Foreign Exchange Rate Exposure Hedging in United Nations Organizations –UNO–
This note is essentially related to the UNO annual budgets for which are usually expressed in euros as the movement of the USD in relation to the euros may have a sizeable impact on the following expenditures indexed to the USD: professional salaries, insurance, pension fund of professional staff members, and daily subsistence allowance as well as purchase of equipment. The USD indexed expenses are actually paid in EUR at the operational rates of exchange set by UN at the beginning of every month, against an approved budget calculated on the basis of UN exchange rate set up the previous year. Some UNO have a foreign exchange rate exposure to the USD exchange rate because the actual amount of euros paid every month could be larger than the budgeted amount; in the case the actual monthly operational rate of exchange EUR/USD moves above the budget exchange rate that was used to convert into euros, the USD indexed expenses in the annual budget. Furthermore, UNO receive their income in euros and pays all its expenses in euros. Therefore, the UNO should consider hedging this exposure.
Spot and Forward Foreign Exchange transactions
The most basic tools of Foreign Exchange risk management are 'spot' and 'forward' transactions. These are transactions between end users and financial institutions that specify the terms of an exchange of two currencies. In any Foreign Exchange spot or forward transaction, there are a number of variables that need to be agreed upon and they are: 1) The currencies to be bought and sold - in every transaction there are two currencies: the one that is bought and the one that is sold, 2) The amount of currency to be bought or sold, 3) In the case of forward transactions, the date at which the contract matures (expiration date), 4) The rate at which the exchange of currencies will occur (spot or forward rate). All exchange rates, which are advertised either in the newspapers or on the various information services, assume a deal with a maturity of two-business days ahead. A deal done on this basis is called a spot deal. In a spot transaction the currency that is bought will be receivable in two days while the currency that is sold will be payable in two days. On the other hand, a Forward Foreign Exchange transaction is a contract between two parties (the Financial Institution and the user). One party contracts to sell and the other party
contracts to buy, one currency for another, at an agreed future date, greater than two days, (the maximum term is 12 months; although for the most liquid currencies such as USD, EUR, GBP or JPY the maximum term is 60 months), at a forward rate of exchange which is fixed at the time the contract is entered into. The forward rate is determined on the basis of the spot rate and the interest rate differential between the two currencies involved. Hence, the forward rate is a market rate. There is no premium to pay in order to enter into a Forward Foreign Exchange Contract. However, given the fact that the UNO does not have a credit line with any bank (actually, the UNO is not allowed to have any credit facility), the banks require a margin in order to enter into a forward contract. The margin will be progressively released after the satisfactory payment of each monthly forward contract. For a 1 million forward, the margin is around 8%; for a 2 million forward is 11%, and for a 12 million is 26%. The average margin for twelve monthly forward contracts would be around 19%. So, if the objective is to hedge around USD 2 to 2.5 million monthly, the total margin would be between euros 4.2 and 5.3 million (assuming an annual amount of expenses between USD 24-30 million and a current EUR/USD exchange rate of 0.93). This margin could be held in time deposits. The benefit of a forward contract is that it gives certainty – the exact amount of required euros, which will be paid for USD in the future, is known. However, if the EUR strengthens against the USD (below the EUR/USD budget rate, as it is the case now) between booking the forward contract and its maturity in the future, the UNO would suffer an opportunity loss. To alleviate this risk, a foreign currency option can be envisaged.
Foreign Currency Options
Foreign Currency Options can provide a fixed exchange rate for a future date if rates move adversely, but also provide the added flexibility of being able to use the prevailing spot rate if rates have moved favorably. If a foreign currency option is bought, the UNO gets the right to choose, on an agreed future date, whether to exercise the option and transact at the option’s exchange rate or not. If the spot rate is more favorable than the option’s exchange rate, then the UNO could choose to transact at the spot rate. However, if the spot rate is less favorable, the option strike price rate can be used. For this right to choose, a premium has to be paid at the outset (as we would for buying an insurance policy). Options give us more flexibility in selecting the exchange the UNO wishes to hedge at. In other words, the Organization would have more flexibility to set the budget rate than it would have with a forward contract, because forward rates are market rates over which control cannot be exerted, while the strike prices in option contracts are tailor-chosen by the end user. Options can be structured in many ways in the management of foreign exchange exposures. The basic option instruments are described below: a) Currency Put Option: The purpose of a Currency Put Option is to limit an adverse fall in exchange rates, while maintaining the ability to take advantage of a favorable rise in exchange rates. A Currency Put Option grants the holder the right, but not the obligation, to sell a fixed amount of currency at a fixed rate (strike price) at a certain time in the future.
Currency Call Option: The purpose of a Currency Call Option is to limit an adverse rise in exchange rates, while maintaining the ability to take advantage of a favorable fall in exchange rates. A Currency Call Option grants the holder the right, but not the obligation, to buy a fixed amount of currency at a fixed rate (strike price) at a certain time in the future.
The price of a currency option is called the premium, which is paid in advance. The strike price is the exchange rate at which the option holder can exercise his right. The expiration date is the pre-determined expiry date of the option contract. There are two types of option styles: American style options and European style options. An American style option allows the option buyer to exercise his right at any time before the expiration date, while the European style option allows the option buyer to exercise his right only on the expiration date. The majority of currency options are European style. The cost of buying currency options depends on the following factors: current spot rate and strike price levels, time to expiration, volatility and interest rates of the underlying currencies.
As mentioned, some UNO has a very special exposure to the USD. Hence, the following solutions can be envisaged: whether to use forward contract or to use the option contracts in combination with spot transactions as follows: a) If the forward contracts are used, then the required margin should be constituted. Afterwards, at the expiration date of each monthly forward contract, US dollars have to be bought at the forward exchange rate and these dollars should be simultaneously sold for Euros using the prevailing spot rate. The market spot rate on the expiration date should be very close to the operational monthly rates set by UN. b) If it is decided to buy put option contracts on the euro then at the expiration date of each monthly option contract; two outcomes are possible: 1) If the spot rate EUR/USD is above our strike price (the strike price must be set at the exchange rate of the UNO budget) then we would exercise our option rights to buy US dollars at the strike price (or the UNO budget exchange rate) and sell simultaneously these dollars for Euros using the prevailing spot rate. 2) If the spot rate EUR/USD is below our strike price (the strike price must be set at the exchange rate of our budget), then we would pay the USD monthly sensitive expenses at the operational exchange rate sets by UN which will be lower than the strike price (The UNO budget exchange rate). In all cases, the expiration date of each monthly forward or option contract must be set at the same date that the UN sets the operational exchange rates every month. The UN Treasury in New York determine the operational exchange rates two business days before the 1 st of the month, based on the spot rate before 12:00 noon New York Time.
The first option imposes to constitute a cash margin, which will be proportionate to our needs. So, a careful and monthly assessment of the expenditures, which have to be paid in USD, is recommends. The second option will give the UNO more flexibility. Still, the real exposure should be assessed for the next budgetary cycle. But, this option would be more flexible because a margin deposit between euros 4.2-5.3 million is not required in this case. The only requirement would be to pay a premium, which will be much lower than the required margin under the forward contracts. The implementation of either option would require a good coordination with Member States due to the fact that the prices for these instruments fluctuate all the time.
Written by Luis Tejada and Elisabeth Carrio, 2003