Hedging Treasury Risk with Forward Foreign Exchange Contracts - PowerPoint PPT Presentation

About This Presentation
Title:

Hedging Treasury Risk with Forward Foreign Exchange Contracts

Description:

Financial institutions, money managers, corporations, and traders use these instruments ... Risk Management. Leslie ulenta, International Business Strategies, ... – PowerPoint PPT presentation

Number of Views:435
Avg rating:3.0/5.0
Slides: 32
Provided by: LESLIES75
Category:

less

Transcript and Presenter's Notes

Title: Hedging Treasury Risk with Forward Foreign Exchange Contracts


1
Hedging Treasury Risk with Forward Foreign
Exchange Contracts
  • Leslie Matthews Šulenta
  • Director
  • International Business Strategies, LLC, Zagreb
  • September, 2005
  • Croatian Association of Corporate Treasurers

2
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

3
FX Forwards Definition, Characteristics and
Features
4
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

5
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

6
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.

7
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

8
FX Forwards Uses
9
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

10
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.

11
Example 1 Hedging With an FX Forward
  • Hedged Item
  • Company must pay EUR 1,000,000 to a eurozone
    supplier in 3 months
  • Spot rate HRK/EUR 7.3000.
  • Treasurer believes HRK will depreciate during
    next 3 months
  • Exposure to FX risk
  • What will be exchange rate HRK/EUR in three
    months??
  • Hedging Instrument
  • Bank buys 1,000,000 EUR forward at forward rate
    of 7.3750
  • FX risk Company is protected against large
    adverse FX rate movements
  • If FX rate is unfavorable in 3 months (ie, gt
    7.3750), Company pays just 7.3750

12
Example 1 Hedging With an FX Forward
  • Hedged Item
  • Company must pay EUR 1,000,000 to a eurozone
    supplier in 3 months
  • Spot rate HRK/EUR 7.3000.
  • Treasurer believes HRK will depreciate during
    next 3 months
  • Advantages of Hedge
  • Company knows its costs and can plan its finances
    accordingly
  • Cost of the hedge is zero --
  • No money is exchanged at inception of the forward
    FX agreement
  • Hedging Instrument
  • Bank buys 1,000,000 EUR forward at forward rate
    of 7.3750
  • Disadvantage of Hedge
  • Company is still exposed to FX risk if the
    HRK/EUR spot rate is less than 7.3750 in 3 months

Effect of hedge is same as buying EUR today and
holding in an interest-bearing account (Forward
FX agreement is NOT a simple speculation)
13
Example 1 Hedging With an FX Forward
  • Unhedged Company
  • If in 3 months, spot rate is 7.4500
  • Unhedged Company must pay
  • 7.45 x 1,000,000
  • HRK 7,450,000
  • Effect of Hedging
  • Hedged Company has already bought EUR forward
  • Hedged Company will pay
  • 7.375 x 1,000,000 HRK 7,375,000

Money saved by hedging 7,450,000 7,375,000
HRK 75,000
14
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?

15
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

16
Example 2 Deriving the Forward Exchange Rate
OPTION 1
OPTION 2
Sell EUR 1 million spot at 7.30 Buy HRK 7.3
million Invest HRK for 3 months at 3
Invest EUR 1 million at 1 for 3 months (91 days)
Interest earned HRK 55,358.33 (7.3 million x 3 x
91/360)
Interest earned EUR 2,493.15
Value after 3 months EUR 1,002,493
Value after 6 months HRK 7,355,358
Forward Exchange Rate 7.3371
17
FX Forwards Problems and Risks
18
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
  • Transaction costs can be large (banks spread)

19
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

20
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.

21
FX Forwards Accounting
22
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

23
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
    todays market rates at the forward date

24
Example 3 Marking to Market
  • After one months 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?

25
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

26
FX Forwards Risk Management
27
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

28
Successful Risk Management
DONT WORRY, IT MAY MELT BEFORE WE GET THERE!
29
Successful Risk Management
WE CAN DECIDE WHAT TO DO, IF AND WHEN WE HIT IT!
30
Successful Risk Management
WE NEVER NEEDED TO USE LIFE BOATS BEFORE!!
31
  • Thank You.
  • Leslie Matthews Šulenta
  • 385 98 355 258
  • Leslie.sulenta_at_consulting-mps.com
  • www.consulting-mps.com
Write a Comment
User Comments (0)
About PowerShow.com