Managing Foreign Exchange Risk with Forex Market Hedge

A firm may be able to reduce or eliminate currency exposure by means of Forex market hedging. Important Forex market hedging tools used for managing Forex risk are :

1. Hedging Through Options Market:

Buying a Call option in Forex can be used by an importer or borrower to hedge his payables against exchange rate fluctuations. This is done only if is felt that the foreign currency is in an appreciation mode. Buying a Put option can be used by an exporter or lender to hedge receivables. This is done only when the foreign currency is in a depreciating mode.

Buying a Call.

Illustration: It is now August. Suppose a US importer has to pay in November 62.5 million yen to a Japanese supplier. The current $/Yen = $0.007739. A December call option in yen is available at a strike of $0.0078, per yen. The premium is $ 0.000108/yen. The brokerage fee per contract is $20. Yen options contract size is 6.25 mn yen.

The US importer has to go for 10 contracts to hedge 62.5 mn yen exposure. The effective cost per yen under the call option = Strike price + Premium + Brokerage = $0.0078 + $ 0.000108 + $[20/6,250,000] = $0.0079112.

If the outlook for the yen by November is that it will never exceed $0.0079112 per yen, there is no need to hedge at all. But if fluctuations in the market is so high, it is good to go for hedging. Let the firm go for hedging.

By Nov, the yen has, say appreciated to $0.0080. Then, the hedging has really saved firm $5550; i.e., ($0.008-$0. 0079112) x 62,500,000 =$5550.

If the yen had depreciated below $0.0079112 per yen, the option contract goes a waste. But, the Dec call option might still have some premium in the market and that by writing a call the firm can earn an income. But that income should be greater than the brokerage commission. You know the brokerage commission at $20 per 6.25mn yen, comes to an amount of $0.0000032. So, if the call premium is greater than $0.0000032, the firm may go writing calls. But the firm is taking up an obligation.

Buying a Put

Illustration: It is now August. Suppose a US exporter has to receive in November 62.5 million yen from a Japanese buyer. The current $/Yen = $0.007739. A December put option in yen is available at a strike of $0.0078, per yen. The premium is $ 0.000108/yen. The brokerage fee per contract is $20. Yen options contract size is 6.25 mn yen.

The US importer has to go for 10 put contracts to hedge 62.5 mn yen exposure. The effective cost per yen under the put option = Strike price + Premium + Brokerage = $0.0078 + $ 0.000108 + $[20/6,250,000] = $0.0079112.

If the outlook for the yen by November is that yen will appreciate beyond $0.0079112 per yen, there is no need to hedge at all. But if fluctuations in the market are high, it is good to go for hedging. Let the firm go for hedging.

By Nov, the yen has, say depreciated to $0.0078. Then, the hedging has really saved firm $6950; i.e., ($0. 0079112- $0.0078) x 62,500,000 =$6950.

If the yen had appreciated above $0.0079112 per yen, the option contract goes a waste. But, the Dec put option might still have some premium in the market and that by writing a put the firm can earn an income. But that income should be greater than the brokerage commission. You know the brokerage commission at $20 per 6.25mn yen, comes to an amount of $0.0000032. So, if the put premium is greater than $0.0000032, it may go for writing puts. But the firm is taking up an obligation.

NB: An exporter with substantial Forex inflow in the future can write calls on these inflows. This is called covered call writing.

2. Hedging through Futures Market:

Futures contract can be used to hedge. Buying futures can help hedging short position in Forex, while selling futures can help hedge long position in Forex. Importers and exporters, investors and borrowers, bidders for global contracts and others can cover their exposure through Forex futures. Importers borrowers and bidders for global contracts go for futures buying. Exporters, investors and others can cover their exposure through selling Forex futures.

Illustration: It is now Sep 3. A UK firm owes $ 2,25,000 due on Dec 5. Present rates are: $/PS Spot: 1.8250 , December Futures: 1.8000 ,3 Month $/PS forward rate: 1.6850

Since the pound sterling is losing, the UK firm decides to hedge. It sells two sterling futures. The $ value of the deal is: $ (62500 x 2 x 1.8) == 2,25,000. This is equal to the payable. Normally such perfect equalization is impossible leading to less than perfect hedge. If on Dec 1 the rates are, say: Spot $/PS 1.7080, Dec. Futures 1.7000. Here the PS has depreciated.

The UK firm can buy $ 2, 25,000 in the spot market. The PS cost is PS 1,31,733. Had the PS not depreciated, the PS cost of the $ 2, 25,000 payable would be PS 1,23,288. So, the loss is PS 8445.

The firm should buy 2 sterling futures to square up the earlier short selling. The profit is $ (62500)(1.8 – 1.7)(2) = $ 12500. The PS equivalent at Dec 3 spot rate is PS 7353. A loss of PS 1092 has resulted. After we add transaction cost of PS 200, the total loss is PS 1292. The total PS outlay is PS 1,31,733 + 1292 = PS 1,33,025. This works out to $/PS rate of: 2,25,000/1,33,025 = 1.6914. This is better than the for -3 months forward rate obtaining at September.

If on Dec 1 the rates are, say: Spot 1.9000 December futures rate at 1.9250. Here the PS has appreciated.

Buy $ in the spot spending PS 2, 25,000/1.9 = PS 1,18,421. The gain in the spot deals, will be PS 1,23,288 – 1,18,421 = PS 4867. In the futures the dollar loss is $ 62500 (1.9250 – 1.8000) (2) = $ 15625. At Dec 3rd spot, the loss comes to PS 9191. The net position is a loss of PS 4324. After transaction cost the loss is PS 4524. The effective $/PS rate is: 2,25,000/ (118421 + 4524) = 1.83. This is much better than the forward rate.

Forwards act the same way as futures. But, forwards are mostly customized and over the counter, while futures are standardized and exchange run.

A receivable in a Forex can be swapped by involving in a spot purchase swapping to a forward sale contract.- So, an exporter can go for this. A Forex payable can be hedged through a spot sale swapped to a forward purchase.

3. Hedging Through Forward Market:

This is similar to futures market hedge. But contracts are not standardized. Hence can be tailor made. But, market may not be as efficient as the futures market. So big operators can fleece small operators.

Illustration: It is now August. Suppose a US importer has to pay in November 62.5 million yen to a Japanese supplier. The current $/Yen = $0.007739. The forward market gives a yen for $0.0079, all inclusive cost, delivery November. A December call option in yen is available at a strike of $0.0078, per yen. The premium is $ 0.000108/yen. The brokerage fee per contract is $20. Yen options contract size is 6.25 mn yen. How the firm can hedge?

Comparison of Call option Forward buying.

Call option market: The effective cost per yen under the call option = Strike price + Premium + Brokerage = $0.0078 + $ 0.000108 + $[20/ 6,250,000] = $0.0079112.

Forward market: The forward yen is priced $0.0079. The forward market is cheaper.

But, the possible benefit of fall in yen in the future cannot be availed as forward market creates mutual obligation, unlike a call option with right, not obligation to buy. But you have to forgo the option premium paid. So a managerial decision in favor either the call or forward buying is to be made.

4. Hedging Through SWAPS

“SWAP” literally means exchange or barter. In the foreign exchange context swap means simultaneous buying and selling of same amount of foreign currency for different settlement (maturity) dates. A Swap deal involves:

  1. simultaneous purchase of spot and sale of forward or vice-versa; or
  2. simultaneous purchase and sale of both forward but for different maturity dates.

Hedging with Currency Swaps

Let us see a swap transaction with the following-rates in March. Spot US Dollar 1 = Rs.46.50 – 46.60 2 months forward = Rs.40 – 50 paise

HDFC Bank sells to SBI US dollar 1 million delivery 2 months. This is an outright forward sale deal for  HDFC Bank and the transaction will be put through by SBI at market 2 months forward buying rate of US dollar 1 = Rs.46.90.  HDFC Bank may buy SPOT US dollar 1 million from another bank say Axis Bank and the transaction will be effected by Axis bank at the market spot selling rate of US dollar 1 = Rs.46.60. The two transactions of  HDFC Bank are two different deals with two different banks and are separate contracts.

On the contrary, in the above, if  HDFC Bank chooses to join the transactions with one bank say either SBI or Canara Bank, then it becomes a. swap transaction. In a swap deal, both purchase and sale are done with the same bank and they constitute 2 legs of the same contract.

In the above example let us presume that  HDFC Bank approaches SBI to quote a swap rate for spot to 2 months forward. SBI will quote the swap rate as 40 – 50 paise per US dollar. Here, SBI the market-maker is selling spot and buying 2 months forward and hence it will quote lesser of the two premium i.e. 0.40 paise as its swap rate and the swap will be done at a swap difference of 0.40 paise.

From the above illustration, one can figure out that in a currency swap deal the rate quoted is not exchange- rate but is only exchange rate differential.

It is the difference which buyer/seller has to pay/receive the swapping spot against forward or forward against forward. Hence, as swap is done at forward differentials, spot rate is immaterial. But spot rate decides the total value in rupees which either of the bank will have to deploy till receipt of forward proceeds on the due date and the banks take either spot buying or spot selling or average of -the two as spot rate for undertaking a swap transaction.

Hedging with Interest Rate swaps

A firm which has a liability in fixed rate market can hedge itself, in case of falling interest rate, by locking with a fixed-floating interest rate swap, by receiving fixed rate interest and paying at floating rate. So, the benefit of falling interest rate is obtained.

A firm which has a liability in floating rate market can hedge itself, in case of increasing interest rate, by locking with a fixed-floating interest rate swap, by receiving floating rate interest and paying at fixed rate. So, to the extent there is floating payment, there is floating receipt and that the problem rising interest rate is effectively dealt.

Illustration: Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5year fixed-rate Eurodollar bonds at 10 percent. Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. It is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. It would make more sense to for the AAA rated bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. It would make more sense for firm B to raise the money by issuing 5-year floating-rate notes at LIBOR + ½ percent. But Firm B would prefer to borrow at a fixed rate. Through a swap arrangement both can benefit. How?

Solution:

                                                                                                Fixed Rate Market                                                       Floating Rate Market

AAA rated bank:                                     10.00%                                                                                                                     LIBOR

BBB rated firm                                           11.75%                                                                                                                     LIBOR + 0.5%

Difference:                                                         1.75%                                                                                                                         0.5 %.

The difference arrived at above is called credit quality spread or in short quality spread as the difference arises due to difference in the credit quality of the entities. In both the markets, the firm is at a disadvantage. But it has less dis-advantage in the floating market.

So let the firm raise fund in the floating interest rate market, at LIBOR + 0.5%. Let the bank raise fund in the fixed interest rate market, at 10%.   The overall gain is the difference between quality spread. The quality spread differential = 1.75% -0.5 %.= 1.25%. This gain could be shared among the swap banker who does the swap arrangement, the bank and the firm. Suppose, the commission for swap banker is 0.25%. The remaining gain 1% say is shared 0.6% for the bank and 0.4% for the firm.

As a result, the bank’s effective cost of raising the fund is: LIBOR — 0.6%. The firm’s effective cost of raising the fund is: 11.75% – 0.4% = 11.35%.

NB: The sum of two effective costs must equal the swap bank’s commission plus the sum of actual costs of borrowing. Sum of two effective costs = LIBOR — 0.6% + 11.35% = LIBOR + 10.75%. Swap bank’s commission plus the sum of actual costs of borrowing = 0.25% + 10% + LIBOR + 0.5% = LIBOR + 10.75%.

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