Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 21 Managing currency risk 615
to exploration and the US operation would transfer $11 million likewise, resulting in
total flows of only $14 million.
Some experts dispute whether netting is a true hedging technique, rather than a
cost-saving device, especially where the netted currency differs from the parent’s
reporting currency. However, if it does result in lower values of currency being
shipped across the exchanges, then it is undeniable that it is capable of saving consid-
erable banking and money transmission costs.
Matching is similar in concept to netting, but involves third parties as well as intra-
group affiliates. A company tries to match its currency inflows by amount and timing
with its expected outflows. For example, a company exporting to the USA and thus
anticipating USD receipts could match this payable by arranging a USD outflow, per-
haps by contracting to import from the same country. Clearly, as with netting, a two-
way flow of currency is desirable – ’natural matching’. However, ‘parallel matching’
can be achieved by matching in terms of currencies that tend to move closely togeth-
er over time, e.g. matching USD outflows to Canadian dollar inflows. Matching can
also be achieved by offsetting Balance Sheet items against Profit and Loss Account
items. For example, a company with a long-term cash inflow stream in USD may also
borrow in USD, to create an offsetting outflow of interest and capital payments.
Leading and lagging currency payments is done to speed up or delay payments
when a change in the value of a currency is expected. This involves forecasting future
exchange rate movements, and therefore carries an element of speculation. Where
payables are involved, the transfer is speeded up if the foreign currency is expected to
appreciate against the domestic currency and slowed down if the overseas currency is
expected to depreciate. A UK company importing from the USA during late 2003,
when the USD was falling against sterling, may well have tried to lag payments.
Leading and lagging within a group of companies is relatively easy to arrange, but
when dealing with other firms, this can be problematic. A customer buying on credit
will advance payment only if offered an inducement such as a discount for early pay-
ment. The same applies to delaying payment to an external supplier – the danger is
loss of goodwill. Even for intra-firm transactions, there may still be local regulations
and currency controls that limit flexibility.
Currency transfers by companies into and out of less-developed countries,
whose currencies tend to be weak, are closely scrutinised by the governments of
those countries because of the destabilising effect they may have on their curren-
cy. In some cases, they are illegal, both for their ability to exacerbate currency
weakness and also because of the effect on local minority shareholders of an over-
seas subsidiary. Leading a payment from the overseas subsidiary to the UK parent
will raise the GBP profits of the parent, but lower the overseas currency profits of
the subsidiary thus damaging local shareholders’ interests, which risks alienating
Table 21.3
Oilex’s internal
currency flows
Paying subsidiary ($m)
UK US Norway Total Net
Receiving UK – 10 4
subsidiary US 5 – 2
($m) Norway 12 8 –
Total 41
Net 14113
61817
1420
117
314
natural matching
A natural match is achieved
where the firm has a two-way
cash flow in the same currency
due to the structure of its
operations, e.g. selling in a
currency in which it sources
supplies
CFAI_C21.QXD 3/15/07 7:47 AM Page 615
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616 Part VI International finance
local opinion and antagonising the host government. This is one reason why repa-
triation of profits from overseas subsidiaries is often closely controlled by foreign
governments.
re-invoicing centre
A corporate subsidiary set up
usually in an off-shore location
to manage transaction expo-
sure arising from trade
between separate divisions
of the parent firm
Self-assessment activity 21.7
Delete as appropriate.
Leading is advancing outflows in a strong/weak currency and advancing inflows in a
strong/weak currency. Lagging is delaying inflows in a strong/weak currency and delaying
outflows in a strong/weak currency.
(Answer in Appendix A at the back of the book)
The UK exporter might also consider a pre-emptive price variation. If it expects GBP
to strengthen against the currency of an overseas customer, it may raise the contract
price. However, this may have adverse consequences for sales, especially if competi-
tors are prepared to shoulder currency risk by accepting payment in the overseas cur-
rency. Conversely, the acceptability of this ploy may be greater if the exporter quotes
a price based on the forward rate rather than the spot rate when setting the value of
the contract. Generally, however, such price variations require a strong competitive
position in overseas markets. For this reason, another such device, switching the cur-
rency in which the contract is denominated to a third currency, say USD, also has to be
used with caution. However, traders in basic commodities have no such flexibility,
since most of these are priced in USD.
The Customs and Excise Survey in 2001 revealed that 29 per cent of UK exports and
34 per cent of imports were invoiced in USD.
Risk-sharing is a contractual arrangement whereby the buyer and seller agree in
advance to share between them the impact of currency movements. This is recom-
mended when the two parties want to build a long-term relationship. However, if
exchange rate variations exceed tolerable limits, the arrangement may have to be
re-negotiated.
It might work like this. Firm X supplies Firm B in another country. They may agree
that all transactions will be made at the ruling spot rate between the two parties’
respective currencies. If, however, the rate at settlement varies by up to, say, 5 per cent
either side of the original spot rate, X may accept the transaction exposure. If the rate
varies by, say 5–10 per cent of the original spot, they may share the difference equally,
but for variations in excess of 10 per cent, the agreement may become void. Harley
Davidson is known to operate this policy with foreign importers.
Re-invoicing centres. A re-invoicing centre (RIC) is a separate corporate subsidiary
that manages from one location, often off-shore, all the transaction exposure arising
from intra-company trading.
For example, a manufacturing unit may sell goods to distribution subsidiaries of its
parent firm indirectly by selling first to the re-invoicing centre, which then re-sells the
goods to the distribution subsidiary. Title to the goods passes to the RIC but the goods
are shipped directly from the manufacturing subsidiary to the distributor. The RIC
thus manages the transactions on paper but keeps no physical stocks. All transactions
exposure resides with the RIC.
A problem may arise due to allegations of profit-shifting via transfer pricing. To
avoid such allegations, the RIC may sell at cost plus a commission for its services. The
resale price is commonly the manufacturer’s price times the forward exchange rate for
the date when settlement by the distributor is expected.
price variation
Adjustment of a firm’s pricing
policy to take into account
expected foreign exchange rate
movements
risk-sharing
An arrangement where the
two parties to an
import/export deal agree to
share the risk, and thus the
impact of unexpected
exchange rate movements
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Chapter 21 Managing currency risk 617
foreign currency swap
A way of using the forward
markets to adjust the maturity
date of an initially agreed con-
tract with a bank
RICs offer the major benefit of concentrating the management of all FX transactions
in one location. As a result, the multinational corporation (MNC) can develop special-
ist expertise in judging which hedging technique is optimal at any one time. However,
it should avoid conducting business with other firms in its country of location in order
to establish non-resident status.
The most widely used external hedging technique is the forward contract. It involves
pre-selling/buying a specific amount of currency at a rate specified now for delivery at
a specified time in the future. It is a way of totally removing risk of currency variation
by locking in the rate quoted today by the forward market. However, there remain the
risks of the trading partner (credit risk) defaulting and that of failure of the bank that
arranges the deal (counterparty risk).
Consider the case of a UK exporter entering an export contract in February for
$10 million with a company in Denver. The companies agree on payment in three
months time, i.e. in May. The current spot rate is valuing the contract at
If the exporter is concerned by the possibility of a decline in the
USD versus GBP, it will look carefully at the rate quoted for 3-month delivery of
USD. Assume the forward market quotes ‘2c discount’. The forward outright is
thus:
If the exporter believes in the predictive accuracy of the forward market, it may
decide to sell forward the anticipated $10 million receipt for
This involves taking a discount on the current spot value of the deal. Hedging costs
the exporter a little over 1 per cent of the original value of the deal (although
a higher proportion of his profits), but this may look trivial beside the losses that could
materialise if GBP strengthens further than this. Conversely, the exporter is excluded
from any gains if the USD appreciates in value.
If the exporter is unsure about the precise payment date by its customer, it may
enter a forward option. In this case, the bank leaves the currency settlement date open,
but books the deal at the worst forward rate ruling over the period concerned. Say the
two companies had agreed on payment ‘sometime over the next three months’, but the
exporter knows that the customer may delay payment for six months. The relevant
forward quotations are:
1 month: 0.5c dis Outright: 1.6050
2 months: 1.0c dis Outright: 1.6100
3 months: 2.0c dis Outright: 1.6200
6 months: 3.0c dis Outright: 1.6300
The worst rate for the exporter is the six-month rate, so the deal will be booked for
again a minor increase in cost. If the customer pays up at any
other time, the bank is committed to paying the exporter the amount agreed in the for-
ward contract when the $10 million is handed over.
Another way of covering uncertainty over settlement dates is to undertake a foreign
currency swap. The Bank of International Settlements (BIS, www.bis.org) defines a swap as
follows:
Foreign exchange swaps commit two counterparties to the exchange of two cash flows
and involve the sale of one currency for another in the spot market with the simultane-
ous repurchase of the first currency in the forward market.
$10 m>1.63 £6.13 m,
£80,000,
$10 m>1.62 £6.17 m.
Spot $1.60 plus 2.0c $1.62 : £1
£6.25 m.$10 m>1.6
$1.6 : £1,
21.9 EXTERNAL HEDGING TECHNIQUES
credit risk
The risk that a foreign
customer might not pay up as
agreed on time or at all.
counterparty risk
The risk that the bank which is
party to a hedging transaction
such as a forward contract
may not deliver the agreed
amount of currency at the
agreed time
CFAI_C21.QXD 3/15/07 7:47 AM Page 617
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An exporter can take forward cover to a specified date, but if a later settlement date
than this is agreed, it can extend the contract to the newly agreed date. For example,
a forward–forward swap is needed if our exporter covers ahead from February until
May, but if in March, a firm settlement date is agreed for June. Contractually, it has to
meet the first contract maturing in May, and then take cover for a further month. This
is done in March by buying $10 million two months forward, i.e. for delivery in May
to meet the existing contract, and by selling $10 million three months forward for
delivery in June. In this case, the exporter swaps the maturity date and ends up hold-
ing three separate contracts. Instead, it could adopt the riskier alternative of a
spot–forward swap, fulfilling the May contract by buying the $10 million on the spot
market, and also arranging to sell $10 million one month forward, i.e. in June. The BIS
estimated average daily swap transactions at US$944 billion in April 2004, 50 per cent
of total non-derivatives trading (US$1,880 billion).
Money market cover involves the exporter creating a liability in the form of a
short-term loan in the same currency that it expects to receive. The amount to bor-
row will be sufficient to make the amount receivable coincide with the principal of
the loan plus interest. Assume the Eurodollar rate of interest, the annual rate payable
on loans denominated in USD, is 8 per cent, i.e. 2.00 per cent over three months. The
UK exporter would borrow This would be converted into
GBP at the spot rate – in our example, – to realise
This looks like a considerable discount on the spot value of the export deal
but the GBP proceeds of this operation can be invested for three months to defray
the cost. Obviously, if the exporter could invest at a rate in excess of 8 per cent p.a.,
it would profit from this, but IRP should make this impossible, i.e. if USD sells at a
forward discount, interest rates in New York should exceed those in London. If USD
should unexpectedly fall in value against GBP, lower than expected receipts from the
US contract are offset by the lower GBP payment required to repay the Eurodollar
loan.
An alternative to a one-off loan to cover a specific contract is for the exporter to
operate an overdraft denominated in one or a set of overseas currencies. The trader
will aim to maintain the balance of the overdraft as sales are made, and use the sales
proceeds as and when received to reduce the overdraft. This is a convenient technique
where a company makes a series of small overseas sales, many with uncertain pay-
ment dates. A converse arrangement, i.e. a currency bank deposit account, may be
arranged by a company with receivables in excess of payables.
International invoice finance is a fast-expanding business among UK traders,
amounting to a total of (measured by client turnover figures) in 2004. This
comprised of export invoice discounting (13 per cent growth on 2003) and
in export factoring (9 per cent growth on 2003). The international factor can
provide many services to the small company, including absorbing the exchange rate
risk. Once a foreign contract is signed, the factor pays, say, 80 per cent of the foreign
value to the UK exporter in GBP. If the exchange rate moves against the UK company
before receipt of the foreign currency, the factor absorbs the loss. In compensation, the
factor also takes any gain arising from a change in rates. Factors make use of overseas
‘correspondent’ factors, enabling clients to benefit from expert local knowledge of
overseas buyers’ credit-worthiness. Overseas factoring is usually expensive but offers
the benefits of lower administration and credit collection costs.
Export receivables that involve settlement via Bills of Exchange can also be dis-
counted with a bank in the customer’s country and the foreign currency proceeds
repatriated at the relevant spot rate. Alternatively, the bill can be discounted in the
exporter’s home country, enabling the exporter to receive settlement directly in home
currency.
The most sophisticated external hedging facilities involve derivatives such as options,
futures and swaps. These are treated in more detail below.
£0.9 billion
£3.3 billion
£4.2 billion
1£6.25 m2,
1$9.80 m>1.62 £6.13 m.$1.6 : £1
1$10 m>1.02 $9.80 m2.
618 Part VI International finance
forward–forward swap
Where the original forward
contract is supplemented by
new contracts that have the
effect of extending the maturi-
ty date of the original one
spot–forward swap
A less comprehensive forward
swap that involves speculation
on the future spot market
CFAI_C21.QXD 3/15/07 7:47 AM Page 618
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Chapter 21 Managing currency risk 619
call option
A financial derivative that gives
the buyer the right but not the
obligation to buy a particular
commodity or currency at a
specific future date
■ Currency options
A currency option confers the right, but (unlike the forward contract) not the obligation,
to buy or sell a fixed amount of a particular currency at or between two specified future
dates at an agreed exchange rate (the strike price).
A call option gives the purchaser of the option the right to buy, while a put option
gives the right to sell. In each case, the buyer of the option pays the ‘writer’ of the
option a premium. Options traded through exchanges are written in specified con-
tract sizes: for example, on the Philadelphia Stock Exchange (PHLX), GBP is dealt
in lot or contract sizes of 31,250 units, i.e. Most exchanges offer a limited
number of alternative exercise prices and maturity dates. PHLX also trades USD
options against the Australian dollar (contract size A$100,000), Canadian dollar
(C$100,000), Japanese Yen (12,500,000) and the Swiss Franc (125,000), as well as euro
contracts (62,500). Delivery dates are for the quarter months of March, June,
September and December plus the two immediately upcoming months. For non-
standard options, the would-be purchaser may have to shop around for a cus-
tomised quotation on the over-the-counter (OTC) market. This may be necessary
for unusual or ‘exotic’ currencies.
A‘European option’ can be exercised only at the specified maturity date, while an
‘American option’ can be exercised at any time up to the specified expiry date. If an
option is not exercised, it lapses and the premium is lost. However, the appeal of an
option is that the maximum loss is limited to the cost of the premium, while the pur-
chaser retains the upside potential. The size of the premium depends on the difference
between the current exchange rate and the strike price (for an unlikely strike price,
premiums will be very low), the volatility of the two currencies, the period to maturi-
ty and, for OTC contracts, the size of the contract.
Here is an example of how a trader could use a currency option for hedging pur-
poses. A UK exporter sells goods for $11.875 million to a customer in Baltimore in
January 2005 for settlement in March. The contract is worth when valued
at spot of but the exporter is concerned that sterling might appreciate before
settlement, thus eroding the profit margin. In this case, it might purchase a call option
on GBP, i.e. an option to sell USD in exchange for GBP. The premiums in cents per
option unit that were available at the Chicago Mercantile Exchange CCME on 3
January 2005 are shown in Table 21.4.
Clearly, the stronger the position of USD, the more expensive the option. The
exporter can lock in the spot rate, or purchase protection against the rate rising above
the current spot by various amounts. This requires it to take a view on the most likely
adverse movements. Choosing the $1.91 strike price gives the exporter insurance
$1.90 : £1,
£6.25 million
£31,250.
Table 21.4
Sterling /US$ options
US $/UK£ Options (CME)
Strike price CALLS PUTS
3 Jan Jan. Feb. Mar. Jan. Feb. Mar.
1890 2.27 – 3.30 0.60 1.56 2.30
1900 0.62 2.67 3.00 1.05 2.64 3.20
1910 0.51 2.21 2.50 1.67 2.50 3.29
1920 0.72 1.24 1.92 2.41 3.11 4.40
Previous day’s data: volume, 29; calls, 17 puts, 46; open interest, 10,036
(Reuters/CME)
Source: Financial Times, 4 January 2005.
over-the-counter
An over-the-counter transac-
tion, e.g. the purchase of an
option, where the terms are
tailor-made to suit the require-
ments of the purchaser
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620 Part VI International finance
against the exchange rate going higher than $1.91. The cost of purchasing March
options is:
i.e. at spot.
If the spot rate in March is less than $1.91, the option is not worth exercising and is
said to be ‘out of money’; if spot is $1.91, it is ‘at the money’; while if spot is over $1.92,
say $2.00, the option is ‘in the money’. In the last case, export earnings of $11.875 mil-
lion can be sold at $1.91 to realise compared with a spot value of
Although the option has cost it has prevented the
exporter from losing In this case, there is a net gain,
allowing for the premium, of nearly
It is important to appreciate that options are ‘zero-sum games’ – what the holder wins,
the writer loses, and vice versa. It is relatively unusual to use currency options to hedge
ongoing trading exposures – options are complex, they are often expensive compared to
using the forward market and it is time-consuming to monitor an American option to
judge whether it is worth closing out the position prematurely. Options tend to be used
to cover major isolated expenditures, e.g. the cost of completing the acquisition of an
overseas company or the phased payments in a major overseas construction project.
The PHLX website (www.phlx.com) gives a history of option trading and also a trad-
ing guide, and daily quotations on sterling and euros appear in the Financial Times.
£200,000.
1£6.22 m £5.94 m2 £280,000.
£82,672,$11.875 m>$2.00 £5.94 m.
£6.22 million,
£82,672
Cost of option £31,250 2.50c 200 $156,250
Number of lots required
$11.875 m
$1.90
£31,250 200
Self-assessment activity 21.8
What is the net cost/benefit of an option that is ‘at the money’?
(Answer in Appendix A at the back of the book)
■ Currency futures
In principle, a futures contract can be arranged for any product or commodity, includ-
ing financial instruments and currencies. A currency futures contract is a commitment
to deliver a specific amount of a specified currency at a specified future date for an
agreed price incorporated in the contract. It performs a similar function to a forward
contract, but has some major differences.
Currency futures contracts have the following characteristics:
1 They are marketable instruments traded on organised futures markets.
2 They can be completed (liquidated) before the contracted date, whereas a forward
contract has to run to maturity.
3 They are relatively inflexible, being available for a limited range of currencies and
for standard maturity dates. The world’s largest market for currency futures is the
Chicago Mercantile Exchange (CME). It trades futures in eleven different currencies
for delivery four times each year: March, June, September and December.
4 They are dealt in standard lot sizes, or contracts.
5 The CME requires a down-payment called a ‘performance bond’ or ‘margin’ of
about 1.5 per cent of the contract value, whereas forward contracts involve a single
payment at maturity.
6 They also involve ‘variation payments’, essentially the ongoing losses on the con-
tract to be paid to the exchange on which the contract is dealt.
7 They are usually cheaper than forward contracts, requiring a small commission
payment rather than a buy/sell spread.
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Chapter 21 Managing currency risk 621
It is difficult to ‘tailor make’ a currency future to the precise needs of the parties
involved, which explains why some exchanges, e.g. LIFFE, have now stopped currency
futures trading.
How a currency future works
This is best shown with an example. In June, a UK importer agrees to buy goods worth
$10 million from a firm in Detroit. The sterling/dollar spot rate is valuing the
deal at Settlement is agreed for 15 August, but the importer is
concerned that appreciation of USD will undermine its profitability (it will have to find
more GBP to meet the import cost). On the CME, the market price (i.e. the exchange rate)
for September GBP futures is $1.48, suggesting that the market expects USD to appreciate.
The importer needs eventually to acquire GBP to pay for its imports, so it should
sell (i.e. go short of) GBP by selling GBP futures contracts at $1.48. With the standard
contract size of the number of whole contracts required is:
Note the indivisibility problem – 108 contracts covers exposure of only
This makes hedging by futures unattractive to small
exporters. There is also a timing problem, as the importer has to supply USD before
the expiry of the contract in August. When payment is due, the importer will close out
the contract by arranging a reverse trade, i.e. one with exactly opposite features, which
means buying 108 September GBP futures at the ruling market price. If USD has
strengthened against GBP between June and August, the importer will make a profit
on the futures contract.
Imagine this does happen and the spot rate on 15 August is $1.49 and the September
futures price is $1.475. As payment for the goods is required, the importer converts
GBP for USD on the spot market at a cost of Compared
with the cost of the deal at the June spot rate, it has made a loss of owing to
the feared USD appreciation. However, the importer holds 108 futures contracts,
enabling it to sell GBP at $1.48. To close its position, the importer can buy the same
number of contracts at an exchange rate of $1.475. It will thus make a profit on the
futures market of:
Valued at spot of $1.49, this is worth leaving a net loss of
This demonstrates the difficulty of achieving a perfectly
hedged position with currency futures. Moreover, the futures market may not always
move to the same degree as the spot market, owing to expectations about future exchange
rate movements.
The CME website (www.cme.com) provides a beginner’s guide to using the futures
markets, and prices for USD currency futures are quoted daily in the Financial Times.
■ Currency swaps
The BIS defines currency swaps as follows:
‘A currency swap (or cross-currency swap) commits two counterparties to several
cash flows, which in most cases involve an initial exchange of principal and a final
re-exchange of principal upon maturity of the contract, and in all cases, several
streams of interest payments.
Currency swaps originated from controls applied by the Bank of England over for-
eign exchange movements prior to 1979. Firms wishing to obtain foreign currency to
1£44,743 £22,6512 £22,088.
1$33,750>1.492 £22,651,
Sells
108 £62,500 1.480
$9,990,000
Buys
108 £62,500 1.475
$9,956,250
Profit
$33,750
£44,743,
1$10 m>1.492 $6,711,409.
£62,500 1.482 $9,990,000.
1108
3$10 m>1£62,500 1.4824 108 approx.
£62,500,
$10 m>1.50 £6,666,666.
$1.50 : £1,
currency swaps
Where two or more parties
swap the capital value and
associated interest streams of
their borrowing in different
currencies
CFAI_C21.QXD 3/15/07 7:47 AM Page 621
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622 Part VI International finance
invest overseas, say in the USA, found they could avoid these controls by entering an
agreement with a US company that operated a subsidiary in the UK. In return for
receiving a loan from the US company to finance its own activity in the USA, the UK
company would lend to the UK-based subsidiary of the US company. The two firms
would agree to repay the loans in the local currency after an agreed period, thereby
locking in a particular exchange rate. The interest rate would be based on prevailing
local rates. Such arrangements were called ’back-to-back loans’ – from the UK compa-
ny’s perspective, they involved agreeing to make a series of future USD payments in
exchange for receiving a flow of GBP income.
After exchange controls were removed in 1979, such loans were replaced by cur-
rency swaps. These need not involve two companies directly. In general terms, a cur-
rency swap is a contract between two parties (e.g. between a bank and an overseas
investor) to exchange payments denominated in one currency for payments denomi-
nated in another. A simple example will illustrate this.
How currency swaps work
Currency swaps are complex. In particular, they require matching up two companies’
mutual requirements in terms of type and amount of currency required and term of
financing. The final agreement will reflect the bargaining power of the parties involved
and is most viable when each party has a differential borrowing advantage in one cur-
rency which it can transfer to the other. This point is important – a currency swap
almost invariably involves an interest rate swap.
To illustrate the process, consider the example of two companies, ABC and XYZ.
ABC, which can borrow in Swiss Francs (CHF) at 5.5 per cent, is seeking USD
financing of $40 million for three years. The Dutch subsidiary of a US bank is pre-
pared to act as intermediary, which involves finding a suitable matching company
which has a borrowing advantage in USD and is seeking CHF finance. Until the
match is found, the bank will be exposed to currency and interest rate risk, which
it may cover by entering the spot market, or possibly using the options market.
Company XYZ emerges as a suitable swap candidate. (More complex swaps might
involve several participant companies if a directly corresponding currency require-
ment cannot be identified.)
XYZ has a borrowing advantage in USD, being able to borrow at 7 per cent, com-
pared to ABC’s borrowing rate of 7.75 per cent. Conversely, XYZ would have to bor-
row in CHF at 6 per cent. XYZ is seeking CHF finance of 52 million. At the ruling
exchange rate of 1.3 CHF per USD, this is an exact match. With the bank’s interme-
diation, the two companies now agree to swap currencies and assume each other’s
interest rate obligations over a three-year term, with transactions conducted via the
bank. Figure 21.5 shows the structure of the swap and the sequence of transactions.
In reality, the two companies would have to pay rather higher interest rates than
those shown in order to yield a profit margin for the bank, sufficient to compensate
it for assuming the risks of either company defaulting on interest payments or re-
exchange of principal.
There are three legs to such deals:
1 Exchange of principal at spot (either notional or a physical transfer) in order to pro-
vide a basis for computing interest.
2 Exchange of interest streams.
3 Re-exchange of principal on terms agreed at the outset.
The principal is fully hedged, unlike the interest rate payments, which may require
hedging perhaps via the forward market.
In the example, the company benefits from lower interest rates and effectively uses
the superior credit rating of the swap specialist to access cheaper finance. Most cur-
rency swaps are undertaken to exploit such interest rate disparities, whereby one
back-to-back loans
A simple form of a swap where
firms lend directly to each
other to satisfy their mutual
currency requirements
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Chapter 21 Managing currency risk 623
21.10 CONCLUSIONS
The globalisation of world trade has forced financial managers to take a keener interest in
managing foreign exchange exposure. There are three types of exposure: transaction expo-
sure, affecting the flow of cash across a currency frontier; translation exposure, affecting
the value of assets and liabilities denominated in a foreign currency; and economic expo-
sure, which is the impact on long-term cash flows of possible changes in exchange rates.
Not all transactions, assets and liabilities denominated in foreign currencies are nec-
essarily exposed to exchange rate risk. The essential skills in currency management are
to identify the assets and cash flows which are at risk and to devise suitable means of
hedging the risks. It is important to differentiate between hedging techniques internal
and external to the firm. Several financial markets have been developed that allow the
international treasurer to hedge foreign exchange risk, and financial instruments such
as swaps, options, futures and forwards can be used for this purpose.
The international treasurer must decide whether or not exchange rates can be fore-
cast with any degree of reliability. With exchange rates floating freely, research sug-
gests that forecasting is not profitable. However, when governments begin to interfere
with the free market, forecasting has proved to be a profitable activity. The dogged, but
ultimately doomed, commitment by international monetary authorities to support
artificially high or low exchange rates may make forecasting worthwhile.
Company
XYZ
Issues $40 m
at 7%
Issues 52 m CHF
at 5 %
Time
Outset
Years 1–3
Pays
Receives
52 m CHF
$40 m
7% on $40
m
5 % on
52 m CHF
$40
m
52 m CHF
$40m
52
m CHF
5 % on 52
m CHF
7% on $40 m
52
m CHF
$40 m
Pays
Receives
End Year 3
Pays
Receives
ABC
Pays
Receives
Pays
Receives
Pays
Receives
XYZ
The sequence of transactions
7%
5 %
1
2
7%
Intermediary
bank
Company
ABC
1
2
5 %
1
2
1
2
1
2
Figure 21.5
Achieving the swap
Self-assessment activity 21.9
Now return to the introductory case on page 593. Can you now explain the apparently dif-
ferent impact of dollar appreciation on these two firms?
(Answer in Appendix A at the back of the book)
party can pass on to another the benefit of superior credit-worthiness. There are two
main forms of currency swap. In a fixed/fixed swap, one party swaps a stream of fixed
interest payments for a corresponding stream of fixed interest payments in another
currency (as in the above example). In a fixed/floating swap, or cross-currency inter-
est swap, one or both payment streams are on a variable basis, e.g. linked to LIBOR.
fixed/fixed swap
A swap agreement where the
parties agree to swap fixed
interest rate commitments
cross-currency interest
swap
A swap agreement where the
parties agree to swap a fixed
interest rate commitment
for a floating interest rate
CFAI_C21.QXD 3/15/07 7:47 AM Page 623
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624 Part VI International finance
SUMMARY
This chapter examined the nature and sources of a company’s exposure to the risk of
adverse foreign exchange rate movements. It explained a number of widely used
strategies to hedge or safeguard against these risks, applying techniques both internal
to the firm and also available on external capital markets.
Key points
■ Corporate profitability can be seriously affected by adverse movements in foreign
exchange rates.
■ Currency can be transacted for immediate payment on the spot market or for future
delivery via the forward market.
■ The international treasurer is faced with three kinds of foreign exchange exposure:
transaction exposure, translation exposure and economic exposure.
■ Transaction exposure relates to the likely variability in short-term operating cash
flows: for example, the cost of specific imported raw materials and the income from
specific exported goods.
■ Translation exposure relates to the risk of exchange rate movements altering the
sterling value of assets located overseas or the sterling value of liabilities due to be
settled overseas.
■ Economic exposure refers to the ongoing risks incurred by the company in its
choice of long-term contractual arrangements, such as licensing deals or decisions
to invest overseas. These risks are the long-term equivalent of transaction exposure.
■ Companies that trade internationally should devise a foreign exchange strategy.
■ The strategy might depend on the treasurer’s belief in the validity of various inter-
national trade theories: Purchasing Power Parity (PPP), Interest Rate Parity (IRP),
the Expectations Theory and the Open Fisher Theory.
■ PPP states that, allowing for the prevailing exchange rate, identical goods must sell
for a common price in different locations. If inflation rates differ between locations,
exchange rates will adjust to preserve the Law of One Price.
■ IRP asserts that any differences in international interest rates are a reflection of
expected exchange rate movements, so that the interest rate offered in a location
whose currency is expected to depreciate will exceed that in an appreciating cur-
rency location by the amount of the expected exchange rate movement.
■ The forward premium or discount should equal the expected rate of appreciation
or depreciation of a currency.
■ The Open Fisher Theory asserts that investment in different countries will offer the
same expected real interest rate, so that differences in nominal rates of interest can
be explained by expected differences in rates of inflation.
■ Once the exposure position of the company is identified and measured, the treas-
urer must devise a hedging strategy to control the foreign exchange risk faced by
the firm.
■ Many apparent exposures are often self-hedging: for example, holdings of plant
and machinery that can be traded internationally.
■ Generally, internal hedging techniques are cheaper to apply than using the external
markets, which offer various financial instruments for hedging currency risks.
■ Hedging cash flows for long-term investment projects is more problematic, but can
be handled by internal methods.
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