Hedging treasury risk with forward foreign exchange contracts
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Transcript of Hedging treasury risk with forward foreign exchange contracts
Hedging Hedging Treasury Risk Treasury Risk with with
Forward Foreign Forward Foreign Exchange ContractsExchange Contracts
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Overview
FX forwards: definition, characteristics and features
Uses of FX forwards– Example 1: Hedging with forwards– Example 2: Deriving the forward rate
Problems and risks Accounting for forwards
– Example 3: Marking to market Risk management
FX Forwards: FX Forwards: Definition, Definition,
Characteristics and Characteristics and FeaturesFeatures
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Forward Foreign Exchange Contract
Definition:
An agreement to exchange one currency for
another, where The exchange rate is fixed on the day of the
contract, but
The actual exchange takes place on a pre-
determined date in the future
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Characteristics and Features of FX Forwards
Available daily in major currencies in 30-, 90-, and 180-
day maturities
Forwards are entered into “over the counter”
Deliverable forwards: face amount of currency is
exchanged on settlement date
Non-deliverable forwards: only the gain or loss is
exchanged
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Characteristics and Features of FX Forwards
Contract terms specify: – forward exchange rate
– term
– amount
– ‘‘value date’’ (the day the forward contract expires)
– locations for payment and delivery.
The date on which the currency is actually exchanged, the
‘‘settlement date,’’ is generally two days after the value date of the
contract.
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Characteristics and Features of FX Forwards
Forward Exchange Rates: “The Iron-Clad Law” Forward exchange rates are different from spot rates, but they are
not a prediction of what the spot rate will be when the deal settles!
The difference between the
forward exchange rate and the spot exchange rate
is the interest differential
between the two currencies
FX Forwards: FX Forwards: UsesUses
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Uses of FX Forwards
(1) Hedge foreign currency risk (2) Arbitrage FX rate discrepancies within and
between markets(3) Speculate on future market movements(4) Profit by acting as market maker
Financial institutions, money managers, corporations, and traders use these instruments for managing currency risk
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Two Types of Hedging
Corporations engaged in international trade
Hedge payments and receipts denominated in foreign currencies. – For example, a Croatian corporation that exports to Germany and
expects payment in Euro (EUR) could sell EUR forward to eliminate the risk of a depreciation of the EUR at the time that the payment arrives.
Hedge the translation of foreign earnings for presentation in financial statements.
Example 1: Hedging With an FX Forward
Hedged Item Company must pay EUR 1,000,000
to a eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK will
depreciate during next 3 months
– Exposure to FX risk: What will be exchange rate
HRK/EUR in three months??
Hedging Instrument Bank buys 1,000,000 EUR
forward at forward rate of 7.3750
– FX risk: Company is protected against large adverse FX rate movements
If FX rate is unfavorable in 3 months (ie, > 7.3750), Company pays just 7.3750
Example 1: Hedging With an FX Forward
Hedged Item Company must pay EUR 1,000,000 to
a eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK will
depreciate during next 3 months
Advantages of Hedge: Company knows its costs and can
plan its finances accordinglyCost of the hedge is zero -- No money is exchanged at
inception of the forward FX agreement
Hedging Instrument Bank buys 1,000,000 EUR forward at
forward rate of 7.3750
Disadvantage of Hedge: Company is still exposed to FX risk
if the HRK/EUR spot rate is less than 7.3750 in 3 months
Effect of hedge is same as buying EUR today and
holding in an interest-bearing account
(Forward FX agreement is NOT a simple speculation)
Example 1: Hedging With an FX Forward
Unhedged Company If in 3 months, spot rate
is 7.4500…
– Unhedged Company must pay:
7.45 x 1,000,000 =
HRK 7,450,000
Effect of Hedging Hedged Company has
already bought EUR forward
– Hedged Company will pay:
7.375 x 1,000,000 = HRK 7,375,000
Money saved by hedging: 7,450,000 –
7,375,000 = HRK 75,000
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Example 2: Deriving the Forward Exchange Rate
The spot rate HRK/EUR is 7.3000
A bank today sells a 3-month HRK/EUR forward to a company for a forward exchange rate of 7.3371
How did the bank compute the forward rate?
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Example 2: Deriving the Forward Exchange Rate
Three month interest rates are:
– 1% on the euro
– 3% on the kuna
A company with EUR 1 million and a need for HRK in three months should be indifferent, financially speaking, as to whether it:
– Invests the EUR 1 million for 3 months at 1% and converts the euros (plus interest) into HRK at the end of this time, or
– Sells the EUR 1 million spot for HRK, and invests the HRK at 3% for 3 months
Example 2: Deriving the Forward Exchange Rate
Invest EUR 1 million at 1%for 3 months (91 days)
Interest earned EUR2,493.15
Value after 3 monthsEUR 1,002,493
Sell EUR 1 million spot at 7.30Buy HRK 7.3 million
Invest HRK for 3 months at 3%
Interest earned HRK55,358.33
(7.3 million x 3% x 91/360)
Value after 6 monthsHRK 7,355,358
OPTION 1 OPTION 2
Forward Exchange Rate: 7.3371
FX Forwards: FX Forwards: Problems and RisksProblems and Risks
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Problems with FX Forwards
Finding counterparties who want to take exactly the opposite position:– Most companies (potential counterparties) are
“in the same boat” (i.e., importers from the eurozone)
– One of the parties to the transaction might want to trade a different amount, or have a different settlement date
– Transaction costs can be large (bank’s spread)
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Problems with FX Forwards Liquidity risk: A party in a forward
contract may find it difficult to exit the position. Alternatives:– If counterparty agrees, cancel the forward for
a fee – Assign the contract to another party. This
requires some compensation– If an exact opposite position can be taken,
offset the obligation and suffer only the price differential
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Problems with FX Forwards
Default risk: There is an incentive for the counterparty who lost on the forward contract to default on the agreement– Forwards are a zero sum game. Each
counterparty that gains is balanced by a counterparty who loses the same amount.
FX Forwards: FX Forwards: AccountingAccounting
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Accounting for FX Forwards
IAS 39 applies (Accounting for
Financial Instruments – derivatives
accounting)
– The deal has no immediate value
– Off-balance sheet accounts are used
initially to record the deal on the books
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Accounting for Forwards
Fair value of the forward changes over time with movements in the foreign exchange rate
Unrealized gain (loss) is measured by applying today’s market rates at the forward date
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Example 3: Marking to Market
After one month’s time, the company has to mark-to-market a 3-month forward which is carried in the off-balance sheet accounts
– On the date of the deal, the spot rate was 7.3000– The forward rate for the deal is 7.3371– The spot rate HRK/EUR is now 7.4150
What is the market value of the forward today?
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Example 3: Marking to Market
The company bought EUR against HRK in 90 days. Today, the company could buy EUR 1,000,000 at the
spot rate of 7.4150 and pay HRK 7,415,000. The company is committed to buy EUR 1,000,000 when
the forward matures at 7.3371 and pay only HRK 7,337,100.
Thus, the deal now has value.
Company records an unrealized GAIN of:HRK 7,415,000 – HRK 7,337,100 = HRK 77,900
FX Forwards: FX Forwards: Risk ManagementRisk Management
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Risk Management
Before using any type of derivatives, companies should:
Discuss the potential risks and benefits of derivatives with Management Board and Supervisory Board
Develop appropriate internal controls and limits Prepare derivatives policy and procedures manual; tax
and accounting manuals Host training seminars for management and
employees
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Successful Risk Management
DON’T WORRY, IT MAY MELT BEFORE WE GET THERE!
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Successful Risk Management
WE CAN DECIDE WHAT TO DO, IF AND WHEN WE HIT IT!
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Successful Risk Management
WE NEVER NEEDED TO USE LIFE BOATS BEFORE!!
Thank You.