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.