Hedging Foreign Exchange
Exposures
Hedging Strategies
• Recall that most firms (except for those involved in
currency-trading) would prefer to hedge their foreign
exchange exposures.
• But, how can firms hedge?
– (1) Financial Contracts
• Forward contracts (also futures contracts)
– See Appendix 1 for a discussion of forward
contracts.
• Options contracts (puts and calls)
• Borrowing or investing in local markets.
– (2) Operational Techniques
• Geographic diversification (spreading the risk)
Forward Contracts
• These are foreign exchange contracts offered by market
maker banks.
– They will sell foreign currency forward, and
– They will buy foreign currency forward
– Market maker banks will quote exchange rates today at which
they will carry out these forward agreements.
• These forward contracts allow the global firm to lock in a
home currency equivalent of some “fixed” contractual
foreign currency cash flow.
– These contracts are used to offset the foreign exchange
exposure resulting from an initial commercial or financial
transaction.
Example # 1: The Need to Hedge
• U.S. firm has sold a manufactured product to a
German company.
– And as a result of this sale, the U.S. firm agrees to
accept payment of €100,000 in 30 days.
– What type of exposure does the U.S. firm have?
• Answer: Transaction exposure; an agreement to receive a
fixed amount of foreign currency in the future.
– What is the potential problem for the U.S. firm if it
decides not hedge (i.e., not to cover)?
• Problem for the U.S. firm is in assuming the risk that the
euro might weaken over this period, and in 30 days it will be
worth less (in terms of U.S. dollars) than it is now.
• This would result in a foreign exchange loss for the firm.
Hedging Example #1 with a Forward
• So the U.S. firm decides it wants to hedge
(cover) this foreign exchange transaction
exposure.
– It goes to a market maker bank and requests a 30
day forward quote on the euro.
– The market marker bank quotes the U.S. firm a bid
and ask price for 30 day euros, as follows:
– EUR/USD 1.2300/1.2400.
– What do these quotes mean:
• Market maker will buy euros in 30 days for $1.2300
• Market maker will sell euros in 30 days for $1.2400
Example #2: The Need to Hedge
• U.S. firm has purchased a product from a British company.
– And as a result of this purchase, the U.S. firm agrees to pay the
U.K. company £100,000 in 30 days.
– What type of exposure is this for the U.S. firm?
• Answer: Transaction exposure; an agreement to pay a fixed amount
of foreign currency in the future.
• What is the potential problem if the firm does not hedge?
• Problem for the U.S. firm is in assuming the risk that the pound might
strengthen over this period, and in 30 days it take more U.S. dollars
than now to purchase the required pounds.
• This would result in a foreign exchange loss for the firm.
Hedging Example #2 with a Forward
• So the U.S. firm decides it wants to hedge
(cover) this foreign exchange transaction
exposure.
– It goes to a market maker bank and requests a 30
day forward quote on pounds.
– The market maker quotes the U.S. firm a bid and ask
price for 30 day pounds as follows:
– GBP/USD 1.7500/1.7600.
– What do these quotes mean:
• Market maker will buy pounds in 30 days for $1.7500
• Market maker will sell pounds in 30 days for $1.7600
So What will the Firm Accomplished with the
Forward Contract?
• Example #1: The firm with the long position in euros:
– Can lock in the U.S. dollar equivalent of the sale to the
German company.
– It knows it can receive $123,000
• At the forward bid: $1.2300/$1.2400
• Example #2: The firm with the short position in
pounds:
– Can lock in the U.S. dollar equivalent of its liability to the
British firm:
– It knows it will cost $176,000
• At the forward ask price: $1.7500/$1.7600
Advantages and Disadvantages of the
Forward Contract
• Contracts written by market maker banks to the
“specifications” of the global firm.
– For some exact amount of a foreign currency.
– For some specific date in the future.
– No upfront fees or commissions.
• Bid and Ask spreads produce round transaction profits.
• Global firm knows exactly what the home currency
equivalent of a fixed amount of foreign currency will be
in the future.
• However, global firm cannot take advantage of a
favorable change in the foreign exchange spot rate.
Foreign Exchange Options Contracts
• One type of financial contract used to hedge
foreign exchange exposure is an options
contract.
• Definition: An options contract offers a global
firm the right, but not the obligation, to buy (a
“call” option) or sell (a “put” option) a given
quantity of some foreign exchange, and to do
so:
– at a specified price (i.e., exchange rate), and
– at some date in the future.
Foreign Exchange Options Contracts
• Options contracts are either written by global banks
(market maker banks) or purchased on organized
exchanges (e.g., the Chicago Mercantile Exchange).
• Options contracts provide the global firm with:
– (1) “Insurance” (floor or ceiling exchange rate) against
unfavorable changes in the exchange rate, and additionally
– (2) the ability to take advantage of a favorable change in the
exchange rate.
• This latter feature is potentially important as it is
something a forward contract will not allow the firm to
do.
• But the global firm must pay for this right.
– This is the option premium (which is a non-refundable fee).
A Put Option: To Sell Foreign Exchange
• Put Option:
– Allows a global firm to sell a (1) specified amount
of foreign currency at (2) a specified future date
and at (3) a specified price (i.e., exchange rate) all
of which are set today.
• Put option is used to offset a foreign currency long
position (e.g., an account receivable).
• Provides the firm with an lower limit (“floor’) price for
the foreign currency it expects to receive in the future.
• If spot rate proves to be advantageous, the holder will
not exercise the put option, but instead sell the foreign
currency in the spot market.
– Firm will not exercised if the spot rate is “worth more.”
A Call Option: To Buy Foreign Exchange
• Call Option:
– Allows a global firm to buy a (1) specified amount
of foreign currency at (2) a specified future date
and at a (3) specified a price (i.e., at an exchange
rate) all of which are set today.
• Call option is used to offset a foreign currency short
position (e.g., an account payable).
• Provides the holder with an upper limit (“ceiling’) price
for the foreign currency the firm needs in the future.
• If spot rate proves to be advantageous, the holder will
not exercise the call option, but instead buy the needed
foreign currency in the spot market.
– Firm will not exercise if the spot rate is “cheaper.”
Overview
of
• Important
advantage:
Options Contracts
– Options provide the global firm which the potential to take
advantage of a favorable change in the spot exchange rate.
• Recall that this is not possible with a forward contract.
• Important disadvantage:
– Options can be costly:
• Firm must pay an upfront non-refundable option premium which it
loses if it does not exercise the option.
– Recall there are no upfront fees with a forward contract.
• This fee must be considered in calculating the home currency
equivalent of the foreign currency.
• This cost can be especially relevant for smaller firms and/or those
firms with liquidity issues.
– See Appendix 2 for a further discussion of options contracts.
Hedging Through Borrowing or Investing in
Foreign Markets
• Another strategy used to hedge foreign
exchange exposure is through the use of
borrowing or investing in foreign currencies.
– Global firms can borrow or invest in foreign
currencies as a means of offsetting foreign
exchange exposure.
– Borrowing in a foreign currency is done to offset a
long position.
– Investing in a foreign currency is done to offset a
short position.
Specific Strategy for a Long Position
• Global firm expecting to receive foreign currency in the
future (long position):
– Will take out a loan (i.e., borrow) in the foreign currency equal
to the amount of the long position.
– Will convert the foreign currency loan amount into its home
currency at the spot exchange rate.
– And eventually use the long position to pay off the foreign
currency denominated loan.
• What has the firm accomplished?
– Has effectively offset its foreign currency long position (with the
foreign currency loan, which is a short position).
– Plus, immediate conversion of its foreign currency long position
into its home currency.
Specific
Strategy
Short
Position
• Global
firm needing
to payfor
out a
foreign
currency
in the
future (short position).
– Will borrow in its home currency (an amount equal to its short
position at the current spot rate).
– Will convert the home currency loan into the foreign currency at
the spot rate.
– Will invest in a foreign currency denominated asset
– And eventually use the proceeds from the maturing financial
asset to pay off the short position.
• Global firm has:
– Offset its foreign currency short exposure (with the foreign
currency denominate asset which is a long position)
– Plus immediate conversion of its foreign currency liability into a
home currency liability.
• See Appendix 3 for more discussion of this borrowing
and lending strategy.
Hedging Unknown Cash Flows
• Up to this point, the hedging techniques we have
covered (forwards, options, borrowing and investing)
have been most appropriate for covering transaction
exposure.
• Why?
– Because transaction exposures have known
foreign currency cash flows and thus they are easy
to hedge with financial contracts
• However, economic foreign exchange exposures do
not provide the firm with this “known” cash flow
information.
Dealing with Economic Exposure
• Recall that economic exposure is long term
and involves unknown future cash flows.
– So this type of exposure is difficult to hedge with
the financial contracts we have discussed thus far.
– What can the firm do to manage this economic
exposure?
• Firm can employ an “operational hedge.”
• This strategy involves global diversification of
production and/or sales markets to produce natural
hedges for the firm’s unknown foreign exchange
exposures.
• As long as exchange rates with respect to these
different markets do not move in the same direction,
the firm can “stabilize” its overall cash flow.
A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure
• Step 1: Determining Specific Foreign
Exchange Exposures.
– By currency and amounts (where possible)
• Step 2: Exchange Rate Forecasting
– Determining the likelihood of “adverse” currency
movements.
• Important to select the appropriate forecasting model.
• Perhaps a “range” of forecasts is appropriate here (i.e.,
forecasts under various assumptions)
A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure
• Step 3: Assessing the Impact of the Forecasted Exchange
Rates on Company’s Home Currency Equivalents
– Impact on earnings, cash flow, liabilities…
• Step 4: Deciding Whether to Hedge or Not
– Determine whether the anticipated impact of the forecasted
exchange rate change merits the need to hedge.
• Perhaps the estimated impact is so small as not to be of
a concern.
• Or, perhaps the firm is convinced it can benefit from its
exposure.
A Comprehensive Approach or Assessing and
Managing Foreign Exchange Exposure
• Step 5: Selecting the Appropriate Hedging
Instruments.
– What is important here are:
• Firm’s desire for flexibility.
• Cost involved with financial contracts.
• The type of exposure the firm is dealing with.