by Ian H. Giddy

TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE RISK

In this article we consider the relative merits of several different tools for hedging exchange risk, including forwards. futures. debt. swaps and options. We will use the following criteria for contrasting the tools.

First, there are different tools that serve effectively the same purpose. Most currency management instruments enable the firm to take a long or a short position to hedge an opposite short or long position. Thus one can hedge a Euro payment using a forward exchange contract, or debt in Euro, or futures or perhaps a currency swap. In equilibrium the cost of all will be the same, according to the fundamental relationships of the international money market. They differ in details like default risk or transactions costs, or if there is some fundamental market imperfection. indeed in an efficient market one would expect the anticipated cost of hedging to be zero. This follows from the unbiased forward rate theory.

Second, tools differ in that they hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge contingent cash flows: options may be better suited to the latter.

Tools and techniques: foreign exchange forwards

Foreign exchange is, of course, the exchange of one currency for another. Trading or dealing in each pair of currencies consists of two parts, the spot market. where payment (delivery) is made right away (in practice this means usually the second business day), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract.

Forward contracts are the most common means of hedging transactions in foreign currencies. The trouble with forward contracts, however, is that they require future performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, sometimes at great cost to the hedger. This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure. For such situations, futures may be more suitable.

Currency futures

Outside of the interbank forward market, the best-developed market for hedging exchange rate risk is the currency futures market. In principle, currency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price. In practice, they differ from forward contracts in important ways.

One difference between forwards and futures is standardization. Forwards are for any amount, as long as it’s big enough to be worth the dealer’s time, while futures are for standard amounts, each contract being far smaller that the average forward transaction. Futures are also standardized in terms of delivery date. The normal currency futures delivery dates are March, June, September and December, while forwards are private agreements that can specify any delivery date that the parties choose. Both of these features allow the futures contract to be tradable.

Another difference is that forwards are traded by phone and telex and are completely independent of location or time. Futures, on the other hand, are traded in organized exchanges such the LIFFE in London, SIMEX in Singapore and the IMM in Chicago.

But the most important feature of the futures contract is not its standardization or trading organization but in the time pattern of the cash flows between parties to the transaction. In a forward contract, whether it involves full delivery of the two currencies or just compensation of the net value, the transfer of funds takes place once: at maturity. With futures, cash changes hands every day during the life of the contract, or at least every day that has seen a change in the price of the contract. This daily cash compensation feature largely eliminates default risk.

Thus forwards and futures serve similar purposes, and tend to have identical rates, but differ in their applicability. Most big companies use forwards; futures tend to be used whenever credit risk may be a problem.

Debt instead of forwards or futures

Debt — borrowing in the currency to which the firm is exposed or investing in interest-bearing assets to offset a foreign currency payment — is a widely used hedging tool that serves much the same purpose as forward contracts. Consider an example.

A German company has shipped equipment to a company in Calgary, Canada. The exporter’s treasurer has sold Canadian dollars forward to protect against a fall in the Canadian currency. Alternatively she could have used the borrowing market to achieve the same objective. She would borrow Canadian dollars, which she would then change into Euros in the spot market, and hold them in a Euro deposit for two months. When payment in Canadian dollars was received from the customer, she would use the proceeds to pay down the Canadian dollar debt. Such a transaction is termed a money market hedge.

The cost of this money market hedge is the difference between the Canadian dollar interest rate paid and the Euro interest rate earned. According to the interest rate parity theorem. the interest differential equals the forward exchange premium, the percentage by which the forward rate differs from the spot exchange rate. So the cost of the money market hedge should be the same as the forward or futures market hedge, unless the firm has some advantage in one market or the other.

The money market hedge suits many companies because they have to borrow anyway, so it simply is a matter of denominating the company’s debt in the currency to which it is exposed. that is logical. but if a money market hedge is to be done for its own sake, as in the example just given, the firm ends up borrowing from one bank and lending to another, thus losing on the spread. This is costly, so the forward hedge would probably be more advantageous except where the firm had to borrow for ongoing purposes anyway.

Currency options

Many companies, banks and governments have extensive experience in the use of forward exchange contracts. With a forward contract one can lock in an exchange rate for the future. There are a number of circumstances, however, where it may be desirable to have more flexibility than a forward provides. For example a computer manufacturer in California may have sales priced in U.S. dollars as well as in Euros in Europe. Depending on the relative strength of the two currencies, revenues may be realized in either Euros or dollars. In such a situation the use of forward or futures would be inappropriate: there’s no point in hedging something you might not have. What is called for is a foreign exchange option: the right, but not the obligation, to exchange currency at a predetermined rate.

A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, the strike or exercise price, but is not required to do so. The right to buy is a call ; the right to sell, a put. For such a right he pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his option. In some options, the instrument being delivered is the currency itself; in others, a futures contract on the currency. American options permit the holder to exercise at any time before the expiration date; European options, only on the expiration date.

Example

Shinji Yamamoto of Nippon Foods had just agreed to purchase AUD 5 million worth of potatoes from his supplier in Australia. Payment of the five million Australian dollars was to be made in 245 days’ time. The Japanese yen had recently fallen against foreign currencies and Yamamoto wanted to avoid any further rise in the cost of imports. He viewed the Australian dollar as being extremely instable in the current environment of economic tensions. Having decided to hedge the payment, he had obtained AUD/JPY quotes of AUD0.050 spot, AUD0.045 for 245 days forward delivery. His view, however, was that the yen was bound to rise in the next few months, so he was strongly considering purchasing a call option instead of buying the Australian currency forward. At a strike price of $0.045, the best quote he had been able to obtain was from the Bank of Melbourne, who would charge a premium of 0.85% of the principal.

Yamamoto decided to buy the call option. In effect, he reasoned, I’m paying for downside protection while not limiting the possible savings I could reap if the yen does recover to a more realistic level. In a highly volatile market where crazy currency values can be reached, options make more sense than taking your chances in the market, and you’re not locked into a rock-bottom forward rate.

This simple example illustrates the lopsided character of options. Futures and forwards are contracts in which two parties oblige themselves to exchange something in the future. They are thus useful to hedge or convert known currency or interest rate exposures. An option, in contrast, gives one party the right but not the obligation to buy or sell an asset under specified conditions while the other party assumes an obligation to sell or buy that asset if that option is exercised.

When should a company like Frito-Lay use options in preference to forwards or futures? In the example, Yamamoto had a view on the currency’s direction that differed from the forward rate. Taken alone, this would suggest taking a position. But he also had a view on the yen’s volatility. Options provide the only convenient means of hedging or positioning volatility risk. Indeed the price of an option is directly influenced by the outlook for a currency’s volatility: the more volatile, the higher the price. To Yamamoto, the price is worth paying. In other words he thinks the true volatility is greater than that reflected in the option’s price.

This example highlights one set of circumstances under which a company should consider the use of options. A currency call or put option’s value is affected by both direction and volatility changes, and the price of such an option will be higher, the more the market’s expectations (as reflected in the forward rate) favor exercise and the greater the anticipated volatility. For example, during the recent crisis in some European countries put options on the Icelandic Krone became very expensive for two reasons. First, high Icelandic interest rates designed to support the Krone drove the forward rate to a discount against the Euro. Second, anticipated volatility of the Euro/ISK exchange rate jumped as dealers speculated on a possible depreciation of the currency. With movements much greater than in the past, the expected gain from exercising puts became much greater. It was an appropriate time for companies with Icelandic exposure to buy puts, but the cost would exceed the expected gain unless the corporate treasurer anticipated a greater change, or an even higher volatility, than those reflected in the market price of options.

Finally, one can justify the limited use of options by reference to the deleterious effect of financial distress. Unmanaged exchange rate risk can cause significant fluctuations in the earnings and the market value of an international firm. A very large exchange rate movement may cause special problems for a particular company, perhaps because it brings a competitive threat from a different country. At some level, the currency change may threaten the firm’s viability, bringing the costs of bankruptcy to bear. To avert this, it may be worth buying some low-cost options that would pay off only under unusual circumstances, ones that would particularly hurt the firm. Out-of-the-money options may be a useful and cost-effective way to hedge against currency risks that have very low probabilities but which, if they occur, have disproportionately high costs to the company.

Conclusion

Many corporate risk managers attempt to construct hedges on the basis of their outlook for interest rates, exchange rates or some other market factor. However, the best hedging decisions are made when risk managers acknowledge that market movements are unpredictable. A hedge should always seek to minimize risk. It should not represent a gamble on the direction of market prices. A well-designed hedging program reduces both risks and costs. Hedging frees up resources and allows management to focus on the aspects of the business in which it has a competitive advantage by minimizing the risks that are not central to the basic business. Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilizing earnings.