To work out how many US$ need to be borrowed now, you need to know US$ interest rates. For example, the US$ three month interest rate might be quoted as: 0.54% – 0.66%.
It is important to understand that, although this might be described as a ‘three month rate’ it is always quoted as an annualised rate. One rate is what you would earn in interest if the money was on deposit, and the other is the rate you would pay on a loan. Again, no prizes for guessing which is which: you will always be charged more than you earn. On the US$ loan we will be charged 0.66% pa for three months and the loan has to grow to become US$2m in that time. So, If X is borrowed now and three months’ interest is added:
X(1 + 0.66%/4) = 2,000,000
X = $1,996,705
This can be changed now from US$ to £ at the current spot rate, say US$/£ 1.4701, to give £1,358,210.
This amount of sterling is certain: we have it now and it does not matter what happens to the exchange rate in the future. Ticking away in the background is the US$ loan which will amount to US$2m in three months and which can then be repaid by the US$2m we hope to receive from our customer. That is the hedging process finished because exchange rate risk has been eliminated.
Why might this somewhat complicated process be used instead of a simple forward contract? Well, one advantage is that we have our money now rather than having to wait three months for it. If we have the money now we can use it now – or at least place it in a sterling deposit account for three months. This raises an important issue when we come to compare amounts received under forward contracts and money market hedges. If these amounts are received at different times they cannot be directly compared, because receiving money earlier is better than receiving it later. To compare amounts under both methods we should see what the amount received now would become if deposited for three months. So, if the sterling three month deposit rate were 1.2%, then placing £1,358,210 on deposit for three months would result in:
£1,358,210 (1 + 1.2%/4) = £1,362,285
It is this amount that should be compared to any proceeds under a forward contract.
The example above dealt with hedging the receipt of an amount of foreign currency in the future. If foreign currency has to be paid in the future, then what the company can do is change money into sufficient foreign currency now and place it on deposit so that it will grow to become the required amount by the right time. Because the money is changed now at the spot rate, the transaction is immune from future changes in the exchange rate.
Further methods of exchange risk hedging
There are two other methods of exchange risk hedging which you are required to know about, but you will not be required solve numerical questions relating to these methods. They involve the use of derivatives: financial instruments whose value derives from the value of something else – like an exchange rate.
1. Currency futures. Simply think of these as items you can buy and sell on the futures market and whose price will closely follow the exchange rate. Let’s say that a US exporter is expecting to receive €5m in three months’ time and that the current exchange rate is US$/€1.24. Assume that this rate is also the price of US$/€ futures. The US exporter will fear that the exchange rate will weaken over the three months, say to US$/€1.10 (that is fewer dollars for a euro). If that happened, then the market price of the future would decline too, to around 1.1. The exporter could arrange to make a compensating profit on buying and selling futures: sell now at 1.24 and buy later at 1.10. Therefore, any loss made on the main the currency transaction is offset by the profit made on the futures contract.
This approach allows hedging to be carried out using a market mechanism rather than entering into the individually tailored contracts that the forward contracts and money market hedges require. However, this mechanism does not offer anything fundamentally new.
Basis risk can arise for both interest rate and exchange rate hedging through the use of futures. Futures contracts will suffer from basis risk if the value of the futures contract does not match the underlying exposure. This occurs when changes in exchange or interest rates are not exactly correlated with changes in the futures prices.
Note that another form of basis risk also exists as part of interest rate risk. In this case basis risk exists where a company has matched its assets and liabilities with a variable rate of interest, but the variable rates are set with reference to different benchmarks. For example, deposits may be linked to the one-month LIBOR rate, but borrowings may be based on the 12-month LIBOR rate. It is unlikely that these rates will move perfectly in line with each other and therefore this is a source of interest rate risk.
2. Options. Options are radically different. They give the holder the right, but not the obligation, to buy or sell a given amount of currency at a fixed exchange rate (the exercise price) in the future (if you remember, forward contracts were binding). The right to sell a currency at a set rate is a put option (think: you ‘put’ something up for sale); the right to buy the currency at a set rate is a call option.
Suppose a UK exporter is expecting to be paid US$1m for a piece of machinery to be delivered in 90 days. If the £ strengthens against the US$ the UK firm will lose money, as it will receive fewer £ for the US$1m. However, if the £ weakens against the US$, then the UK company will gain additional money. Say that the current rate is US$/£1.40 and that the exporter will get particularly concerned if the rate moved beyond US$/£1.50. The company can buy £ call options at an exercise price of US$/£ = 1.50, giving it the right to buy £ at US$1.50/£. If the dollar weakens beyond US$/£1.50, the company can exercise the option thereby guaranteeing at least £666,667. If the US$ stays stronger – or even strengthens to, say, US$/£1.20, the company can let the option lapse (ignore it) and convert at 1.20, to give £833,333.
This seems too good to be true as the exporter is insulated from large losses but can still make gains. But there’s nothing for nothing in the world of finance and to buy the options the exporter has to pay an up-front, non-returnable premium.
Options can be regarded just like an insurance policy on your house. If your house doesn’t burn down you don’t call on the insurance, but neither do you get the premium back. If there is a disaster the insurance should prevent massive losses. Options are also useful if you are not sure about a cash flow. For example, say you are bidding for a contract with a foreign customer. You don’t know if you will win or not, so don’t know if you will have foreign earnings, but want to make sure that your bid price will not be eroded by currency movements. In those circumstances, an option can be taken out and used if necessary or ignored if you do not win the contract or currency movements are favourable.
Ken Garrett is a freelance author and lecturer