Tools to manage foreign exchange risk involved due to fluctuations in exchange rates and interest rates

A firm may be able to reduce or eliminate currency exposure by means of internal and external hedging strategies.

Internal Hedging Strategies

1. Invoicing

A firm may be able to shift the entire risk to another party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency, but in the presence of well functioning forwards markets this will not yield any added benefit compared to a forward hedge. At times, it may diminish the firm’s competitive advantage if it refuses to invoice its cross-border sales in the buyer’s currency.

In the following cases invoicing is used as a means of hedging:

  1. Trade between developed countries in manufactured products is generally invoiced in the exporter’s currency.
  2. Trade in primary products and capital assets are generally invoiced in a major vehicle currency such as the US dollar.
  3. Trade between a developed and a less developed country tends to be invoiced in the developed country’s currency.
  4. If a country has a higher and more volatile inflation rate than its trading partners, there is a tendency not to use that country’s currency in trade invoicing.

Another hedging tool in this context is the use of “currency cocktails” for invoicing. Thus for instance, British importer of fertilizer from Germany can negotiate with the supplier that the invoice is partly in DEM & partly in Sterling. This way both the parties share exposure. Another possibility is to use one of the “standard currency baskets” such as the SDR or the ECU for invoicing trade transactions.

Basket invoicing offers the advantage of diversification and can reduce the variance of home currency value of the payable or receivable as long as there is no perfect correlation between the constituent currencies. The risk is reduced but not eliminated. Also, there is no way by which the exposure can be hedged since there is no forward markets I these composite currencies. As a result, this technique has not become very popular.

2. Netting and Offsetting:

A firm with receivables and payables in diverse currencies can net out its exposure in each currency by matching receivables with payables. Thus a firm with exports to and imports from say Germany need not cover each transaction separately; it can use a receivable to settle all or part of a payable and take a hedge only for the net DEM payable or receivable. Even if the timings of the two flows do not match, it might be possible to lead or lag one of them to achieve a match.

To be able to use netting effectively, the company must have continuously updated information on inter-subsidiary payments position as well as payables and receivables to outsiders. One way of ensuring efficient information gathering is to centralise cash management.

3. Leading and lagging:

Another internal way of managing transactions exposure is to shift the timing of exposures by leading or lagging payables and receivables. The general rule is lead, i.e. advance payables and lag, i.e. postpone receivables in “strong” currencies and, conversely, lead receivables and lag payables in weak currencies. Simply shifting the exposure in time is not enough; it has to be combined with a borrowing/lending transaction or a forward transaction to complete the hedge.

Both these tools exist as a response to the existence of market imperfections.

External Hedging Strategies

A. Using hedging for forwards market:

In the normal course of business, a firm will have several contractual exposures in various currencies maturing at various dates. The net exposure in a given currency at a given date is simply the difference between the total inflows and the total outflows to be settled on that date. Thus suppose ABC Co. has the following items outstanding:

Item                                                               Value                         Dates to maturity

1.USD receivable                                        800,000                      60

2.NLG payable                                            2,000,000                  90

3.USD interest payable                             100,000                      180

4.USD payable                                            200,000                      60

5.USD purchased forward                       300,000                      60

6.USD loan installment due                    250,000                      60

7.NLG purchased forward                      1,000,000                  90

Its net exposure in USD at 60 days is:

(800,000+300,000)-(200,000+250,000)=+USD 650,000

Whereas it has a net exposure in NLG of –1,000,000 at 90 days.

The use of forward contracts to hedge transactions exposure at a single date is quite straightforward. A contractual net inflow of foreign currency is sold forward and a contractual net outflow is bought forward. This removes all uncertainty regarding the domestic currency value of the receivable or payable. Thus in the above example, to hedge the 60 day USD exposure, ABC Co. can sell forward USD 650,000 while for the NLG exposure it can buy NLG 1,000,000 90 day forward.

What about exposures at different date? One obvious solution is to hedge each exposure separately with a forward sale or purchase contract as the case may be. Thus in the example, the firm can hedge the 60 day USD exposure with a forward sale and the 180 day USD exposure with a forward purchase.

B. Hedging with the money market:

Firms, which have access to international money markets for short-term borrowing as well as investment, can use the money market for hedging transactions exposure.

E.g.: Suppose a German firm ABC has a 90 day Dutch Guilder receivable of NLG 10,000,000. It has access to Euro deposit markets in DEM as well as NLG. To cover this exposure it can execute the following sequence of transactions:

  1. Borrow NLG in the euroNLG market for 90 days.
  2. Convert spot to DEM.
  3. Use DEM in its operations, e.g. to pay off a short-term bank loan or finance inventory.
  4. When the receivable is settled, use it to pay off the NLG loan.

Suppose the rates are as follows:

NLG/DEM Spot: 101025/35 90day forward: 1.1045/65

EuroNLG interest rates: 5 1/4/5 ½

EuroDEM interest rates: 4 3/4/5.00

Comparing the forward cover against the money market cover. With forward cover, each NLG sold will give an inflow of DEM (1/1.064)= DEM 0.9038, 90 days later. The present value of this (at 4.74%) is 0.9038/[1+ (0.0475/4)]= DEM 0.8931

To cover using the money market, for each NLG of receivable, borrow NLG 1/[1+ (0.055/4)]

= NLG 0.9864, sell this spot to get DEM (0.9864/1.1035)

=DEM 0.8939

Pay off the NLG loan when the receivables mature. Thus the money markets cover; there is a net gain of DEM 0.0008 per NLG of receivable or DEM 8000 for the 10 million-guilder receivable.

Sometimes the money market hedge may turn out to be the more economical alternative because of some constraints imposed by governments. For instance, domestic firms may not be allowed access to the Euromarket in their home currency or non-residents may not be permitted access to domestic money markets. This will lead to significant differentials between the Euromarket and domestic money market interest rates for the same currency. Since forward premia/ discounts are related to Euromarket interest differentials between two currencies, such an imperfection will present opportunities for cost saving.

E.g. A Danish firm has imported computers worth $ 5 million from a US supplier. The payment is due in 180 days. The market rates are as follows:

DKK/USD Spot: 5.5010/20

180 days forward: 5.4095/ 5.4110

Euro $: 9 1/2/ 9 ¾

Euro DKK: 6 1/4/ 6 ½

Domestic DKK: 5 1/4/ 5 ½

The Danish government has imposed a temporary ban on non-residents borrowing in the domestic money market. For each dollar of payable, forward cover involves an outflow of DKK 5.4110, 180 days from now. Instead for each dollar of payable, the firm can borrow DKK 502525 at 5.5%, acquit $ 0.9547 in the spot market and invest this at 9.50% in a Euro $ deposit to accumulate to one dollar to settle the payable. It will have to repay DKK 5.3969 [=5.2525* 1.0275], 180 days later. This represents a saving of DKK 0.0141 per dollar of payable or DKK 70,500 on the $5 million payable.

From the above example it is clear that from time to time cost saving opportunities may arise either due to some market imperfection or natural market conditions, which an alert treasurer can exploit to make sizeable gains. Having decided to hedge an exposure, all available alternatives foe executing the hedge should be examined.

C. Hedging with Currency Options:

Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while an inflow can be hedged by buying a put option. (Or writing a call option. This is a “covered call” strategy).

Options are particularly useful for hedging uncertain cash flows, i.e. Cash flows those are contingent on other events. Typical situations are:

  1. International tenders: Foreign exchange inflows will materialise only if the bid is successful. If execution of the contract also involves purchase of materials, equipments, etc. from third countries, there are contingent foreign currency outflows too.
  2. Foreign currency receivables with substantial default risk or political risk, e.g. the host government of a foreign subsidiary might suddenly impose restrictions on dividend repatriation.
  3. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/bonds currently worth say DEM 50 million, which he is planning to liquidate in 6 months time. If he sells Dem 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates, he will find himself to be over insured and short in DEM.

E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on September 1. The market rates are as follows:

DEM/GBP Spot: 2.8175/85

90-day Swap points: 60/55

September calls with a strike of 2.82 (DEM/GBP) are available for a premium of 0.20p per DEM. Evaluating the forward hedge versus purchase of call options both with reference to an open position.

  1. Open position: Suppose the firm decides to leave the payable unhedged. If at maturity the pound sterling/ DEM spot rate is St., the sterling value of the payable is (5,00,000) St.
  2. Forward hedge: If the firm buys DEM 5,00,000 forward at the offer rate of DEM 2.8130/PS or PS0.3557/ DEM, the value of the payable is PS (5,00,000 * 0.3557)=PS 1,77,850.
  3. A Call option: Instead the firm buys call options on DEM 5,00,000 for a total premium expense of PS 1000.

At maturity, its cash outflow will be

PS [(5,00,000)St +1025] for St<= 0.3546

and PS[5,00,000)(0.3546)+1025]

= PS 178325 for St>=0.3546.

Here it is assumed here that the premium expense is financed by a 90 day borrowing at 10%.

D. Hedging with currency futures:

Hedging contractual foreign currency flows with currency futures is in many respects similar to hedging with forward contracts. A receivable is hedged by selling futures while a payable is hedged by buying futures.

A futures hedge differs from a forward hedge because of the intrinsic features of future contracts. The advantages of futures are, it easier and has greater liquidity. Banks will enter into forward contracts only with corporations (and in rare cases individuals) with the highest credit rating. Second, a futures hedge is much easier to unwind since there is an organized exchange with a large turnover.

A firm may be able to reduce or eliminate interest rate exposure by mean of  following hedging strategies.

1. Forward rate Agreements:

A FRA is an Agreement between two parties in which one of them (The seller of FRA), contracts to lend to other (Buyer), a specified amount of funds, in a specific currency, for a specific period starting at a specified future date, at an interest rate fixed at the time of agreement. A typical FRA quote from a bank might look like this:

USD 6/9 months: 7.20 – 7.30% P.a.

This is to be interpreted as follows.

  • The bank is willing to accept a three month USD deposit starting six months from now, maturing nine months from now, at an interest rate of 7.20% P.a. (Bid Rate).
  • The bank is willing to lend dollars for three months, starting six months from now at a interest rate of 7.30% P.a. (Ask Rate).

The important thing to note is that there is no exchange of principal amount.

2. Interest rate futures:

Interest rate futures are one of the most successful financial innovations in recent years. The underlying asset is a debt instrument such as a treasury bill, a bond, and a time deposit in a bank and so on. For e.g. the International Monetary Market (a part of Chicago Mercantile Exchange) has a futures contract on US government treasury bills, three-month Eurodollar time deposits and US treasury notes and bonds. The LIFFE has contracts on Eurodollar deposits, sterling time deposits and UK government bonds. The Chicago Board of Trade offers contracts on long-term US treasury bonds.

Interest rate futures are used by corporations, banks and financial institutions to hedge interest rate risk. A corporation planning to issue commercial paper for instance can use T-Bill futures to protect itself against an increase in interest rate. A corporate treasurer who expects some surplus cash in near future to be invested in short-term instruments may use the same as insurance against a fall in interest rates. A fixed income fund manager might use bond futures to protect the value of her fund against interest rate fluctuations. Speculators bet on interest rate movements or changes in the term structure in the hope of generating profits.

3. Interest Rate Swaps:

A standard fixed-to-floating interest rate swap, known in the market jargon as a plain vanilla coupon swap (also referred to as “exchange of borrowings”) is an agreement between two parties in which each contracts to make payments to the other on particular dates in the future till a specified termination date. One party, known as the fixed ratepayer, makes fixed payments all of which are determined at the outset. The other party known as the floating ratepayer will make payments the size of which depends upon the future evolution of a specified interest rate index (such as the 6-month LIBOR). The key feature of this is: The Notional Principal; The fixed and floating payments are calculated if they were interest payments on a specified amount borrowed or lent. It is notional because the parties do not exchange this amount at any time; it is only used to compute the sequence of payments. In a standard swap the notional principal remains constant through the life of the swap.

4. Interest rate Options:

A less conservative hedging device for interest rate exposure is interest rate options. A call option on interest rate gives the holder the right to borrow funds for a specified duration at a specified interest rate, without an obligation to do so. A put option on interest rate gives the holder the right to invest funds for a specified duration at a specified return without an obligation to do so. In both cases, the buyer of the option must pay the seller an up-front premium stated as a fraction of the face value of the contact.

As interest rate cap consists of a series of call options on interest rate or a portfolio of calls. A cap protects the borrower from increase in interest rates at each reset date in a medium-to-long-term floating rate liability. Similarly, an interest rate floor is a series or portfolio of put options on interest rate, which protects a lender against fall in interest rate on rate dates of a floating rate asset. An interest rate collar is a combination of a cap and a floor.

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