Fin management materials / 11 P4AFM-Session13_j08

SESSION 13 – FOREIGN EXCHANGE RISK MANAGEMENT

6.4Comparison of futures with forward contracts

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7CURRENCY SWAPS

Definition

A currency swap is a formal agreement between two parties to exchange principal and interest payments in different currencies over a stated time period.

¾Currency swaps can be used:

to obtain foreign currency loans at lower interest rates than via direct borrowing in overseas markets.

to eliminate transaction risk on existing foreign currency loans e.g. on Eurobonds.

¾The steps are as follows:

On commencement of the swap; an exchange of agreed principal amounts, usually at the prevailing spot rate.

Over the life of the swap; an exchange of interest payments.

At the end of the swap; a re-exchange of principals, usually at the original spot rate (thereby removing foreign currency risk).

Illustration 3

Consider a UK company wishing to borrow dollars to finance an investment project in the US. If the UK firm is not well known in the US money markets it might have to pay higher interest rates on the dollar than a similar US company, To mitigate this problem the UK company could (via an international bank) locate a US company facing the opposite situation on borrowing sterling. The two parties could then arrange the following swap.

(a)The US company borrows dollars and the UK firm borrows an equivalent amount of sterling. The two parties then swap funds at the current spot rate i.e. there is a swap of principals

(b)The US company agrees to pay the UK company the annual interest on the sterling loan. In return the UK company pays the interest on the dollar loan.

(c)At the end of the period the two parties then swap back the principal amounts. This could be at prevailing spot rates or at a predetermined rate (e.g. the original spot rate) in order to eliminate foreign exchange transaction exposure.

By following the above procedure each party has taken advantage of the other’s credit rating in its local capital markets and therefore reduced its financing costs.

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¾Foreign exchange/FX swaps – where there is a swap of currencies between counterparties but no swap of interest. The key advantage is avoiding the transaction costs of exchanging currency on the market. Two variations are common:

“spot against forward” – where the counterparties swap principals today at spot rate and then re-exchange on a set date at forward rate

“forward against forward” – where both legs of the deal are performed at the forward rate.

Key points

The favoured method of forecasting long-term exchange rate changes is relative purchasing power parity theory. Short term fluctuations may have a closer connection with interest rate parity – indeed IRP is used to set forward rates.

Although three types of currency risk may affect a firm (translation, economic and transaction) only two of them need to be hedged (economic and transaction) and from these only one can be easily hedged (transaction).

Practical internal hedging techniques should of course be considered before even considering the use of derivatives.

The most “mysterious” of derivatives is the futures contract as physical delivery is very rare - most participants close out their positions before the delivery date and therefore do not actually exchange currency using the contract but take a gain/loss on the change in contract’s price.

FOCUS

You should now be able to:

¾discuss the determinants of foreign exchange rates;

¾discuss the various types of currency risk and internal methods of currency risk management;

¾evaluate external hedging scenarios using forward foreign exchange contracts, money markets, foreign currency options, foreign currency futures and swaps.

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EXAMPLE SOLUTIONS

Solution 1

= $1.88 to £1

This is a predicted fall in the value of sterling.

Solution 2

F0 = S0 x ((1+ ic )) 1+ ib

(1 + 0.0325) F0 = 1.78 x (1 + 0.045)

= $1.76 to £1

Sterling is weaker in the forward market than the spot market

Solution 3

Solution 4

Expected receipt after 3 months = $300,000

Dollar interest rate over three months = 5.4/4 = 1.35%

Dollars to borrow now to have $300,000 liability after 3 months = 300,000/ 1.0135 = $296,004 Spot rate for selling dollars = 1.7820 + 0.0002 = $1.7822 per £

Sterling deposit from borrowed dollars = 296,004/ 1.7822 = £166,089 Sterling interest rate over three months = 4.6/4 = 1.15%

Value in 3 months of sterling deposit = 166,089 x 1.0115 = £167,999

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Solution 5

(a)$ receivables and hence we will want to sell $ and buy £ - a call option on £ is required. Receipt is in April therefore April call options.

Any exercise price can be chosen - this hedge will be illustrated using 1.610 exercise price.

Number of option contracts required:

____________

£186,346

____________

Therefore exercise option

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(ii) Exchange rate 1.605

_____________

£186,332

_____________

Therefore do not exercise option i.e. sell $ at spot.

Premium is always payable whether the option is exercised or not.

Solution 6

The company needs to protect itself against a rise in the price of the Euro. Therefore it should set up an options position that produces a gain upon a rising Euro i.e. buy calls on the Euro

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Solution 7

(a)

KYT needs to purchase yen on the spot market in two months time. To protect against the risk of the yen strengthening against the $US, KYT should buy yen futures contracts, hoping to sell them at a higher price if the yen strengthens. This is intended to offset any loss relative to the current spot rate when the yen are purchased in the spot market in two months time.

Use contracts that mature at the nearest date after 1 September, the September contract. To protect 280 million yen, 22 contracts will need to be bought.

(b)

Basis is the difference between the current spot price and the futures price, in this case Y128·15 – Y125·23 or 2.92 yen. (September futures in terms of yen per $1 = 1/0.007985 = 125.23)

(c)

The expected futures price is 0·973 yen below the spot price of 120 = 119·027 or 0·008401Yen/$

Expected result of the hedge:

Loss on the spot market = $148, 394

Hedge efficiency is 114,400148,394 = 77%

This result may not occur as basis is unlikely to decrease in a linear manner. Depending on the movement in basis the hedge efficiency might be higher or lower than 77%.

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