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Hedging Strategies For Foreign Exchange Risks Finance Essay

This report is intended to critically analyse the different alternative hedging techniques available to the ‘General Devices’ Company for hedging its foreign exchange risk. The company offers one of the industry’s most complete selections of electronic packaging hardware in more than 26 countries. The report will highlights the basic processes involved in these hedging techniques (how these hedging techniques work?) and how the company can use them to reduce their possible exchange rate risk. We will calculate the expected proceeds from all three hedging techniques Money market hedge, Billing in US dollars and Forward Contracts. This evaluation will form the basis of recommendations to the company for adopting the best possible hedging technique under consideration to maximise their proceeds and try to minimize the foreign exchange risk.

2.0 Introduction:

General Device Company trades in electronic packaging hardware and exports most of its products in more than 26 countries. The company products are designed for use in electronics/computer, telecom/datacom, broadcast, medical, aerospace, military and other leading industries The floating exchange rate system has presented a risk to trade participants and the introduction of currency conversion risk. Furthermore, the exchange rate regime is country specific. The effect of currency exchange rate fluctuations shows why the hedging behaviour is an essential element in international pricing models. When the contract is denominated in the destination country’s currency, an appreciation of exporter’s currency over the contract period may create a currency conversion loss to the exporter.

3.0 Foreign Exchange Risk:

Foreign exchange risk is the probability of loss occurring due to adverse movements in the foreign exchange rates. We can put in this way that the exchange rate risk on a foreign currency will move against the position of the investor such that the value of the investment is reduced. The exposure to foreign exchange rate is common to all who conduct international business or do trading. If someone buying or selling goods or services which are denominated in foreign currencies can immediately expose to foreign exchange rate risk. International commerce has rapidly increased as the internet and communication media has provided new and more transparent marketplace for individuals and entities alike to conduct international business and trading activities.

The pressure to monitor and manage foreign currency risks has led many companies to develop sophisticated computer based systems to keep track of their foreign exchange exposure and aid in managing that exposure. Economists handles these exposures in different ways where as the accountants favour other approaches for measuring and managing these exposures.

Management of accounting exposure which includes both translation and transaction exposure centres on the idea of hedging.

4.0 Hedging Foreign Exchange Risk:

Hedging in foreign exchange risk is a method of reducing risk in those situations where you can make or get higher returns on foreign exchange investments with bearing minimum risks. Hedging a particular currency exposure means establishing an offsetting currency position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange loss or gain on the currency hedge.

5.0 Purpose of Hedging Foreign Exchange Risk:

Hedging foreign exchange risk helps you to reduce your level of risk and increase the ability to leverage your position. The usefulness of a particular hedging strategy depends on both acceptability and quality. Acceptability refers to approval by those in the organization who will implement the strategy and quality refers to the ability to provide better decisions. Different companies hold different reasons to hedge foreign exchange risk. The most common reasons behind foreign exchange hedge are:

Foreign Exchange Rate Risk Exposure

Interest Rate Risk Exposure

Foreign Investment/ Stock Exposure

Hedging Speculative Positions

This and other explanations for hedging all relate to the idea that there is likely to be an inverse relation between total risk and shareholder value. Given this view the main purpose of hedging is to reduce exchange risk where exchange risk is defined as that element of cash flow variability attributable to currency fluctuations. Many firms follow a selective hedging policy designed to protect against anticipated currency movements. A selective hedging policy is especially prevalent among those firms that organize their treasury department as profit centres. In such a firms the desire to reduce the expected costs of hedging and thereby increase profits often leads to taking higher risks by hedging only when a currency change is expected and going unhedged otherwise.

6.0 Hedging Techniques

The most common hedging techniques are

Forward Exchange Contracts (Forward Market Hedge)

Futures

Options

Swap

Money Market Hedge

All of the above mentioned hedging techniques are well famous and companies select one or more techniques which are align to their strategy for minimizing foreign exchange risk. All of these techniques differ from each other and involve different processes.

6.1 Forward Exchange Contract

Forward contract is a contract between two parties in which a buyer agrees to sell a sum of money or product on a future date in exchange for something in return and the parties reach their agreement without the involvement of a future exchange or clearinghouse. Unlike other hedging techniques the contract can contain non- standard terms and conditions, such as unusual quantities or expiration dates.

The contract basically relying on the creditability of both parties and the forward contract must agree to assume the credit risk of the other party. Because of these features, forward contracts are generally not designed to be tradable and there is no secondary market for them.

Forward contracts are customized agreements between two parties to fix the exchange rate for a future transaction. Forward contracts are somewhat less familiar, probably there exit no formal trading facilities, building or even regulating bodies.

How does it work?

Suppose gold is currently selling at Rs.11500/- per 10 grams. Based on the perception of the movement of gold prices, A & B enter into a contract where A takes a short position and thereby agrees to deliver 10 gms of gold to B on 31st Dec of the year at a price of Rs. 12000/- and B agrees to take the delivery and pay the agreed price. Now, if there is a spurt in market price of gold, it would make investor B happy since an increase in spot price would also cause the price expected in future to increase. If the price increase does stay at the date of the maturity of contract, the buyer would stand to gain and the seller to lose from it

6.2 Future Contracts

A future contract is an agreement between two parties where a buyer and a seller

buys or sells a particular currency at a future date at particular exchange rate that is fixed or agreed upon today. In fact the future contract is similar to the forward contract but is much more liquid and the reason for its liquidity is that it is traded in an organized exchange the future market just like the stock market.

Future contracts are standardized contracts and therefore they can bought and sold just like the normal shares on the stock market. As for hedging with futures, if the risk is an appreciation of value one needs to buy futures and in case if the risk is depreciation then one needs to sell futures. The profits and losses of futures contracts are paid over every day at the end of trading, a practice called marking to market.

This daily settlement reduces the default risk of futures contracts relative to forward contracts. In case of future contracts, futures investors must pay over any losses or receive any gains from the day’s price movements. These losses or gains are generally added to or subtracted from the investor’s account.

6.3 Options

An option is a financial instrument that gives the holder the right but not the obligation to sell (put) or buy (call) another financial instrument at a set price and expiration date. The seller of the put option or call option must fulfil the contract if the buyer so desires it.

There are two types of options:

• Call options – gives the buyer the right to buy a specified currency at a specified

exchange rate, at or before a specified date.

• Put options – gives the buyer the right to sell a specified currency at a specified

exchange rate, at or before a specified date.

Of course the seller of the option needs to be compensated for giving such a right.

The compensation is called the price or the premium of the option. Since the seller

of the option is being compensated with the premium for giving the right, the seller

thus has an obligation in the event the right is exercised by the buyer.

An option that would be profitable to exercise at the current exchange rate is said to be in -the –money conversely an out- of- the- money option is one that would not be profitable to exercise at the current exchange rate. The price at which the option is exercise is called the exercise price or strike price. An option whose exercise price is the same as the spot exchange rate is termed at- the-money.

6.4 Swaps

If we talk about the simplest form title a plain swap, you are offering a set of cash

flows for another set of cash flows of equivalent market value at the time of the

swap. Currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency.

The counterparties to a currency swap will be concerned about their all in cost that is effective interest rate on the money they have raised. Currency swaps contain the right of offset, which gives each party the right to offset any non-payment of principal or interest with a comparable non-payment. The most common swaps are US$ followed Japanese yen, sterling .The typical uses of a currency swap is conversion from a liability in one currency to a liability in another currency and conversion from an investment in one currency to an investment in another currency.

6.5 Money Market Hedge

Money market hedge is an alternative forward market hedge is to use a money market hedge. A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the dollar value of a future foreign currency cash flow.

How does it work?

To understand how money market hedge works let say a UK company with a 1 year receivable of $1,000,000. If the spot foreign exchange is 2.00 and US interest rates were 4% and UK interest rates were 5%. The company would borrow money in dollars equivalent to its receivable which is $1,000,000.00 discounted by 4% ($1,000,000.00/1.04)= $961,538.46 and then convert it into sterling at spot rate 2.00 which will be £480,769.23. The sterling then would be deposited @5% and after 1 year we would have (£480,769.23*1.05= £504,807.69). In one year’s time the company receives the expected $1,000,000 and repays the sterling equivalent for the full. In this case the company has hedged the foreign exposure and has enjoyed the sterling equivalent for the full period. The formula for calculation of effective Foreign Exchange Forward outright is $1,000,000/£504,807.69 = 1.98

In reality there are transaction costs associated with hedging, the bid- ask spread on the forward contract and the difference between borrowing and lending rates. These transactions costs must be factored in when comparing a forward contract hedge with a money market hedge.

7.0 Calculation of Expected proceeds in US$

The expected proceeds from each of the 3 methods are calculated as

7.1 Billing in US$

The company will use the rate 15.3555 (Peso/USD) to bill the other party in US dollars. The expected proceeds will be calculated as follows:

Expected proceeds in US $ in six months=500M /15.3555= $ 32.56162287M

7.2 Six Month Forward Rate Contract

If the company engage in 6 month forward rate contract then the expected proceeds will be calculated as

Expected proceeds in US $ in six months= 500M/15.0134= $33.30358213M

(Using Forward Rate Contract)

7.3 Money Market Hedge

If the company is interested in money market hedge the expected proceeds will calculated using these steps:

The company first borrow peso @ 1.3% (for 6 month borrowing rate in Mexico) which is [500M/(1.013)]= 493.5834156M Peso

The company will convert US dollars @ 15.3561 exchange rate which will result into 493.5834156M/15.3561= $ 32.14249813M

Now deposit $32.14249813M in US bank @ (1.55% for 6 months) which will result into

$32.14249813M *1.0155= $ 32.64070685.

After a year the company will receive its 500M peso and will adjust its loan of 500m peso

with the Mexican bank.

Recommendations

On the basis of proceeds from the all of the three hedging techniques billing in US dollars, money market hedge and forward contracts, the forward contract is resulted into more proceeds as compared to the other two. So, it is recommended to go with forward contracts. The reason why is because when we will charge our client in current spot rate we know exactly what we will get after 6 months and in 6 months our proceeds will be devalued due to inflation factor and can’t benefit from the possible gains. In money market hedge the reasons for low proceeds are the transaction costs and the higher borrowing rate in Mexico than Mexico t- bill rate. In forward contract we are getting the maximum proceeds and the costs attached with forward contract are very low. What should be apparent is that whether the peso appreciate or depreciate we have locked- in the amount that we will receive $33.30358213M.

8.0 Forward Exchange Fixed and Option Contracts.

To distinguish forward exchange contracts from option contracts we will critically analyse both forward exchange fixed and forward contracts.

8.1 Forward Exchange Fixed Contract

A forward exchange contract is a contract to conduct a transaction at a fixed rate of exchange on either a fixed future date or during a fixed period of time. Forward exchange contracts help to manage the risk of foreign currency denominated payables or receivables. By entering in to a forward exchange contract, we are benefiting of locking in the rate of currency exchange to mitigate the risk inherent in a future payments obligation.

Some of the advantages and disadvantages of forward contracts will be highlighted to understand its characteristics.

Advantages

Some of the advantages of forward contracts are as:

Protection against unfavourable exchange rate fluctuations.

The exact values of the import and export orders can be calculated on the day it is processed.

Budgeting and costing are accurate.

It can be written for any amount and term.

Offers a complete edge.

They cater for a diverse type of commercial and financial transactions and both importers and exporters can make use of it.

Disadvantages

Company cannot take advantage of preferential exchange rate movements once entered into forward exchange fixed contracts.

If an order is cancelled or there is any surplus amount outstanding on a forward exchange, it must be surrendered at the prevailing spot exchange rate, which can result in a financial loss.

Early deliveries, extensions, surrenders and cancellations during the fixed period of a forward exchange contract are done on a swap basis causing additional administration

Difficult to find a counterpart (No liquidity)

Requires typing up capital

Subject to default risk.

8.2 Forward Exchange Option Contracts

A forward exchange option contract is different from forward fixed contract as in option contract the buyer of the option has the right but not the obligation to buy or sell a specified currency or stock at a specified exchange rate, at a specified date from the seller of the option. There are two types of options, one is called ‘Call Option’ and the one is called ‘Put Option’.

Call Option- It gives the right to buy a specified currency or stock at a specified exchange rate at specified date.

Put Option- It gives the buyer the right to sell a specific currency or stock at a specified exchange rate at a specified price.

Advantages

The main advantage of forward exchange option is flexibility. Secondly in options there is neither initial margin nor daily variation margin as the position is not market to market. Due to it many companies enjoys significant cash flow relief.

Disadvantages

Some of the disadvantages of options are

Written for fixed amount and terms

Subject to basis risk

Offers only partial hedge

9.0 Conclusion:

This report highlights the impact of different hedging techniques on the expected proceeds of the company. As the company trades across the borders so it is exposed to the transaction exposure or exchange rate risk. The company should take the centralization position in decision making and could use centralization as tool to see total cash, borrowings and currency position to attain economies of scale in large transaction. This report examines the feasibility of three alternative hedging techniques to eliminate the exchange rate exposure by evaluating the results of each. The result suggests that forward contract is best tailored hedging instrument and they also can be bought or sold at any time without any cost. As a result, the positively practical results told that hedging exchange risk with the forward contract for the company is feasible as compared to the results of money market hedge and billing in US dollars.

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