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currency hedging

Page history last edited by Brian D Butler 11 years, 4 months ago

Currency Hedging

 

As a financial manager of a company, you would be stupid to bet your company's future on an FX rate.  You cant possibly know what the FX rate will be in the future.  So, you need to protect yourself from changes in currency movements...you need to HEDGE!

 

Volatile exchange rates can have a significant impact on the earnings, cash flows, and profitability of your company. Effective management of foreign currency risk can help stabilize your company's performance relative to currency markets and is a source of competitive advantage.

 

Related (but different) pages of content in KookyPlan:

 

 

 

 

 

Table of Contents:


 

 

Currency Hedging - Definition

 

Currency Hedging is used both by financial investors to parse out the risks they encounter when investing overseas, as well as by non-financial actors in the global economy for whom multi-currency activities is a necessary evil rather than a desired state of exposure.

 

For example, cost of labor variables dictate that much of the simple commoditized manufacturing in the global economy today goes on in China and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of never having done business in foreign countries, so many businesses are jumping into the fray and becoming part of the globalization trend of moving manufacturing operations overseas. The benefits of doing this however, come with numerous risk that were never a problem when manufacturing was done at home--among them currency risk.

 

If your cost of manufacturing goods in another country is denominated in a currency other than the one that you sell the finished goods in, there is the risk that the currency "volatility" alone may destroy the margin between what you pay to produce your product, and what you collect when you sell it (note you may be selling your product in a foreign country too, so you can hedge against the currency risk on this side as well!). So when you convert all costs on the production side, and all sales receipts from the retail side, back into your home currency, you may be alarmed to find that your profits have diminished significantly, or disappeared altogether. That's currency risk-- it is germane to doing business globally, but entirely independent of your specific business or products. Currency hedging then, is the insurance you can purchase to limit the impact this unpredictable risk has on your business, the same way Fire or Hurricane insurance protects your physical premises from unexpected events beyond your control.

 

Why should you hedge?

 

If you are working in a company with foreign operations, you are foolish not to hedge your currency exposures.   Look what happened to the Brazilian company "Sadia" in 09/2008... the CFO was fired after exposing that he lost R$760million ($415m) on the currency markets, or the equivalent to nearly 1/3 of last years annual profits.  He had bets on currency derivatives that went bad.  Another company in Brazil called "Aracruz" also fired their CEO in September of '08 due to failed currency bets, and huge losses.   The combination of these two bets gone wrong?  The BOVESPA, the brazilian stock exchange plunged on fears that other companies may also have similar losses....Dont be like them!  Dont get your company in trouble (and yourself fired) due to not properly hedging currency exposures!

 

 

 

 

How to hedge

 

Currency hedging, like many other forms of financial hedging, can be done in two primary ways, with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).

 

The financial investor may be a hedge fund that decides to invest in a company in, for example, Brazil, but does not want to necessarily invest in the Brazilian currency. The hedge fund can separate out the credit risk (i.e. the risk of the Company defaulting), from the currency risk of the Brazilian Real by "hedging" out the currency risk. In effect, this means that the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to someone else who does want a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, similar to insuring against other types of events.

 

As with other types of financial products, hedging may allow economic activity to take place that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be "too expensive". The increased investment is assumed in this way to raise economic efficiency.

 

 

Types of Hedging

 

Retail forex traders typically use foreign currency options as a hedging vehicle. Banks and commercials are more likely to use options, swaps, swaptions and other more complex derivatives to meet their specific hedging needs.

 

Spot Contracts - A foreign currency contract to buy or sell at the current foreign currency rate, requiring settlement within two days. As a foreign currency hedging vehicle, due to the short-term settlement date, spot contracts are not appropriate for many foreign currency hedging and trading strategies. Foreign currency spot contracts are more commonly used in combination with other types of foreign currency hedging vehicles when implementing a foreign currency hedging strategy.  (see spot exchange rate )

 

Forward Contracts - A foreign currency contract to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period.  Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount.  ( see forward exchange rate )

 

Important: Please note that forwards contracts are different than futures contracts ( see Futures market ). Foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) due to the fact that there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.

 

Foreign Currency Options - A financial foreign currency contract giving the buyer the right, but not the obligation, to purchase or sell a specific foreign currency contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign currency option buyer pays to the foreign currency option seller for the foreign currency option contract rights is called the option "premium."   A foreign currency option can be used as a foreign currency hedge for an open position in the foreign currency spot market. Foreign currency options can also be used in combination with other foreign currency spot and options contracts to create more complex foreign currency hedging strategies. There are many different foreign currency option strategies available to both commercial and retail investors.  ( see Foreign exchange Options )

 

Interest Rate Options - A financial interest rate contract giving the buyer the right, but not the obligation, to purchase or sell a specific interest rate contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the interest rate option buyer pays to the interest rate option seller for the foreign currency option contract rights is called the option "premium." Interest rate option contracts are more often used by interest rate speculators, commercials and banks rather than by retail forex traders as a foreign currency hedging vehicle.  (see Foreign exchange Options )

 

Foreign Currency Swaps - A financial foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. Foreign currency swaps are more often used by commercials as a foreign currency hedging vehicle rather than by retail forex traders.  (see foreign exchange Swaps )

 

Interest Rate Swaps - A financial interest rate contracts whereby the buyer and seller swap interest rate exposure over the term of the contract. The most common swap contract is the fixed-to-float swap whereby the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Other types of swap include fixed-to-fixed and float-to-float. Interest rate swaps are more often utilized by commercials to re-allocate interest rate risk exposure.

 

 

Tools for Currency Hedging

 

 

Rules to Remember:  tips for dealing with future risk...

 

  1. A/R protection:   If you have an expected A/R account receivable in the future in a foreign currency, and you want to protect yourself (you want protection against the risk that the foreign currency might depreciate...meaning that you will receive relatively less of your own currency in the future...after exchanging in the future at the lower rate)... then you have 4 choices to protect yourself:
    • forward contract:  forward sale of foreign currency
    • futures contract:  futures contracts to sell foreign currency
    • options contract:  purchase put options to sell foreign currency
    • money market hedge:  use a loan -type of hedge, where you convert the money today at the spot rate from a loan in a foreign currency, and deposit that cash today in your bank account.  You then pay back the loan in foreign currency in the future with the proceeds from the A/R.  This is a great option because it puts money in your bank account today.
  2. A/P protection:   If you have an expected A/P account payable in the future in a foreign currency, and you want to protect yourself (you want protection against the risk that the foreign currency might appreciate...meaning that you will have to pay more of your own currency in the future...after exchanging in the future at the higher rate)... then you have 4 choices to protect yourself:
    • forward contract:  forward purchase of foreign currency
    • futures contract:   futures contracts to purchase foreign currency
    • options contract:  purchase call options (to buy foreign currency in the future)
    • money market hedge:  use a deposit-type of money market hedge, where you convert money today at the spot rate, then deposit that money in a bank account of a foreign bank, and let that money grow to the exact amount needed to pay off the A/P in the future.

 

More tips:

  • Conceptually remember which type of problem you are dealing with...
    • for A/P...seek the lowest number = best
    • for A/R...seek the highest number = best
  • Pay all commissions today
  • For options, pay premium today
  • For futures, the number of contracts is abritrarily set at 125,000 euros per contract
  • Options is always half that amount, for some reason
  • Always ask...is it even important to hedge at all?
    • Is there bankruptcy risk?
    • Is there operational risk?
    • How to determine?  look at ration of deal size to firm size (revenue or profits)
    •  

 

 

Risk Management

 

When dealing with foreign exchange risk, you have a few choices as a business manager to reduce the risk of currency changes affecting your profitablity:

 

  1. Operationally hedge - use operations in more than one country to balance your assets and liabilities so that currency is generated in revenues in the same country where liabilities are owed.   Another way to operationally hedge is to have operations in multiple countries, so that if one currency goes down, another will go up, etc.
  2. Add a "currency risk premium" to your customers...ie, you can try to avoid currency risk by passing along the risk-premium to your customers.  You can charge a risk premium, say for example 7% extra to all clients, and keep a fund ready for incase the currencies change, and then, that way...you will have money ready.  Its not a very good method, but some companies do it.
  3. Protect yourself - hedge - transfer the risk to someone else that is more willing / able to take on that risk... if there is someone that is willing to take on risk for a fee, then sell them that risk, and take the money now.  This is the essence of currency hedging

 

 

Other ways to transfer risk to someone else

 

  1. (e) sell your A/R to someone else  ....companies that buy your receivables at a discount.
  2. Bankers Acceptance -
    • is an agreement between an importer and exporter,
    • with payment in 30 days
    • cover goods in transit
    • irrevocable letter of credit (L/C) = confirmation + insurance + Bill of Lading (BL)
    • Then, if you have the irrevocable L/C...then you can get the "Bankers Acceptance
    • you sell the package of contracts
    • go to bank
    • sell those receivables at a discount...to get money today.
  3. factoring
    • might buy next 15 shipments
    • multiple shipments
    • but, because there is no guarantee, then the banks charge a higher commission
    • get money today
  4. forefeiting
    • committment by a country (government)
    • host country guarantee
    • popular in older times, and in Middle east.

 

 

 

If you choose not to hedge....

 

If, for some reason, you think you can out-smart the FX market pros....then you might want to check out our guide to  predicting trends in foreign exchange rates

 

 

 

Links from KookyPlan

 

This is a subsection of hedging....see also:  our discussion on Currencies, and foreign currency trading

 

 

 

 

Books about FX trading from Amazon.com

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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