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Financial Management | March 2012

Notes

Paper T4 (part b)

The seven deadly sins o a case study p45S t u d y

In association with

H

edging involves reducing or eliminat-ing nancial risk by passing that riskon to someone else. It can provide cer-tainty o cash ows, which helps withbudgeting, encourages managementto undertake investment, reduces the

possibility o nancial collapse and makes or amore attractive company to risk-averse staf.

Foreign currency hedging specically tries toreduce the risk that arises rom uture movementsin an exchange rate. This is a two-way risk sinceexchange rates can move adversely or avoura-bly. Management generally hedges or adversemovements only, or example higher costs andreduced income.

Foreign currency hedging is a topic that re-

quently worries CIMA P3 students. Many seemto understand the basic principles o the availa-ble hedging techniques. However, demonstratingthe calculations in an exam, under pressure, cancause problems. In this article, each oreign cur-rency hedging technique is demonstrated numeri-cally to give students urther practice. Then theconditions or the use o each technique are dis-cussed. Throughout this article the ollowing sce-nario will be used:

Paper P3

hedging

Foreign currency

By Christine Bligh,

content specialist, Kaplan

Many P3 students understand the principles behind

oreign currency hedging techniques but struggle to

demonstrate the calculations in an exam. Lets get

some practice on how to fgure out those numbers

Imagine USB Inc, an American sotware house,is due to pay a UK supplier 1m in three monthstime. It is now 1 May.

Relevant data rom the oreign currency andmoney market is given below.Exchange rates quoted today are:

$ / Spot rate 0.5120 0.5152

One-month orward rate 0.5141 0.5171

Three-month orward rate 0.5171 0.5202

Interest rates (p.a.) are: %

UK 5 5.5

US 2 2.4

Futures market (100,000 contracts, margins

are $1,000 per contract)1

June $1.9305

September $1.9170

December $1.9005

Note: The contract size o 100,000 has been chosen

to avoid under- or over-hedging. The usual contract

size is 62,500.

Options market (250,000 contracts, premi-

ums are quoted in cents per 1)

Let us calculate the dollar payment using eachtype o hedging technique suggested by the inor-mation above.

Hedging using a forward contractThe transaction is to pay 1m in three months time.USB is an American company that would usuallytrade in dollars. It will have to buy some pounds

Call option Put option

Exercise price June September June September

1.9000 2.88 3.55 0.15 0.28

1.9200 1.59 2.32 1.00 1.85

1.9400 0.96 1.15 2.05 2.95

Note: The contr act si ze o 250,000 has been chosen to avoid under- orover-hedging.

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41Study notes

sterling (by selling some dollars) so that it can makethis payment to its UK supplier.

The three-month orward rates are given: 0.5171 0.5202. But which one is it? And what do you dowith it?

To answer which one is it? you need to remem-ber that whenever you buy something you invari-ably pay more than you want to. (And when you sellsomething you will usually get less than you wanted.Believe me, I have just sold my old car and boughta new one it was painul.) Alternatively you canthink o yoursel as a loser. The bank will always winand you will always lose when exchanging money.

(I you are ever in doubt as to which rate to use, cal-culate both and choose the one where you lose.)

In this example we use the rate of 0.5171.To answer what do you do with it? you need to lookat the brackets at the top o the table $ / . Thismeans that the numbers in the table are the poundsyou would swap or $1. (The sign on the let-handside is the 1, in this case the $.) This means that wewill swap 0.5171 or $1.

So i we want to swap 1m or dollars we need todivide the 1m by 0.5171, giving $1,933,862. This isthe xed amount o dollars it will cost USB in threemonths time to pay its 1m supplier invoice.

Hedging using the money marketA money market hedge tries to eliminate oreigncurrency risk by trading the currency today on thespot market. To do this we must rely on interest ratesinstead, which might be more stable (although youshould realise that the Interest Rate Parity theorylinks these two variables exchange rates and inter-est rates which means that i exchange rates varythen interest rates may have also varied).

To perorm a money market hedge USB willundertake three steps:1 USB is going to make a payment o 1m in three

months time. It should put these pounds sterlingaside now (invest) in readiness or this payment.2 Since USB doesnt have any spare pounds sterling,it will need to buy some. To do this it sells some dol-lars and buys pounds sterling today (at spot).3To sell the dollars it will need to have some dollarsin the rst place. The usual way to get the dollars inan exam question is to borrow them. (We assume thisin order to make a valid comparison with the orwardcontract, where delivery is at a later date.)

Using our example:1Invest pounds sterling for three monthsTo calculate the amount to invest now you needto calculate the amount o interest that would beearned over the three months. To do this you shoulduse the ormula:Amount invested today x (1 + 3 months interest as a

decimal) = 1m

The interest is interest earned or depositingpounds sterling in a bank account or three monthsuntil USB needs to make the payment. Since it isa deposit it will earn the lower interest o ve percent. This interest is per annum, but USB will only

be depositing or three months, so you should dividethis by our to get 1.25 per cent.Amount invested today x (1 + 0.0125) = 1m

Amount invested today = 987,654

2Buy pounds sterling at spot987,654 / 0.5120 = $1,929,012

3USB will borrow the dollarsThe interest rate used will be the borrowing (higher)one or3 months (per annum / 4) = 2.4% / 4 = 0.6%.

$1,929,012 x (1 + 0.006) = $1,940,586

So, to summarise, we have borrowed dollars orthree months, swapped them today or pounds ster-ling, earned interest on the pounds sterling until it

reached 1m and then paid the supplier at a costo $1,940,586.

(This equates to an exchange rate o $1,940,586 /1,000,000 = $1.9406 or 0.5153 (1 / 1.9406), whichis close to the orward rate, as it should be.)

Hedging using the futures marketThe best way to tackle a utures question is to adopta step-by-step approach, such as the one outlinedbelow:

Paper P3Foreign currency hedging

Buy or sell Look at the utures contract currency type. It is in (100,000

utures? contracts). We need to sell $ and buy , so we need to buy utures.How many 1,000,000 / 100,000 = ten contracts

contracts?

Which Futures contracts have quarterly close-out dates that may not be the

expiry date? same date as the transaction. You should choose the irst quarterly

date that expires ater the transaction date, i.e. September.

(You could use a December contract but this leaves more basis risk,

which is why you should choose the irst quarterly date.)

Price? 1.9170 $/

Summary Buy ten September utures contracts at a price o 1.9170 $/.

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Study notesStudy notes42 43

(Note that closing out a September future on 31

July will leave some risk, since futures prices varywith time. However, we dont know from the ques-ion what this might be, so ignore it.)

The intention rom setting up the utures contracts that we have now xed the exchange rate at 1.9170,

which would give a cost o $1,917,000.(Dont orget the margin o $1,000 per contract.

USB needs to buy ten contracts leading to an uprontost o $10,000. This is reunded at close-out, but theime value o money will have cost USB a small sum,

which we will ignore. Alternatively, had the exam-le been based on a UK company, then the buying

nd selling o dollars or the margin payment andts reund would have given rise to a urther prot oross on exchange. Again this would tend to be smallnd oten ignored.)

Hedging using an optionAgain the best way to tackle an options question iso adopt a step-by-step approach such as the oneet out below:

Depending on what happens to the dollars/poundssterling exchange rate on 31 July, USB may or maynot exercise the option. Let us imagine it does. It willpay $1,900,000 in exchange or 1m (having alreadypaid the premium o $35,500 on 1 May).

The total cost o the option (ignoring the time valueo money) is $1,900,000 + $35,500 = $1,935,500.Summary of costs $

Forward contract 1,933,862

Money market hedge 1,940,586

Futures market 1,917,000

Option 1,935,500

In this example, the utures market was the cheap-est technique as at 1 May.

However, the option may actually have workedout to be the best choice i the uture exchange ratewas avourable and we chose not to exercise theoption. For example, i the uture spot on 31 Julywas, say, / $ 0.5320, then USB would only need topay $1,879,699 (1,000,000 / $0.5320), which whenadded to the $35,500 premium gives a total optioncost o $1,915,199.

(Whichever hedging technique you have used, youare efectively doing the same thing buying. You will

buy a forward contract, buy at spot using a moneymarket hedge, buy pounds sterling utures or buy (call

= buy pounds sterling) options.)

Currency swapA urther possible oreign currency hedging techniqueis a currency swap. I USB could nd an Americancompany it trusted, which was going to receive 1m,it could simply agree a rate o exchange and take the1m or the agreed number o dollars.

Currency swaps are usually a longer-term hedg-ing technique.

Narrative question

Having perormed the calculations there is, unor-tunately, also the (greater) possibility o a writtenquestion on oreign currency hedging. The exam-iner so ar has tended to concentrate on written ele-ments o the oreign currency syllabus rather thanthe numbers. In act, it is highly unlikely that youwould encounter a question testing all the hedgingtechniques numerically.

Choosing which, i any, o the hedging techniqueswould be appropriate or the transaction is a higher-

level skill. Key considerations are:lWhether to hedge at all USB may consider thecurrency markets to be relatively stable and, th ere-ore, doesnt expect the cost o the transaction tobe materially dierent in the uture. The use o ahedging technique would be considered a waste otime and money. Alternatively, USB may be a risktaker and predict that exchange rates will move inits avour. Again, it may do nothing, anticipatingthe making o a prot or USB.

It might also make many transactions in a widevariety o currencies and thereore argue that not allrates would go down. Losses on the transaction inone currency could be ofset by an equivalent gainrom another currency.lInternal hedging USB may be able to negoti-ate a price in dollars with its supplier, passing theexchange rate risk to the supplier. It might pay earlier(or later), taking advantage o a avourable exchangerate. It may already have some pounds sterling in a

bank account that could be used to make the pay-ment or it might have made a sale to a customer whois going to pay it in pounds sterling, which could beused. In rare circumstances USB may be abl e to oerits supplier some sotware or other services where nomoney actually changes hands. (The taxman doesntlike this, which is why it is quite rare.)

However, USB may choose, or need, to hedge.Which technique it chooses might depend on:lCurrency The transaction is exchanging

dollars or pounds sterling. The dollar and the poundare two o the most widely traded currencies in theworld. All the hedging techniques detailed above areavailable or exchanging dollars or pounds sterlingand vice versa. However, i the transaction includeda less commonly traded currency, say, the Angolan kwanza, then many o the hedging techniques,such as utures and options, would be much moredifcult or unavailable since there is no activelytraded market.lAmount The transaction is a payment o 1mAlthough this amount might be large to you or Iin big businesses it is a relatively small sum. Alsothe exposure will be on the ull 1m, but the actualcash-ow eect will be ar less. Some o the hedging techniques, particularly utures and options, areonly worthwhile when hedging very large amountso money (several million pounds). The premiumsinvolved will be costly or these hedging techniqueswhere the purchaser o the dollars rom USB wil

undertake a certain level o administration (accounting, monitoring and reporting) to set up and managethe contracts. These administrative xed costs arereected in the premiums, which will be relativelyhigh or smaller value transactions, putting buyersof using this orm o hedging.lExpertise Hedging using utures and options isrelatively complicated to administer and manageOnly larger companies, thereore, tend to use themwhere the company is large enough to warrant

Paper P3Foreign currency hedging

ut or call? A put option is to sell whereas a call option is to buy.

In order to know which one you need you frst need to

know the currency o the options. The question uses

250,000 contracts, the key part being the .

We are required to buy so we must buy a call .

How many 1,000,000 / 250,000 = our contracts

ontracts?

Which September, or the same reason as or utures the frst

xpiry quarter that expires ater the transaction date. (Remember

ate? that there are two types o options European (exercisable on

a particular date, or example 30 June, 30 September) and

American (exercisable any time up to and including expiry).

We will assume that these are American options and can be

exercised on our preerred date o, say, 31 July.)

Which We are using these options as a orm o insurance. We dont

xercise want to use them, but we will i we have to when the worst

price? happens. You should choose the cheapest one that includes

the exercise price and the premium. For example, i you are buying then you add the premium cost to the $ cost. (I you were selling

then you would deduct the premium rom the $ receipt.)

In the question this gives:

1.9000 + 0.0355 = 1.9355 (this is the cheapest)

1.9200 + 0.0232 = 1.9432

1.9400 + 0.0115 = 1.9515 (this is the most expensive)

ummary Buy our September call options at an exercise price o

1.9000 $/ at an upront premium cost o 0.0355, which

equates to $35,500 (0.0355 x 1m).

Some of thehedging

techniques,particularlyfutures and

options, onlybecomeworthwhile

when hedgingvery largeamounts of

money

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Further reading CIMA Ofcial Study Text, Perormance Strategy 2011-2012 edition.

the salary o employees who know how to use them.Because these are usually used by large companies,they are invariably or larger-value transactions.lCost Each o the hedging techniques has a cost some are visible, some are hidden. The option pre-mium, or example, can be clearly seen. However,you must realise that all techniques come with acost and the orward contract costs, or example, aresimply actored in to the spread on the rate quoted or instance it is worse than it could be due to thecost being included. (You didnt think that ThomasCook and the Post Ofce really oered ree commis-sion on your holiday currency, did you?) However,

some techniques are cheaper than others. Generallyutures or orward rates will be one o the cheapertechniques while options are oten the most expen-sive. (Because rather than xing the rate you arereceiving a minimum, which could get better...)Futures can be cheaper than a orward contract dueto its standardisation.

lThe money market hedge should be relatively

cheap Exchanging currency at spot should becheaper than at a orward rate, but there will beadministration costs to consider: taking out a loan indollars and opening a pounds sterling bank account.Depending on the size o the company, opening aoreign currency bank account, particularly or aloan, can be problematic.

Options are usually the most expensive hedgingtechnique or two reasons the prices charged by thecounterparty and the management time involved indealing with the more complex technique.

ConclusionsIn our example, USB appears to be a relatively largecompany, being incorporated (like a UK plc). Forthis reason it may be happy to use any o the tech-niques. However, i it is actually quite small, andlacks experience in hedging, it may preer to avoidthe uture and option techniques.

Paper T4 (part b)

Sins of a Case StudyThe Seven Deadly

By David Harris

Chartered management accountant, reelance

lecturer and management consultant

Dont miss the killer issue. Dont ignore the numbers.

Dont yield to indecision. Take heed o these pitalls

and youll be ready to crack the T4B Case Study

Most o the articles that have been writ-ten about the T4B Case Study tell you,sometimes at great length, what youshould do. This one is diferent itsa summary o the main things youshouldnt do. I call these the seven

deadly sins seven ways to show your marker thatyou arent to be trusted as a qualiied manage-ment accountant. These are the things that make

markers nervous, and nervous markers dont likegiving marks.

1 Not recommending anythingThe main cause o this is just poor time manage-ment. The problem with recommendations is thatthey come at the end o the report. So i you run outo time (and dont have an exit strategy) you maynever get round to recommending anything. Thisis a shame, because a report with no recommenda-tions has no value. The whole reason or asking youto produce a report is to get your advice.

Your exit strategy should be to stop writing onehour rom the end o the exam, leave a ew blankpages, and then write your recommendations(adding clear and detailed explanations and justi-

cations see below). Once youve done that, spendthe remaining time lling in the gaps, includingpart (b). You should adjust your style, writing moreor less detail or each point you cover, dependingon how large the gaps are and how little time youhave let.

A report with clear recommendations, but whichis a little light on content in the middle, has a loto value. A report with no recommendations hasno value at all.

You must

realise that all

techniques comewith a cost.

Generally,

futures or

forward rateswill be one of the

cheaper

techniques

while optionsare often the

most expensive

Study notes44