9.2Exchange rate risk management techniques

A variety of techniques have been developed to help rms counter foreign exchange

risk (to allow companies to cover themselves against risk, or to move from an open to

a closed position in the market). These may be divided into internal techniques, which

relate to the accounting systems and the payment and invoicing procedures used by

companies, and external techniques, which concern the development of new instru-

ments and markets. We are interested in the market techniques here. They include the

use of forward exchange markets, the use of derivatives markets such as those in n-

ancial futures and options, swap deals and short-term borrowing in a foreign currency.

Consider, rstly, the use of forward exchange markets. To deal with transactions

exposure, a British company selling goods in the US needs to estimate when it will

receive the dollars it is expecting in payment for its goods and to sell those dollars

forward at an exchange rate agreed now. Equally, an importing company, expecting

to have to pay a bill in US dollars at some known time in the future, needs to buy

dollars forward to the required amount. By acting in such ways, rms are said to lock

in to current exchange rates. They thus obtain a form of insurance against exchange

rate change. The cost of this insurance is the premium or discount on forward

exchange rates (explained in Chapter 8).

Forward foreign exchange transactions are over-the-counter (OTC) business – that

is, they are contracts between a bank and another market agent. The amount of the

contract and its terms are determined by the two parties involved. In practice, the

period for which insurance is required by rms against exchange rate changes may

be longer than the one month or three months most commonly available on the

forward market, and is unlikely to be for a precise period. Worse, the date on which

the payment might actually be made or required is probably uncertain and subject

to change. Because forward deals are individual contracts negotiated with a bank,

the amount of the contract is variable, and some exibility is possible in the time

period, although the costs of special arrangements might be quite high.

We have been discussing forward sales and purchases of currency. Another widely

used OTC forward instrument is the forward rate agreement (FRA). FRAs were not

specically designed to counter exchange rate risk but rather the risk of loss from

changes in interest rates. Thus, FRAs are alternatives to interest rate futures and

options and, particularly, to interest rate swaps.

Forward rate agreement (FRA):Interest rate forward contract in which the interest

rate to be paid or received on a specic obligation for a set period of time, beginning

at some time in the future, is determined when the contract is signed.

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		9.3 Derivatives markets
9.3	Derivatives markets

Perhaps the major development in nancial markets over the past thirty-ve years

has been the establishment and growth of nancial derivatives markets. Derivatives

contracts promise to deliver underlying products at some time in the future or give

the right to buy or sell them in the future. For example, a contract may promise

the delivery of a specied quantity of US dollars. The derivative contract can then

be traded in a different market from that in which the underlying product is itself

traded (in the case of a derivative contract in US dollars, this would be the foreign

exchange market). Markets in which underlying products are traded (such as the

forex market) are often referred to as cash marketsto distinguish them from derivatives

markets.

Although cash and derivatives markets are separate, the derivatives markets are

linked to cash markets through the possibility that a delivery of the underlying

product might be required. Consider the following example.

A has some form of derivative contract that requires him to take delivery of a

specied quantity of US dollars, say $18,000, in one month’s time at a xed rate of

exchange (say, £1 $1.80) – he is currently long in US dollars. A hopes that the value

of the dollar will rise so that as soon as he receives the dollars, he can sell them on

the spot market at a prot. With the spot exchange rate at £1 = $1.80, the contract

is worth £10,000. If the dollar does start rising in value, in line with A’s expectations,

clearly the value of A’s contract rises above £10,000 (it would now cost more than

£10,000 to buy $18,000 on the spot market). In fact, the pricing of derivatives con-

tracts is very complex and we shall have little to say about it here.* Nonetheless,

it is clear that there is a close relationship between the prices of derivatives con-

tracts and the prices of the underlying assets they represent, and that the value of

a derivative, and hence its price, varies as the price in the cash market uctuates.

We should also add that, in practice, derivatives seldom lead to the exchange of the

underlying product. Instead, contracts are closed out or allowed to lapse before the

delivery date arrives.

Derivatives, then, are instruments that allow market agents to gamble on move-

ments in the prices of other instruments without being required to trade in the

instruments themselves. There are three major types of nancial derivatives – futures,

options and swaps– and myriad variations upon them. Exchange-traded derivatives

(futures and options, which are traded through nancial futures exchanges) are dealt

with here. They are not OTC business. Contracts differ from those in forward foreign

exchange in the form of operation of the market, the terms of the contract, and the

likelihood of their leading to delivery of the underlying product. A crucial difference

is that a derivatives contract is a tradable instrument and can be sold on to a third

party. Swaps, which are quite different in nature and operation, are considered in

Chapter 10.

* But see section 9.3.2 on the pricing of options and, for more detail, see Howells and Bain,

2005.

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

Although derivatives trading based upon commodities (agricultural products or

minerals) has existed for well over a century, the need for nancial derivatives

markets was not recognised until the early 1970s. Their development resulted from

the globalisation of business, the increased volatility of foreign exchange rates, and

increasing and uctuating rates of ination.