How to answer a foreign exchange risk management question

The Advanced Financial Management syllabus states that there will be at least one question with a focus on syllabus section E, Treasury and advanced risk management techniques. Within Section E, foreign exchange risk management is frequently examined. This article will explain the significance of the information you’ll be given in foreign exchange risk management questions and show you what you’ll be asked to do.

The scenario is adapted from Nutourne Co, Question 2 in the December 2018 exam, which ACCA published. Some of the numbers have been changed. In this question, the closing futures price and spot rate are not given and so the predicted futures rate has to be calculated. (See the article 'Exchange traded foreign exchange derivatives' for an example of when the spot rate and futures price on the day of settlement are given). There is also a spreadsheet provided showing how the calculations could be set out in the spreadsheet tool in the exam.

Scenario

Nutourne Co is a company based in the USA, supplying medical equipment to the USA and Europe. Nutourne Co’s treasury department hedges foreign exchange risk on transactions using forward contracts, the money market, traded futures or traded options.

It is currently 30 November 20X8.

Nutourne Co’s treasury department is currently dealing with a sale to a Swiss customer of CHF12.3 million which has just been agreed, where the customer will pay for the equipment on 31 May 20X9.

 Exchange rates (quoted as US\$/CHF 1) Spot 1.0292 – 1.0309 Three months forward 1.0322 – 1.0341 Six months forward 1.0356 – 1.0378

Annual interest rates available to Nutourne Co

 Investing rate Borrowing rate Switzerland 3.2% 4.4% USA 4.6% 5.8%

Currency futures (contract size CHF125,000, futures price quoted as US\$ per \$1)

 Futures price December 1.0306 March 1.0336 June 1.0369

Currency options (contract size CHF125,000, exercise price quotation US\$ per CHF1, premium: US cents per CHF1)

 Calls Puts Exercise price December March June December March June 1.0375 0.47 0.50 0.53 0.74 0.79 0.86

If futures or options are chosen, any amount not hedged by a futures or options contract will be hedged on the forward market.

Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals.

Required:
Evaluate which of the possible methods of hedging being considered would give Nutourne Co the highest receipt, assuming the options are exercised.

Approaching the question

You must read the requirements before reading the scenario in detail. Knowing what you have to do will help you analyse the scenario and ensure that you answer the question fully.

Breaking down the requirements for Nutourne Co:

 Evaluate which of the possible methods of hedging being considered would give Nutourne Co the highest receipt The answer needs to state which method gives the highest receipt, but it does not ask you to recommend a method. However, if there are uncertainties relating to the amounts received for any of the methods, it would be legitimate to discuss them. Assuming the options are exercised This means that the amount hedged by the options contracts will be translated at the exercise price.

Identify the important data in the scenario

• Hedging methods to be used
• Transaction to be hedged
• Time period
• Spot and 6 month forward rates

Hedging methods to be used
The scenario states that the following methods should be considered:

• Forward contracts
• The money market

Transaction to be hedged
Nutourne Co is a company based in the USA … currently dealing with a sale to a Swiss customer of CHF12.3 million which has just been agreed.

Nutourne Co needs to hedge against the USD strengthening (the CHF weakening).

Implications for hedging methods

 Forward contract Money market Futures contracts Options contracts SELL CHF to bank at forward rate when money received from customer. BORROW in CHF – the amount borrowed will be repaid by the CHF receipt from Swiss customer. CONVERT amount borrowed into USD. INVEST translated amount. SELL CHF  futures now to hedge against sale of CHF when money received from Swiss customer. BUY CHF PUT options now to hedge against sale of CHF when money received from Swiss customer.

Time period
It is currently 30 November 20X8… the customer will pay for the equipment on 31 May 20X9.

Two things to note:

• The length of time between today’s date (30 November 20X8) and the date of settlement (31 May 20X9) – 6 months
• The date of settlement – 31 May

Implications for hedging methods

 Forward contract Money market Futures contracts Options contracts 6 month forward rate will need to be used. Annual interest rates will have to be divided by 2. Date of futures will have to be after May. Date of options will have to be after May.

Spot rate

1.0292 – 1.0309 (quoted as US\$/CHF 1)

Remember that the bank ‘always wins’ – so if there is a choice of two exchange rates, choose the one that gives the lowest receipt.

Implications for hedging methods

 Forward contract Money market Futures contracts Options contracts Not relevant. Determines USD received when translating CHF amount borrowed. Use lower of two rates (1.0292), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. Could be used in basis calculation.   Use lower of two rates (1.0292), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. Could be used in basis calculation.   Use lower of two rates (1.0292), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received.        Note that premium is quoted in US\$, so it will not be translated.

6 month forward rate

1.0356 – 1.0378 (quoted as US\$/CHF 1)

6 month rate is used, as it is 6 months between today‘s date (30 November) and date of settlement (31 May).

Remember again that the bank ‘always wins’.

Implications for hedging methods

 Forward contract Money market Futures contracts Options contracts Use lower of two rates (1.0356) as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. Not relevant Could be used if there is an amount not hedged.   If there is a under -hedge, use lower of two rates (1.0356) as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. Could be used if there is an amount not hedged.   If there is a under -hedge, use lower of two rates (1.0356) as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received.

Forward contract
Receipt = CHF12,300,000 × 1.0356 = \$12,737,880

 Three months 1.0322 – 1.0341 Six months 1.0356 – 1.0378 Use six months rate and lower of two rates (1.0356), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received.

Money market hedging

• Borrow CHF

Amount borrowed = CHF12,300,000/(1 + [0.044/2]) = CHF12,035,225

 CHF Investing 3.2% Borrowing 4.4% Borrow in CHF at 4.4%, as CHF receipt from Swiss customer will pay back borrowing. Adjust rate as borrowing is for 6 months.
• Convert into US\$ at spot rate

Receipt = CHF12,035,225 × 1.0292 = US\$12,386,654

 Spot 1.0292 – 1.0309 Use lower of two rates (1.0292), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received.
• Invest in US\$

Receipt = US\$12,386,654 × (1 + [0.046/2])  = CHF12,671,547

 US\$ Investing 4.6% Borrowing 5.8% Invest translated receipt at 4.6%. Adjust rate as investment is for 6 months.

Futures

• Sell CHF futures
 Sell CHF futures now to hedge against sale of CHF when money received from Swiss customer.
• Use June CHF futures contracts
 December 1.0306 March 1.0336 June 1.0369 Must be June (1.0369) as only date after 31 May.
• Number of contracts

Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000

 Contract size is \$125,000 Number of contracts = Receipt/\$125,000, rounded to the nearest contract
• Remainder to be hedged on forward market

Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000

Receipt = CHF50,000 × 1.0356 = \$51,780

 Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of CHF. Underhedge = Amount of transaction – Amount hedged Use same rate as for forward contract above of 1.0356
• Futures price and expected receipt

Estimate from March and June futures rates

Predicted futures rate at the end of May = 1.0336 + ([1.0369 – 1.0336] × 2/3) = 1.0358

Expected receipt = CHF12,250,000 × 1.0358 = \$12,688,550

 Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. 31 May is 2/3 of time between 31 March and 30 June, so use 2/3 of the difference between March futures price of 1.0336 and June futures price of 1.0369. This method is a shortcut, used to work out a ‘lock-in’ rate that will be the net result of the underlying transaction and the hedge gains or losses.

Or

Estimate from spot rate and June futures rate

Predicted futures rate at the end of May = 1.0292 + ([1.0369 – 1.0292] × 6/7) = 1.0358

Expected receipt = CHF12,250,000 × 1.0358 = \$12,688,550

 Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. 31 May is 6/7 of time between 30 November and 30 June, so use 6/7 of the difference between spot rate of 1.0292 and June futures rate of 1.0369. This method is a shortcut, used to work out a ‘lock-in’ rate that will be the net result of the underlying transaction and the hedge gains or losses.
• Outcome
\$

Futures

12,688,550

Remainder on forward market

51,780

12,740,330

Options

 Buy CHF put options to hedge against sale of CHF when money received from Swiss customer.
 Put: December March June Must be June as only date after May.
• Number of contracts and receipt

Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000 (as for futures)

Receipt = CHF125,000 × 98 × 1.0375 = \$12,709,375

 Contract size is \$125,000 Number of contracts = Receipt/\$125,000, rounded to the nearest contract
• Remainder to be hedged on forward market

Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000

Receipt = CHF50,000 × 1.0356 = \$51,780 (as for futures)

 Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of CHF. Underhedge = Amount of transaction – Amount hedged Use same rate as for forward contract above of 1.0356.

1.0375 options = 98 × 125,000 × 0.0086 = \$105,350

 Put June 0.86 US cents per CHF Multiply number of contracts × size of one contract × 0.0086, as premium is quoted in US cents (not US dollars) per CHF.

\$

Receipt

12,709,375

Forward contract

51,780

(105,350)

12,655,805