The document discusses foreign exchange risk management. It covers hedging transaction exposure using forwards, futures, money markets and options. Hedging manages risk from unanticipated exchange rate changes. The decision to hedge depends on expected exchange rate movements. Hedging produces a more stable income stream for firms.
The document discusses foreign exchange risk management. It covers hedging transaction exposure using forwards, futures, money markets and options. Hedging manages risk from unanticipated exchange rate changes. The decision to hedge depends on expected exchange rate movements. Hedging produces a more stable income stream for firms.
The document discusses foreign exchange risk management. It covers hedging transaction exposure using forwards, futures, money markets and options. Hedging manages risk from unanticipated exchange rate changes. The decision to hedge depends on expected exchange rate movements. Hedging produces a more stable income stream for firms.
The document discusses foreign exchange risk management. It covers hedging transaction exposure using forwards, futures, money markets and options. Hedging manages risk from unanticipated exchange rate changes. The decision to hedge depends on expected exchange rate movements. Hedging produces a more stable income stream for firms.
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Chapter 13
Foreign Exchange Risk Management
Objectives To explain why there is concern about FX risk To illustrate how to manage transaction, economic and translation exposure
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-2
Hedging Hedging, which is the core risk management operation, is a process whereby a firm can protect itself from unanticipated changes in exchange rates and other sources of risk
(cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-3
Hedging (cont.) The decision to hedge or not to hedge an uncovered or open foreign currency position is basically a speculative decision It all depends on the expected exchange rate or the movement of the exchange rate between the point in time when the decision is taken and when its effect materialises
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-4
Why is there no need to worry about FX risk?
If international parity conditions hold, FX risk will not arise If it is possible to forecast exchange rates accurately, FX risk can be controlled Shareholders are naturally hedged though diversification
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-5
Why worry about FX risk?
International parity conditions do not hold Forecasting exchange rates is rather difficult Hedging produces a more stable income stream
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-6
Benefits of hedging Hedging has a positive effect on the value of the firm It produces a more stable corporate income stream
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-8
Financial hedging By taking an affecting position on a hedging instrument (forward, etc), the profit/loss on the unhedged position is offset by the loss/profit on the hedging instrument
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-9
Forward hedging Forward hedging entails locking in the exchange rate at which payables and receivables are converted from the domestic currency into a foreign currency, and vice versa
(cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-10
Forward hedging (cont.)
V
KS1 (no-hedge)
KS0 (hedge)
S0 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
S1
13-11
Offsetting profit/loss on payables
+ Long forward
S0
S1
F0 Payables
(a) F0 S0 (par)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
(cont.) 13-12
Offsetting profit/loss on payables (cont.)
+
Long forward
S0
F0
S1
Payables
(b) F0 S0 (premium)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
(cont.) 13-13
Offsetting profit/loss on payables (cont.)
+
Long forward
F0
S1
S0
Payables
(c) F0 S0 (discount)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-14
Introducing the bid-offer spread
Hedge
No-Hedge
Payables
KFa 0
KS a1
Receivable s
KFb 0
KSb1
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-15
Futures hedging Futures hedging results may differ quantitatively from those of forward hedging Because of the standardisation of contracts, it may not be possible to hedge the exact amount
(cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-16
Futures hedging (cont.)
The due date may not coincide with the settlement date Marking-to-market introduces some variation
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-17
Money market hedging
A money market hedge amounts to taking a money market position to cover expected payables or receivables By borrowing and lending, a synthetic forward contract is created
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-18
K S 0
( 1
i ) K ( 1
i)K S ( 1
i ) 0
S ( 1
i) 0
Money market hedging of payables
P a y a b le s ( K ) B o r o w i n g d m e s t c c u rn c y C n v e n g a to s p o trtia te
L o a n R e p a y m e n t
I v tin g t fn o re is g r a ta e K Im p lic itfo rw a rd ra te
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-19
(1 iK
) S 0
( 1
i ) K S (1
i)S 0
(1
i) 0
Money market hedging of receivables
R e c e iK v a b le s ( ) B o r o w i n g fc e i g n u rc y C n v e n g a to s p o trtia te
L o a n R e p a y m e n t
Id n v e sts itn g te o m ic ra K Im p lic itfo rw a rd ra te
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-20
K S a 0
(1 iK
) b (1
ib)K S ( 1
i ) a 0 a
b S (1
ia) a 0
Money market hedging of payables with
bid-offer spreads
P ay ab les ( K ) B o r o w i n g d m e s t c cu rn cy C v e n g ato sn p o trtia te
L o n R ea p ay m en t
Ifn v tin t o re isg rg ata e K Im p licitfo rw ardrate
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-21
Money market hedging as a pricing
mechanism When the banker quotes a forward rate for a future delivery of a particular currency, the banker will be exposed to the risk arising from possible appreciation of the underlying currency
(cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-22
Money market hedging as a pricing
mechanism (cont.) The banker can protect himself by hedging the forward position in the money market, so that he receives the amount of the underlying currency to be delivered on the maturity date
(cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-23
Money market hedging as a pricing
mechanism (cont.) The minimum forward rate that the banker can quote, therefore, is the cost of money market hedging, which is the forward rate implicit in the synthetic forward contract created by the hedge
(cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-24
Money market hedging as a pricing
mechanism (cont.) The bid and offer forward rates quoted by the banker are
1 ib Fb S b 0 * 1 ia
1 ia Fa S a 0 * 1 ib Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-25
Option hedging The outcome of option hedging is not known with certainty, since it depends on whether or not the option is exercised
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-26
Hedging with a call option
H edge D ecision N o-hedge
S V
K (S R ) 1 0 1 S
K ( S
R ) 1 0 0 S V
K S 1 0 1 S V
K S 1 0 1
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-27
Hedging with a put option
H edge D ecision N o-hedge
S V
K (S R ) 1 0 0 S
K ( S
R ) 1 0 1 S V
K S 1 0 1 S V
K S 1 0 1
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-28
Contingent exposure A contingent exposure arises only if a certain outcome materialises, such as winning a contract
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-29
Contract is won Firm receives KF0
Hedging a contingent long exposure
Forward
Contract is not won Firm loses K ( S1 F0 )
S1 S 0 Firm receives K ( S0 R )
Contract is won
S1 S 0 Firm loses KR Put Option S1 S 0 Firm receives K ( S 0 S1 R )
Contract is not won
S1 S 0 Firm loses KR
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-30
Managing long-term transaction exposure
Long-term forward contracts
Currency swaps Parallel loans Leading and lagging Cross hedging Currency diversification Exposure netting Price variation and currency of invoicing Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
(cont.) 13-31
Managing long-term transaction exposure
(cont.) Price variation and currency of invoicing Risk sharing arrangement Currency collars
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-32
Long-term forward contracts
Commercial banks do provide forward contracts in major currencies with long maturities (for example, five or ten years) Because of the risk involved, banks only offer these contracts to the most creditworthy customers
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-33
Currency swaps Two parties exchanging cash flows denominated in two different currencies
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-34
Parallel loans Parallel loans are the origin of currency swaps. They can be used to exchange cash flows
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-35
Leading and lagging
If the foreign currency is expected to appreciate, foreign currency dues are paid sooner rather than later: this is called leading If, on the other hand, the foreign currency is expected to depreciate, payables are met later rather than sooner: this is called lagging
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-36
Cross hedging Hedging a position on one currency with a position on another currency Correlation between the exchange rates against the base currency is important
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-37
Currency diversification Depending on correlation of the exchange rates against the base currency, currency diversification reduces risk
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-38
Exposure netting A natural hedge would arise when the firm has payables and receivables in the same currency, in which case only net exposure should be covered
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-39
Price variation and currency of invoicing
The foreign currency price of a product can be adjusted by varying its domestic currency price Exposure to FX risk can be eliminated completely by using the domestic currency as the currency of invoicing
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-40
Risk sharing and currency collars
Risk-sharing arrangements and currency collars involve the use of various values of the exchange rate to convert cash flows
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-41
AUD value of receivables with and without
risk-sharing arrangement 60000
50000
Hedge 40000
30000
20000 0.10
0.12
0.14
0.16
0.18
0.20
0.22
0.24
0.26
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
0.28
0.30
13-42
AUD value of receivables with and without
currency collar 60000
50000 Hedge 40000
30000
20000 0.10
0.12
0.14
0.16
0.18
0.20
0.22
0.24
0.26
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
0.28
0.30
13-43
Economic exposure Economic exposure arises because revenues and costs vary with changes in the real exchange rate
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-44
The effects of real appreciation
Assuming elastic demand, real appreciation of the foreign currency leads to: an increase in domestic sales revenue an increase in foreign sales revenue an increase in the costs of imported raw materials and foreign borrowing
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-45
The effects of real depreciation
Assuming elastic demand, real depreciation of the foreign currency leads to: a decrease in domestic sales revenue a decrease in foreign sales revenue a decrease in the costs of imported raw materials and foreign borrowing
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-46
Hedging economic exposure
Reducing economic exposure requires: changing sales in new or existing foreign markets changing dependence on foreign supply of raw materials establishing or eliminating production facilities abroad changing the level of foreign debt
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-47
Why worry about translation exposure?
Translation exposure does not affect the economic value of the firm Different translation methods affect reported earnings per share and other financial indicators
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-48
Hedging translation exposure
Fund adjustment Forward contracts Exposure netting and balance sheet hedging
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-49
Fund adjustment Fund adjustment involves altering the amounts and/or currencies of the planned cash flows of the firm or its subsidiaries to reduce exposure to the currency of the subsidiary (the local currency)
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-50
Forward contracts If the base currency of a foreign subsidiary is expected to depreciate against the parent firms base currency, then translation exposure exists
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
13-51
Exposure netting and balance sheet hedging
Exposure netting can be used by multinational firms with offsetting positions in more than one foreign currency A balance sheet hedge eliminates the mismatch between assets and liabilities in the same currency
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa
