Fin management materials / 11 P4AFM-Session13_j08

SESSION 13 – FOREIGN EXCHANGE RISK MANAGEMENT

OVERVIEW

Objective

¾To forecast future exchange rates.

¾To discuss the various types of currency risk that a company may face and recommend internal methods of currency risk management.

¾To use and evaluate external hedging strategies.

FOREIGN EXCHANGE

RISK MANAGEMENT

INTERNAL EXTERNAL

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1FORECASTING EXCHANGE RATES

1.1Four-way equivalence model

¾The key models for forecasting future exchange rates focus either on inflation rate differences, or interest rate differences.

¾The relationships between these macro-economic variables can be summarised in the “four-way equivalence model” shown below

¾Spot exchange rate - the market exchange rate for buying/selling currency for immediate delivery.

¾Forward exchange rate – the exchange rate for buying or selling currency at a specific date in the future.

1.2Purchasing Power Parity (PPP)

¾Absolute PPP states that the exchange rate simply reflects the different cost of living in two countries. For example if a representative basket of goods and services costs $1, 700 in the US and £1,000 in the UK, the exchange rate should be $1.70 to £1.

¾While absolute PPP exchange rates may represent the long-run equilibrium rate between two currencies, they are of limited practical use in financial management.

¾Financial managers are more interested in market exchange rates than theoretical rates. This is where relative PPP is useful.

¾Relative PPP claims that changes in market exchange rates are caused by the rate of inflation in different countries.

¾For example if the rate of inflation is higher in the US than in the UK, relative PPP predicts that the value of the dollar will fall.

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¾The formula for relative PPP is as follows:

where:

S1 = expected spot exchange rate after one year

S0 = today’s spot exchange rate

hc = foreign inflation rate (as a decimal) hb = domestic inflation rate

¾Spot rates should be put into the formula as indirect rates i.e. Units of foreign currency per one unit of domestic currency

Example 1

Required:

What is the predicted exchange rate for 31 December 19X6?

Solution

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1.3Interest Rate Parity (IRP)

¾IRP states that the forward exchange rate is based upon the spot rate and the interest rate differential between the two currencies:

Forward rate = spot rate × (1+overseas interest rate/1+ domestic interest rate)

¾ F0 = S0 x ((1 + ic )) 1 + ib

where:

F0 = forward exchange rate

S0 = spot exchange rate

ic = overseas interest rate

ib = domestic interest rate

Example 2

If spot is $1.78 to £1 and the dollar and sterling interest rates are 3.25% and 4.5% respectively, what is the one year forward exchange rate?

Solution

¾If this theory did not hold it would be possible for investors to make a risk-free profit using covered interest rate arbitrage as follows:

borrow domestic currency

convert it into foreign currency at the spot exchange rate

deposit the foreign currency

sign a forward exchange contract to repatriate the foreign currency into domestic currency.

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1.4Fisher effect

¾Countries with a higher rate of inflation have higher nominal interest rates in order to offer the same real return as countries with low inflation:

(1+i) = (1+r) (1+h)

¾ States that the spot exchange rate will change to offset interest rate differences between countries.

¾ The calculations are basically as per Interest Rate Parity theory.

1.6 Expectations theory

¾ Differences between forward and spot rates reflect the expected change in spot rates.

1.7 Other factors influencing exchange rates

¾Current and prospective government policies.

¾Balance of payments surpluses/deficits.

¾Actions of speculators.

¾Financial contagion - the extent to which a currency is dependant on another currency,

2TYPES OF EXCHANGE RATE RISK

There are three types of exchange rate risk to consider – translation risk, economic risk and transaction risk:

2.1Translation risk

¾This occurs where a parent company holds an overseas subsidiary.

¾In order to consolidate the subsidiary’s financial statements into the group accounts, they must first be translated into the reporting currency of the parent company. The exact method for doing this depends on the relevant financial reporting standards.

¾Translating the statement of financial position/balance sheet of an overseas subsidiary can lead to significant translation gains/losses.

¾If the home currency has appreciated against the foreign currency, it is likely to produce a translation loss when converting the value of overseas net assets.

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¾If the home currency has depreciated against the foreign currency, it is likely to produce a translation gain when converting the value of overseas net assets.

¾Although such gains/losses can be significant in size, they do not represent actual cash gains/losses for the group – they are simply caused by financial accounting methods for consolidating overseas subsidiaries.

¾As long as users of financial statements understand that translation differences do not represent cash flows, they should not affect the value of the group.

¾Therefore the financial manager should ensure that the nature of translation gains/losses is clearly explained e.g. in the annual report and at shareholder meetings.

¾However the financial manager does not need to hedge translation risk, because it is not a cash flow risk.

2.2Economic risk

¾Economic risk is the risk that cash flows will be affected by long-term exchange rate movements.

¾As the value of a firm is the present value of its future cash flows, economic risk is a significant issue for the financial manager. Unfortunately it is difficult to hedge against.

¾For example, take a UK company which exports to the US and therefore has dollar export earnings. Suppose that, over time, sterling becomes stronger against the dollar. The sterling value of export earnings will fall, damaging the cash flow and the value of the company. What can the company do to reduce this risk?

Increase the dollar price of the exports – however this may not be practical, particularly when exporting to a competitive market.

Diversify exports into other markets – in the hope that sterling will fall against some currencies while rising against the dollar. Again this may not be practical.

Use hedging techniques such as forward contracts – however, in the long run this will not give effective protection. As sterling rises over time in the spot markets it also rises in the forward markets – and the value of exports still falls.

“Matching” costs against revenues i.e. attempt to convert the cost base into dollars - for example by importing materials from the US or setting up operations in the US. However these may not be practical options for many companies.

¾Note that economic risk can affect a company even if it does not export or import. Domestic producers may face tougher competition from overseas firms if the home currency appreciates. Again there is no easy method of protecting against this.

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2.3Transaction Risk

¾Transaction risk is the short-term version of economic risk.

¾It is the risk that the exchange rate changes between the date of a specific export/import and the related receipt/payment of foreign currency.

¾Like economic risk this affects cash flows and hence affects the value of the firm. It is therefore a significant issue for financial management.

¾Transaction risk can be effectively managed using both internal and external techniques.

2.4Internal management of exchange rate risk

¾Invoicing in the domestic currency – an exporter could denominate sales invoices in its domestic currency, effectively transferring the transaction risk to the customer. However this may lead to lost sales.

¾“Leading and lagging” - paying overseas suppliers earlier (“leading”) if the home currency is expected to fall, or later (“lagging”) if the home currency is expected to rise.

¾Netting - where there are both sales and purchases in a foreign currency offset the receivables and payables and only consider an external hedge on the net difference.

¾Matching - consider using foreign currency loans to finance overseas subsidiaries. Overseas earnings can be used to pay the loan interest and repay principal, reducing the net foreign currency cash flow exposed to risk upon repatriation to the parent company. This may be effective as a longer-term hedge against economic risk.

¾Asset and Liability Management – if overseas subsidiaries borrow locally rather than receiving finance from the parent company this reduces the net assets of the subsidiary. This “balance sheet hedge” reduces exposure to translation risk upon consolidation of the subsidiaries’ net assets into the group accounts (although, as mentioned above, translation risk should not affect the value of the group).

2.5External hedging techniques

Transaction risk can be managed using a variety of external hedges. The syllabus mentions the following:

¾Forward exchange contracts

¾Money market hedges

¾Currency options

¾Currency futures contracts

¾Currency swaps

Each of these will now be considered in detail.

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3FORWARD EXCHANGE CONTRACTS

3.1With physical delivery

¾Forward contract – a legally binding agreement to buy or sell:

a specified quantity

of a specified currency

on an agreed future date (“delivery date”)

at an exchange rate agreed today

¾Forward contracts are not traded but agreed between a company and a bank. This means they are customised agreements which can match the exact requirements of the company regarding quantity and delivery date.

¾Forward contracts are not bought, they are entered into. Therefore no premium needs to be paid to set up a forward hedge (unlike options).

¾Forward contracts do not require any margin to be posted i.e. no deposit of cash is required when setting up a forward hedge (unlike futures contracts). However there will usually be a small arrangement fee to set up a forward contract.

¾The major disadvantage is that physical delivery must occur i.e. if a company signs a forward contract to buy/sell foreign currency then it must physically exchange currency on the agreed date at the agreed rate, even if that rate has become unattractive compared to the spot rate.

¾Therefore forward contracts are not a flexible method of hedging.

Example 3

Today is 1 January 19X1. A UK-based company is expecting dividend income of $200,000 to be received from its US subsidiary on 31 March 19X1.

Required:

(a)How much sterling will be received if forward cover is taken out?

(b)How much sterling would be received if no forward cover is taken out and the actual spot rate on 31 March 19X1 = 1.5247–1.5361?

Solution

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3.2Non-Deliverable Forwards (NDF’s)

Definition

An NDF is a short-term, cash-settled currency forward contract between two counterparties.

¾On the settlement date, the gain/loss is transferred between the two counterparties based on the difference between the contracted forward rate and the prevailing spot rate, multiplied by an agreed notional amount.

¾The notional amount is the "face value" of the NDF. There is no exchange of the notional amount; the only exchange of cash flows is the difference between the forward rate and the prevailing spot market rate on the settlement date – multiplied by the notional amount. Such contracts are therefore cash settled rather than requiring physical delivery of the underlying currency.

¾Both the counter-parties are obliged to honour the deal and hence like all forward contracts there is little flexibility. However counterparty risk in cash settled forwards is lower than in physically delivered contracts as the cash flows at settlement are smaller.

¾Banks quote NDFs from between one month to one year, although some quote up to two years upon request.

¾They can also be referred to as Synthetic Agreements for Foreign Exchange (SAFE’s).

4MONEY MARKET HEDGES

¾Money market hedges involve either borrowing or investing foreign currency in order to protect against transaction risk. Whether to borrow or invest depends on whether the company is exporting or importing.

¾Suppose a UK company has dollar export earnings. A money market hedge could be set up as follows:

1.Today borrow dollars.

2.Exchange these dollars into sterling, which can then be invested.

3.Use the dollar export earnings to repay the dollar loan.

¾A money market hedge effectively produces a “home-made” forward exchange rate. The resulting exchange rate depends on the interest rate differential between the two currencies i.e. Interest Rate Parity theory holds.

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Example 4

A UK-based company expects to receive $300,000 in 3 months.

£/$ spot rate (indirect) : 1.7820 ± 0.0002

One year sterling interest rates: 4.9%(borrowing) 4.6% (investing)

One year dollar interest rate: 5.4% (borrowing) 5.1% (investing)

Required:

Set up a money market hedge.

Solution

5CURRENCY OPTIONS

5.1Terminology

¾If a company wants a more flexible hedge it may consider buying a currency option.

¾Options are an example of derivatives – a financial instrument based upon an underlying asset. In the case of currency options the underlying asset is a currency.

¾The purchaser of a currency option has the right, but not the obligation, to buy (if calls) or sell (if puts):

a specified quantity

of a specified currency

on or before a specified date (expiry date)

at an exchange rate agreed today (exercise price/strike price)

¾The owner of the option can either:

exercise their right or

allow it to lapse i.e. not exercise it.

¾However the owner of an option must pay for this flexibility. The cost of an option is known as its premium.

¾Premiums are paid at the date the option is bought and are non-refundable.

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