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Foreign exchange risk management 2

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Background Growing world trade over the past 25 years Companies involved in transactions involving

foreign currencies about 22% of sales in FTSE 350 companies directly

exposed to the US further 11% in regions tied to the dollar Pike & Neale, chapter 21

Foreign exchange rate exposure of increasing importance

Companies need to insure against adverse movements in exchange rates

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Scenario A UK company expects to receive $300,000 in

3 months time. It is concerned that the pound will appreciate relative to the dollar and decides to hedge the transaction risk

Current exchange rate is $1.50

How much is $300,000 worth currently? How much would it be worth in three months

time if the exchange rate moved to $1.60?

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Scenario A UK company expects to receive $300,000 in

3 months time. Current exchange rate is $1.50

How much is $300,000 worth currently? $300,000/1.50 = £200,000

How much would it be worth in three months time if the exchange rate was $1.60? $300,000/1.60 = £187,500

Unhedged, this is a LOSS to the company

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Futures A financial futures contract is an agreement to buy or sell,

through an organised exchange

a standard amount of a financial instrument for delivery at a specified date in the future at a price which is agreed on the trade date

Only members of the exchange can trade Chicago Mercantile Exchange (CME); Euronext.liffe

Contracts are standardised in terms of contract amounts, dealing dates and size

Delivery in the future at a price agreed today

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Futures - background Commodity futures have been traded for more

than 100 years in the US Financial futures are similar to commodity

futures However, the underlying asset is a financial

instrument, not wheat, soya beans or another crop

Only a small percentage of futures reach final delivery

Speculators dominate the market

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Jargon Holding futures contract – long position Selling futures contract – short position Party and counterparty Clearing house

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Example using Futures(adapted from Watson and Head)

A UK company expects to receive $300,000 in 3 months time. It is concerned that the pound will appreciate relative to the dollar and decides to use futures to hedge its transaction risk

Delivery in the future at a price agreed today

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Using futures contracts Holding a futures contract means delivery at a

specified date in the future of a pre-agreed amount of foreign currency

The company will buy sterling futures

This means it will take delivery of sterling and pay with the dollars it expects to receive

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Example using Futures

CME rates at 1 Jan

Spot rate: $1.54 - $1.55£ futures price (Apr): $1.535Standard contract size: £62,500

CME : the Chicago Mercantile Exchange

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Futures contractSpot rate: $1.54 - $1.55£ futures price (Apr): $1.535Standard contract size: £62,500

The futures price quoted is the amount of dollars needed to buy one unit of foreign currency (one pound)

To work out the number of contracts needed, divide the sterling amount by the standard contract size

Each contract will cost £62,500 x $1.535 = $95,937.50i.e. to take delivery of £62,500 in three months time,

will cost $95,937.50

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Using futures contractsHow many contracts? divide amount in dollars by sterling futures price $300,000/1.535 = £195,440 now divide sterling amount by standard contract size

£195,440/£ 62,500 = 3.13, or 3

Three contracts will provide £187,500 in three months time

This will cost the company $287,813 = 187,500 x1.535

The difference (300,000 – 287,813) is unhedged(could be sold spot in 3 months or a forward contract

arranged)

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What has happened?The UK company expects dollars in the future and wants to fix

the exchange rate now buys 3 futures contracts now receives a known amount of sterling in the

future (from the contracts) settles in dollars from its dollar payment

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Differences between forwards and futures contracts

Forward Contracts Over-the-counter Each contract is tailor -

made The market is operated

by the banks and is self regulatory

90% contracts are carried out

Cost of the forward contract is based on the bid-ask spread

No margin is required High transaction costs

Futures Contracts Traded on an exchange Standardised contracts Formal margin

requirements The contract is marked-to-

market on a daily basis Requires a brokerage fee The exchange is the

counterparty Less than 1% of futures

contracts are carried out → liquid market

Speculation as well as hedging

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Less than 1% of contracts are carried out means…. Liquid market in contracts Euronext.liffe has an average daily volume of

around 3 million contracts worth hundreds of billions of pounds

Standardised legal agreements Wide market appeal It is the contracts that are bought and sold,

not the commodity Liquidity is good

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Options An option gives the owner the right but not

the obligation to take delivery of a physical asset at or before a pre-agreed date

Examples of options share options currency options

The physical asset is called the underlying asset

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Currency Options

The right to buy/sell currency at a given price at a given date

CALL option - the right to buy PUT option - the right to sell Types of options

American European

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What are you buying? Buying a currency option - a call - gives you

the right, but not the obligation, to buy currency at a pre-agreed exchange rate at or before a pre-agreed time

The pre-agreed exchange rate is called the strike

The pre-agreed date is called the exercise date or the expiry

The price you pay is called the premium

If you do not trade at or before the exercise date, then the option expires worthless

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Option terminology In-the-money - profitable at the current exchange

rate Out-of-the-money - not profitable at the current

exchange rate At-the-money - exercise price = spot rate

Intrinsic value – the value the holder of the option could realise if the option traded today positive if option in-the-money otherwise zero

For the buyer of options, loss is limited to premium, potential gain is unlimited

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Example using options(adapted from Watson and Head)

A UK company expects to receive $1m in 3 months and decides to hedge its transaction risk with currency options.

Currently $1.63/£.

£ is the foreign currency (on CME) and so company buys £ call options, strike price $1.65/£

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Using options The company will buy CME sterling currency

options The underlying is a futures contract Contract size is £62,500 Sterling is the foreign currency The company will buy call options This gives the company the right but not the

obligation to sell dollars and buy sterling at a pre-agreed exchange rate

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Example using options

CME contract

Strike $1.65Standard contract size: £62,500Premium 7cents

Each contract costs $4,375

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Using optionsHow many contracts? divide amount in dollars by strike $1,000,000/1.65 = £606,060 now divide sterling amount by standard contract

size£606,060/£ 62,500 = 9.7

Company can buy 9 contracts or 10 contracts

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Decision 10 contracts

cost: $43,750 amount hedged: $1,031,250

(=62,500x10x1.65)

9 contracts cost : $39,375 amount hedged: $928,125 (=62,500x9x1.65)

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MechanismIn 3 months time

if the spot rate is below $1.65 the company will allow the option to expire it will exchange its dollars in the spot market

if the spot rate is above $1.65 it will exercise the option

1,000,000/1.65 = £606,061 AT-THE-MONEY 1,000,000/1.75 = £571,428 IN-THE-MONEY 1,000,000/1.60 = £625,000 OUT-OF-THE-MONEY

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Buying a call option

Profit

Loss

0 Underlying PriceStrike

P P = premium

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Buying a put option

Profit

Loss

0 Underlying Price

P

Strike

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The difference between options and futures

An option confers the right not the obligation to trade

A premium is payable The seller (writer) of the option is obliged to

honour the contract Options: one party purchases all the rights;

the other has all the obligations Futures: commit both parties to obligations

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Risk ManagementPros Maintaining competitiveness Reduction of bankruptcy risk Reduction in volatility of cash flows

Cons Complexity of instruments Costs Complex fin reporting and tax

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Key Points: currency risk Considered use of futures and options to

hedge forex risk Differences between forward/futures plus

options/futures discussed Forex exposure management strategies

discussed

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Reading Watson, D. & Head, A. Corporate Finance

Principles and Practice, Chapter 12 Arnold, G. Corporate Financial Management,

Chapter 24 Pike, R. & Neale, B. Corporate Finance and

Investment, Chapter 21