Hedging treasury risk with forward foreign exchange contracts


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  • The unhedged bank has to buy $ spot at 5.6. The cost of the hedge is the price paid for insurance. And what if exchange rate is 5.3 on 31.12.2005? Bank pays 5.3 x 11,000,000 = 58,300,000 + 189,000 cost of hedge = 58,489,000 Yes, bank had to “eat” the cost of the hedge, but it still paid less than it would have paid if it somehow could have locked in the spot rate on the date of the borrowing without paying a premium (5.4 x 11,000,000 = 59,400,000). The cost of the hedge is the price paid for insurance.
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  • Hedging treasury risk with forward foreign exchange contracts

    1. 1. HedgingHedging Treasury RiskTreasury RiskwithwithForward ForeignForward ForeignExchange ContractsExchange Contracts
    2. 2. 2Overview FX forwards: definition, characteristics andfeatures Uses of FX forwards– Example 1: Hedging with forwards– Example 2: Deriving the forward rate Problems and risks Accounting for forwards– Example 3: Marking to market Risk management
    3. 3. FX Forwards:FX Forwards:Definition,Definition,Characteristics andCharacteristics andFeaturesFeatures
    4. 4. 4Forward Foreign ExchangeContractDefinition:An agreement to exchange one currency foranother, where The exchange rate is fixed on the day of thecontract, but The actual exchange takes place on a pre-determined date in the future
    5. 5. 5Characteristics and Features of FXForwards Available daily in major currencies in 30-, 90-, and 180-day maturities Forwards are entered into “over the counter” Deliverable forwards: face amount of currency isexchanged on settlement date Non-deliverable forwards: only the gain or loss isexchanged
    6. 6. 6Characteristics and Features of FXForwards Contract terms specify:– forward exchange rate– term– amount– ‘‘value date’’ (the day the forward contract expires)– locations for payment and delivery. The date on which the currency is actually exchanged, the‘‘settlement date,’’ is generally two days after the valuedate of the contract.
    7. 7. 7Characteristics and Features of FXForwardsForward Exchange Rates: “The Iron-Clad Law” Forward exchange rates are different from spot rates, but they arenot a prediction of what the spot rate will be when the deal settles!The difference between theforward exchange rate and the spot exchange rateis the interest differentialbetween the two currencies
    8. 8. FX Forwards:FX Forwards:UsesUses
    9. 9. 9Uses of FX Forwards(1) Hedge foreign currency risk(2) Arbitrage FX rate discrepancies within andbetween markets(3) Speculate on future market movements(4) Profit by acting as market maker Financial institutions, money managers,corporations, and traders use these instrumentsfor managing currency risk
    10. 10. 10Two Types of HedgingCorporations engaged in international trade Hedge payments and receipts denominated in foreigncurrencies.– For example, a Croatian corporation that exports to Germany andexpects payment in Euro (EUR) could sell EUR forward toeliminate the risk of a depreciation of the EUR at the time thatthe payment arrives. Hedge the translation of foreign earnings for presentationin financial statements.
    11. 11. Example 1: HedgingWith an FX ForwardHedged Item Company must pay EUR 1,000,000to a eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK willdepreciate during next 3 months– Exposure to FX risk:What will be exchange rateHRK/EUR in three months??Hedging Instrument Bank buys 1,000,000 EURforward at forward rate of 7.3750– FX risk: Company isprotected against largeadverse FX rate movementsIf FX rate is unfavorable in 3months (ie, > 7.3750),Company pays just 7.3750
    12. 12. Example 1: HedgingWith an FX ForwardHedged Item Company must pay EUR 1,000,000 toa eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK willdepreciate during next 3 monthsAdvantages of Hedge:Company knows its costs and canplan its finances accordinglyCost of the hedge is zero -- No money is exchanged atinception of the forward FXagreementHedging Instrument Bank buys 1,000,000 EUR forward atforward rate of 7.3750Disadvantage of Hedge:Company is still exposed to FX riskif the HRK/EUR spot rate is lessthan 7.3750 in 3 monthsEffect of hedge is same asbuying EUR today andholding in an interest-bearingaccount(Forward FX agreement isNOT a simple speculation)
    13. 13. Example 1: HedgingWith an FX ForwardUnhedged Company If in 3 months, spot rateis 7.4500…– Unhedged Companymust pay:7.45 x 1,000,000 =HRK 7,450,000Effect of Hedging Hedged Company hasalready bought EURforward– Hedged Company will pay:7.375 x 1,000,000 = HRK7,375,000Money saved byhedging: 7,450,000 –7,375,000 =HRK 75,000
    14. 14. 14Example 2: Deriving the ForwardExchange Rate The spot rate HRK/EUR is 7.3000 A bank today sells a 3-month HRK/EURforward to a company for a forwardexchange rate of 7.3371 How did the bank compute the forwardrate?
    15. 15. 15Example 2: Deriving the ForwardExchange Rate Three month interest rates are:– 1% on the euro– 3% on the kuna A company with EUR 1 million and a need for HRK in threemonths should be indifferent, financially speaking, as to whetherit:– Invests the EUR 1 million for 3 months at 1% and converts theeuros (plus interest) into HRK at the end of this time, or– Sells the EUR 1 million spot for HRK, and invests the HRK at 3%for 3 months
    16. 16. Example 2: Deriving the ForwardExchange RateInvest EUR 1 million at 1%for 3 months (91 days)Interest earned EUR2,493.15Value after 3 monthsEUR 1,002,493Sell EUR 1 million spot at 7.30Buy HRK 7.3 millionInvest HRK for 3 months at 3%Interest earned HRK55,358.33(7.3 million x 3% x 91/360)Value after 6 monthsHRK 7,355,358OPTION 1 OPTION 2Forward Exchange Rate: 7.3371
    17. 17. FX Forwards:FX Forwards:Problems and RisksProblems and Risks
    18. 18. 18Problems with FX Forwards Finding counterparties who want to takeexactly the opposite position:– Most companies (potential counterparties) are“in the same boat” (i.e., importers from theeurozone)– One of the parties to the transaction might wantto trade a different amount, or have a differentsettlement date– Transaction costs can be large (bank’s spread)
    19. 19. 19Problems with FX Forwards Liquidity risk: A party in a forwardcontract may find it difficult to exit theposition. Alternatives:– If counterparty agrees, cancel the forward fora fee– Assign the contract to another party. Thisrequires some compensation– If an exact opposite position can be taken,offset the obligation and suffer only the pricedifferential
    20. 20. 20Problems with FX Forwards Default risk: There is an incentive forthe counterparty who lost on theforward contract to default on theagreement– Forwards are a zero sum game. Eachcounterparty that gains is balanced by acounterparty who loses the same amount.
    21. 21. FX Forwards:FX Forwards:AccountingAccounting
    22. 22. 22Accounting for FX ForwardsIAS 39 applies (Accounting forFinancial Instruments – derivativesaccounting)– The deal has no immediate value– Off-balance sheet accounts are usedinitially to record the deal on the books
    23. 23. 23Accounting for Forwards Fair value of the forward changes overtime with movements in the foreignexchange rate Unrealized gain (loss) is measured byapplying today’s market rates at theforward date
    24. 24. 24Example 3: Marking to Market After one month’s time, the company has tomark-to-market a 3-month forward which iscarried in the off-balance sheet accounts– On the date of the deal, the spot rate was 7.3000– The forward rate for the deal is 7.3371– The spot rate HRK/EUR is now 7.4150 What is the market value of the forward today?
    25. 25. 25Example 3: Marking to Market The company bought EUR against HRK in 90 days. Today, the company could buy EUR 1,000,000 at thespot rate of 7.4150 and pay HRK 7,415,000. The company is committed to buy EUR 1,000,000 whenthe forward matures at 7.3371 and pay only HRK7,337,100. Thus, the deal now has value.Company records an unrealized GAIN of:HRK 7,415,000 – HRK 7,337,100 = HRK 77,900
    26. 26. FX Forwards:FX Forwards:Risk ManagementRisk Management
    27. 27. 27Risk ManagementBefore using any type of derivatives, companiesshould: Discuss the potential risks and benefits of derivativeswith Management Board and Supervisory Board Develop appropriate internal controls and limits Prepare derivatives policy and procedures manual; taxand accounting manuals Host training seminars for management andemployees
    28. 28. 28Successful Risk ManagementDON’ T WORRY,IT MAY MELTBEFORE WE GETTHERE!
    29. 29. 29Successful Risk ManagementWE CAN DECIDEWHAT TO DO,IF AND WHENWE HIT IT!
    30. 30. 30Successful Risk ManagementWE NEVER NEEDEDTO USE LIFEBOATS BEFORE! !
    31. 31. Thank You.