hedging risk and exposure

MANAGEMENT OF TRANSACTION
EXPOSURE
19-Mar-17 2ASHOK PATIL

MANAGEMENT OF OPERATING
(ECONOMIC) EXPOSURE

INTEREST RATE AND CURRENCY
SWAPS

HEDGING INTEREST RATE

• When money is lent (borrowed) to earn (pay)
interest and interest rate is volatile, then this
risk can be hedged using futures contract.
• It is hedged in such a way that whenever there
is a loss due to interest rate, the same is
recovered in the futures market.
19-Mar-17 ASHOK PATIL 6

Hedging interest rate with futures
contract
• There are two main interest rate futures
contract
– Eurodollar futures (Chicago Merchantile
Exchange- CME)
– US treasury bond (T-bill) futures (CBOT)
• The eurodollar futures is most popular and
active contract. Open interest is in excess of
$4 trillion at any point in time.

T-bill Futures
• These futures are listed using the IMM (International
Monetary Market) index
• IMM = 100 – Annualized forward discount yield (DY)
• For example, if the Price of a $100, 90 Day Treasury were
$98.
• IMM price of futures =100 – 8 =92
• Note that forward discount yield is not rate of return.
• You can observe that futures prices are inversely related to
interest rates (in this case DY).
%8100
90
360
100
98$100$
100
90
360
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DY
FV
PFV
DY

©David Dubofsky and 10-9
Thomas W. Miller, Jr.
T-bill Futures, II.
• Note that the discount yield is not a rate of return.
• If the day count method is actual/365, the
annualized rate of return, r, with simple interest, is
• This is called the bond equivalent yield (if t < 182
days)
t
365
P
PF
r 



T-bill Futures, III.
• The futures discount yield is the forward yield on a 3-month T-bill,
beginning on the delivery date of the contract. Example:
– Suppose today is October 8, the delivery day for the Dec contract is Dec.
18th, and the futures price is 97.22.
– Then, someone who goes long a T-bill futures contract has “essentially”
agreed to buy $1 million face value of 3-month T-bills on Dec. 18th, at a
forward discount yield of 2.78%, which is a forward price of $992,972.78.
• One tick = $12.50 = 1/2 basis point change in the yield.
• The contract is cash-settled.
• To speculate, go long T-bill futures if you think that 3-month T-bill
prices will rise (yields on 3-month T-bills will fall). Sell T-bill futures to
bet on falling prices (rising yields).

Eurodollar Futures, I.
• When foreign banks receive dollar deposits, those dollars are called
Eurodollars.
• Underlying asset is the 90-day $1,000,000 Eurodollar time deposit
interest rate; LIBOR
• Cash settled
• IMM Index = 100 – aoy = 100 - LIBOR
• aoy = add on yield on a 90-day forward Eurodollar time deposit
(LIBOR).
• If the IMM Index is 95.19, then the futures LIBOR is 4.81%. (100 –
95.19 = 4.81)
• LIBOR rises => IMM index falls.
t
360
P
PF
LIBORaoy 



Eurodollar Futures
• The futures price is quoted in terms of LIBOR rate.
Since LIBOR rate is decided by transactions between
banks and is floating, the futures price is also floating.
• IMM Futures price = 100 – LIBOR (at the time)
• If LIBOR is 4.14% at maturity, then futures price is
95.86
• Let’s say if futures price today is 94.86, how much is
the implied LIBOR?
• = 100 – 94.86 = 5.14
• Futures price negatively related to LIBOR.

Eurodollar futures hedge example
(lending or depositing)
• An MNC expects to receive $20,000,000 in cash from a
large sale of merchandise on June 15, 2005. The money
will not be needed for a period of 90 days after receipt.
Thus the treasurer of this MNC should invest the excess
funds for this period in a money market instrument
such as Eurodollar deposit.
• He notes that three-month LIBOR is currently 2.91
percent. The implied three-month LIBOR rate in the
June 2005 contract is at 3.44 percent.
• Treasurer would like to lock in this interest rate of 3.44
percent by taking a position in futures contract.

• Recall futures price is inversely related to LIBOR
i.e. futures price will increase if LIBOR decreases.
• Therefore, to hedge against the downside risk in
the interest rate, treasurer will have to take short
position in the interest rate. But there is no
futures contract on the interest rate. However,
the futures contract based 100 – LIBOR is
available.
• Therefore, treasurer would take a long position in
20 such futures contract.

Case 1
• Assume that on the last day of trading in the June 2005
contract three-month LIBOR is 3.10 percent.
• At 3.10 percent, when the MNC deposits in a 90-day
Eurodollar, deposit of $20,000,000 will generate only
$155,000 of interest income, or $17,000 less than that
at a rate of 3.44 percent.
• But the shortfall will be made up by profits from the
long futures contract. At a rate of 3.10 percent, the
final settlement price on the June 2005 contract is
96.90 (=100-3.10). The profit earned on the futures
position is
• [96.90 – 96.56]/4*10000*20 contracts = $17,000.

Or alternatively,
• Hedging profit/loss from futures = $25*no of
basis points*no of contracts
• Hedging profit = $25*34*20=$17,000

Money market
Futures market
2.91
96.56
Implied LIBOR = 3.44
3.10
96.90
LIBOR =3.10
MNC receives money
Now and invests at 3.10%
For 3 months from here.
Settlement in futures
[96.90 – 96.56]/4*10,000*20 contracts = $17,000

Case 2
• Assume that on the last day of trading in the June 2005
contract three-month LIBOR is 3.60 percent.
• At 3.60 percent, a 90-day Eurodollar deposit of
$20,000,000 will generate $180,000 of interest income,
or $8000 more than that at a rate of 3.44 percent.
• But the surplus will be offsetted by losses from the
long futures contract. At a rate of 3.60 percent, the
final settlement price on the June 2005 contract is
96.40 (=100-3.60). The profit earned on the futures
position is
• [96.40 – 96.56]/4*10000*20 contracts = -$8,000.

Money market
Futures market
2.91
96.56
Implied LIBOR = 3.44
3.60
96.40
LIBOR =3.60
MNC receives money
Now and invests at 3.60%
For 3 months from here.
Settlement in futures
[96.40 – 96.56]/4*10,000*20 contracts = -$8,000

Eurodollar Futures Example
• Suppose in February you buy a March Eurodollar
futures contract. The quoted futures price at the
time you enter into the contract is 94.86.
• If the 90-day LIBOR rate at the end of March
turns out to be 4.14% p.a., what is the payoff on
your futures contract?
– The price at the time the contract is purchased is
94.86.
– The LIBOR rate at the time the contract expires is
4.14%.
– This means that the futures price at maturity is 100 -
4.14 = 95.86.

The payoff of contract?
• LIBOR has decreased from 5.14 to 4.14
indicating the futures price must have
increased.
• Payoff = (95.86-94.86)/4*10000 = 2500
– The increase in the futures price is multiplied by
$10,000 because the futures price is per $100 and
the contract is for $1,000,000.
– We divide the increase in the futures price by 4
because the contract is a 90-day (90/360)
contract.

Using Eurodollar futures contract to
hedge interest rate risk (borrowing)
• Suppose a firm knows in February that it will be
required to borrow $1 million in March for a
period of 90 days.
• The rate that the firm will pay for its borrowing is
LIBOR + 50 basis points.
• The firm is concerned that interest rates may rise
before March and would like to hedge this risk.
• Assume that the March Eurodollar futures price is
94.86.

Using Eurodollar futures contract to
hedge interest rate risk…continued
• Step 1: Specify the risk.
– Your company will lose if interest rates rise. That is, if the
interest rate is higher, your firm will have to pay more
interest on the loan.
• Step 2: Determine an appropriate futures position.
– You want a futures position that gives a positive return if
interest rates rise. That is, you want a futures position that
gives a positive return if (100-LIBOR) falls. Hence, you want
a futures position that gives a positive return if the futures
price falls. Therefore you sell Eurodollar futures.
• Step 3: Determine the amount.
– $1 mm amounts to one contract.

Continued…
• The LIBOR rate implied by the current futures
price is: 100-94.86 = 5.14%.
• If the LIBOR rate increases, the futures price
will fall. Therefore, to hedge the interest rate
risk, the firm should sell one March Eurodollar
futures contract.
• The gain (loss) on the futures contract should
exactly offset any increase (decrease) in the
firm’s interest expense.

Case I: LIBOR rises to 6.14%
• Suppose LIBOR increases to 6.14% at the maturity date of the
futures contract.
• The interest expense on the firm’s $1 million loan
commencing in March will be:
• The payoff on the Eurodollar futures contract is
– As (94.86-93.86)*10000/4=2500
• Therefore total payoff = payment of loan + gain in futures
• = -16600+2500= -14100
• This is equivalent to interest payment of 5.14% at which
futures was signed plus 0.5 = 5.64%

Case II: LIBOR falls to 4.14%
• That is, the loan will be available at 4.14%+5 basis
points. Therefore the interest expense will be
• The payoff on the Eurodollar futures contract is
(94.86-95.86)*10000/4=-2500
• Therefore total payoff = payment of loan + loss in
futures
• = -11600-2500= -14100
• This is equivalent to interest payment of 5.14% at
which futures was signed plus 0.5 = 5.64%

• The net outlay is equal to $14,100 regardless of
what happens to LIBOR.
• This is equivalent to paying 5.64% p.a. over 90
days on $1 million.
• The 5.64% borrowing rate is equal to the current
implied LIBOR rate of 5.14%, plus the additional
50 basis points that the firm pays on its short-
term borrowing.
• The firm’s futures position has locked in the
current implied LIBOR rate.

Another example
• On July 28, 1999, a firm plans to borrow $50
million for 90 days, beginning on September 13,
1999.
• The firm will borrow at the Eurodollar spot
market on September 13th.
• The current spot 3-month Eurodollar rate is
5.3125%.

• The firm will be borrowing in the spot market 47 days hence. Thus, on
July 28th, the interest rate at which the firm will be borrowing on
September 13th is unknown.
• The firm fears that when it comes time to borrow the funds in the
Eurodollar spot market, interest rates will be higher (Eurodollar Index
will be lower).
• Such a situation calls for a short hedge using Eurodollar futures
contracts.
• On July 28, 1999, the closing price for September Eurodollar futures
was 94.555. (IMM Index=futures price)
• Assuming transactions costs of zero, by shorting 50 Eurodollar futures
contracts on July 28, 1999, the firm can lock in a 90-day borrowing
rate of 5.445%.
• Rate: 100 – 94.555.

Case I. Spot 90-Day LIBOR on
September 13th is 5.445%.
• The firm’s interest expense would be:
$680,625 = 50,000,000 * 0.05445 * (90/360)
• Thus, in this case, there is no profit or loss on the
futures contracts because the firm went short at
94.555.

Case II. Spot 90-Day LIBOR on
• Here, the bank’s actual interest expense would be higher than “anticipated”
because interest rates rose above the original futures interest rate:
$730,625 = 50,000,000 * 0.05845 * (90/360)
• To calculate the futures profit on the 50 contracts, one must recall that each
full point move in the IMM Index (i.e., 100 basis points) represents $2,500 for
one futures contract. The delivery day futures price is 100-5.845 = 94.155.
Thus,
(94.555 – 94.155) * 10000/4 * 50 = $50,000
• Here too, the net interest expense for the firm is
-$730,625 +$50,000 = -$680,625.

Case III. Spot 90-Day LIBOR on
• The bank’s actual interest expense would be:
$630,625 = 50,000,000 * 0.05045 * (90/360)
• However, because interest rates are lower, the bank loses on its short futures
position. The delivery day futures price is 100-5.045 = 94.955. The futures loss
is
(94.555 – 94.955) * 2500 * 50 = ($50,000)
• The net interest expense for the firm equals the interest expense with the
5.045% rate, plus the loss on the futures position. It is the same as the two
previous cases: -$630,625 - $50,000 = -$680,625.

What is a Eurodollar Futures Contract?
• Contract: Eurodollar Time Deposit
• Exchange: Chicago Merchantile Exchange
• Quantity: $1 Million
• Delivery Months: March, June, Sept., and Dec.
• Delivery Specs: Cash Settlement Based on 3-
Month LIBOR
• Min Price Move: $25 Per Contract (1 Basis Pt.)
– 1% change = 100 basis points
– Therefore, 1 basis point is 1/100 of 1%=0.0001
– 1 basis point value = 0.0001/4*1,000,000=$25

• 1% change = 100 basis points (percentage terms)
• This means that 1 basis point is 0.01 %
– Interest rate change from 3 to 4 % is change of 100 basis
points.
• 0.01 = 100 basis points (decimal terms)
• This means that 1 basis point is 0.0001 in decimal
terms.
– If 0.03 has become 0.0348, how many basis points have
been changed?
• 48 basis points
– 48 basis points is represented as 0.0048 in decimal terms
– 48 basis points is represented as 0.48 in percent terms.

Note
• Futures price is quoted per hundred value
basis. So if the futures price is quoted as 94.00
and the value of the contract is 1000, then the
quote will be multiplied by 10.
• If the value is 1, 000,000, then the quoted
price will be multiplied by 10,000
• Alternatively, use the formula
25$
360
90*0001.0*000,000,1
int____
360
__int*_1*___
int____


pobasisoneofValue
or
daysofnumberpobasiscontracttheofValue
pobasisoneofValue

FORWARD-FORWARDS

Forward Forwards
• Suppose a company needs to borrow $10 million
in six months for a three-month period.
– It can wait or enter into forward forward with a bank.
• If bank fixes this rate at 8.4% per annum, then
– Bank will loan the company $10 million in six months
from now for a period of 3 months @8.4/4=2.1.
– The company will repay principal plus interest at the
maturity $10210000 (=10000000*1.021)

Forward Rate Agreement
• Suppose a company needs to borrow $50 million in two
months for a six-month period.
• Company buys (long) FRA (2x6) on LIBOR from the bank @
6.5% on a notional principal of $50 million
– If LIBOR6 exceeds 6.5%, then bank will pay the difference in interest
expense
– If LIBOR6 is less than 6.5%, then company will pay the bank.
• if LIBOR6 after two months is 7.2% then,
730,170$
)360/180(072.01
)
360
180
0.065)(-(0.072
50000000positionshortforpaymentInterest
)360/(1
)
360
days
AR)(-(SR
principalnotionalpositionshortforpaymentInterest





daysSR

PARTICIPATING FORWARDS

Participating Forward
• A PFC is an agreement with a bank that provides
protection against unfavourable exchange rate
movements by setting a contract rate at which
you will exchange one currency for another.
• At the same time it provides you with some
ability to participate in any favourable exchange
rate movements on a pre-determined proportion
of your contract amount.

Case of importer/payment of foreign
currency/buying foreign currency: use of PFC
(Participating Forward Contract)
• You are an Australian based importer due to
pay 100,000 United States dollars (USD) in 3
months’ time for goods bought overseas.
• Assume the current AUD/USD market foreign
exchange rate is 1.265823 and the 3-month
forward exchange rate is 1.275511

The contract: PFC
• You enter into a PFC to buy USD 100,000 with
AUD in 3 months’ time and set the contract
rate at 1.2903226
– In establishing a PFC, the contract rate must be set
at a rate above the current forward exchange rate.
• Based on a contract rate of 1.2903226 the
bank determines the participation ratio to be
40 per cent.

Case I (PFC): If the market exchange rate is
above AUD 1.2903226/USD
• You would exchange your AUD, on the full
contract amount, at the contract rate. You will
pay:
• USD 100,000*1.2903226 = AUD 129, 032.26

Case II: if the
market foreign exchange rate is 1.219512
• You would exchange your AUD, on 60% (equal
to 100 % - participation ratio of 40%) of the
contract amount, at the contract rate of
1.2903226.
• You will buy USD 60,000 at contract rate of
1.2903226:
• USD 60,000*1.2903226 = AUD 77,419.35
• AND (NEXT SLIDE)

• You may also choose to exchange the remaining 40%
(the participation ratio) of your contract amount at the
prevailing market rate. For example, if you choose to
do this and as the AUD/USD market foreign exchange
rate at the time is 1.2195122, you will require:
• USD 4 0,000 * 1.2195122 = AUD 48,780.49
• In this scenario the total amount of AUD you pay will
be AUD 126,199.84 (equal to AUD 77,419.35 + AUD
48,780.49).
• Your effective dealing rate will equate to:
• AUD 126,199.84 /USD 100,000 = 1.2619984 (which is
less than current forward rate)

Case of exporter/receipt of foreign currency: use
of PFC (Participating Forward Contract)
• You are an Australian based exporter due to
receive 100,000 United States dollars (USD) in
3 months’ time for goods sold overseas.
• Assume the AUD/USD market foreign
exchange rate is 1.2658228 and the 3-month
forward exchange rate is 1.2755102.

The contract
• You enter into a PFC to sell USD 100,000 for
AUD in 3 months’ time and set the contract
rate at 1.2610340.
– In establishing a PFC, the contract rate must be set
at a rate below the current forward exchange rate.
• Based on a contract rate the bank determines
the participation ratio to be 40 per cent.

Case I: if the market foreign exchange rate
is below the 1.2610340 contract rate
• You would exchange your USD, on the full
contract amount, at the contract rate.
• You will receive:
USD 100,000 *1.2610340 = AUD 126,103.40

Case II: if the market foreign exchange rate
is above the 1.2610340 contract rate
• You would exchange your USD on 60 % (equal to
100 % - participation ratio of 40%) of the contract
amount, at the contract rate. You will receive:
• USD 6 0,000*1.2610340 = AUD 75,662.04
• You may also choose to exchange the remaining
40 % (the participation ratio) of your contract
amount at the prevailing market rate.
• For example, if you choose to do this and as the
AUD/USD market foreign exchange rate at the
time is 1.3333333, you will receive:
• USD 4 0,000*1.3333333 = AUD 53,333.33

The result
• In this scenario the total amount of AUD you
receive will be AUD 128,995.37 (equal to AUD
75,662.04 + AUD 53,333.33).
• Your effective dealing rate will equate to:
• AUD 128,995.37 /USD 100,000 = 1.2899537
(which is more than current forward rate)

NON-DELIVERABLE FORWARDS

Non-deliverable Forwards
• A Non Deliverable Forward Transaction (NDF) is an
agreement between you and Bank which protects you
against unfavorable exchange rate movements.
– It is a cash settled transaction, meaning that there is no
exchange of currencies at maturity as there is with a
typical foreign exchange transaction.
– Rather, there is a single amount payable by either you or
bank.
• A contract rate is agreed up-front, together with the
fixing rate (spot rate on fixing date). The contract rate
and fixing rate are used to calculate the amount
payable on the nominated maturity date.

Hedging Foreign Currency Payables
(importer) with NDF
• Suppose, you are an Australian based
company importing goods from China. You are
billed 1 million in Chinese Renminbi (CNY) but
you are required to pay in US dollars (USD).
• Your supplier’s latest invoice requires you to
pay the USD equivalent of CNY 1 million in 3
month’s time.
• Assume the current exchange rate for value
spot is 1 CNY = 0.146199 USD

• It’s an importer’s case. If the firm were required
to pay in CNY, it would have been short in CNY
against AUD in spot market. i.e. if CNY
appreciated against AUD it would make a loss.
• So you would take a LONG position in CNY against
AUD in forward market.
• But it is required to pay in USD. So using cross
rate formula
• You will be short in CNY against USD in spot
market. i.e. if CNY appreciated (or dollar
depreciated), it would make a loss.
• Therefore, it would take a LONG position in CNY
against USD.
SELL
BUY
CNY
AUD
SELL
BUY
SELL
BUY
SELL
BUY
CNY
USD
USD
AUD
CNY
AUD
*

NDF with bank
• You wish to protect yourself against the USD
depreciating against the CNY, in order to limit the
amount of USD you will have to pay in 3 months’
time.
• You enter into an NDF and set a contract rate for
3 months’ time.
– You set the notional principal amount of your trade to
be CNY 1,000,000.
– At the same time you also agree the fixing date (two
days prior to the NDF’s maturity date).
– Bank gives you a contract rate of 0.14556041
USD/CNY.

Case I: if the fixing rate for USD/CNY is
0.14814815 (rate on Fixing Date)
• The fixing settlement currency amount will be: USD
148,148.15 (= CNY 1,000,000 *0.14814815) while, the
contract settlement currency amount will be:
USD 145,560.41 (=CNY 1,000,000 *14556041)
Accordingly, the difference (USD 2,587.74) will be
payable by Bank to you on the maturity date.
If the fixing rate on the fixing date is less favorable to
you than the contract rate Bank will pay you the cash
settlement amount in USD on the maturity date.

How did the hedge work?
The cash settlement amount will compensate you
for the higher USD amount you will need to pay
for your goods.
To purchase your goods, you would have had to
pay USD 148,148.15.
With the benefit of the USD cash settlement amount
you receive under the NDF (USD 2,587.74),
Your total USD outlay will be reduced to USD
145,560.41
This is equivalent to a USD/CNY exchange rate of
0.14556041, i.e. the NDF contract rate.

Case II: if the fixing rate for USD/CNY is
0.14265335
• The fixing settlement currency amount will be:
USD 142,653.35 (= CNY 1,000,000 *0.14265335)
while, the contract settlement currency amount
will be:
USD 145,560.41 (=CNY 1,000,000 *0.14556041)
If the fixing rate on the fixing date is more
favorable to you than the contract rate you will
pay the cash settlement amount in USD to Bank
on the maturity date.

How did the hedge work?
• Accordingly, the difference (USD 2,907.06) will be
payable by you to Bank on the maturity date.
• The cash settlement amount you pay Bank will
diminish the extent to which you would have benefited
through the lower USD amount when you pay for your
goods.
• To purchase your goods, you pay USD 142,653.35.
Adding the cash settlement amount (USD 2,907.06)
your total USD outlay will now be USD 145,560.41.
• This is equivalent to a USD/CNY exchange rate of
0.14556041, i.e. the NDF contract rate.

Note this…
• Entering into an NDF has effectively removed the
uncertainty of fluctuations in the USD/CNY exchange
rate on the USD amount you will pay for your goods.
• However, you should also note that as an Australian
company while you have effectively fixed your USD
requirement with an NDF you will still need to obtain
the required USD amount to pay for your goods.
• Accordingly, you will need to decide how you manage
this risk to the AUD/USD exchange rate over the 3
months. NDFs can be denominated in AUD or
alternatively the AUD/USD risk can be managed
separately.

hedging risk and exposure

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