Hedging Treasury Risk with Forward Foreign Exchange Contracts by gio15356

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									Hedging Treasury Risk
        with
  Forward Foreign
 Exchange Contracts

         Leslie Matthews Šulenta
                       Director
    International Business Strategies, LLC, Zagreb

                  September, 2005
    Croatian Association of Corporate Treasurers
                  Overview
 FX forwards: definition, characteristics and
  features
 Uses of FX forwards
   – Example 1: Hedging with forwards
   – Example 2: Deriving the forward rate
 Problems and risks
 Accounting for forwards
   – Example 3: Marking to market
 Risk management
               Leslie Šulenta, International Business   2
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  FX Forwards:
   Definition,
Characteristics and
    Features
  Forward Foreign Exchange
          Contract
                      Definition:
An agreement to exchange one currency for
              another, where
 The exchange rate is fixed on the day of the
  contract, but
 The actual exchange takes place on a pre-
  determined date in the future


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 Characteristics and Features of FX
              Forwards

 Available daily in major currencies in 30-, 90-, and 180-
  day maturities
 Forwards are entered into “over the counter”
 Deliverable forwards: face amount of currency is
  exchanged on settlement date
 Non-deliverable forwards: only the gain or loss is
  exchanged


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 Characteristics and Features of FX
              Forwards
 Contract terms specify:
   – forward exchange rate
   – term
   – amount
   – „„value date‟‟ (the day the forward contract expires)
   – locations for payment and delivery.



 The date on which the currency is actually exchanged, the
  „„settlement date,‟‟ is generally two days after the value
  date of the contract.
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   Characteristics and Features of FX
                Forwards
    Forward Exchange Rates: “The Iron-Clad Law”
 Forward exchange rates are different from spot rates, but they are
  not a prediction of what the spot rate will be when the deal settles!




                     The difference between the
         forward exchange rate and the spot exchange rate
                      is the interest differential
                     between the two currencies

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FX Forwards:
    Uses
        Uses of FX Forwards
(1) Hedge foreign currency risk
(2) Arbitrage FX rate discrepancies within and
  between markets
(3) Speculate on future market movements
(4) Profit by acting as market maker

 Financial institutions, money managers,
  corporations, and traders use these instruments
  for managing currency risk
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         Two Types of Hedging
Corporations engaged in international trade

 Hedge payments and receipts denominated in foreign
  currencies.
   – For example, a Croatian corporation that exports to Germany and
      expects payment in Euro (EUR) could sell EUR forward to
      eliminate the risk of a depreciation of the EUR at the time that the
      payment arrives.

 Hedge the translation of foreign earnings for presentation
  in financial statements.


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                      Example 1: Hedging
                      With an FX Forward
            Hedged Item                       Hedging Instrument
 Company must pay EUR 1,000,000        Bank buys 1,000,000 EUR
  to a eurozone supplier in 3 months     forward at forward rate of 7.3750
 Spot rate HRK/EUR: 7.3000.
 Treasurer believes HRK will
  depreciate during next 3 months

                                           – FX risk: Company is
    – Exposure to FX risk:                    protected against large
                                              adverse FX rate movements
    What will be exchange rate
     HRK/EUR in three months??             If FX rate is unfavorable in 3
                                              months (ie, > 7.3750),
                                              Company pays just 7.3750
                      Example 1: Hedging
                      With an FX Forward
             Hedged Item                       Hedging Instrument
 Company must pay EUR 1,000,000 to    Bank buys 1,000,000 EUR forward at
  a eurozone supplier in 3 months       forward rate of 7.3750
 Spot rate HRK/EUR: 7.3000.
 Treasurer believes HRK will
  depreciate during next 3 months     Disadvantage of Hedge:
                                      Company is still exposed to FX risk
Advantages of Hedge:                     if the HRK/EUR spot rate is less
                                         than 7.3750 in 3 months
Company knows its costs and can
  plan its finances accordingly
Cost of the hedge is zero --
 No money is exchanged at               Effect of hedge is same as
  inception of the forward FX              buying EUR today and
  agreement                             holding in an interest-bearing
                                                   account
                                         (Forward FX agreement is
                                         NOT a simple speculation)
                  Example 1: Hedging
                  With an FX Forward
   Unhedged Company                       Effect of Hedging
 If in 3 months, spot rate          Hedged Company has
                                      already bought EUR
  is 7.4500…
                                      forward

                                        – Hedged Company will pay:
   – Unhedged Company                       7.375 x 1,000,000 = HRK
     must pay:                                7,375,000

   7.45 x 1,000,000 =           Money saved by
   HRK 7,450,000              hedging: 7,450,000 –
                                  7,375,000 =
                                  HRK 75,000
 Example 2: Deriving the Forward
         Exchange Rate
 The spot rate HRK/EUR is 7.3000

 A bank today sells a 3-month HRK/EUR
  forward to a company for a forward
  exchange rate of 7.3371

 How did the bank compute the forward
  rate?
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 Example 2: Deriving the Forward
         Exchange Rate
 Three month interest rates are:

    – 1% on the euro
    – 3% on the kuna


 A company with EUR 1 million and a need for HRK in three
  months should be indifferent, financially speaking, as to whether
  it:

    – Invests the EUR 1 million for 3 months at 1% and converts the
      euros (plus interest) into HRK at the end of this time, or
    – Sells the EUR 1 million spot for HRK, and invests the HRK at 3%
      for 3 months
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   Example 2: Deriving the Forward
           Exchange Rate
OPTION 1                           OPTION 2
                                    Sell EUR 1 million spot at 7.30
  Invest EUR 1 million at 1%
                                          Buy HRK 7.3 million
    for 3 months (91 days)
                                    Invest HRK for 3 months at 3%



                                         Interest earned HRK
     Interest earned EUR
                                                55,358.33
           2,493.15
                                      (7.3 million x 3% x 91/360)



    Value after 3 months                 Value after 6 months
       EUR 1,002,493                        HRK 7,355,358


                   Forward Exchange Rate: 7.3371
   FX Forwards:
Problems and Risks
  Problems with FX Forwards
 Finding counterparties who want to take
  exactly the opposite position:
  – Most companies (potential counterparties) are
    “in the same boat” (i.e., importers from the
    eurozone)
  – One of the parties to the transaction might want
    to trade a different amount, or have a different
    settlement date
                  costs can be large
  – TransactionLeslie Šulenta, International Business(bank‟s spread) 18
                            Strategies, LLC
  Problems with FX Forwards
 Liquidity risk: A party in a forward
  contract may find it difficult to exit the
  position. Alternatives:
  – If counterparty agrees, cancel the forward for
    a fee
  – Assign the contract to another party. This
    requires some compensation
  – If an exact opposite position can be taken,
    offset the obligation and suffer only the price
    differential Leslie Šulenta, International Business   19
                                Strategies, LLC
  Problems with FX Forwards
 Default risk: There is an incentive for
  the counterparty who lost on the
  forward contract to default on the
  agreement
  – Forwards are a zero sum game. Each
    counterparty that gains is balanced by a
    counterparty who loses the same amount.


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FX Forwards:
 Accounting
 Accounting for FX Forwards
 IAS 39 applies (Accounting for
  Financial Instruments – derivatives
  accounting)
  – The deal has no immediate value
  – Off-balance sheet accounts are used
    initially to record the deal on the books
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   Accounting for Forwards
 Fair value of the forward changes over
  time with movements in the foreign
  exchange rate

 Unrealized gain (loss) is measured by
  applying today‟s market rates at the
  forward date

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                         Strategies, LLC
Example 3: Marking to Market
 After one month‟s time, the company has to
  mark-to-market a 3-month forward which is
  carried in the off-balance sheet accounts

   – On the date of the deal, the spot rate was 7.3000
   – The forward rate for the deal is 7.3371
   – The spot rate HRK/EUR is now 7.4150


 What is the market value of the forward today?

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 Example 3: Marking to Market
 The company bought EUR against HRK in 90 days.
 Today, the company could buy EUR 1,000,000 at the spot
  rate of 7.4150 and pay HRK 7,415,000.
 The company is committed to buy EUR 1,000,000 when
  the forward matures at 7.3371 and pay only HRK
  7,337,100.
 Thus, the deal now has value.

       Company records an unrealized GAIN of:
      HRK 7,415,000 – HRK 7,337,100 = HRK 77,900

                 Leslie Šulenta, International Business   25
                            Strategies, LLC
  FX Forwards:
Risk Management
          Risk Management
Before using any type of derivatives, companies
  should:
 Discuss the potential risks and benefits of derivatives
  with Management Board and Supervisory Board
 Develop appropriate internal controls and limits
 Prepare derivatives policy and procedures manual; tax
  and accounting manuals
 Host training seminars for management and
  employees


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                            Strategies, LLC
Successful Risk Management
          DON’T WORRY,
          IT MAY MELT
          BEFORE WE GET
          THERE!




       Leslie Šulenta, International Business   28
                  Strategies, LLC
Successful Risk Management
                     WE CAN DECIDE
                     WHAT TO DO,
                     IF AND WHEN
                     WE HIT IT!




       Leslie Šulenta, International Business   29
                  Strategies, LLC
Successful Risk Management

                       WE NEVER NEEDED
                       TO USE LIFE
                       BOATS BEFORE!!




       Leslie Šulenta, International Business   30
                  Strategies, LLC
      Thank You.
 Leslie Matthews Šulenta
     +385 98 355 258
Leslie.sulenta@consulting-
         mps.com
www.consulting-mps.com

								
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