Risk Management

(P3)

Forex - 01

http://virtual.lk/
 Hedging of exchange rate risk

Hedge No Hedge

Internal External

1. Internal hedging techniques

1. Invoicing in home currency

2. Leading and lagging

3. Netting

4. Matching

5. Restructuring

1. Invoicing in home currency

This is a situation where an organization invoicing a customer in the local currency.
This will clearly hedge the risk because the company will manage the exposure to
not associating foreign currency. This is not recommended hence the customer will
bear the risk and will negatively influence the demand.
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CIMA- SL - £87 - Rs 210/£

- Rs 230/£

- Rs 180/£

Home currency for UK

2. Leading and Lagging

Leading

This is creating a particular payment in advance anticipating the future direction of

the exchange rate. The objective is to minimise and to generate a profit from the
transaction.

01/06/2014 31/12/2014

$ 1 mill Rs 115/$ Rs 140/$

Rs 130/$ Pay on 01.08.2014

Lagging

This is a similar situation where the organization will delay a particular payment or
a receipt in order to minimize the risk or generate a profit. However this is not
very practical because the other party should accept the conditions for late
payments.

3. Netting

This technique emphasize on hedging forex risk by adjusting the internal

transactions.

A. Bilateral netting

B. Multilateral netting
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A. Bilateral netting

This is netting the balance based on transactions by using two different currencies.

Example:-

J ltd operates in UK with a subsidiary in US. The head office has to pay the
subsidiary $ 150m. The subsidiary has to pay the head office 80 m.

Develop a bilateral net assuming $ 1.5/ £

Head office –pay $150m – {$150/$1.5/£} = £100m

Subsidiary –pay = £ 80m

Finally one transaction Head office Pay Subsidiary £20m

B. Multilateral net

This is an extension of the bilateral net where more than 2 currencies are
considered. This can be used to manage complex situations.

Example

AB ltd operate with a head office in US. The company has subsidiaries in UK,
Canada, Italy and Japan.

The following transactions can be identified;

$
UK pay Japan ¥ 20 000 m 200 m

UK pay Italy € 100 m 125 m

Japan pay Canada $ 600 m 500 m

Canada pay UK £ 500 m 800 m

Italy pay Canada C$ 300 m 250 m

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 Exchange rate: £ .625: € .8: C$ 1.2: ¥100 / $

Receiving Subsidiary
UK Italy Canada Japan
Total payment

UK $ 125m $ 200 m $ 325 m

Italy $ 250 m $ 250 m
Canada $ 800 m $ 800 m
Japan $ 500 m $ 500 m
Total receipts $ 800 m $ 125 m $ 750 m $ 200 m
Total payments ($ 325 m) ($ 250m) ($ 800m) ($ 500 m)
Net $ 475 ($125m) ($ 50 m) ($ 300 m)

Final Transactions

1. Italy Pay UK $ 125

2. Canada Pay UK $ 50
3. Japan Pay UK $ 300

4. Matching

This technique can be used to hedge foreign exchange exposure by offsetting the
impact of assets and liabilities. Therefore a similar cash inflow or outflow will be
used in hedging the exposure. This can be used to hedge assets and liabilities or
any other form of transactions.

UK company invest in US by Borrowing in US $

E.g. Indian Oil Company invested in Sri Lanka through an IPO in Sri Lanka

5. Restructuring

This is the process of changing the organizational structure in order to minimize

the impact of exchange rate risk. The following strategies can be considered.

5.1 Adjust imports and exports.

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5.2 Establish a foreign subsidiary.

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2. External hedging techniques
This demonstrate the use of derivatives from the external market. The following
techniques can be identified.

1. Forward rate agreement

2. Futures contract

3. Options contract

4. Money market hedge

5. Swap

6. Swaption

1. Forward Rate Agreement (FRA)

This is a formal agreement developed with a bank to buy or sell a particular foreign
currency at a specific date considering a specific rate.

This is a legal agreement which has to be honoured irrespective of the actual rate at
maturity. The bank will charge a specific fee for the service.

The basis for determining the forward rate is developed through the IRP

This will enable the organization to operate with certainty regarding future receipt
or payment based on a fixed exchange rate (pre-determined)

Example

ABC ltd is a UK based company, expecting to pay $ 100 million in 3 months’ time.
The current spot rate is $1.5/£. The company is expected to hedge the risk with a
FRA. The bank has provided a FRA for 3 months at $ 1.47/£.

Determine the cost for the company based on the FRA.

FRA= $ 100m/ ($1.47/£)

= £ 68.03 m
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Evaluate the situation of the company if the actual rate @ maturity is

1. $ 1.6/£ 2. $1.4/£

1. $1.6/£ 2. $1.4/£
FRA= $100m/ ($ 1.6/£) FRA= $100m/ ($1.4/£)

= £ 62.5 m = £ 71.4 m

Loss Gain

In practice organizations prefer FRA since the exact cost and revenue is known
and as a result can plan the decisions. This is preferred in practice over the other
techniques due to this reason.

The FRA can be flexible based on a period. This is referred to as “option forward
contract”

Fixed- 25/04/2015

FRA

Option 24/04/2015 - 29 /04/2015, with a commission

2. Future’s contract
This is a standard contract developed based on international futures exchange.
This is mainly used by large organizations.

The futures contracts originated from the 16th century, initially from commodity
futures. In the present context every large commodity and currency transaction are
developed through futures.

E.g. oil, gold, sugar, beef

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Characteristics of future’s contract

1. Standard maturity period (quarterly basis)

2. Standard contract size (£ 62500, $ 100,000)

3. Available only in selected currencies ($, £)

4. Available only in selected exchanges

E.g. Chicago future’s exchange

London international financial future’s exchange

Tokyo future’s exchange

5. Legally binding contract

6. Closing out

In practice these instruments are used by large organizations which operate

regularly with contracts. Therefore each contract will not be honoured individually,
instead will be closed out based on an account maintained by the company.

Wallmart

01/01/2015 100 05/01/2015 120

05/01/2015 Closed 30 contracts

7. Mark to Market (Market to Market)

The futures contracts are market driven, therefore can be purchased and sold in
order to minimize the risk, create a profit (similar to shares)

01/10/2014 - Buy $ 1.5 / € 31/12/2014 - Sell $ 1.4 /€

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Development of futures contract

1. Initial margin

2. Variation margin

3. Actual transaction

1. Initial margin

This is the initial deposit that a customer should provide to the futures exchange.
This depend on the number of contracts and should be paid per contract.

**In actual practice the initial margin is used to adjust against the daily variation
(variation margin)

Exam focus:-

The initial margin deposit will be recovered at maturity. The opportunity cost
should be adjusted using the prevailing interest rate.

It is important to identify the currency of the transaction and the currency of the
futures exchange.

However if the currency of the transaction is different from the currency of the
exchange the transaction has to be converted using the future’s spot rate relevant
for the period..

However unlike the FRA, the future’s contract may or may not indicate a perfect
hedge due to the standard contract size.

2. Variation Margin

In practice this is the daily fluctuation of the futures price.

**In actual practice the daily profit or loss adjusted against the initial margin

Exam focus -The variation margin is determined as the difference between the
futures spot rate for the period and the actual future spot rate at maturity. This is
used to determine the profit or loss of the contract.
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Actual Transaction

The actual transaction will originate regardless of the hedging or not. The
transaction will be converted at the actual spot rate at maturity (market rate).

Example

JP ltd, a UK based company is expected to pay $ 12m to a supplier in 6 months’

time. The current spot rate is $1.5/£. The following information is available based
on the futures market.

Contact size - £62500

Futures market:

Period Spot rate Initial margin

31/03/2015 $1.56/£ £1000 per contract
31/06/2015 $1.59/£ £1500 per contract
30/09/2015 $ 1.61/£ £2000 per contract

Today is 01/01/2015.

Assume the following information is available at maturity: (Actual details)

Spot rate- $ 1.6 /£

Futures rate- $ 1.662/£

The interest rate inn UK is 6%

Solution:

Initial margin (w1) (£181,500)

Initial margin recovery £ 181,500

Interest (w2) (£ 5445)

Variation margin (w3) (£ 141,797)

Actual transaction (w4) (£7,500,000)

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£7,647,242
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W1:

No. of contracts = $ 12,000,000/ $1.59 = £ 7,547,170

= £ 7,547,170 / £62500 = 120.75 121 Contracts

Initial Margin = 121×£1500 = £ 181500

W2:

Interest = £181500×6 %×( 6/12) = £ 5445 => opportunity cost

W3:

Variation margin = Futures spot rate (forecast) - Future spot rate (actual)

=($1.59/£)-($1.62/£)

=$0.03/£

Variation margin = [Margin ×contract size × No. of contracts]/spot rate at maturity

= [$0.03/£ × £ 62500 ×121] / ($1.6/£)

= (£141,797)

W5:

Actual transaction= $12,000,000/ $1.6/£

= £ 7,500,000

*The contract value is in £ due to the exchange. However the transaction is in $.

Therefore the transaction was converted at future’s spot rate (Rate at Maturity) for
the period (transaction is for 6 months. Therefore future’s spot rate for 6 months
is considered)
*The number of contract required is 120.75. However since the contract size is a
standard 121 is used

*The initial margin has to be paid per contract. The margin for 6 months contract
is £1500

*However since this is a deposit it will be repaid at the end of the period (refer IM
recovery)
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* However the money is idling for 6 months. This creates an opportunity cost.
This is adjusted based on the prevailing interest.

*The variation margin is the difference between the futures spot rate and the
future’s rate at maturity ($ 1.59/£- $1.62/£). The VM indicate the effectiveness of
the hedge JP ltd hedged expecting the $ to appreciate.

(Expecting a Loss) However the $ has depreciated. Therefore the Hedge is

ineffective

* However the company will benefit from the actual transaction due to
depreciation of the $

* Since the hedge is ineffective the VM will be a loss as a result paying more

* The situation of the company after the hedge is £7,647,242 payment.

However if the company did not hedge the actual cost would have been
£7,500,000

Actual procedure for Initial Margin & Variation Margin

02/01/2015 £21 01/01/2015 £181500

03/01/2015 £ 318

Interpretation of the VM

In practice the VM is interpreted as the Basis risk. A basis risk demonstrate the
lowest possible variation .This is calculated considering the fourth decimal point
(0.0001)

Current size = £62500×0.0001

= £6.25
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Margin = ($0.03/$)/0.0001 = 300

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VM= (Margin× Contract size × No.of contracts)/Spot rate

= ($300×£6.25×121)/ ($1.6/£)

= £ 141,797

3. Options contract

Option demonstrate a right but not an obligation for engage in a foreign currency
transaction. This technique provides flexibility to the option holder either to accept
or reject the contract.

However to provide this flexibility the option provider charges a higher premium
at the beginning of the contract.

Types of options

1. Call option

2. Put option

1. Call option

This is a right to buy a particular contract

2. Put option

This is a right to sell a particular currency. The option provider will operate with a
standard contract size.

Example £31250

The option type whether call or put has to be determined based on the intention of
the customer and the nature of the exchange.

If Gajendra buys a Cup of Coffee by Paying Rs 150 from Burger King

Gajendra Call – Coffee Put Rs 150

Burger King Call – Rs 150 Put Coffee

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Example

RS ltd is a US based company expecting to receive £ 800,000 from a UK customer

in 6 months’ time. Today is 01/01/2015. The following information is available
based on option market

Contract size £31250

Commission ($/£) Call Put

Mar June Sep Mar June Sep

$1.5/£ 5 6 7 2 4 6

$1.55/£ 3 5 6 5 6 8

$1.6/£ 2 3 5 8 9 10

5% Commission

Identify the most suited option for RS

Have (£) Want ($)

Sell => Put Buy =>Call

No of contracts = £ 800,000/£31,250 = 25.6

$1.5/£ = 26 × £ 31250 × $1.5/£ = $ 1,218,750

$1.55/£ =26 × £ 31250 × $1.55/£ = $1259375

$1.6/£ = 26 × £ 31250 × $1.6/£ = $1300000

Amount($) Commission($) Net amount ($) Rate

1,218,750 (48750)=>4% 1,170,000 $1.5/£

1,2593,75 (75563)=>6% 1,183,813 $1.55/£ (Strike price)

1,300,000 (117000)=>9% 1,183,000 $1.6/£

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4. Money market hedge

This technique can be used to hedge the exchange rate risk based on the available
interest rate in the market (money market).

The organization can create a deposit borrowing in a respective currency to hedge

against foreign currency receipts and payments

The following options are available

A. Hedging Foreign Currency Payments

B. Hedging Foreign Currency Receipts

A. Hedging Foreign Currency Payments

The following steps can be considered:

1. Identify the equivalent amount of foreign currency that is requested to create a

foreign currency deposit, today.

2. Convert the identified foreign currency amount using the spot rate and borrow
the equivalent amount in local currency.

* On the due date;

i. Use the foreign currency deposit to pay for the foreign contract (imports)
ii. Pay the local currency loan

The cost of the local currency loan is the cost of the imports

The foreign currency exposure is hedged through the foreign currency deposit.
B. Hedging foreign currency receipts

The following steps can be considered

1. Identify the equivalent amount of foreign currency that should be borrowed

today.

2. Identify the equivalent amount of the local currency by converting foreign at

the spot rate and create a local currency deposit
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 *On the due date;

i. Pay the foreign currency loan using the export receipts (foreign currency
receipts)
ii. Consider the local currency deposit value at maturity as the actual receipts.

The foreign currency receipts are hedged through the foreign borrowing

Following information is available;

Interest rate p.a (%) Deposit Borrowing

US 4 8

UK 3 6

i. KKS ltd is a UK based company expects to pay $10m to a US supplier in 3

months’ time

ii. TTP ltd is a UK based company expected to receive $12m in 6 months’ time
from a US based customer

Develop a money market hedge for both situations. Assume spot rate $1.5/£

1. UK- pay $10m in 3 months

$10m / 1.01 = $9.9m (.04 / 4) 3 months rate

$9.9m /$1.5 = £6.6m

£6.6 m × 1.0156 = £6.69 (.06 /4) 3 months rate

Creating an exchange rate;

$10m/£6.69 = $1.49/£
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2. UK- receive $12 m in 6 months

$12m/ 1.04 = $ 11.54m (.08 /2) 6 months rate

$11.54/$1.5/£ = £ 7.69m

£7.69 m × 1.015= £ 7.8 m (.03/2) 6 months rate

Creating an exchange rate

$12m/ £7.80 m= $1.54/£

Homework

Referring to the worked examples consider the following adjustments

1. Future’s contract- assume the futures rate of maturity is $ 1.57/£ and the spot
rate at maturity is $ 1.58/£

2. Options contract- assume a new contract for the company where the expected
revenue in 3 months’ time is £600,000.

3. Money market hedge-

a. A ltd a US based company expected to pay £8m in 3 months’ time. B ltd, a US

based company expected to receive £4m in 4 months’ time.

5. Swap
This technique is developed by identifying two entities or people with mutual
interest. The objective is to exchange a particular asset or liability with another
party, with similar interest.

To practice swap, the following conditions has to be available;

1. Each party with mutual interest regarding the cash flow or a particular
transaction (Asset vs. Liability)

2. Both parties should expect similar maturity period

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3. Both parties should indicate similar value considering the transaction.

A Swap will involve each party, exchanging a specify cash flow. This always creates
counter party risk (one party not honouring the contract).

*However this problem can be solved by operating the swap agreement with a
financial institute (bank). The bank will charge a commission for the service.

Example:

ABC ltd, a UK based company is expected to invest $150m in US SQ ltd, a US

based company is expected to invest £ 100 million in UK. Both investments
demonstrate a maturity period of 3 years. Both parties are expected borrow from
local currency from the home market to finance the investment.

The exchange rate is $15/£

Required:-

Develop a swap to minimize the foreign currency expense

£ 100 m £150m

ABC-UK Based SQ- US Based

US-$150 m UK- £100 m

ABC SQ

£ Liability $ Liability
$ Asset £ Asset

$ Liability £ Liability

This will also enable either party to hedge the expected return since the asset and
liability is mentioned.
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This is an effective technique, however the following practical problems can be
seen;

1. Finding a reliable party

2. Identifying a party with a same maturity period

3. Identifying a party with similar value

6. Swaption

This demonstrate the characteristics of both options and a Swap. A swapton

demonstrate an option to swap. Therefore either party can move out from the
swap.

No Hedge Policy

This is a deliberate strategy of not hedging the foreign exchange exposure. This
should be developed with a clear plan and understanding regarding the forex
markets.

In practice this can be accepted based on the following characteristics.

1. A particular forex transaction demonstrating less impact on the organization as a

whole.

E.g. Transaction value less than 2% of total revenue.

This risk can be absorbed by the company

2. Successful trading history (international trade) over a period of time (any impact
considering gain or loss will be offset).

3. Organization operating with similar assets and liabilities in foreign currency.

4. Organization operating with similar imports and exports

5. A large company with a specialised treasury function.

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Arbitrage

In general terms arbitrage demonstrate an opportunity to generate a profit due to

market imperfections. This indicates an abnormal profit beyond the general market
conditions.

Example:-

T20 Final- 2012

Tickets in August- Rs 150

Tickets in October- Rs 3000

This can be applied to any commodity real estate capital markets and for exchange
rate (foreign currency)

Development of Arbitrage

A dealer associated with a financial market has offered a forward rate of $ 1.59/ £,
for 6 months period (value at maturity). The spot rate is $ 1.5/£. The interest rate
in US is 6% and in UK 3%. The financial market will allow a person to borrow up
to $ 5 m. The transaction cost per conversion is $ 5000.

Required:-

1. Identify any arbitrage opportunity

2. Develop steps indicating the generation of an arbitrage profit

1. Yes

IRP

Actual rate in 6 months = Spot rate × {(1+rF)/ (1+rD)}

= $ 1.5/£ × (1+.03)/ (1+.015)

= 1.52£
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The rate according to the IRP is different from the dealer rate of $159/£.
Therefore there is a possibility of arbitrage. Clearly there is an opportunity for
arbitrage since the most likely rate developed through IRP is different from the
rate offered by the dealer.

The following steps can be identified;

1. The dealer has undervalued the $ and over valued the £ at maturity

2. A person should have £ at maturity to receive more $ than the market by selling
to the dealer

3. A person can borrow $ today and convert into £ and invest for 6 months

4. After 6 months sell the £ with interest to the dealer and obtain $.

Now pay the loan with interest with the additional $ received from the dealer

Borrow $ 5 m and convert

$1.5 /£1

$ 5 m = £ 3.33 m

Deposit the £ 3.33 m in the bank @ 1.015 for 6 months = £ 3.38

$ Loan value after 6 months = $ 5m× 1.03% = $ 5.15m

Convert £ 3.80m at maturity @ $1.59 = 5.37 m

The company will receive $ 5.37million at maturity and will pay the loan of $ 5.15
million. The result will be a profit at which a commission has to be paid.
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Profit = $ 5,370,000 - $ 5,150,000 - ($ 5000*2) = $210 000

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(Assume that it is converted twice)