ACCA F9 Financial Management - 2010 - Study text

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Chapter 19: Foreign exchange risk

6.3 Constructing a hedge for a future currency payment

To create a money market hedge for a future currency payment, a similar approach

is required.

 A company with an obligation to make a payment in foreign currency at a future

date should buy a quantity of the currency now and place it on deposit until the

payment is due to be made. The amount of currency placed on deposit, plus the

accumulated interest, should equal the amount of the future payment.

 Buying the currency now spot will cost money. For the examination, it should

usually be assumed that the company has to borrow in domestic currency to buy

the foreign currency spot, and that the length of the loan period is the same as

the deposit period for the foreign currency.

 At the end of the deposit period, the foreign currency deposit plus interest is

used to make the currency payment. The domestic currency loan has

accumulated interest, and the total amount now payable to settle the loan can be

used to calculate the effective interest rate for the currency transaction.

Again, an example might help to clarify the method.

Example

Suppose that a UK company is expecting to pay a supplier US$500,000 in six

months’ time, and it wants to fix an effective exchange rate for this transaction with

a money market hedge.

Spot six-month interest rates currently available in the money markets are as

follows:

Deposits

Borrowing

US dollar 4.125%

4.250%

British pound 6.500%

6.625%

The spot exchange rate (US$/£1) is 1.9770 – 1.9780.

Step 1

The company should deposit US dollars for six months. The deposit rate will be

4.125% (the lower of the two quoted rates). This is an annual rate, and in an

examination the rate for the interest period is calculated as an appropriate fraction

of the annual rate. Here, the interest for six months will be 4.125% × 6/12 = 2.0625%

or 0.020625.

The dollars placed on deposit plus accumulated interest after six months needs to be

$500,000, therefore the amount of dollars placed on deposit for six months should

be:

()

$489,896

1.020625

$500,000

periodtheforrateinterest1

amountFinal

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Step 2

These dollars should be bought with British pounds. The appropriate spot rate is

1.9770. The company will therefore pay £247,798 to obtain the dollars.

We now assume that this money has to be borrowed for a six-month loan period.

The interest rate on deposits for sterling is 6.625%. This is an annual rate, and the

interest for six months will be 6.625% × 6/12 = 3.3125% or 0.033125.

After three months, the loan plus accumulated interest will be £247,798 × 1.033125 =

£256,006.

Step 3

At the end of six months, the US deposit plus interest is used to make the payment

of $500,000. The sterling loan is repayable with interest, and the amount payable can

be used to calculate an effective exchange rate for the money market hedge.

The effective exchange rate is therefore £1 = $1.9531 (= $500,000/£256,006)

Conclusion: forward exchange contracts and money market hedges

In practice, a money market hedge should result in an effective exchange rate

similar to the forward exchange rate. In the examination, however, one method of

hedging might well result in a more favourable exchange rate than the other.

An examination question might give you a set of exchange rates and interest rates

for two currencies, and details of a transaction that creates a currency risk exposure.

The question might then ask you to compare a forward exchange contract with a

money market hedge, and recommend which method of hedging is better.

Chapter 19: Foreign exchange risk

Foreign currency derivatives

 The nature of derivatives contracts

 Futures contracts

 Closing out a futures position

 Other features of currency futures

 Options

 Features of currency options

 Hedging risks with currency options

 Advantages and disadvantages of hedging with options

 Currency swaps

 Conclusion: using currency derivatives

7 Foreign currency derivatives

7.1 The nature of derivative contracts

The concept of derivative contracts can be difficult to understand. A derivative

contract is a contract for the purchase or sale of an item that is derived from

something else.

For example, there might be a derivative contract for a commodity item such as

copper. A contract for the actual purchase of a quantity of copper involves the

delivery of the agreed quantity of copper by the supplier and payment by the buyer.

A derivative contract in copper involves an agreement for the future sale/purchase

of a quantity of ‘notional’ copper at an agreed price, with no intention to make an

actual delivery of any copper to the buyer. The purpose of the derivative contract is

to make an agreement now on the future price of the copper, and when the contract

is settled the payment (from buyer to seller or seller to buyer) depends on the

difference between the agreed price in the contract and the market price of copper

when the contract is settled.

Derivatives contracts are therefore contracts that deal in the price of an underlying

item, rather than a contract for the actual purchase and sale of the item.

Financial derivatives are derivative contracts in the price of financial items,

including:

 foreign exchange rates (the price of currency), and

 interest rates (the price of borrowing or lending).

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Types of derivative contract

The main types of financial derivative contract are:

 financial futures

 options

 swaps

This section describes currency derivatives.

7.2 Futures contracts

A future is a forward contract for the purchase or sale of a standard quantity of an

item, for settlement or delivery at a specified future date. Futures contracts have

some special features.

 They are traded on an exchange, known as a futures exchange. In contrast,

actual forward contracts are negotiated ‘over-the-counter’. For example, a

company wishing to hedge a currency risk with a forward contract must

negotiate a deal directly with a bank. A company using currency futures must

buy or sell futures contracts on a futures exchange that deals in the relevant type

of contract.

 Futures are standardised contracts. Every futures contract for the purchase/sale

of a particular item is identical to every other futures contract for the same item,

with the only exception that their settlement dates/delivery dates may differ.

For example, a currency future for euros against the US dollar is for the

purchase/sale of €125,000.

 On every futures exchange, there are regular settlement dates for futures

contracts. These are usually in March, June, September and December. A

company might therefore buy or sell March futures for settlement in March, or

June futures for settlement in June, and so on.

Most currency futures are contracts for the major international currencies. For

example:

Currencyfuture(CME) Amount

USdollar–euro €125,000

USdollar–yen 12.5millionyen

USdollar–Britishpound £62,500

USdollar–Swissfranc SFr125,000

USdollar–Canadiandollar C$100,000

An important feature of most futures contracts, including currency futures, is that

the contract involves the purchase and sale of a

notional quantity of the underlying

item. For example a futures contract is a contract for the purchase of a notional

quantity of one currency in exchange for another currency. The purpose of a

currency futures contract is to trade on the exchange rate, not to arrange to buy or

sell currency.

Chapter 19: Foreign exchange risk

This concept might seem unusual and difficult to understand, and an example

might help to illustrate the nature of futures contracts.

Example

It is August. A UK company has sold goods to a US customer for $600,000, with

payment due at the end of December. It wants to hedge its exposure to currency

risk.

The most usual methods of hedging this risk would be a forward exchange contract

or a money market hedge.

However, the company might decide to hedge the risk exposure with currency

futures. Futures contracts are available for buying or selling sterling in exchange for

US dollars, and the standard amount for a sterling-dollar future is £62,500. The UK

company will be receiving US dollars in December, so it will want to sell dollars and

buy sterling.

It can therefore buy an appropriate quantity of sterling-dollar December futures,

which fix an exchange rate for the purchase of a quantity of dollars.

At the end of December, the company will receive $600,000 at sell these in exchange

for sterling at the spot rate. It will also settle its futures contracts. The contracts are

settled by payment of the difference between the exchange rate agreed in the

contracts and the current spot rate at the settlement date for the contract. This might

involve a receipt or a payment, depending on whether the spot rate at settlement is

more favourable or less favourable than the rate agreed in the futures contract.

Currency futures provide a hedge because:

 If the spot rate moves adversely between August and December, there will be an

offsetting profit on the futures position.

 On the other hand, if the spot rate moves favourably for the UK company

between August and December, there will be an offsetting loss on the futures

position.

In principle, the gain or loss on the futures position, taken together with the spot

rate at settlement date, means that the exchange rate was effectively ‘fixed’ when the

futures contracts were arranged in August.

Example

It is April. A US company has sold goods to a customer in France for €1,000,000,

with payment due at the end of June. It wants to hedge its exposure to currency risk.

It could hedge the exposure with a forward contractor a money market hedge, and

these are the most likely types of hedge that will be used. However the company

could hedge its position with June futures.

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In June, it will receive payment in euros and will want to exchange the euros into

US dollars. It therefore wants to buy dollars and sell euros. Futures contracts are for

€125,000, so it will sell 8 June futures (= €1,000,000/€125,000 per contract) at a price

agreed in the contract.

At the end of June it will sell the euros it receives at the spot rate in exchange for

dollars. When the futures are settled there will be a gain or loss on the contracts,

depending on the difference between the exchange rate in the futures contract and

the spot exchange rate in June when the futures are settled.

Taking the dollars received from selling the euros ‘spot’ in June, and the gain or loss

on the futures dealing, the net effect will be to fix an effective forward rate for the

euros against the dollar when the futures are sold in April.

7.3 Closing out a futures position

Futures contracts are for settlement in March, June, September or December. A

company using futures to hedge a currency risk exposure might want to hedge a

currency risk that will occur at a date that does not coincide with the settlement date

for a futures contract.

This problem is overcome by closing out a futures position.

 If a company has bought September futures, it can close its position by selling an

equal number of September futures before settlement date in September, at any

time to suit its requirements. On closing out the position there is a gain or loss,

which is the difference between the price at which the original futures were

bought and the price at which they were sold.

 If a company has sold September futures, and has a ‘short position’ in the

futures, it can close its position by buying an equal number of September futures

before settlement date in September, at any time to suit its requirements. On

closing out the position there is a gain or loss, which is the difference between

the price at which the original futures were sold and the price at which futures

were bought to close the position.

7.4 Other features of currency futures

Other features of currency futures that should be noted are as follows.

 It is not usually possible to arrange a ‘perfect hedge’ for a currency risk exposure

with futures contracts. This is because futures contracts are for a standard

amount of a currency, and the exposure might not be for a convenient multiple

of this standard amount.

 The current exchange rate for buying or selling currency futures is never the

same as the current spot exchange rate, until the futures contract eventually

reaches settlement date. If a position is closed out before then, the hedge will not

be ‘perfect’.

Buying or selling futures therefore rarely provides a perfect hedge for a currency

risk. This fact, combined with the relative simplicity of arranging a forward contract

Chapter 19: Foreign exchange risk

or a money market hedge, explains why futures are not often used by non-bank

companies for hedging currency risk.

Example

This final example of currency futures might help to show how futures provide a

hedge against currency risk. The example is simplified.

It is May. A US company expects to receive £250,000 from a UK customer at the end

of September and wants to hedge the currency risk with futures.

Sterling-US dollar futures are for £62,500. The US company will receive payment in

sterling and will therefore want to sell sterling in exchange for dollars at the end of

September. It should therefore sell 4 September futures (= £250,000/£62,500 per

contract). Suppose the price for the sale of the futures is $1.9800 to £1.

At the end of September, the company receives £250,000 from the UK customer and

sells this money at the spot rate, which is $1.9600. It also settles its futures contracts,

and the settlement price for these contracts is the same as the spot rate, $1.9600.

The situation is as follows:

$ $

Original sale price of futures 1,9800

Purchase price at settlement 1.9600

Gain on futures trading (per £1) 0.0200

× 4 contracts × £62,500 per contract

Total gain on futures dealing 5,000

Revenue from sale of £250,000 spot (× $1.9600)

490,000

Total income 495,000

This gives an effective exchange rate of $495,000/£250,000 = $1.9800 to £1.

This was the exchange rate at which the futures were sold in May. Hedging with

futures therefore fixed an effective exchange rate of $1.9800.

7.5 Options

An option is another type of derivative contract. However an option contract differs

from a normal contract. In a normal contract both parties have a legal obligation to

carry out the terms of the contract agreement. For example a futures contract

commits the buyer and the seller to their contract obligation.

An option contract, however, gives the buyer of the option a choice about whether

to enforce the terms of the contract agreement or whether to let the contract lapse.

An option gives its holder the right, but not the obligation, to take a particular

course of action at sometime in the future. Typically, an option gives its holder the

right, but not the obligation, either to buy or to sell a quantity of a particular item on

or before a specified date in the future, at a price that is fixed in the contract.

Paper F9: Financial management

A currency option give the buyer of the option the right, but not the obligation

either to buy or sell a quantity of currency in exchange for another currency, on or

before a specified date in the future, at an exchange rate (‘strike rate’ or ‘exercise

rate’) that is specified in the option contract.

Call options and put options

Financial options are either call options or put options.

 A call option gives its holder the right to purchase the underlying item in the

option agreement.

 A put option gives its holder the right to sell the underlying item in the option

agreement.

For example, a call option on $1,000,000 might give the option holder the right to

buy $1,000,000 in exchange for British pounds on a specified date in three months

time, at an exercise rate of, say, $2 to £1.

A put option on $1,000,000 might give its holder the right to sell $1,000,000 in

exchange for sterling at an exercise rate of, say, 1.9800 on or before a specified date

in six months’ time.

Expiry date: American-style and European-style options

An option agreement has an expiry date, after which the option lapses and the

agreement comes to an end.

 An American-style option can be exercised by its holder at any time on or before

the expiry date.

 A European-style option can be exercised only at the expiry date for the option

and not before.

The terms ‘American’ and ‘European’ do not refer to the countries where these

types of option are available. Both types of option agreement are made throughout

the world.

For example, if a company holds an American-style call option to buy US$500,000 in

exchange for euros at a rate of 1.5000 (US$/€1) with an expiry date of 20

September, the company can exercise its right to buy the $500,000 at the agreed rate

at any time up to and including 20

September. However, if the option is not

exercised by that date, it will lapse (cease to exist).

Option premium

An option has value to an option buyer, because it gives a right that can be exercised

at the choice of the option holder. The seller of the option, or option ‘writer’, has a

contractual obligation to comply with the terms of the option contract if the option

is exercised by its holder; but the option seller has no rights if the option holder

allows the option to lapse.

Chapter 19: Foreign exchange risk

Option buyers must therefore pay the option seller (option writer) for the option.

The purchase price for an option is called the premium.

The premium is paid when the option contract is arranged. It is non-refundable, and

the option writer receives the option no matter whether it is eventually exercised or

allowed to lapse.

7.6 Features of currency options

The main features of currency options are as follows:

 A currency option gives its holder the right to buy (call option) or sell (put

option) a quantity of one currency in exchange for another, on or before a

specified date, at a fixed rate of exchange (the strike rate for the option).

 Currency options can be purchased over-the-counter or on an exchange. In

practice, companies buying call or put currency options do so in over-the-

counter deals with a bank.

 Traded currency options are bought and sold on an options exchange.

7.7 Hedging risks with currency options

An important feature of hedging currency risks with options is that they give the

option holder a choice. Some examples will be used to illustrate how this operates.

Example

A UK company expects to receive $5 million from a US customer in six months time.

The dollar-sterling exchange rate is volatile, and the UK company cannot predict

which way it thinks the exchange rate will move, up or down. The current spot

exchange rate is $1.9800 = £1.

It therefore decides to hedge its exposure to risk with a currency option. It wants to

sell the dollars it receives in six months time, therefore it can buy a put option on $5

million, with an expiry date in six months. The exercise rate might be $1.9900. The

bank that writes the option will charge a suitable premium.

 At the expiry date for the option, if the spot exchange rate is higher than $1.9900,

the company will exercise its option to sell $5 million at the strike rate of $1.9900.

The income in sterling will be £2,512,563 (less the premium paid initially to buy

the option).

 At the expiry date for the option, if the spot exchange rate is lower than $1.9900,

the company will not exercise the option. Instead it will sell the $5 million it

receives at the available spot rate. For example if the spot rate is $1.9500, the

company will let the option lapse and sell its $5,000,000 at $1.9500 to earn

£2,564,103 (less the premium paid initially to buy the option).

Paper F9: Financial management

Example

A German company expects to pay $3 million to a US supplier in three months time.

It cannot predict which way the dollar-euro exchange rate will move, up or down.

The current spot exchange rate is $1.6000 = €1.

It therefore decides to hedge its currency risk with an option. It needs to buy US

dollars, so it will arrange to buy a call option on $3 million with an expiry date in

three months time. The strike rate in the option might be $1.6200 and an appropriate

premium will be charged by the bank that writes the option.

 At the expiry date for the option, if the spot exchange rate is lower than $1.6200,

the company will exercise its option to buy $3 million at the strike rate of

$1.6200. The cost will be €1,851,852 (plus the premium paid initially to buy the

option).

 At the expiry date for the option, if the spot exchange rate is higher than $1.6200,

the company will not exercise the option. Instead it will buy the $3 million at the

available spot rate. For example if the spot rate is $1.6500, the company will let

the option lapse and buy the $3,000,000 at $1.6500. This would cost €1,818,182

(plus the premium paid initially to buy the option).

7.8 Advantages and disadvantages of hedging with options

The advantages of an option for the option buyer are that:

 it gives the option holder the right to buy or sell currency at the spot rate f this is

more favourable than the strike rate in the option

 it gives the option holder the right to exercise the option and buy or sell at the

strike rate if this is more favourable than the spot rate.

The key problem with an option is its cost. The cost of the premium might exceed

the benefits.

7.9 Currency swaps

Swaps are another form of derivative. Whereas currency futures and options are

fairly short-term in nature, with settlement dates or expiry dates in the next few

months, swaps are longer in duration and can operate over a period of many years.

A swap is a contract between a bank and a customer (a company) in which the two

parties agree to exchange or ‘swap’ payments over the term of the swap.

A currency swap involves one party making payments in one currency and the

other party makes payments in exchange in a second currency.

These contractual payments can be used to fix an exchange rate over a period of

several years, for currency exposures that arise over a similar period of time.

Companies can also use currency swaps to borrow at a favourable interest rate in

the international loans or bonds markets, and swap their liabilities into a currency of

their preference. This could enable them to borrow more cheaply than borrowing

directly in the currency of their preference.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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