Techniques to hedge foreign exchange exposures.

Answer:
Every business faces risks and the first step in managing risk is through understanding
the risks faced and getting a measure of the exposure to each risk.

Foreign exchange risk exposures can be classified in terms of the impact on a firm’s
cash flows, balance sheet, competitive position and value.

The types of risk exposures are:

 Transaction exposure
 Translation or accounting exposure
 Operational exposure
 Economic exposure

i. Transaction exposure or Trade flows, Borrowings

It is the risk that future foreign currency denominated cash flows will vary due to
exchange rate movements
 e.g. a contract by an Australian firm to import goods from the US
denominated in USD

In this example transaction exposure risk is:

i. The risk faced by Australian firms that the AUD will change between the time an order
is placed and the time of its payment. This risk is caused by the uncertainty as to the
exact value of the transaction

Risk associated with transaction exposure:

This is on account of:
a. Currency variability: It relates to the probability of the spot rate changing between
contract date and payment date. It is measured by standard deviation.
b. Currency correlations: Correlation measures the degree to which two currencies
move in relation to each other. In considering whether to hedge an FX exposure, the
correlations between the currencies should also be considered. Correlation ranges from
+ 1 (perfectly positively correlated) to – 1 (perfectly negatively correlated)

ii. Translation or accounting exposure

It is the risk that conversion and consolidation of foreign currency assets or liabilities will
adversely impact the balance sheet
 e.g. a firm accumulates assets and liabilities overseas and at a
future date translates their value onto its consolidated balance sheet

iii. Operational exposure

The risk that day-to-day operating revenues and expenses will be affected by FX
movements
 E.g. foreign subsidiary operating expenses paid in the currency of
the foreign country but sourced in another country such as the parent company

iv. Economic exposure

The effect of exchange rate movements on the ongoing business operations of a firm
(i.e. the net present value of its future cash flows)
 It includes both transaction exposures and operating FX
exposures and extends further to recognise the impact of FX risk on the value of a
firm

To hedge these risk exposures there are various techniques which can be classified as
internal or external:

a. External Risk Management Techniques:

Also called Market-based hedging these are done through forward exchange contracts
and money market hedging, Future, options and swaps.

i. Forward exchange contracts

 The firm locks in an exchange rate today for delivery or receipt of a foreign
currency at a specified future date. When a firm has an agreement to pay (receive) a
fixed amount of foreign currency at some date in the future, in most currencies it can
obtain a contract today that specifies a price at which it can buy (sell) the foreign
currency at the specified date in the future. This essentially converts the uncertain
future home currency value of this liability (asset) into a certain home currency value
to be received on the specified date, independent of the change in the exchange
rate over the remaining life of the contract.

ii. Futures Contracts - These are equivalent to forward contracts in function,

although they differ in several important features. Futures contracts are exchange
traded and therefore have standardized and limited contract sizes, maturity dates,
initial collateral, and several other features. Given that futures contracts are
available in only certain sizes, maturities and currencies, it is generally not possible
to get an exactly offsetting position to totally eliminate the exposure. The futures
contracts, unlike forward contracts, are traded on an exchange and have a liquid
secondary market that make them easier to unwind or close out in case the contract
timing does not match the exposure timing.

iii. Money-market hedging to cover FX risk: This is also called ‘BSI hedge-borrow,
spot, invest’ i.e. borrow, convert spot and invest in other currency.
– Example:
• An Australian firm has say USD1 million receivable in 6 months’ time
• Money market hedging involves
• STEP I: Borrow USD today
• STEP II: Spot convert USD to AUD
• STEP III: Invest the AUD today
Money Market Hedge is also known as a synthetic forward contract; this method
utilizes the fact from covered interest parity, that the forward price must be exactly
equal to the current spot exchange rate times the ratio of the two currencies' riskless
returns. It can also be thought of as a form of financing for the foreign currency
transaction. A firm that has an agreement to pay foreign currency at a specified date
in the future can determine the present value of the foreign currency obligation at
the foreign currency lending rate and convert the appropriate amount of home
 currency given the current spot exchange rate. This converts the obligation into a
home currency payable and eliminates all exchange risk. Similarly a firm that has an
agreement to receive foreign currency at a specified date in the future can
determine the present value of the foreign currency receipt at the foreign currency
borrowing rate and borrow this amount of foreign currency and convert it into home
currency at the current spot exchange rate. Since as a pure hedging need, this
transaction replicates a forward, except with an additional transaction, it will usually
be dominated by a forward (or futures) for such purposes; however, if the firm needs
to hedge and also needs some short term debt financing, wants to pay off some
previously higher rate borrowing early, or has the home currency cash sitting
around, this route may be more attractive than a forward contract.

iv. Foreign Exchange Options, Interest rate caps, Floors, Swaptions, Bond
Options-
Options - Foreign currency options are contracts that have an up front fee, and give the
owner the right, but not the obligation to trade domestic currency for foreign currency (or
vice versa) in a specified quantity at a specified price over a specified time period. There
are many different variations on options: puts and calls,

b. Internal Risk Management Techniques:

These are done through invoicing in home currency, natural hedge, currency
diversification, leading and lagging FX transactions, mark-ups, counter-trade and
currency offsets. Internal hedging minimises FX exposures and the need to use market-
based hedging techniques

Advantages of the various internal risk management techniques are:

i. Invoicing in the home currency
 Avoids FX exposure
 Effectively transfers all FX risk to the other party in the business transaction
 The other party may charge a higher price to compensate for the extra risk

ii. Creating a natural hedge

 Done through matching of foreign currency receivables and payables in
terms of currency, timing and magnitude
  Difficulties with this approach
 Unlikely that an exact hedge can be achieved
 Costs of hedge-motivated transactions
• Extra costs associated with borrowing in markets where the
business may not be well known
• Risk of imported inputs or lease agreements not being good in
quality or price than another supplier in a non-matching currency

iii. Currency diversification

 Limits impact of adverse exchange rate movements by spreading
transactions over a large number of currencies
 Chance of adverse movements in a large number of currencies is very
small
 Greatest diversification achieved where currencies are perfectly
negatively correlated

iv. Leading and lagging FX transactions

 Leading
 Changing the timing of a cash flow so that it takes place prior to the originally
agreed date
 e.g. pay a USD payable before an expected AUD depreciation
 Lagging
Delaying the timing of an existing FX cash flow
e.g. delay a USD payable to coincide with a USD receivable
 Need to assess costs/impact of strategies, e.g. unpredictable payment behaviour

v. Mark-ups
 Increasing prices on exports or imports to cover worst-case
scenario changes in an exchange rate
• e.g. exporter marks-up export price of goods sold
• e.g. importer marks-up the domestic price of imported goods
 Competition is a constraint to this strategy
 vi. Counter-trade and currency offsets
 Counter-trade
• The exchange of product for product, rather then currency-based buy or sell
contracts
• Limited to companies wishing to exchange products of equal value and at the
same time
 Currency offsets
• Recognition of the timing and amount of cash inflows and outflows in the same
currency
• Applicable to both internal cash flows of a firm and FX cash flows between
different firms
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