FX_Risk_Management LMS (student).ppt

FX_Risk_Management LMS (student).ppt - FINC3011 Foreign...

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Unformatted text preview: FINC3011 Foreign Exchange Risk Management & Currency Hedging Decision Dr Tro Kortian Finance Discipline The Business School University of Sydney email: [email protected] Overview Transaction Exposure to Foreign Exchange Risk - Management of transaction exposure using financial instruments. - - Other techniques for managing transaction exposure internally: - Money-Market instruments; Currency Forwards; Currency Futures; Currency options. Cross-hedging; Leading & Lagging; Currency of invoicing; Exposure netting. Rationales for Risk Management and Foreign Currency hedging decision. Introduction Risk Management: - Management of unpredictable events that have adverse for the firm. - Entails assessment & management of exposure to various sources of risk through use of financial instruments, insurance & other activities . Hedging Risk mitigation - Use of financial instruments/contracts to insure against or offset variety of business risks. - Take one risk to offset another risk - Use of financial instruments to generate an offsetting exposure & thereby create a zero net exposure - Long physical + offsetting short zero net exposure Short physical + offsetting long zero net exposure Transaction Exposure Transaction Exposure - Sensitivity of “realised” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies, to unexpected exchange rate changes. - the extent to which currency fluctuations affect contractually binding future foreign-currencydenominated cash inflows and outflows. - Arises if the economic entity’s cash inflows and outflows are denominated in foreign currencies. - Associated with trade flows (resulting from exports and imports), as well as with capital flows (e.g. dividends and interest payments). - Can arise, from: - a foreign currency denominated asset or liability already recorded on balance sheet of the firm; - a contract or an agreement involving a future foreign currency cash-flow Transaction Exposure Transaction exposure stems from the possibility of incurring future exchange gains or losses on foreigncurrency-denominated transactions already entered into but not settled. Transaction exposure is measured currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency. Managing Transaction Exposure Measures to protect against/manage exposure to foreign exchange transaction risk: Using financial instruments/markets: - Money-Market hedge - Currency Forward hedging - Currency Futures hedging - Currency options hedging Management of foreign exchange transaction exposure via financial markets & instruments Other techniques: - Cross-hedging - Leading & Lagging - Currency of invoicing: risk shifting; currency risk sharing; diversification - Exposure netting Managing foreign exchange transaction exposure internally. Managing Transaction Exposure: Financial Market Hedges Financial market hedges Transaction exposure to foreign exchange risk may be hedged via use of different financial instruments: money market instruments Management of forward contracts Foreign Exchange Transaction Exposure futures contracts via Financial Markets options contracts Money Market Hedging Money Market Hedge Involves using money market instruments (borrowing & lending domestic and foreign currencies) to cover expected foreign currency payables or receivables. Involves simultaneous borrowing and lending activities in two different currencies to lock in the domestic currency value of a future foreign currency cash flow. Money Market Hedging of Foreign Currency Payables To hedge foreign currency payables: payables create via the money market an offsetting foreign currency asset position. - Borrow domestic currency Convert into foreign currency Invest in foreign currency denominated asset Use proceeds from foreign currency investment to payoff foreign currency amount that is owed (foreign currency payables) - Payoff certain amount on domestic currency loan Money Market Hedging of Foreign Currency Receivables To hedge foreign currency receivables: create via the money market an offsetting foreign currency liability position. - Borrow foreign currency Convert into domestic currency Invest in domestic currency denominated asset Use proceeds from foreign currency receivables to payoff amount that is owed on foreign currency loan - Receive the certain amount on domestic currency investment Money Market Hedging Notation: l = foreign currency; j = domestic currency i = domestic nominal interest rate i* = foreign nominal interest rate S(j/l) = price of foreign currency l in terms of units of domestic currency j. K(l) = foreign currency receivables, payables amount 1. Money Market Hedging of Foreign Currency Payables 2. Money Market Hedging of Foreign Currency Receivables Money Market Hedging of Foreign Currency Payables Today (t=0) Borrow the domestic currency equivalent of the present value of the foreign currency payables ie borrow S 0(j/l)K(l)/(1+i*) units of domestic currency. Convert into foreign currency at prevailing spot exchange rate S0(j/l) so as to obtain K(l)/(1+i*) units of foreign currency (= PV of FX payables). Use these funds to invest in foreign currency denominated asset paying interest rate of i*. (create long foreign currency position). Future (t=1) Use the K units of foreign currency obtained from investment in foreign currency asset to pay the amount that is owed. Payoff the certain amount owing on domestic currency loan (principal + interest) = [S0(j/l)K(l)/(1+i*)](1+i). This amount is known in advance and is not dependent on exchange rate prevailing at time 1, S 1(j/l). If foreign currency payables were not hedged, the domestic currency needed would be the uncertain amount S 1(j/l)K(l). Money Market Hedging of Foreign Currency Payables Payables (K) Borrowing domestic currency KS 0 (1 i ) Converting at spot rate Loan Repayment K (1 i ) Investing at foreign rate KS 0 (1 i ) (1 i ) K Implicit forward rate S 0 (1 i ) (1 i ) To hedge foreign currency payables: - create via the money market an offsetting foreign currency asset position. •Borrow domestic currency •Convert into foreign currency at spot exchange rate •Invest in foreign currency denominated asset •Use proceeds from foreign currency investment to payoff foreign currency amount that is owed (foreign currency payables) •Payoff certain amount on domestic currency loan Money Market Hedging of Foreign Currency Receivables Today (t=0) Borrow a foreign currency amount equal to the present value of the foreign currency receivables: ie borrow K(l)/(1+i*) units of foreign currency. (create a foreign currency liability position). Convert this foreign currency amount into domestic currency units at prevailing spot exchange rate S0(j/l) so as to obtain S0(j/l) [K(l)/(1+i*)] units of domestic currency. Use these funds to invest in a domestic currency denominated asset paying interest rate of i. Future (t=1) Principal and interest on foreign currency loan is due (= K(l)). Use the K(l) units of foreign currency obtained from foreign currency receivables to pay the amount that is owed. Receive the certain amount on the domestic currency investment (principal + interest) = S0(j/l)K(l)/(1+i*)](1+i). This domestic currency amount is also known in advance and is not dependent on exchange rate prevailing at time 1, S 1(j/l). If foreign currency receivables were not hedged, the domestic currency equivalent of the foreign currency receivables would be the uncertain amount S1(j/l)K(l). Money Market Hedging of Foreign Currency Receivables Receivables (K) To hedge foreign currency receivables: - create via the money market an offsetting foreign currency liability position. •Borrow foreign currency •Convert into domestic currency •Invest in domestic currency denominated asset •Use proceeds from foreign currency receivables to payoff amount that is owed on foreign currency loan •Receive the certain amount on domestic currency investment Borrowing foreign currency K (1 i ) Converting at spot rate Loan Repayment KS0 (1 i ) Investing at domestic rate KS 0 (1 i ) (1 i ) K Implicit forward rate S0 (1 i ) (1 i ) Money Market Hedging of Foreign Currency Receivables Example - GE has a €10 million receivables due in one year iEur = 15%, iUS = 10% If S($/ €)0 = $1.3382 and f($/ €)1 = $1.28, the market expects a euro depreciation To protect against currency depreciation: NOW - Borrow PV of €10 million = €(10 million/1.15) = €8.70 million for one year - Convert €8.70 million to $11.64 million (€8.70 million * $1.3382) - Deposit $11.64 million for one year at 10% IN ONE YEAR - Collect $11.64 million * 1.10 = $12.8 million - Use proceeds from receivable to repay loan of €8.70 million * 1.15 = €10 million If S($/ €)1 =$1.3382, receivable = $13.382 million and loss on hedge = $582,000 = $1.28, receivable = $12.8 million and gain/loss on hedge = $0 = $1.25, receivable = $12.5 million and gain on hedge = $300,000 Money Market Hedging with Bid & Offer Quotes* Hedge foreign currency payables & receivables via money market with bid and offer quotes. Analysis is the same as before; create offsetting foreign currency asset/liability position. Take care in using the correct bid & offer exchange rate quotations, and correct bid & offer interest rates. - price-taker in FX market buys the commodity currency at the (higher) offer exchange rate and sells at the (lower) bid exchange rate of the market maker. - price-taker in the money market borrows at the (higher) offer interest rate and lends at the lower bid interest rate of the market maker. Money Market Hedging of Foreign Currency Payables** Today (t=0) Borrow the domestic currency equivalent of the present value of the foreign currency payables ie borrow S a,0(j/l)K(l)/(1+ib*) units of domestic currency. Convert into foreign currency at prevailing spot ask exchange rate S a,0 (j/l) so as to obtain K(l)/(1+ib*) units of foreign currency (= PV of FX payables). Use these funds to invest in foreign currency denominated asset paying interest rate of ib* to obtain K units of foreign currency when payables are due. Future (t=1) Use the K units of foreign currency obtained from investment in foreign currency asset to pay the amount that is owed. Payoff the certain amount owing on domestic currency loan (principal + interest) = [Sa,0(j/l)K(l)/(1+ib*)](1+ia). This amount is known in advance and is not dependent on exchange rate prevailing at time 1, S a1(j/l). If foreign currency payables were not hedged, the domestic currency needed would be the uncertain amount S a1(j/l)K(l). Money Market Hedging of Payables with Bid & Offer Quotes** Payables (K) Borrowing domestic currency KS a 0 (1 ib ) Converting at spot rate Loan Repayment K (1 ib ) Investing at foreign rate K KS a 0 (1 ia ) (1 ib ) Implicit forward rate S a 0 (1 ia ) (1 ib ) To hedge foreign currency payables: - create via the money market an offsetting foreign currency asset position. •Borrow domestic currency •Convert into foreign currency •Invest in foreign currency denominated asset •Use proceeds from foreign currency investment to payoff foreign currency amount that is owed (foreign currency payables) •Payoff certain amount on domestic currency loan Money Market Hedging of Foreign Currency Receivables** Today (t=0) Borrow a foreign currency amount equal to the present value of the foreign currency receivables: ie borrow K(l)/(1+ia*) units of foreign currency. (create a foreign currency liability position). Convert this foreign currency amount into domestic currency units at prevailing bid spot exchange rate Sb,0(j/l) so as to obtain Sb,0(j/l)[K(l)/(1+ia*)] units of domestic currency. Use these funds to invest in a domestic currency denominated asset paying interest rate of ib. Future (t=1) Principal and interest on foreign currency loan is due (= K(l)). Use the K(l) units of foreign currency obtained from foreign currency receivables to pay the amount that is owed. Receive the certain amount on the domestic currency investment (principal + interest) = Sb,0(j/l)K(l)/(1+ib)](1+ia*). This domestic currency amount is also known in advance and is not dependent on exchange rate prevailing at time 1, S b1(j/l). If foreign currency receivables were not hedged, the domestic currency equivalent of the foreign currency receivables would be the uncertain amount Sb1(j/l)K(l). Money Market Hedging of Receivables with Bid & Offer Quotes** Receivables (K) To hedge foreign currency receivables: - create via the money market an offsetting foreign currency liability position. Borrow foreign currency Convert into domestic currency Invest in domestic currency denominated asset Use proceeds from foreign currency receivables to payoff amount that is owed on foreign currency loan Receive the certain amount on domestic currency investment Borrowing foreign currency K (1 ia ) Converting at spot rate Loan Repayment KSb 0 (1 ia ) Investing at domestic rate KS b 0 (1 ib ) (1 ia ) K Implicit forward rate Sb 0 (1 ib ) (1 ia ) Hedging using the Forward FX market FORWARD MARKET HEDGE consists of offsetting a foreign currency receivable (foreign currency payable) by entering into a forward contract to sell (buy) that currency at a set delivery date which coincides with receipt (payment) of the foreign currency. - buying foreign currency forward to cover expected foreign currency payables and selling foreign currency forward to cover expected foreign currency receivables. Forward Hedging of Foreign Currency Payables Forward Hedging of Foreign Currency Payables Suppose K(l) units of foreign currency needs to be paid at some time in the future (foreign currency liability position; “short” foreign currency position). To hedge: create an offsetting foreign currency asset position via the forward FX market. buy foreign currency forward. Today (t=0) - Enter into forward FX contract agreeing to purchase K(l) units of foreign currency at the forward price of F 0(j/l) at some prespecified date in the future. Future (t=1) - Forward contract matures. Pay F0(j/l) K(l) units of domestic currency and obtain K(l) units of the foreign currency. Use this to payoff foreign currency obligations due at this point in time. Gain: G = K(l)[S1(j/l) - F0(j/l)] Forward Hedging of Foreign Currency Receivables Foreign currency receivables suppose K(l) units of foreign currency will be received in the future (foreign currency asset position; “long” foreign currency position). To hedge: create an offsetting foreign currency liability position via the forward FX market. sell foreign currency forward. Today (t=0) - Go “short” forward FX contract agreeing to sell K(l) units of foreign currency at the forward price of F0(j/l) Future (t=1) - Forward contract matures. Sell the K(l) units of the foreign currency obtained from foreign currency receivables to obtain F0(j/l) K(l) units of domestic currency. Gain: G = K(l)[ F0(j/l) - S1(j/l)] Forward Market Hedge: an Example Suppose you are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year. ( US firm has foreign currency payables; has a ‘short” position in £s. Question: How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers £100M in one year — a long forward contract on the pound. Forward Market Hedge Profit profile for unhedged FX payable position (£s) Suppose the forward exchange rate is $1.50/£. If he does not hedge the £100m payable, in one year his gain (loss) on the unhedged position is shown in green. The importer will be better off if the pound depreciates: he still buys £100 m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/ $30 m $0 Value of £1 in $ in one year $1.20/£ $1.50/£ $1.80/£ –$30 m But he will be worse off if the pound appreciates. Forward Market Hedge If he agrees to buy £100m in one year at $1.50/£ his gain (loss) on the forward are shown in blue. If you agree to buy £100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80. Long forward $30 m $0 Value of £1 in $ in one year $1.20/£ $1.50/£ $1.80/£ –$30 m Profit profile for long position in FX forward contract on £s. If you agree to buy £100 million at a price of $1.50 per pound, you will lose $30 million if the price of a pound is only $1.20. Forward Market Hedge The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. Long forward $30 m $0 Hedged payable Value of £1 in $ in one year $1.20/£ $1.50/£ $1.80/£ –$30 m Unhedged payable Hedging using Forward FX Contracts Example: Fancy Foods (FF), a U.S. company, imports meat pies from British firm. FF has to pay £1,000,000 in 90 days in return for supplies. The spot rate is $1.50/£ and FF expects the £ to appreciate by 2%. They can: 1) wait and buy £’s on the market or 2) hedge. No hedge: If FF expectations realized and £ appreciates, then $ cost = S(t+90, $/£)*(£1,000,000) =($1.53/ £)*(1,000,000)=$1,530,000 Hedge: Purchase a forward contract and lock in rate. No uncertainty. Forward exchange rate is the market’s best guess as to what the spot will be in 90 days so if the market is right, you’re only out the bid/ask spread. If the market is wrong, hedging could be good or bad! If £ appreciates (takes more $’s to buy a £), hedging would have been better, if it depreciates (takes fewer $’s to buy a £), then hedging would have been worse Fancy Foods can buy £1,000,000 at $1.53/£, which gives them an asset to match the liability (also £1,000,000) and then they have only a $ liability ($1,530,000) but no exchange rate risk. Exhibit 3.4 – Panel A Gains and Losses Associated with Hedged Versus Unhedged Strategies If revenue, hedged position is preferable If cost, unhedged position is preferable If revenue, unhedged position is preferable If cost, hedged position is preferable Exhibit 3.4 – Panel B Gains and Losses Associated with Hedged Versus Unhedged Strategies Unhedged position: cost or revenue will fluctuate one-for-one with domestic currency price of foreign currency Exhibit 3.5 Costs and Benefits of Hedging Cost of 1 foreign currency unit Hedging using Forward FX Contracts Hedging import payments (FX payables) - Example: Hedge a €4M payment due in 90 days Spot: $1.10/€; 90-day forward: $1.08/€ Hedge by going ‘long’ forward on €. Hedged you will pay €4 M * $1.08/€ = $4,320,000 If dollar strengthens, you could lose money relative to remaining unhedged though. Hedging export receipts (FX receivables) - Example: Hedge a ¥500M receivable to arrive in 30 days Spot: ¥176/£; 30-day forward: ¥180/£ Hedge by going ‘short’ forward on ¥. Hedged you will receive ¥500M/(¥180/£) = £2,777,778 If the yen strengthens, you could lose money relative to remaining unhedged though. Forward Hedge Forward market hedge – a company fixes the domestic currency value of the future foreign currency cash flow by selling or buying currency forward. Currency Position Hedging Strategy Protect Against Long (receivable) Sell forward Currency depreciation Short (payable) Buy forward Currency appreciation Example - GE has a €10 million receivable in one year. - If S0 = $1.3382 and F = $1.28, the market expects a euro depreciation. To protect against currency depreciation, GE sells forward €10 million for delivery in one year. - By selling forward, in one year, GE will receive a fixed amount of $12.8 million. - If S1 = $1.3382, receivable = $13.382 million and loss on hedge = $582,000 = $1.28, receivable = $12.8 million and gain/loss on hedge = $0 = $1.25, receivable = $12.5 million and gain on hedge = $300,000 Hedging using Currency Futures Contracts Futures-market hedging achieves the same result as hedging via the forward FX market. - involves buying and selling foreign currency futures contracts to cover expected foreign currency pa...
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