Purpose of Foreign Exchange Risk Hedge Finance Essay

This report has been produced as a request of the course "International Financial Management". This report has been developed in three segments. Part one explaining the factors related to hedging and the alternative techniques available. It also brings into consideration the factor that the CEO's request of the techniques have also been brought under and compared. Part two has compared all three selected options and has produced the final selection. Last part has a comparison of the forward and option derivatives. Part (a) Explain the purpose of hedging foreign exchange risk and describe the alternative hedging techniques available, particularly the processes involved for each of the three hedging approaches preferred by the CEO and referred to above. Foreign exchange risk comes in when companies start dealing across boundaries and they find dealing in foreign exchange. The common dealing that happens among companies Is when taking receivables and giving payables. Following transactions always takes place in foreign and home currency and the rate involved is the risky factor. The risk involved in the factor is that before the transaction has happened the exchange rate might fluctuate and change in such a scenario the company might end up losing money [1] . The difference paid between two countries currency is called foreign exchange risk. The currency of one country when sees a fall there will always be a gain in another countries currency value, this depreciation and appreciation between currency values can occur drops in value. Depreciation takes place when purchasing of another currency requires more of the home currency. Appreciation is just the opposite; the currency is able to purchase more units of the other country's currency. Nearly all currencies are valued according to the rate in the market so the exchange rates keeps on fluctuates. This risk is the exchange risk and hedging is one solution to cover it up. There are many ways to reduce this risk but the two popular approaches used very commonly are called hedging and netting. Hedging is when u buy a forward contract in a date in the future this is done to cover the liabilities occurring in the future. Forward exchange contracts are often used to cover the risk of foreign exchange fluctuations. Apart from hedging another popular technique very commonly used is called netting. Netting is used to maintain equal levels of foreign exchange as compared to equal levels of payables. This would help you to net out the effect and the difference between the two hence the result would be zero and the company would not incur any loss. Using this technique the buyer and the seller both can be at advantage, if the buyer nets at a good rate than he would be able to earn more and same goes for the seller he can also earn a lot. This technique helps both the buyer and the seller. There are many other ways of dealing with hedging which can be options, futures forwards. Further in this answer I will elaborate each one of them one by one. The only differences between each of them are the related requirements and the costs associated with each one of them. The cost of one can be very high as compared to another one at a certain time period and vice versa. If a company is having foreign exchange risk than they would certainly want to compare a number of techniques and see whether which one of them is profitable and which one is not.

Purpose of Foreign Exchange Risk Hedge

In normal words speaking the purpose of any hedging technique is to help the investor protect against any such events in the future that will cause him/her to lose their investment. When it comes to currency then thee simple idea is to simply either convert or exchange the currency to cover the risk. While keeping in mind the exchange rate one would want to hedge and save themselves by changing into another currency that would provide them cover. For example, instead of trying to pay for shares of a company's stocks which is in the UK but is paying in US dollars, the investor will look to first make a conversion into Pounds and then later see to make it into the united states dollars, once the conversions are done only than purchases can be made. To further protect themselves the investors might also look up selling the purchased shares on a particular date.

Alternative Techniques

1. Futures

A future contract is a standardized, transferable, exchange traded contract that requires delivery of a commodity, bond, currency, or stock index at a specified price, on a specified future date. Generally the delivery does not occur instead before the contract expires the holder usually "square their position" by paying or receiving the difference between the current market price of an underlying asset and the price stipulated in the contract.

Specifications of a future contract

The future contract itself tells why it is being used to sell and purchase, it also defines the way in which the contract would take place. A future contract would define it as: It will tell a fixed amount of commodity or any other thing that is being traded. (e.g, 5,00 bags of rice, 100 Euros, dollars etc.) It would also define the quality of the commodity being traded (this might not be true for all sort of commodities thus needs to be adjusted accordingly; currencies if used in the transaction do not have various levels quality and thus stay plain as they are). The rules for price adjustments would also be defined be the future contract for commodities and price would be adjusted accordingly to quality which can be of a specified rating. The minimum amount of fluctuations that the contract can bear would also be mentioned. The contract would also define the day of delivery and the way the possession would be taken would be defined too. The contract would further define the per unit price. Finally the number of days i.e. the hours and the time would also be explained about how much time would be taken for the exchange to happen.

2. Currency Swaps [2]

A currency swap is something in which two investors exchange a particular amount of currency for another one for a particular time period and this amount is used agreed between two parties. Once the agreement gets over both the parties give back the original sum that was exchanged between both of them. To take care of legislations for currencies all over the world the currency swap is an efficient and useful technique. A currency swap can have a maturity up to 30 years maximum. According to international accounting standards the currency swap would not be considered as a loan hence if it is not a loan than it would not ever appear on the liabilities or any other part of the balance sheet. Rather it appears as a foreign exchange transaction with a forward contract so that it can be closed. All the funds involved in the transaction are paid [3] . It is not a very common transaction that happens instead companies use it to service debts as well. This technique can also be used to get better cash flows in which one company borrows at a lower cost in one currency and then exchanges it for a debt to another company which really desires to get some. In this way both the companies can earn easily and improve their cash flows [4] .

Advantages

The main advantage of getting into a currency swap is that you can keep negotiating it for a longer period of time rather as compared to a normal swap. Entering the swap can help the parties to fight against factors such as fluctuation of both interest rates and currencies. Even a better access to the local market can be gained via doing so. When companies tend to do so in currency swaps they can easily cope up with their currency rate risk and exchange rate risk too. The extra benefit gained from doing currency swaps is that they can help reduce the A counterparty risk, whihch comes from bid and ask price. By default it can be said to combine with interest rate risks and currency swaps can help avoid them. The terms can also set up asking either a fix or a floating rate thus the flexibility of the terms can also help to focus.

Disadvantages

The benefits are good but the disadvantage is the cost that is involved in such transactions and along with them the settlement and the un settlement risks involved in it. The biggest risk involved in doing a currency swaps is that the other party might fill up their obligation and in this case the main party might end up losing money, yes legal actions can be taken but in some cases they remain in vain [5] . The other disadvantage is that one of the party might want to quit the transaction before time, the party that remains should have an approval of the other party and thus can decide upon which exit strategy needs to be taken, same is the case when it comes to futures and forwards that the exit strategy must be pre decided between both the parties. Following can be some ways of taking an exit: Entering into an offsetting swap Selling the swap to aA third party Purchasing a "swaption."

3. Options

An option is a contract but not an obligation and the holder of the option might or might not use it on the date of the option, the price of the use is already predetermined. An option can be either a put option or a call option. A put option will allow the holder to sell a particular security on the date of maturity for a desired price, while the call option will allow the holder to buy it. It is also defined in some places as a promise by the issuer to the holder to fulfill a particular price on a particular date, the risk is that the price can be higher or lower on the desired date. It also protects the offeere from the offer to revoke it . Still careful consideration is required as still it is a type of contract. Typically, an offeree can provide consideration for the option contract by paying money for the contract or by providing value in some other form such as by rendering other performance orA forbearance [6] .

CEO's Requested Techniques

1. Forwards

Forwards are rather similar contracts between two parties in which they decide on a particular asset to be sold on a price on a future date.A This is similar to a spot in contrast, sots asks to sell the asset on date today but forwards decide a date in the future. The costs for a forward contract is nothing. The party looking to buy the asset would be looking at a longer termed position, while the seller will see a shorter termed position. The price agreed upon is called theA delivery price, which is equal to theA forward priceA at the time the contract is entered into [7] .

2. Money Market Hedge

Money market hedges refers to things where techniques are used to lock in particular rates related to foreign exchange and cash equivalents. Even after having the design to hedge against risk they have a particular set of risk involved with them. Some of the shortfalls of a money market hedge are complexity and disclosure which are further elaborated below:

Complexity

Hedging strategies are mostly misunderstood due to their complexity levels apart from the market insiders common people do mix them. The commonly used money market hedges are futures, forwards, options, swaps etc [8] . Furthermore the complexity adds on when the people involved and responsible for financial engineering keep on rolling out new ways of hedging making the entire process more and more complex. The second most common issue is the selection of the appropriate hedge for an appropriate situation making things difficult.

Disclosure

Disclosure has always been an issue with derivatives. The disclosure issues more because of the rapid pace at which they are traded all over the place. If the investor's trust shakes in a particular institution they tend to liquidate very rapidly this can cause a market or a institution to shake. This is one main reason that the impact remains unknown.

3. Billing in US Dollars

First of all this is not a hedging technique. This is just a billing technique where by a company invoices its clients in US dollars by using the current spot rates. The spot rate in our case is mentioned in the data which is 15.3555 as we have shown in our calculations in the next part. Part (b) Show your calculations of the expected proceeds in dollars after six months using each of the three chosen hedging approaches respectively and indicate which of them you would recommend and explain why.

Calculation of Expected proceeds in US$

The expected proceeds from each of the 3 methods are calculated as

Billing in US$

The company will use the rate 15.3555 (Peso/USD) to bill the other party in US dollars. The expected proceeds will be calculated as follows: Expected proceeds in US $ in six months=500M /15.3555= $ 32.56162287M

Six Month Forward Rate Contract

If the company engage in 6 month forward rate contract then the expected proceeds will be calculated as: Expected proceeds in US $ in six months= 500M/15.0134= $33.30358213M (Using Forward Rate Contract)

Money Market Hedge

If the company is interested in money market hedge the expected proceeds will calculated using these steps: The company first borrow peso @ 1.3% (for 6 month borrowing rate in Mexico) which is [500M/(1.013)]= 493.5834156M Peso The company will convert US dollars @ 15.3561 exchange rate which will result into 493.5834156M/15.3561= $ 32.14249813M Now deposit $32.14249813M in US bank @ (1.55% for 6 months) which will result into $32.14249813M *1.0155= $ 32.64070685. After a year the company will receive its 500M peso and will adjust its loan of 500m peso with the Mexican bank.

Recommendation

My recommendation is the six month forward rate contract as this is the one which is more appropriate than any others. This gives maximum returns to its investors and covers their six months return. Part (c) Critically assess the features which distinguish forward exchange fixed contracts and forward exchange option contracts. To distinguish forward exchange contracts from option contracts we will critically analyse both forward exchange fixed and forward contracts.

Forward Exchange Fixed Contract

A forward exchange contract is a contract to conduct a transaction at a fixed rate of exchange on either a fixed future date or during a fixed period of time. Forward exchange contracts help to manage the risk of foreign currency denominated payables or receivables. By entering in to a forward exchange contract, we are benefiting of locking in the rate of currency exchange to mitigate the risk inherent in a future payments obligation. Some of the advantages and disadvantages of forward contracts will be highlighted to understand its characteristics.

Advantages

Some of the advantages of forward contracts are as: Protection against unfavourable exchange rate fluctuations. The exact values of the import and export orders can be calculated on the day it is processed. Budgeting and costing are accurate. It can be written for any amount and term. Offers a complete edge. They cater for a diverse type of commercial and financial transactions and both importers and exporters can make use of it.

Disadvantages

Company cannot take advantage of preferential exchange rate movements once entered into forward exchange fixed contracts. If an order is cancelled or there is any surplus amount outstanding on a forward exchange, it must be surrendered at the prevailing spot exchange rate, which can result in a financial loss. Early deliveries, extensions, surrenders and cancellations during the fixed period of a forward exchange contract are done on a swap basis causing additional administration Difficult to find a counterpart (No liquidity) Requires typing up capital Subject to default risk.

Forward Exchange Option Contracts

A forward exchange option contract is different from forward fixed contract as in option contract the buyer of the option has the right but not the obligation to buy or sell a specified currency or stock at a specified exchange rate, at a specified date from the seller of the option. There are two types of options, one is called 'Call Option' and the one is called 'Put Option'. Call Option- It gives the right to buy a specified currency or stock at a specified exchange rate at specified date. Put Option- It gives the buyer the right to sell a specific currency or stock at a specified exchange rate at a specified price.

Advantages

The main advantage of forward exchange option is flexibility. Secondly in options there is neither initial margin nor daily variation margin as the position is not market to market. Due to it many companies enjoys significant cash flow relief.

Disadvantages

Some of the disadvantages of options are Written for fixed amount and terms Subject to basis risk Offers only partial hedge

Cite this page