risk management

Many firms refrain from active management of their foreign exchange exposure , even though they understand that exchange rate fluctuations can affect their earnings and value . They make this decision for a number of reasons

Management does not understand it . They consider any use of risk management tools , such as forwards , futures and options , as speculative Or they argue that such financial manipulations lie outside the firm 's field of expertise "We are in the business of manufacturing slot machines , and we should not be gambling on currencies " Perhaps they are right

to fear abuses of hedging techniques , but refusing to use forwards and other instruments may expose the firm to substantial speculative risks . They claim that exposure cannot be measured . They are right - currency exposure is complex and can seldom be gauged with precision But as in many business situations , imprecision should not be taken as an excuse for indecision

Finally , they assert that the balance sheet is hedged on an accounting basis--especially when the "functional currency " is held to be the dollar . The misleading signals that balance sheet exposure measure can give are documented in later sections

Today we speak about the theory of three

- PPP theory . The purchasing power parity (PPP ) exchange rate is the exchange rate that would make the purchasing power of a unit of a currency the same in two countries if expressed in terms of one common currency , under these conditions the same basket of goods and services should cost the same when expressed in terms of the same currency (2 ) The above refers to what is called the absolute version of the PPP theory . The PPP relationship becomes a theory of exchange rate determination by introducing assumptions about the behavior of importers and exporters in response to changes in the relative costs of national market baskets Recall , in the story of the law of one price , when the price of a good differed between two country 's markets , there was an incentive for profit-seeking individuals to buy the good in the low price market and resell it in the high price market . Similarly , if a market basket containing many different goods and services , costs more in one market than another , we should likewise expect profit-seeking individuals to buy the relatively cheaper goods in the low cost market and resell them in the higher priced market . If the law of one price leads to the equalization of the prices of a good between two markets , then it seems reasonable to conclude that PPP , describing the equality of market baskets across countries , should also hold

However , adjustment within the PPP theory occurs with a twist compared to adjustment in the law of one price story . In the law of one price story , goods arbitrage in a particular product was expected to affect the prices of the goods in the two markets . The twist that 's included in the PPP theory is that arbitrage , occurring across a range of goods and services in the market basket , will affect the exchange rate rather than the market prices . The relationship is derived from the basic idea that , in the absence of trade restrictions changes in the exchange rate mirror changes in the relative price levels in the two countries (6 At the same time , under conditions of free trade , prices of similar commodities cannot differ between two countries , because arbitragers will take advantage of such situations until price differences are eliminated . This "Law of One Price " leads logically to the idea that what is true of one commodity should be true of the economy as a whole--the price level in two countries should be linked through the exchange rate--and hence to the notion that exchange rate changes are tied to inflation rate differences

This is the basic idea behind Purchasing Power Parity computation of the GDP of an economy . It is worth adding that (as you probably have guessed by now ) the resulting difference between the two ways of computing the GDP is dependent on how much open trade there is in a country , and dependent on how well the country is integrated in the world economy and its products ' competitiveness , as these things tend to equalise how much the same money can buy . That is why you will find less difference in western countries ' GDP 's when computed the standard way , or the Purchasing Power Parity way

Example

In a closed economy with no olive production , you can control the price of olives but in an open economy , the price of olives will be determined by the international market value , since if the price is too high , people will import cheaper olives , and if it is too low , people will export olives for profit , so that the price of olives comes into equilibrium with the international price . Now this assumes perfect market conditions , which never exist , and does not account for transport cost of the product (olives

In addition , if a house in Yemen costs 10 per month and no one wants to live there because there is no demand for housing , for whatever reason then that does not mean that the price of housing will go up (to reach equilibrium with the international market ) since you cannot export that house . Other issues to think about include how exchange rates affect GDP calculations

Example : Suppose a basket of goods sells for 11 ,000 in the U .S . sells for 10 ,000 euro in euro zone . According to PPP theory , the exchange rate should be 1 .10 per euro . If it were not (suppose the exchange rate was 1 .00 per euro ) you could buy the basket in the euro zone for 10 ,000 euro and sell it for 11 ,000 in the U .S . You could then exchange the 11 ,000 for 11 ,000 euro for a profit of 1 ,000 euro . Selling dollars and buying euros drives up the price of the euro

The PPP theory does not usually explain exchange rates at any particular point in time because of trade barriers , central bank interventions , etc . But is a valuable long-run predictor

A country 's currency generally appreciates during periods when its inflation rate is lower than the rest of the world

A country 's currency generally appreciates when real interest rates are higher than in the rest of the world

The main problem with the PPP theory is that the PPP condition is rarely satisfied within a country . There are quite a few reasons that can explain this and so , given the logic of the theory , which makes sense , economists have been reluctant to discard the theory on the basis of lack of supporting evidence

Transportation costs and trade restrictions - Since the PPP theory is derived from the law of one price , the same assumptions are needed for both theories . The law of one price assumed that there are no transportation costs and no differential taxes applied between the two markets . These means that there can be no tariffs on imports or other types of restrictions on trade . Since transport costs and trade restrictions do exist in the real world this would tend to drive prices for similar goods apart . Transport costs should make a good cheaper in the exporting market and more expensive in the importing market Similarly , an import tariff would drive a wedge between the prices of an identical good in two trading countries ' markets , raising it in the import market relative to the export market price . Thus the greater are transportation costs and trade restrictions between countries , the less likely for the costs of market baskets to be equalized

Costs of Non-Tradable Inputs - Many items that are homogeneous nevertheless sell for different prices because they require a non-tradable input in the production process

Perfect information - The law of one price assumes that individuals have good , even perfect , information about the prices of goods in other markets . Only with this knowledge will profit-seekers begin to export goods to the high price market and import goods from the low priced market . Consider a case in which there is imperfect information . Perhaps some price deviations are known to traders but other deviations are not known . Or maybe only a small group of traders know about a price discrepancy and that group is unable to achieve the scale of trade needed to equalize the prices for that product

Other market participants - Notice that in the PPP equilibrium stories it is the behavior of profit-seeking importers and exporters that forces the exchange rate to adjust to the PPP level . These activities would be recorded on the current account of a country 's balance of payments Thus , it is reasonable to say that the PPP theory is based on current account transactions . This contrasts with the interest rate parity theory in which the behavior of investors seeking the highest rates of return on investments motivates adjustments in the exchange rate . Since investors are trading assets , these transactions would appear on a country 's capital account of its balance of payments . Thus , the interest rate parity theory is based on capital account transactions

Section B

In this section we consider the relative merits of several different tools for hedging exchange risk , including forwards , futures , debt swaps and options . We will use the following criteria for contrasting the tools

First , there are different tools that serve effectively the same purpose . Most currency management instruments enable the firm to take a long or a short position to hedge an opposite short or long position Second , tools differ in that they hedge different risks . In particular symmetric hedging tools like futures cannot easily hedge contingent cash flows : options may be better suited to the latter

Tools and techniques : foreign exchange forwards

Foreign exchange is , of course , the exchange of one currency for another . Trading or "dealing " in each pair of currencies consists of two parts , the spot market , where payment (delivery ) is made right away (in practice this means usually the second business day , and the forward market . The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange , or delivery , taking place at a specified time in the future While the amount of the transaction , the value date , the payments procedure , and the exchange rate are all determined in advance , no exchange of money takes place until the actual settlement date . This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract

Forward contracts are the most common means of hedging transactions in foreign currencies . The trouble with forward contracts , however , is that they require future performance , and sometimes one party is unable to perform on the contract . When that happens , the hedge disappears sometimes at great cost to the hedger . This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure . For such situations futures may be more suitable

Currency futures

Outside of the interbank forward market , the best-developed market for hedging exchange rate risk is the currency futures market . In principle , currency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price . In practice , they differ from forward contracts in important ways (3

One difference between forwards and futures is standardization Forwards are for any amount , as long as it 's big enough to be worth the dealer 's time , while futures are for standard amounts , each contract being far smaller that the average forward transaction . Futures are also standardized in terms of delivery date . The normal currency futures delivery dates are March , June , September and December , while forwards are private agreements that can specify any delivery date that the parties choose . Both of these features allow the futures contract to be tradable

Another difference is that forwards are traded by phone and telex and are completely independent of location or time . Futures , on the other hand , are traded in organized exchanges such the LIFFE in London , SIMEX in Singapore and the IMM in Chicago

But the most important feature of the futures contract is not its standardization or trading organization but in the time pattern of the cash flows between parties to the transaction . In a forward contract whether it involves full delivery of the two currencies or just compensation of the net value , the transfer of funds takes place once at maturity . With futures , cash changes hands every day during the life of the contract , or at least every day that has seen a change in the price of the contract . This daily cash compensation feature largely eliminates default risk

Thus forwards and futures serve similar purposes , and tend to have identical rates , but differ in their applicability . Most big companies use forwards futures tend to be used whenever credit risk may be a problem

Debt instead of forwards or futures

Debt - borrowing in the currency to which the firm is exposed or investing in interest-bearing assets to offset a foreign currency payment - is a widely used hedging tool that serves much the same purpose as forward contracts . Consider an example

Currency options

Many companies , banks and governments have extensive experience in the use of forward exchange contracts . With a forward contract one can lock in an exchange rate for the future . There are a number of circumstances however , where it may be desirable to have more flexibility than a forward provides . For example a computer manufacturer in California may have sales priced in U .S . dollars as well as in German marks in Europe Depending on the relative strength of the two currencies , revenues may be realized in either German marks or dollars . In such a situation the use of forward or futures would be inappropriate : there 's no point in hedging something you might not have . What is called for is a foreign exchange option : the right , but not the obligation , to exchange currency at a predetermined rate

A foreign exchange option is a contract for future delivery of a currency in exchange for another , where the holder of the option has the right to buy (or sell ) the currency at an agreed price , the strike or exercise price , but is not required to do so . The right to buy is a call the right to sell , a put . For such a right he pays a price called the option premium . The option seller receives the premium and is obliged to make (or take ) delivery at the agreed-upon price if the buyer exercises his option . In some options , the instrument being delivered is the currency itself in others , a futures contract on the currency American options permit the holder to exercise at any time before the expiration date European options , only on the expiration date . Futures and forwards are contracts in which two parties oblige themselves to exchange something in the future . They are thus useful to hedge or convert known currency or interest rate exposures . An option , in contrast , gives one party the right but not the obligation to buy or sell an asset under specified conditions while the other party assumes an obligation to sell or buy that asset if that option is exercised

So , now we try to analyze every strategy for our Company

First of all let 's start with forward contracts . If our company conclude contract for 20m USD and have only 5m of them guaranteed with receipt due on 1st of July . Other 15m USD to be paid upon delivery in three months ' time . To protect our company , we arrange to set forward rate According to currency futures (Financial Time April 2 , 2004 ) we can submit , that the high rate of dollar will be 1 .8490 and the low rate is 1 .8257 . When we calculate the average rate , we 'll have the three month forward contract price set up to 1 .8373 (for about 8164153 .92 pounds For analyzing this forward , image that three months later , the rate will be for about 1 .8283 (according currency futures , so we 'll have 8204342 .83 pounds . In this way we 'll have 40188 .91 pounds benefits . The trouble with forward contracts , however , is that they require future performance , and sometimes one party is unable to perform on the contract . When that happens , the hedge disappears , sometimes at great cost to the hedger . This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure . For such situations , futures may be more suitable

With futures , cash changes hands every day during the life of the contract , or at least every day that has seen a change in the price of the contract . This daily cash compensation feature largely eliminates default risk . Thus forwards and futures serve similar purposes , and tend to have identical rates , but differ in their applicability . Most big companies use forwards futures tend to be used whenever credit risk may be a problem . In our way , we can conclude the contract under 1 .8373 rate . So , if in three months the rate we 'll be lower , we 'll have benefits . At the same time , when the market have rate fluctuations the company we 'll have loss

For this solution we can realized that Benefits we can received from forward contract are

Known protection rate

Gain potential from a favourable move

Protection rate improves if trigger hit

No premium outlay

However , the company can faced with such risk

Small sacrifice relative to the forward rate

Gain potential limited to the trigger rate

This strategy allows a hedger to nominate a protection rate which represents the worst rate achievable should the market move adversly - at the same time allowing the opportunity to gain from a favourable move

The protection rate is slightly worse than the forward rate and represents the amount the hedger is willing to risk in to potentially capture gains from a favourable move . Provided the market never trades at a rate , known as the "trigger " rate , the hedger will deal at either the market rate or the protection rate - whichever is more favourable for the hedger

Should th br

?A futures contract is identical to a forward contract , except for the following differences : Futures contracts are standardized contracts and are traded on organized exchanges . Futures contracts are marked-to-market daily ?Futures contracts allow investors to hedge and speculate ?Futures contracts are available on commodities and financial assets :a gricultural products and livestock , metals and petroleum interest rates , currencies , stock market indices . Forwards and futures are redundant instruments and can be replicated through transactions in spot markets and borrowing or lending . Futures and forwards are derivatives : value depends on value of other asset . Forwards and futures can be used to hedge risks : foreign exchange rate risk , stock market risk , commodity price risk , interest rate risk . Forwards and futures are very volatile instruments due to leverage . They increase risk unless they are used for hedging , the portfolio includes sufficient investments in riskfree assets

Part 2

Forward Contract

For calculating outcome of forward contract , make a table and have some assumes . Currently , our company is long in spot (underlying asset ) of . Current exchange rate (April ) is 1 .8349 US /UK POUND . We will sell (deliver ) the underlying in 3 months and convert it to US dollars . Primary risk is exchange rate risk . The current 3-month forward contract on US dollars is priced at 1 .8542 . Here is one possible outcome

Date

Spot Prices Basis

St - Ft (T ) Forward K

t 0 Hold

S0 1 .8349

-0 .02 Sell 3 month

Forward at

F0 1 .8542 t 3 Assume S3 1 .6438

Sell 0 .00 F3 1 .6438

Buy Forward

(netting out

-----------------------

-------------

Loss -0 .1911

2866500

Gain 3156000

0 .2104

Notes

Forward Locks in F0 1 .8542 , Not the Spot Price of 0 .1 .8349

Increase in Basis is Perfectly Anticipated

Hedge is Perfect - Gain will be 289500 Regardless of Spot Price at Time 3 (zero Variance

Using a Futures Contract would Decrease the Amount of the Loss Slightly (interest from Mark-to-Market , but Risk would Increase

Although there is a Guaranteed Gain , this is not Arbitrage

Imperfect Hedge (Mismatched Maturities

Currently , our Company is anticipated short in spot (underlying asset of 100 ,000 Canadian . Current exchange rate is 1 .8349 US /UK POUND . We will buy the underlying in 5 months with a U .S . Dollar position Primary risk is exchange rate risk . There does not exist a 5-month Forward on UK POUNDS , but the 6-month forward is currently priced at 1 .8349 US /UK POUND . Here is one possible outcome

Date

Spot Prices Basis

St - Ft (T ) Forward K

t 0 Will Buy

In 5 months

S0 1 .8349 US /UK POUND

0 .00 Buy 6 month

Forward at

F0 1 .8349 US /UK POUND t 5 Assume S5 1 .7618 US /UK POUND

Buy Can 0 .01 F5 1 .8316 US /UK POUND

Sell Forward

(netting out

-----------------------

-------------

Gain 0 .07

1050000

Loss - 49500

0 .003

Notes

This is an Anticipatory (LONG ) Hedge

Expected Gain /Loss 0 (b0 0

Change in Basis causes Unexpected Gain Hedge is not Perfect

Basis need not be 0 EXCEPT at Maturity

Futures Contract

Current futures price for a British Pounds is 1 .8349 (I .e . exchange rate is 1 .8349 /Pound . If exchange rate falls to 1 .6438 /Pound than the cash we get from our goods is 1 .6438 /Pound x USD A loss of due to fall in exchange rate . But , the profit on our futures contracts is : 8 x USD x 1 .8349 - 1 .6438 ) which equals 1433250 . This exactly offsets our loss . If the exchange rate increases to 1 .9408 /Pound ) than the cash we get from the goods is 1 .9408 /Pound x . An extra gain of due to increase in exchange rate . But , our futures contracts suffer a loss exactly equal to the extra profit : 8 x 7500000 USD x 1 .8349 - 1 .9408 -6354000 . Point : We don 't lose or gain beyond original sale , but we eliminate risk

In a corporation , there is no such thing as being perfectly hedged . Not every transaction can be matched , for international trade and production is a complex and uncertain business . As we have seen , even identifying the correct currency of exposure , the currency of determination , is tricky . Flexibility is called for , and management must necessarily give some discretion , perhaps even a lot of discretion , to the corporate treasury department or whichever unit is charged with managing foreign exchange risks . Some companies , feeling that foreign exchange is best handled by professionals , hire ex-bank dealers other groom engineers or accountants . Yet however talented and honorable are these individuals it has become evident that some limits must be imposed on the trading activities of the corporate treasury , for losses can get out of hand even in the best of companies

In 1992 a Wall Street Journal reporter found that Dell Computer Corporation , a star of the retail PC industry , had been trading currency options with a face value that exceeded Dell 's annual international sales , and that currency losses may have been covered up . Complex options trading was in part responsible for losses at the treasury of Allied-Lyons , the British foods group . The 150 million lost almost brought the company to its knees , and the publicity precipitated a management shake-out . In 1993 the oil giant Royal Dutch-Shell revealed that currency trading losses of as much as a billion dollars had been uncovered in its Japanese subsidiary

Clearly , performance measurement standards , accountability and limits of some form must be part of a treasury foreign currency hedging program . Space does not permit a detailed examination of trading control methods , but some broad principles can be stated

First , management must elucidate the goals of exchange risk management preferably in operational terms rather than in platitudes such as "we hedge all foreign exchange risks

Second , the risks of in-house trading (for that 's often what it is must be recognized . These include losses on open positions from exchange rate changes , counterparty credit risks , and operations risks

Third , for all net positions taken , the firm must have an independent method of valuing , marking-to-market , the instruments traded . This marking to market need not be included in external reports , if the positions offset other exposures that are not marked to market , but is necessary to avert hiding of losses . Wherever possible , marking to market should be based on external , objective prices traded in the market

Fourth , position limits should be made explicit rather than treated as "a problem we would rather not discuss " Instead of hamstringing treasury with a complex set of rules , limits can take the form of prohibiting positions that could incur a loss (or gain ) beyond a certain amount , based on sensitivity analysis . As in all these things , any attempt to cover up losses should reap severe penalties

Finally , counterparty risks resulting from over-the-counter forward or swap contracts should be evaluated in precisely the same manner as is done when the firm extends credit to , say , suppliers or customers

In all this , the chief financial officer might well seek the assistance of an accounting or consulting firm , and may wish to purchase software tailored to the purposes Worked Cite

HYPERLINK "http /business .baylor .edu /Tom_Kelly http /business .baylor .edu /Tom_Kelly

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Rodney Sebire To hedge or not to hedge ? February 2004

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