International Banking
Assessing and
Mitigating Financial
Risks in Global
Business
February 7, 2007
Jonathan Marcus
SVP, Director Int’l Banking
Eastern Bank
Where FX May Impact Your Business
Foreign exchange rates affect virtually every aspect of a
company’s business:
 Sales income
 Labor costs
 Material costs
 Financing costs
 Capital purchases
 Pricing
 Margins
 Competition
 Market share
FOREIGN EXCHANGE EXPOSURE
MANAGEMENT
Doing business outside your home country creates
exposure to currency movements. Doing
business inside your home country can have
foreign currency implications, too!
Global business, regardless of geographic borders,
generates exposure to currency swings.
Unless all exposure is understood and quantified,
management decisions put your company at risk
not only to margin and profit disruptions, but
also to share price ramifications.
COMPANY EXPOSURES
TYPES
DEFINITIONS
TRANSACTION
EXPOSURE
Arises whenever any company unit commits to pay or
receive funds in a currency other than its national currency.
TRANSLATION
EXPOSURE
The risk that financial statements of overseas subsidiaries
will gain or lose value because of exchange rate
movements when translated into the currency of the parent
company upon consolidation.
CONTINGENT
EXPOSURE
Exists when the dollar value of anticipated but not yet
committed cash flows are subject to changes in exchange
rates.
ECONOMIC
EXPOSURE
Impact of foreign exchange rate changes on the value of
the firm.
COMPETITIVE
EXPOSURE
Impact of foreign exchange rate
competitiveness of a firm’s products.
changes
on
the
Interest Rates
Exchange
Rates
Inflation
Netting
Simple and CHEAP!
Reduce overall exposure and need to hedge by netting local
payables against local receivables.
Increase effectiveness through coordinated timing
Includes - payrolls, rent, local sourcing of goods and services,
taxes, local sales, advertising
Selecting the “Right” Approach
The right hedge for your company will depend upon the exposure, your market view,
and your corporate philosophy toward managing risk.
Your Perspective The exposure is a firm commitment. Your goal is to know the exact USD value of future foreign
payments/receivables. You are not concerned about sacrificing upside potential. - Forward
There may be some uncertainty regarding the amounts and timing of your exposure. You want to
retain upside potential and do not mind paying a premium for it. - Option
You can tolerate some variance due to FX movements. Your job is to protect against large
negative surprises. You would like to retain some upside potential, but are unwilling to pay any
premium for hedge protection. Range Forward/Participating Forward
FORWARDS
STRATEGY 1: FORWARD
One simple way to eliminate exchange rate risk is to enter into a contract that locks in a
guaranteed exchange rate for converting foreign currency to U.S. dollars (USD).
• A forward rate agreed upon today for a future currency transaction.
• Exchange rate will be no worse and no better than the agreed forward rate. Hence, you will
forego the potential to do any better than the forward rate.
• No up-front fee.
• Forward exchange rate will be a function of the spot rate and interest rate differentials
between the two currencies.
• Can be made into a window forward in order to accommodate the need for flexible delivery
dates. No money changes hands until customer requests their specified contract draw
down within a designated window period.
Forward Hedge
EXAMPLE: Customer to receive EUR 5,000,000 in 3 months
spot = EUR 1.24; 3 Month forward = -28.8
at spot:
EUR 5,000,000 * 1.24 = $6,200,000
forward:
EUR 5,000,000 * 1.2371 =$6,185,600
By locking in the rate the customer has fixed the U.S. amount to be received ($6,185,600).
Suppose in three months time, spot EUR is 1.15. The customer would have received $5,750,000 had
the forward not been in place. Conversely, if spot is 1.35 the amount received would have been
$6,750,000.
SPOT RATE IN THREE MONTHS IS:
EUR 1.15
EUR 1.24
EUR 1.35
HEDGED
$6,185,600
$6,185,600
$6,185,600
UNHEDGED
$5,750,000
$6,200,000
$6,750,000
Summary of Forward Rates
Forward exchange rate is not a forecast
Both parties are contractually obligated to settle at maturity
Funds are settled at maturity
Difference between spot and forward rates are interest rate
differentials
Only one forward rate for a currency on a particular date
Currency Options
A foreign currency option is the right, not the obligation, to buy or
sell a predetermined amount of currency against another, at a
specific exchange rate, at (or within) a certain time. An up
front fee, or premium, allows you to purchase this right.
A PUT is the right to SELL a currency to protect, or hedge, against
its potential depreciation.
A CALL is the right to BUY a currency to protect, or hedge,
against its potential appreciation.
Expiry: Final maturity past which your option can no longer be
exercised.
Amount: Face amount on which the contract is made.
Currency Options
European Style Options: exercisable only on expiry
date.
American Style Options: exercisable anytime during
the life of the option.
Strike: Price at which a holder may buy (call) or sell
(put) the underlying currency
Premium: Cost of purchasing the option contract,
generally expressed as a percentage of the nominal
Hedging With Options
Example: You expect to receive 100,000 CAD in 3 months and want to lock
in a minimum
rate at which to sell CAD against USD. You buy a CAD put:
Current Spot Rate USD/CAD: 1.3700
Strike Price: 1.3761
Maturity: 3 months
Style: European
Premium: 1.22%
This option gives you the right, but not the obligation, to sell CAD at 1.3761
at maturity.
Your cost for this option is USD $886.56
Scenarios at Maturity with an option hedge:
CAD appreciates: USD/CAD =1.2500
You choose not to exercise your option because you can sell your
USD/CAD at the prevailing market rate. Net of the premium you receive
is $79,113.44.
CAD depreciates: USD/CAD = 1.4900
You choose to exercise your option and sell your CAD at 1.3761, receiving
$72,669.14 versus the prevailing market rate where you would only
receive $67,114.09. Net of the premium you receive is $71,782.58.
Hedging with Options
Advantages
Total protection against
adverse currency moves
Profit potential from full
participation in a favorable
currency move
No potential currency
exposure if the receivable
is not realized
Buying an option does not
obligate currency delivery
Disadvantages
Reduction of potential
participation in favorable
currency movement by the
premium charge (premium
outweighs the savings)
Options - “Zero Cost” Collars
– Buy a cap, sell a floor Definition:
A zero cost collar consists of the simultaneous purchase of one option
and sale of another at different strikes, both for the same amount, for
the same time frame. This offers complete protection against adverse
currency moves beyond a certain level. This is paid for by giving up
gains beyond a second (more favorable) rate.
Market Conventions & Language:
Zero Cost Collars are also called Risk Reversals, Range Forwards,
Tunnels, Caps and Floors.
Implied View:
· Complete protection desired against adverse currency moves beyond
a floor level.
· Limited beneficial move expected.
· Complete gains desired from beneficial move up to a ceiling level.
OPTIONS - The “Zero Cost” Collar
Advantages
· Complete protection against adverse currency moves beyond
the floor level.
· Zero transaction cost.
· Complete gains from beneficial moves up to a limit.
Disadvantages
· Benefit given up beyond a certain point.
Zero Cost Collars for Exporters
If your company exports goods to the U.S., you need to buy Canadian dollars (sell U.S. dollars) to
convert your U.S. receivables. You will lose money if the Canadian dollar rises in value because
your U.S. dollar receivables will buy fewer of them. Combining options to create a Zero-Cost Range
Forward can protect you against this by giving you a range of exchange rates within which you
may buy Canadian dollars at expiry. By using the income from the sale of one option to purchase
another, you can cover your exposure with no premium paid up front.
As an example, assume:
Expiry in three months
Spot (CAD$ it takes to buy U.S.$)
1.3600
Forward rate
- .0060
_______
All-in forward rate
1.3540
 You purchase an "out of the money" Canadian Dollar Call at 1.3240. This gives
you the right to buy Canadian dollars at a lower rate than the current forward
rate.
 You sell an "out of the money" Canadian Dollar Put at 1.3740. This obliges you
to buy Canadian dollars at a higher rate than the current forward rate.
These combined contracts create a Zero-Cost Range Forward that defines a range of 1.3240-1.3740 within which your company will buy Canadian dollars at expiry:
 If, at expiry, the Canadian dollar has strengthened to a spot rate below
1.3240, you exercise your Call option and buy Canadian dollars at 1.3240. This
is your maximum downside risk. The Put option will simply expire.
 If the Canadian dollar has weakened to a spot rate above 1.3740, the bank will
exercise the Put option and your company must buy Canadian dollars at
1.3740. This is your maximum upside potential.
If the Canadian dollar spot rate is between 1.3240 and 1.3740, you let both the Call and Put
options expire and simply buy Canadian dollars at the prevailing spot rate.
Zero Cost Collars for Importers
If your company imports goods from the U.S., you will need to sell Canadian dollars (buy U.S.
dollars) to pay these U.S. bills. You will lose money if the Canadian dollar falls in value because it
will take more of your Canadian dollars to cover the same U.S. payables. Combining options to
create a Zero-Cost Range Forward can protect you against this by giving you a range of
exchange rates within which you may sell Canadian dollars at expiry. By using the income from the
sale of one option to purchase another, you can cover your exposure at no cost. As an example,
assume:
Expiry in three months
Spot (CAD$ it takes to buy U.S.$)
1.3600
Forward rate
-.0050
_______
All-in forward rate
1.3550
 You purchase an "out of the money" Canadian Dollar Put at 1.3800. This gives
you the right to sell Canadian dollars (buy U.S. dollars) at a higher rate than
the current forward rate.
 You sell an "out of the money" Canadian Dollar Call at 1.3300. This obliges you
to sell Canadian dollars at a lower rate than the current forward rate.
These combined contracts create a Zero-Cost Range Forward that defines a range of 1.3300-1.3800 within which your company will sell Canadian dollars at expiry:
 If, at expiry, the Canadian dollar has weakened to a spot rate above 1.3800,
you exercise your Put option and sell Canadian dollars at 1.3800. This is your
maximum downside risk. The Call option will simply expire.
 If the Canadian dollar has strengthened to a spot rate below 1.3300, the bank
will exercise the Call option and your company must sell Canadian dollars at
1.3300. This is your maximum upside potential.
 If the Canadian dollar spot rate is between 1.3300 and 1.3800, you let both
the Put and Call options expire and simply sell Canadian dollars at the
prevailing spot rate.
RANGE FORWARDS
STRATEGY 2: RANGE FORWARD aka ZERO COST COLLAR
You can enter into a Range Forward to establish a worst-case (floor) and best-case (cap) exchange rate for
a future currency transaction.
• The range can be as wide or as narrow as you wish depending on your risk tolerance.
• The range will be centered around the current forward rate.
• No up-front fee.
• Protects against any weakening of the currency against the USD below the floor rate.
• You retain upside potential associated with a strengthening of the currency against the USD up to the
cap rate.
• May also be structured with a window to allow for payment date uncertainty.
50% PARTICIPATING FORWARD
STRATEGY 3: 50% PARTICIPATING FORWARD
The participating forward combines the best features of a conventional currency forward and a currency
option. Like a conventional forward, the participating forward provides guaranteed protection against
adverse exchange rate movements with no up-front premium. Like a currency option, the participating
forward offers unlimited upside potential if the exchange rate subsequently moves in your favor.
• Known worst-case rate
• Ability to participate in up to 50% of favorable market movements.
• No up-front fee
• Worst-case rate for participating forward will be somewhat less favorable than current forward rate to
finance the upside potential inherent in the participating forward.
• Significantly more upside potential than a Range Forward.
• May also be structured with a window to allow for payment date uncertainty.
FORWARD EXTRA
STRATEGY 4: FORWARD EXTRA
Forward Extras provide protection against adverse currency rate fluctuations while allowing you to take
advantage of favorable currency movement up to a negotiated "trigger" rate. As long as spot rates never
reach the "trigger" rate, you receive the full benefit of favorable exchange rate activity. The installation of
the "trigger" rate into the option reduces or can eliminate the premium of the option purchased. Should
the spot rate touch the "trigger" rate anytime during the course of the contract the fixed exchange rate
immediately reverts back to the original strike price. The customer would then be locked into the fixed
exchange rate, like a forward contract, for the duration of the contract.