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«Χρηματοοικονομική και Τραπεζική Χρηματοδοτήσεις και Επενδύσεις»

Capital & Money Markets

Section 2

Hedging Foreign Exchange Rates

Michail Anthropelos, Ph.D.

anthropel@unipi.gr

http://bankfin.unipi.gr/faculty/anthropelos/

1Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D.

Recent FOREX articles

Dollar rises to a record high, amid a rush for cash in anticipation of a

prolonged coronavirus pandemic. All Group-of-10 currencies tumbled, with the

oil-linked Norwegian krone suffering the most heavy losses. Even

traditional safe assets, such as the yen, dropped as much as 1.4% as liquidity

evaporated with investors rushing to meet margin calls […]

The rush for dollars is gaining pace despite every attempt by the Federal

Reserve and its peers to provide liquidity through swaps, repurchase

operations and emergency rate cuts […] Yet ECB huge boost offered little

relief for the beleaguered euro, which fell as much as 1% on Thursday. […]

“Simply put, it’s a liquidity mismatch as there are far more U.S. dollars in

demand than currently on offer” […] Emerging-markets are bearing much of

the brunt from the dollar’s supremacy as they try to cope with collapsing

exchange rates and plunging demand.

From Bloomberg.com (19/3/2020)

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 2

Recent FOREX articles

The pound plunged 5% to its lowest level against the dollar in over three

decades as the shocks caused by the coronavirus rippled through global

markets. Investors fled from U.K. assets as the pandemic began spreading

through Britain, with many fearing Prime Minister Boris Johnson’s response has

fallen short compared to measures taken by other European nations.

From Bloomberg.com (18/3/2020)

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 3

The report additionally stated that in purchasing power parity (PPP) terms,

India's GDP (PPP) is $10.51 trillion, exceeding that of Japan and Germany.

From businesstoday.in (23/2/2020)

Η SNB ανακοίνωσε ότι οι παρεμβάσεις της στις αγορές ξένου

συναλλάγματος είναι περισσότερο δυναμικές προκειμένου να συμβάλει στη

"σταθεροποίηση της κατάστασης", προσθέτοντας ότι οι παρεμβάσεις αυτές

είναι αναγκαίες για να μετριάσει "την ελκυστικότητα του ελβετικού

φράγκου".

From capital.gr (19/3/2020)

Foreign Exchange Risk

Definition: The foreign exchange risk is the possibility of changes in

the values of a company’s assets and liabilities, which are results of

fluctuations in the exchange rates of foreign currencies with respect to

the domestic currency.

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 4

The sources of foreign exchange risk can be categorized in three types

of risk exposure:

1. Economic exposure: changes in the value of a company caused

by unanticipated changes in exchange rates.

2. Transaction exposure: changes in a company’s contractual

cashflows denominated in foreign currencies caused by

unanticipated changes in the corresponding exchange rates.

3. Translation exposure: refers to the potential that the company’s

consolidated financial statements can be affected by changes in

exchange rates.

Management of Transaction Exposure

The magnitude of a firm’s transaction exposure on a given foreign

currency is equal to the amount of the currency that is receivable or

payable.

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 5

In this section, we focus on (some) ways to hedge the transaction

exposure using various financial contracts:

o Forward market hedge.

o Money market hedge.

o Option market hedge.

o Other ways of hedging.

A generic example: Suppose that the firm CM is going to receive £1 mil.

in a year and r€ = 4% and r£ = 5% p.a., S(€/£) = 1.2 and F12(€/£) =1.1885.

The Forward Market Hedge

➢ Perhaps the most direct way of hedging transaction exposure is by a

currency forward contracts.

➢ If a firm goes long (short) in a forward contract this, it is going to buy

(sell) a certain amount of a foreign currency at a given (the forward) rate.

In our generic example: The firm CM could hedge its pound risk

exposure by going short in a forward contract on the amount of £1 mil. In

one year time, it going to receive £1 mil. and sell them at the (known)

one year forward rate, that is F12(€/£) = 1.1885. Hence, CM is going to

get €1.1885, regardless the spot exchange rate after a year S12(€/£).

The gain/loss from forward hedging is given by:

G/L = [F12(€/£) - S12(€/£)]xM

where M is the total amount of the hedged position.

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Facts about Forward Market Hedge

➢ Hedging with forward contracts eliminates the downside risk at the

expense of forgoing the upside potential.

➢ It costs nothing to enter a forward contract.

➢ A forward contract is a zero-sum game against another investor. This

implies the existence of credit risk.

➢ Why not futures contracts?

• No credit risk, but:

• A margin account should be set up (in our example, when pound

appreciates, the firm will be asked to increase the margin).

• Usually, not suitable delivery dates and sizes.

➢ Transactions on forward contracts capture 12% of the global FOREX

market transactions.

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 7

The Money Market Hedge

➢ The money market hedge involves simultaneous borrowing and

lending activities in two different currencies to lock in the value of the

future foreign currency cash flows in terms of the domestic currency.

➢ A firm may borrow (lend) in foreign currency to hedge its foreign

currency receivables (payables), thereby matching its assets and

liabilities in the same currency.

In our generic example: The firm CM can eliminate its pound

exposure by:

(a) first borrowing in pounds and converting the loan into euros.

(b) then investing these euros at the domestic interest rate.

(c) In one year, CM is going to use the pounds that is supposed to

receive in order to pay off the pound loan.

The key point is that the amount in pounds borrowed is equal after a

year to the receivable amount, the risk exposure becomes zero.

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 8

The Money Market Hedge cont’d

CM borrows £y such that

£1mil.=y(1+ r£ )

i.e., CM borrows £953,380.

Step 1: Borrow £953,380 at r£ = 5% for a year.

Step2: Convert £953,380 into €1.1429mil. at S(€/£) = 1.2.

Step 3: Invest € 1.1429mil. in Euroland at r€ = 4% for a year.

Step 4: Collect £1mil. and use it to repay the pound loan.

Step 5: Receive the maturity value of the euro risk-free investment, that

is €1,188,571.

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 9

➢ What is the G/L from the money market hedging?

Money market and forward hedge should have the same outcome in thecase where there is no transaction cost (e.g. forward bid-ask).

➢ What about the case where there is some transaction costs (bid-askspread)?

Option Market Hedging

➢ Currency options provide a flexible ‘optional’ hedge against theexchange risk exposure compared to the forward and money markethedge.

In our generic example: The firm CM can reduce (but not eliminate)its pound exposure by:

(a) Buy (OTC) a put option on £1 mil. with strike price 1.25 €/£ at a costof say 0.08 €/£, i.e., CM pays €80,000. That is CM pays upfront €80,000and gets the right to sell £1 mil. after a year at 1.25 €/£.

(b) After a year, CM exercises its right in the case where the spot rate atthat time is less than 1.25.

• If CM exercises the option the net euro proceeds is

1,250,000 - 80,000x(1+0.04) = €1,166,800.

This is a guaranteed income from pounds selling. However, a higherincome is also possible (‘limit the download risk while preserving theupside potential’).

✓ Why does this hedging method have flexibility?

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The FOREX Mini-Case Study

Setting

Suppose that a European company, called EC, has to pay 1 mil. UK pounds in 3 months. EC’sfinancial manager is considering hedging its pound exposure and is wondering which is the mostpreferable way to do so. For this he needs the following quotes:

• Spot rate

• Forward rate (3 months)

• 3 month put option on pound with strike price close to spot rate

• 3 month call option on pound with strike price a bit higher than the spot rate

• The 3-month Euribor interest rate

• The 3-month pound-Libor interest rate

Questions

1. What are the hedging choices for EC?

2. Apply the money to market hedge and calculate its cost

(assume that EC can lend euros at euribor and pound at libor rate; and that EC can borroweuros at euribor+0.5% and pounds at libor+1%).

3. Use an option for the hedge.

4. Make a graph of the effective price that EC is going to pay at any possible exchange rateafter 3 months, when it uses the available ways of hedging.

5. Is there any arbitrage opportunity with the data you have?

Capital Markets The FOREX Markets Μ. Anthropelos, Ph.D. 11

Bibliography

• C. Eun & B.G. Resnick: ‘International Financial Management’, 5th

ed., Chapters 4, 5 and 13.

• A.C. Shapiro: ‘Multinational Financial Management’, 10th ed.,

Chapters 7 and 10.

• Rene M. Stulz: ‘Risk Management & Derivatives’, Chapter 6.

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