Foreign exchange hedging

problem

(a) As the question gives only the S$/US$ and US$/£FX rates, we first have to calculate the S$/£ cross rate:

Two months forward:

S$/US$ = 2.0964 US$/£ = 1.5047 ∴ £/US$ = 1/1.5047 = 0.6646 ∴ S$/£ =20964 0 6646 . . = 3.1544

Three months forward:

S$/US$ = 2.0915 US$/£ = 1.5105 ∴ £/US$ = 1/1.5105 = 0.6620 ∴ S$/£ =20915 0 6620 . . = 3.1592

There are basically two ways an exporter can hedge against FX risk if they have to invoice customers in the overseas currency. One is to use the forward market and the other is to use the money market.

Singapore sale

With Oxlake, as far as the Singapore sale is concerned, they could investigate either approach. However, due to the uncertainty as to when the customer will pay and the fact that the company wishes to hedge ‘without taking any risks’, this means that only the forward market approach is possible.

The reason for this is that, with a money market hedge, the company would be open to risk in that it doesn’t know whether to take out a two- or three-month loan. If they just take out a two-month loan, there is the risk that the customer will not pay until three months have elapsed. Thus the loan would have to be extended for a month (sub- jecting the company to interest rate risk) and the increased level of interest payable (three months rather than two) would also expose the firm to a small FX risk on the difference.

In order for Oxlake to hedge the Singapore contract without any risk they will need to take out an option forward contract as the timing of the S$ receipts is uncertain and could arise at any time between two and three months. Option forward contract rates are always set at the least favourable rate to the company. A two-month forward contract has an exchange rate of 3.1544, whilst the three-month contract is at a rate of 3.1592. As it is the latter which is the least favourable to Oxlake, this will be the rate they are charged on their option forward contract. Hence the company will take out an option forward con- tract to sell S$715 500 at some time between two and three months in the future, at an exchange rate of 3.1592. Thus the expected £ cash flow will be:

S$715 500 ÷ 3.1592 = £226 481

C H A P T E R 2 6 F O R E I G N E X C H A N G E H E D G I N G 7 7 3

Chapter 26 Foreign exchange hedging

Indonesian sale

As there is no forward market in Indonesian rupiahs against £, and no rupiah loans are available, Oxlake must accept their customer’s offer of US$125 000 in three months if they wish to be able to hedge the FX risk.

The US$ could be sold three months forward as a FX hedge to yield: US$125 000 ÷ 1.5105 = £82 754 received in three months.

The alternative is to use the money market to hedge by taking out a three-month US$ loan for US$x: such that:

US$x (1 + 0.03) = US$125 000. Therefore they should take out a loan for:

US$x = 125 000 ÷ 1.03 = US$121 359.

This loan will be repaid (capital, plus interest, will amount to US$125 000) with the money received from the customer in three months’ time.

The US$ loan can be converted into £ at spot:

US$121 359 ÷ 1.4875 = £81 586 available now.

In order to compare this alternative with the forward market deal, we need to be able to compare like with like (i.e. £82 754 in three months’ time as against £81 586 now). Therefore, assuming that the £81 586 is placed on three-month £ deposit then this will yield in three months’ time:

£81 586 (1 + 0.01625) = £82 912.

As this amounts to marginally more than Oxlake could obtain from the forward market transaction, the company should hedge the Indonesian sale through the use of the money market.

Summary

Singapore sale: Expected £ revenues in three months’ time = £226 481.

Indonesian sale: £ revenues immediately = £81 586 (or £82 912 in three months’ time)

The Singapore hedge is achieved through a two-to-three month option forward sale contract. The Indonesian hedge is achieved through a three-month US$ loan (a so-called currency overdraft).

(b) Standard sale price:

100 000 × 2 246 = 224.6mn rupiahs. Discount price: 224.6mn × 0.95 = 213.37mn rupiahs. The R/US$ spot rate is the cross rate of the R/£ and the US$/£ spot rates:

2481

1 4875. =1 668= R / US$ spot rate. Therefore the Indonesian customer will pay immediately:

US$ = 213.37mn ÷ 1 668 = 127 920 which Oxlake can sell at spot for:

As this is more than the £81 586 available immediately from use of the money market, the offer made by the Indonesian importer is likely to be accepted by Oxlake.

(c) There are three main reasons why it may be advantageous for a company to invoice an export sale in a foreign currency. First, the foreign currency might be expected to appre- ciate (i.e. the forward rates would be at a premium) and therefore the company could expect a favourable FX movement.

The second reason is that the exporter may have an existing liability in that overseas currency. Therefore, by invoicing the customer in that currency, some hedging of the FX risk can be gained through the matching principle.

Finally, it may be advantageous to agree to invoice in the foreign currency in order to gain a competitive advantage over your rival suppliers. Export markets are often very competitive and offering to invoice in the customer’s currency may be an effective mar- keting device.

The main disadvantage of invoicing in a foreign currency is the exposure it creates to foreign exchange risk. This exposure may be difficult to hedge (because no forward market exists and there is no convenient ‘proxy’ currency to invoice in instead) or, if hedging is possible, then the company has to incur the transaction costs involved, which can be significant.

problem

(a) Four FX hedging techniques are: 1. forward market hedge;

2. money market or financial hedge; 3. futures market hedge;

4. options market hedge.

With a forward market hedge an exporter who is due to receive payment in a foreign currency arranges with a bank to sell that currency at a specific rate of exchange for delivery on a specific future date (or, sometimes, between two specific future dates) which coincides with the expected payment of the invoice.

With a money market hedge the exporter would borrow an amount of money in the foreign currency for the period of the credit granted to the customer, such that the prin- cipal sum plus the accumulated interest at the end of the loan’s term would exactly equal the amount of foreign currency due from the customer on payment of the invoiced amount. The amount borrowed is sold at spot for £ and represents the outcome of the export deal. The principal plus interest is then repaid using the money received from the customer at the end of the credit period.

If the company were to use a futures market hedge, the exporter would open up a position on the futures market such that any profit or loss made on the futures when the position is subsequently closed out approximately offsets the loss or gain made on the invoiced amount arising out of a movement on exchange rates over the credit period.

Finally an options market hedge guarantees the company a minimum rate of exchange for its future foreign currency receipt, known as the option ‘exercise’ or ‘strike’ price. Thus, when the foreign currency is received from the export customer, if a better rate of exchange is available on the spot market, then the option is allowed to lapse and the cur- rency is sold spot. On the other hand, if the spot market provides a less favourable rate of exchange, then the option is exercised to take advantage of its guaranteed minimum rate of exchange.

Each of the first three of these hedging techniques hedges the company against both an adverse and a favourable movement in exchange rates over the credit period granted to the customer. In contrast, the FX options hedge the exporter against an adverse C H A P T E R 2 6 F O R E I G N E X C H A N G E H E D G I N G 7 7 5

movement in exchange rates, but allows him to take advantage of any favourable movement.

(b) The $/£ rates are:

Spot: 1.7106 – 1.7140 3 months forward: 1.7024 – 1.7063 6 months forward: 1.6967 – 1.7006 (i) Fidden has the following transactions due: Due to pay : £116 000 – No FX risk

Due to receive : $197 000 – Requires hedge [a] Due to pay : $447 000 – Net out for a ‘natural’ hedge,

Due to receive : $154 000  

 leaving the balance

Net payment due : $293 000 – Requires hedge [b]

(1) Forward market hedge

[a] Sell $197 000 at 1.7063 = £115 454 receivable in 3 months. [b] Buy $293 000 at 1.6967 = £172 688 payable in 6 months.

(2) Money market hedge

[a] Borrow $x for 3 months at 9% ÷ 4 = 2[1/4]% so that: $x(1 + 0.0225) = $197 000

$x = $197 000 ÷ 1.0225 = $192 665

Sell the $192 665 spot, at 1.7140, to give £112 407 received immediately. Use the $197 000 received in three months time to repay loan, plus accumulated interest. [b] Deposit $x for 6 months at 6% ÷ 2 = 3% so that:

$x(1 + 0.03) = $293 000

$x = $293 000 ÷ 1.03 = $284 466

Purchase the $284 466 spot, at 1.7106, to give £166 296 payable now. The net payment of $293 000 due in six months time can be made with the contents (capital plus interest) of the $ deposit account.

Therefore the net £ position from the forward markets will be: (i) Three months’ time:

Pay: £116 000

Receive: £115 454

Net pay: £ 546

(ii) Six months’ time:

Pay: £172 688

The net £ position for the money markets will be: (i) Immediately:

Receive: £112 407

Pay: £166 296

Net pay: £ 53 889

(ii) Three months’ time:

(ii) As the question only gives details of the spot rate in six months’ time, it is assumed that the question only refers to the net payment of $293 000, payable in six months’ time.

To hedge this FX risk in the option market we will need to buy £ June put options. June options are involved because the payment is due in June (although September options could possibly be used). Put options are involved because in the ‘cash’ market we will need to buy $293 000 to pay the invoice by selling £. Therefore we need to buy options to sell £: £ puts.

With £ June puts, there is a choice of two exercise prices. (Notice that the more favourable the exercise price is to the company – $1.80 – the more expensive will be the option cost.)

However, we can see that in this case we would not select the $1.70 exercise price, the reason being that the cost of paying the invoice at this exercise price would be: $293 000 ÷ $1.70 = £172 353. This is only marginally cheaper than the cost of paying the invoice through a forward market hedge: £172 688. The cost of the £ July options will certainly be in excess of this saving of £335, therefore we can ignore the $1.70 exercise price in this case.

Therefore, we would hedge with £ June puts at an exercise price of $1.80. Paying the invoice at this rate of exchange would have a £ cost of:

$293 000 ÷ $1.80 = £162 778.

Given the size of £ option contracts, to hedge the FX risk we would need: £ 162 778 ÷ £12 500 = 13.02 contracts.

We are now faced with a choice of two alternatives:

1. hedge with just 13 option contracts and leave a very small amount unhedged; 2. over-hedge by using 14 option contracts.

Assuming that the company wants no FX risk, it will go for the over-hedge. Therefore we will hedge by buying 14 £ June puts at an exercise price of $1.80 and a cost of:

14 × £12 500 × 9.32¢ = $16 310

In June, we also have a choice. We either allow the option to lapse and buy $293 000 on the spot market in order to pay the amount due or, alternatively, buy $ through the exercise of the option contracts.

As the June $/£ spot rate is 1.6967–1.7006, it is obviously better to buy $ by exercising the option as they can be bought at a more favourable rate of exchange – $1.80 – than the 1.6967 rate on the spot market.

Exercising the option contracts:

Buy: 14 × £ 12 500 × $1.80 = $315 000 at a £ cost of: $315 000 ÷ $1.80 = £175 000.

The invoice of $293 000 can then be paid out of these purchased $, leaving a surplus of: $315 000 – $293 000 = $22 000. The surplus can then be used to pay the option cost of $16 310. This leaves a residual of: $22 000 – $16 310 = $5690 which can be sold spot at 1.7006 to yield: $5690 ÷ 1.7006 = £3346.

Therefore, overall:

£ cost of exercising option contracts : £175 000

Less the proceeds from sale of surplus $ : £ 3 346

Net cost : +£171 654

As this net cost, payable in six months’ time, is less than the forward market hedge cost of £172 688, the option hedge is preferred.

(However, note you can only tell with the benefit of hindsight whether the option hedge is more or less favourable than the forward market hedge. In this question the option turns out to be the better alternative, but this will not always be the case.) (iii) A forward market hedge locks the company into a specific future exchange rate (as does a futures hedge). Therefore the company is hedged against a favourable move in FX rates, as well as hedged against an adverse movement.

With options, the company has additional flexibility. The option allows the company to hedge against an adverse move in FX rates (by exercising the option), but at the same time the company can take advantage of a favourable movement in FX rates (by allowing the option to lapse).

This extra flexibility means that options are more expensive than forward contracts, but they are particularly useful where a company has a contingent exposure to FX risk.