
125,000
Step 3: We assume that the three month contract is the best available.
Step 4: Calculate profit or loss in the futures market and calculate the value of the
transaction
Tick size – minimum price movement × contract size = 0.0001 × 125,000 = $12.50
Closing futures price – we are told it will be 0.9367
Hedge outcome:
Outcome in futures market
Opening futures price = 0.9245
Closing futures price = 0.9367
Movement in ticks = 122 ticks
Futures profit = 122 × $12.50 × 6 contracts = $9,150
Net outcome
Spot market payment (720,000 × 0.9351 $/€)
Futures market profit
$
673,272
(9,150)
664,122
Question 2
It is 4 May and the treasurer of a Swiss company has identified a net receipt of US$2
million on 10 June. These dollars will need to be converted into Swiss Francs (CHF). The
treasurer has decided to use US dollar – Swiss Franc futures contracts to hedge with the
following details:



New York Board of Trade (NYBOT) options and futures exchange
Contract size $200,000
Prices given in Swiss Franc per US dollar

Tick size CHF 0.0001 or CHF 20 per contract
Expiry date
Futures price
June
1.2200
September
1.2510
The spot rate on 4 May is CHF 1.2160/$.
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Education Course Notes
[Session 9 & 10]
Required:
Calculate the financial position using the relevant futures hedge, assuming that the
spot rate on 10 June is CHF 1.2750/$, and that the futures price is CHF 1.2760/$.
5.5
Hedge efficiency
5.5.1 The company can use the futures markets quite safely provided they understand how
the system operates. The only risk to hedgers is that the futures market does not
always provide a perfect hedge. This can result from two causes.
(a)
The first reason is that amounts must be rounded to a whole number of
contracts, causing inaccuracies.
(b)
The second reason is basis risk.
5.5.2 A measure of hedge efficiency compares the profit made on the futures market with
the loss made on the cash or commodity market, or vice versa.
Example 12
You are given the following details about the results of a hedge by an American company
for a payment of SFr 650,000 in 30 days’ time under two scenarios. In each case compute
the hedge efficiency. Assume today’s spot rate is $0.5803/SFr. Contract size is SFr125,000,
and tick size is $12.50.
Number of contracts = 650,000 ÷ 125,000 = 5.2, round to 5.
Futures hedge (5 contracts)
Today: Buy 5 at
In 30 days: Sell 5 at
Gain/(loss) per contract in ticks
Scenario 1
$/Sfr
0.5725
0.6030
$
305
Scenario 2
$/Sfr
0.5725
0.5610
$
(115)
Total gain/(loss) on 5 contracts:
5 × $12.50 × no. of ticks
Cash transaction
In 30 days: SFr650,000 are
actually bought at
19,063
0.6112
Net cost of the Swiss francs
(397,280)
(378,217)
(7,187)
0.5680
(369,200)
(376,387)
Solution:
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[Session 9 & 10]
The futures hedge gives slightly more or less than the target payment of $377,195
(SFr650,000 × 0.5803) because of hedge efficiency. To compute the hedge efficiency in
each case, compute gain/loss as a percentage. In scenario 1 the gain comes from the futures
contract. In scenario 2 the gain comes from the cash market.
Hedge efficiency
Target payment (650,000 × 0.5803)
Actual cash payment
$
377,195
397,280
$
377,195
369,200
Gain/(loss)
(20,085)
7,995
Futures gain/(loss)
19,063
(7,187)
Hedge efficiency
94.9%
111.2%
5.6
Margins and marking to market
(Jun 15)
5.6.1 There are two types of margin – initial margin and variation margin.
5.6.2 An initial margin is similar to a deposit. When a currency futures is set up, the
trader would be required to deposit some cash (the initial margin) with the futures
exchange in a margin account – this acts as security against the trader defaulting on
their trading obligations. This money will remain in the margin account as long as the
currency futures remains open.
5.6.3 We mentioned above the process of calculating the profit or loss on a contract when
there is movement in the exchange rate. This profit or loss is received into or paid
from the margin account on a daily basis rather than in one large amount when the
contract matures. This procedure is known as marking to market.
5.6.4 The futures exchange monitors the margin account on a daily basis. If the trader is
making significant losses, the futures exchange may require additional margin
payments known as variation margins. This practice creates uncertainty as the trader
will not know in advance the extent (if any) of such margin payments.
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5.7
[Session 9 & 10]
Advantages and disadvantages of currency futures
5.7.1 Advantages and disadvantages:
Advantages
Disadvantages
(a) Transaction costs should be lower (a) The contracts cannot be tailored to the
than other hedging methods.
user’s exact requirements.
(b) Futures are tradeable on a secondary (b) Hedge inefficiencies are caused by
market so there is pricing
having to deal in a whole number of
transparency.
contracts and by basis risk.
(c) The exact date of receipt or (c) Only a limited number of currencies
are the subject of futures contracts.
payment does not have to be
known.
(d) Unlike options, they do not allow a
company to take advantage of
favourable currency movements.
6.
Currency Options
(Jun 11, Dec 12, Jun 13, Jun 14)
6.1
Principles of currency options
6.1.1 A currency option is a right, but not an obligation, of an option holder to buy (call) or
sell (put) foreign currency at a specific exchange rate at a future date.
6.1.2
Basic terminology
(a)
(b)
(c)
Call option – gives the purchaser a right, but not the obligation, to buy a
fixed amount of currency at a specified price at some time in the future.
The seller of the option, who receives the premium, is referred to as the
writer.
Put option – gives the holder the right, but not the obligation, to sell a
specific amount of currency at a specified date at a fixed exercise price (or
(d)
strike price).
In-the-money option (價內期權) – the underlying price is above the
(e)
strike price.
At-the-money option (等價期權) – the underlying price is equal to the
(f)
option exercise price.
Out-of-the-money option (價外期權) – the underlying price is below the
(g)
option exercise price.
American-style options – can be exercised by the buyer at any time up to
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the expiry date.
(h)
European-style options – can only be exercised on a predetermined
future date.
6.1.3 Companies can choose whether to buy:
(a)
(b)
a tailor-made currency option from a bank, suited to the company’s specific
needs. These are over-the-counter (OTC) or negotiated options, or
a standard option, in certain currencies only, from an options exchange. Such
options are traded or exchange-traded options.
Example 13
A typical pricing schedule for the US$/€ currency option on the Philadelphia exchange is as
follows.



6.2
Here, the options are for a contract size of €125,000 and prices (both strike price and
premium) are quoted in US$(cents) per €1.
So to buy a call option on €125,000 with an expiry date of September and at a strike
price of €1 = $1.17 would cost 1.55 cents per euro, or $1,937.50.
Similarly, the premium on a June put at a strike price of 115.00 (€1 = $1.15) would
cost 0.64 cents per euro, or $800.
Options hedging calculations
6.2.1 The steps for options hedging:
Step 1:
Determine the company needs call or put options?
Step 2:
Determine the expiry date which should be chosen
Step 3:
Determine the strike price / exercise price
Step 4:
Determine the number of contracts
Step 5:
Calculate the premium payable
Step 6:
On the transaction date, compare the option price with the prevailing
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[Session 9 & 10]
spot rate to determine whether the option should be exercised or
allowed to lapse.
Step 7:
Calculate the net cash flows – beware that if the number of contracts
needed rounding, there will be some exchange at the prevailing spot
rate even if the option is exercised.
Example 14
Pongo plc is a UK-based import-export company. It has an invoice, which it is due to pay on
30 June, in respect of $350,000.
The company wishes to hedge its exposure to risk using traded options.
The current $/£ spot rate is 1.5190 – 1.5230
On LIFFE, contract size is £25,000.
Exercise price ($/£)
1.45
1.50
June contracts
Calls
Puts
8.95
10.20
6.80
12.40
Option premium are given in cents per £.
Assume that it is now the 31 March.
Required:
Calculate the cash flows in respect of the payment if the spot rate is $1.4810 – $1.4850
to £1 on the 30 June.
Solution:
Step 1: The company needs to sell £ to get $, so buy put options on £.
Step 2: Only June quoted here, but that matches the transaction date exactly, so choose
June contracts.
Step 3: The choice between $1.45/£ and $1.50/£. Since the company is selling £ to buy $,
the $1.50 rate looks initially more attractive. However, the premium for the
$1.50/£ option is more expensive as a consequence. The final decision can only be
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[Session 9 & 10]
made after looking at the net benefit of each alternative, as follows:
The $1.45 option has a premium of $0.1020 so net receipt = 1.45 – 0.102 =
$1.3480/£.
The $1.50 option has a premium of $0.1240 so net receipt = 1.50 – 0.124 =
$1.3760/£
Hence, the better option is the $1.50/£ exercise price.
350,000  1.5
Step 4: Number of contracts:
 9.33 , round to 9 contracts
25,000
Step 5: Calculate the premium:
= 12.40c × 9 contracts × £25,000 = $27,900
It has to be purchased at spot, so costs = 27,900 ÷ 1.5190 = £18,367
Step 6: On the settlement date compare the option price ($1.50) with the prevailing spot
($1.4810) to determine whether the option would be exercised or allowed to lapse.
Here it is preferable to exercise.
Step 7: Determine net cash flows
£
£ payment under options (9 × £25,000)
Amount not hedged [$350,000 – (9 × £25,000 × 1.50)] =
$12,500
Assume these unhedged $ are bought at spot rate.
Cost = $12,500 ÷ 1.4810
Add: Option premium
225,000
Total costs
251,807
8,440
18,367
Question 3
Using the circumstances described in Example 14 above, suppose Pongo plc is also due to
receive $275,000 from a US customer on 30 September. LIFFE quotes for September
option contracts are as follows:
Exercise price ($/£)
1.45
1.50
Prepared by Patrick Lui
September contracts
Calls
Puts
14.15
10.45
8.00
13.40
P. 300
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Education Course Notes
[Session 9 & 10]
Required:
Calculate the cash flows in respect of the receipt if the spot rate is $1.5250 –
$1.5285/£ on 30 September.
6.3
Advantages and disadvantages of currency option
6.3.1 Advantages and disadvantages:
Advantages
Disadvantages
(a) Opportunity to capture profits (a) Option premium is expensive.
when currency moves in favourable (b) Premium needs to be paid up front.
direction.
(c) Due to contract size, not all currency
(b) It is a right, not an obligation,
exposure can be fully hedged.
therefore offers flexibility.
(d) Only options for major currencies are
(c) It can close out position before
available.
expiration.
(d) OTC option can provide a fully
hedged arrangement.
7.
Currency Swap
(Jun 11)
7.1
Swap procedures
7.1.1 In a currency swap, the parties agree to swap equivalent amounts of currency for a
period. This effectively involves the exchange of debt from one currency to
another.
7.1.2 Liability on the main debt (the principal) is not transferred and the parties are
liable to counterparty risk: if the other party defaults on the agreement to pay
interest, the original borrower remains liable to the lender.
7.1.3 In practice, most currency swaps are conducted between banks and their customers.
Example 15
Consider a UK company X with a subsidiary Y in France which owns vineyards. Assume a
spot rate of £1 = 1.6 Euros. Suppose the parent company X wishes to raise a loan of 1.6
million Euros for the purpose of buying another French wine company. At the same time,
the French subsidiary Y wishes to raise £1 million to pay new up-to-date capital equipment
imported from the UK. The UK parent company X could borrow the £1 million sterling and
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the French subsidiary Y could borrow the 1.6 million Euros, each effectively borrowing on
the other’s behalf. They would then swap currencies.
£1 million
UK
Company X
France
Subsidiary Y
€1.6 million
Borrow
£1 million
Borrow
€1.6 million
Bank
7.2
Bank
Advantages and disadvantages of currency swaps
7.2.1 Advantages and disadvantages:
Advantages
Disadvantages
(a) Flexibility – Swaps are easy to (a) It has counterparty risk.
arrange and are flexible since they (b) Sovereign risk – There may be a risk of
political disturbances or exchange
can be arranged in any size and are
reversible.
controls in the country whose currency is
being used for a swap.
(b) Cost – Transaction costs are low,
only amounting to legal fees.
(c) Market avoidance – The parties can
obtain the currency they require
without subjecting themselves to the
uncertainties of the foreign exchange
markets.
(d) Access to finance – The company
can gain access to debt finance in
another country. It can take advantage
of lower interest rates.
(e) Conversion of debt type – The
company can convert fixed rate debt
to floating rate or vice versa.
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8.
FOREX Swaps
8.1
In a FOREX swap, the parties to swap equivalent amounts of currency for a period
and then re-swap them at the end of the period at an agreed swap rate. The swap
rate and amount of currency is agreed between the parties in advance. Thus it is called
8.2
a ‘fixed rate/fixed rate’ swap.
The main objectives of a FOREX swap are:
(a)
(b)
8.3
To hedge against forex risk, possibly for a longer period than is possible on
the forward market.
Access to capital markets, in which it may be impossible to borrow
directly.
FOREX swaps are especially useful when dealing with countries that have exchange
controls and/or volatile exchange rates.
Example 16
Suppose that A plc, a UK construction company, wins a contract to construct a bridge in
Argentina. The bridge will require an initial investment now, and will be sold to the
Argentinean Government in one year’s time. The Government will pay in pesos.
The problem is the company’s exposure to currency risk. They know how much will be
received in one year’s time in pesos but not in sterling as the exchange rate changes daily.
Various possible hedging strategies:
(a) Decided to do nothing, i.e. accept the risk – win some, lose some.
(b) Lock into a forward contract for converting the amount receivable in one year’s time
into sterling, if a forward market exists.
(c)
(d)
Undertake a money market hedge: take out a loan in pesos to cover the initial cost,
and repay the loan from the disposal proceeds in a year’s time. We would then only be
exposed on the profit we make.
Enter into a FOREX swap. Instead of taking out a loan in pesos, we
(i)
swap sterling today for the pesos required to cover the initial investment, at an
agreed swap rate.
(ii) Take out a loan in sterling today to buy the pesos.
(iii) In one year’s time (in this example) arrange to swap back the pesos obtained in
(i) for pounds at the same swap rate.
(iv) Just like taking out a loan in pesos the company is therefore only exposed on the
profit that it makes. The company could of course use another hedging technique
to hedge the profit element.
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[Session 9 & 10]
Example 17
Say the bridge will require an initial investment of 100m pesos and will be sold for 200m
pesos in one year’s time.
The currency spot rate is 20 pesos/£, and the government has offered a FOREX swap at 20
pesos/£. A plc cannot borrow pesos directly and there is no forward market available.
The estimated spot rate in one year is 40 pesos/£. The current UK borrowing rate is 10%.
Required:
Determine whether A plc should do nothing or hedge its exposure using the FOREX
swap.
Solution:
Year 0
£m
(5.0)
Without swap
Buy 100m pesos @ 20
Sell 200m pesos @ 40
Interest on sterling loan (5m × 10%)
Year 1
£m
5.0
(0.5)
(5.0)
With FOREX swap
Buy 100m pesos @ 20
Swap 100m pesos @ 20
Sell 100m pesos @ 40
Interest on Sterling loan (5m × 10%)
4.5
(5.0)
5.0
2.5
(0.5)
Net receipt of (£2 million)
(5.0)
7.0
A plc should use a FOREX swap.
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