foreign exchange hedging

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FOREIGN EXCHANGE HEDGING


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INTRODUCTION The price of one currency in terms of another

currency is called exchange rate.

To purchase goods and services produced by theresidents of another country generally requires

first purchasing the other country's currency. This is done by selling one's own currency for the

currency of the country with whose residents youdesire to transact. More formally, one's own

currency has been used to buy foreign exchange,and in doing so the buyer has converted hispurchasing power into the purchasing power ofthe seller's country.


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INTRODUCTION. Different countries issues different currencies and

the relative values of currencies may changequickly, substantially, and without warning.

This is to say that, exchange rate are highly

volatile. The exchange rate affects the economy of the

country, the companies and our daily lives,because when Tanzanian shilling becomes more

stronger relative to foreign currencies, foreigngoods become cheaper for the citizens ofTanzania and the Tanzanian firms enjoys lowcosts of spare parts and raw materials fromforeign countries, but Tanzanian goods become

more expensive for foreigners in foreign market.


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When Tanzanian shilling falls in value, foreigngoods become more expensive for the

Tanzanians and goods made in Tanzania will be

cheaper for foreigners.

Also when Tanzanian shilling falls in value the

higher prices of foreign products push up the

price level and inflation of the country e.g fuel

prices.

At the same time that fall in value of Tanzanian

shilling makes Tanzanian products cheaper for

foreigners, increasing the demand for Tanzanian

goods and therefore stimulate production and

output.


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TYPES OF RISK EXPOSURE Movements of exchange rate affects the firms doing

transactions with other firms outside borders andtherefore any firm that is engaged in foreign-currencydenominated transactions is exposed to exchangerate risk

There are three main types of exchange rate riskexposure.

1. Transaction risk

Which is basically cash flow risk and deals with

the effect of exchange rate movements ontransactions related to receivables (exportcontracts), payables (import contracts). Anexchange rate change in the currency ofdenomination of any such contract will result in a

direct transaction exchange rate risk to the firm


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2. Translation risko This is the risk that occurs when assets and

liabilities denominated in a foreign currency in asubsidiary company need to be translated to aparent companys domestic currency for

accounting purposes.o The conversion normally results in foreign

exchange gains or losses. This is of particularconcern to parents companies that have foreignsubsidiaries and want to consolidate a foreign

subsidiary to the parent companys balance sheet.So this is basically a balance sheet exchange raterisk.

o In consolidating financial statements, thetranslation could be done either at the end-of-the-

period exchange rate or at the average exchangerate of the period, depending on the accounting


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TYPES OF RISK EXPOSURE

3. Economic risk

o This is the risk that relates to the overall

impact that exchange rate fluctuations can

have on a companys value. Companies

that only sell domestically can also face

economic exposure when, for example, the

domestic currency strengthens and

improves the competitive position of

foreign producers.

o Economic risk therefore reflects the risk to

the firms present value of future operating

cash flows from exchange rate movements


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HEDGING It is important for the firms that are involved in

foreign currency transactions to protectthemselves against exchange rate exposure.

This can be done through the process known as

foreign exchange hedging. Foreign exchangehedging is the act of entering into a financialcontract in order to protect against unexpected,expected or anticipated changes in currencyexchange rates.

Foreign exchange hedging therefore is used byfinancial investors and businesses to eliminaterisks they encounter when conducting businessinternationally


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EXCHANGE RATE EXPOSURE

TECHNIQUES

The aim of Foreign exchange hedging is to stabilizethe cash flows and reduce the uncertainty fromfinancial forecasts.

Various techniques for managing the exposure are asfollows

Derivatives

o A derivatives transaction is a contract (orpayment exchange) agreement whose valuedepends on the value of an underlying

reference rate . Every derivatives transactionis constructed from two simple building blocksthat are fundamental to all derivativesforwards and options.

o They include forwards-based Derivativeswhich contains three divisions of forwards-


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TECHNIQUES.

The Forward Contract hedgeo Under this contract (obligation)the firm

may sell (buy) its foreign currencyreceivables (payables) forward by setting

the exchange rate today in order toeliminate its exchange risk exposure.

o In quoting the forward rate of currency, abank will use a rate at which it is willing to

buy the currency (bid) and a rate at whichit will sell a currency (offer) for delivery,typically one, two, three or six months afterthe transaction date. Setting up foreigncontract hedge involves no upfront costs


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TECHNIQUES.

Swaps

o This is an agreement to exchange one

currency for another at a predetermined

exchange rate known as the swap rate.

o This method suits the films which often

have to deal with sequences of accounts

payables or receivables in terms of a

foreign currency. Swaps are very flexible in

terms of amount and maturity; the maturity

can range from a few months to 20 years.


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TECHNIQUES.

Futures Contractso This is the contract that requires a firm to sell

or buy its foreign currency at standard contractsizes, time periods, settlement procedures andis traded on regulated exchanges.

o An agreement to make or take delivery of astandard quantity of a specific foreign currencyat a specified future date and at a price agreedon an Exchange.

o This method (just like Forward contract)completely eliminates exchange rate riskexposure but also( like forward contract) thefirm has to forgo the opportunity to benefitfrom favorable exchange rate changes


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TECHNIQUES.

B. Optionso A foreign currency option is a contract giving the

option purchaser (the buyer) the right but not theobligation, to buy or sell a fixed amount of foreignexchange at a fixed price per unit for a specifiedtime period.

o Currency options therefore provide such a flexibleoptional hedge against exchange exposure.

o The firm may buy a foreign currency call (put)

option to hedge its foreign currency payables(receivables) or choose not to exercise the optionand let it expire is the prevailing foreign currencyrate are favorable to them as compared to the ratecontained in option contract.


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TECHNIQUES.o Or is a contract which has one or other of the two key

attributeso An Option to buy (call option) - It is a contract that gives the

buyer the right, but not the obligation, to buy a specifiednumber of units of foreign currency from the seller of optionat a fixed price on or up to a specific date.

o Option to sell (put option )-It is a contract that gives the buyer the right, but not

the obligation, to sell a specified number of units ofcommodity or a foreign currency to a seller of optionat a fixed price on or up to a specific date.

o

Option can be classified as American Option or asEuropean option. The holder of an American optionhas the right to exercise the contract at any stageduring the period of the option, whereas the holder ofa European option can exercise his right only at theend of the period.


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OTHER TECHNIQUES Invoice currency exchange hedging

o This is the process whereby firm can shift,share or diversify exchange risk by appropriatelychoosing the currency of invoice

for example a Tanzania firm can invoice in

Tanzanian shillings rather than Rwandese francto a Rwandan firm for the sale of the products .

o Here Tanzanian firm does not face exchangeexposure anymore.

o But the exchange risk has been shifted to a

Rwandese importer and now a Rwandese firmhas account payable denominated in Tanzanianshillings. Also the two firms can agree to sharethe exchange rate exposure by the pre agreedmargins


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OTHER TECHNIQUES

As a practical matter, however the firm may notbe able to use risk shifting or sharing as much as

it wishes to for fear of losing sales to competitors.

Also if the currencies of both the exporter and the

importer are not suitable for settling internationaltrade, neither party can resort to risk shifting or

sharing to deal with exchange exposure.


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OTHER TECHNIQUES Leading and Lagging

o Another operational technique the firm canuse to reduce transaction exposure is leadingand lagging foreign currency receipts and

payments. To lead means to pay (orcollect) early, and to lag means to pay (orcollect) late.

o The firm would like to lead soft currency

receivables to avoid the loss fromdepreciation of the soft currency and lag hardcurrency receivables in order to benefit fromthe appreciation of the hard currency. For thesame reason, the firm will attempt to lead the

hard currency payables and lag soft currency


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OTHER TECHNIQUES Leading and Lagging

o If lead/lag strategy are effectivelyimplemented then firm can manage to reduce

transaction exposure. The lead/lag strategycan be employed more effectively to dealwith intra firm payables and receivables, suchas material costs, rents, royalties, interests,

and dividends, among subsidiaries of thesame multinational corporation. It is difficultto implement these techniques to firms withimport export relationship due to existence ofcompetitions in the market and the exporting

firm would fear losing the future market.


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OTHER TECHNIQUES Netting

o Netting means consolidation of all exposedinflows and outflows for a particular time andcurrency.

Matchingo A firm that has an ongoing inflow of foreign

currency as accounts receivable, can borrow thesame currency so as to have a matchingaccounts payable (interest and principal) as a

natural hedge.o Or a firm that has an ongoing outflow of foreign

currency as accounts payables cansimultaneously use its account receivable tomatch with that account payable when they due.

foreign exchange hedging

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