fund-hedging-strategies-for-foreign-exchange-rate-risk

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TABLE OF CONTENTS

1 DIRECT VS INDIRECT QUOTE…………………………………………………………….5

1.1 DIRECT QUOTE…………….…………………………………………………………5

1.2 INDIRECT QUOTE.…………………………………………………………………..6

2 BUYING & SELLING RATE………………………………………………………………….6

2.1 DIRECT QUOTE……………………………………………………………………….7

2.2 INDIRECT QUOTE……………………………………………………………………7

3 AGREEMENT & SETTLEMENT DATE………………………………………………….7

3.1 AGREEMENT DATE..……………………………………………………………….7

3.2 SETTLEMENT DATE..……………………………………………………………….7

4 FOREIGN EXCHANGE RISK………………………………………………………………..8

5 TYPES OF FOREIGN EXCHANGE RISK…………………………………………………8

5.1 TRANSACTION RISK.……………………………………………………………….8

5.2 TRANSLATION RISK.……………………………………………………………..10

5.3 ECONOMIC RISK.………………………………………………………………….11

6 MANAGING FOREIGN EXCHANGE RISK.………………………………..12

6.1 HEDGING.…………………………………………………………………………….12

6.2 INVOICING IN HOME CURRENCY.………………………………………….13

6.3 MATCHING.………………………………………………………………………….13

6.4 BARTER TRADE…………………………………………………………………….14

7 NETTING………………………………………………………………………………………..15

8 LEAD & LAG PAYMENT…………………………………………………………………..15

9 STEP BY STEP SOLUTION………………………………………………………………..16

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10 SPOT & FORWARD RATE ………………………………………………………………16

10.1 SPOT RATE………………………………………………………………………….16

10.2 FORWARD RATE………………………………………………………………….16

11 INFLATION RATE PARITY THEORY………………………………………………….17

12 INTEREST RATE PARITY THEORY……………………………………………………18

13 FORWARD CONTRACT HEDGE……………………………………………………….20

13.1 RECEIPT……………………………………………………………………………….20

13.2 PAYMENT…………………………………………………………………………….21

13.3 BENEFITS……………………………………………………………………………..23

13.4 LIMITATIONS……………………………………………………………………….23

14 FUTURE CONTRACT HEDGE……………………………………………………………24

14.1 FUTURE MARKET.………………………………………………………………..24

14.2 CONTRACT PRICE.………………………………………………………………..24

14.3 CONTRACT SIZE.…………………………………………………………………..25

14.4 BASIS RISK……………………………………………………………………………25

14.5 TICK……………………………………………………………………………………..25

14.6 AGREEMENT DATE……………………………………………………………….26

14.7 SETTLEMENT DATE……………………………………………………………….26

14.8 BENEFITS……………………………………………………………………………..27

14.9 LIMITATIONS……………………………………………………………………….27

15 MONEY MARKET HEDGE……………………………………………………………….27

15.1 STEP BY STEP PROCESS………………………………………………………..27

15.2 BENEFITS.……………………………………………………………………………33













15.3 LIMITATIONS……………………………………………………………………..33

16 CURRENCY OPTION……………………………………………………………………..33

16.1 BENEFITS.…………………………………………………………………………..35

16.2 LIMITATIONS.…………………………………………………………………….35

17 CURRENCY SWAP…………………………………………………………………………36

18 DERIVATIVE…………………………………………………………………………………37

19 RELATED PRODUCTS……………………………………………………………………39













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BENENFITS OF FUND HEDGING STRATEGIES FOR FOREIGN

EXCHANGE RISK

Fund Hedging Strategies for foreign exchange rate risk provides knowledge from zero. It assumes that reader has no prior financial background. It is suitable for small & medium sized entities and entrepreneurs wishing to manage foreign exchange risk.

It explains when foreign exchange risk arises and the types of foreign exchange risk exposure. Foreign exchange risk affects all entities regardless of involvement in foreign trade.

Foreign exchange risk management is complex concept. Therefore, it simplifies the complexity by providing real life examples and diagrams.

It explains the pros & cons and circumstances in which each foreign exchange hedging strategy would be useful taking account of factors, such as cost of hedging, duration, effectiveness, risk, flexibility, availability of currency pair.

Therefore, you can choose best strategy according to your circumstances and risk appetite. Foreign exchange rate movement can create huge losses. In practice, many companies went into liquidation due to foreign exchange risk exposure. Therefore, it is essential to spent some time and learn foreign exchange risks & strategies to reduce these risks.

If you have not enough budget or want save fee to hire a hedging expert as sum of money at risk do not justify paying fee, then you can choose to do it yourself. However, even if you hire hedging expert, then you must have suitable knowledge to find suitable hedging expert, collaborate and review its work effectively. It is always advisable to obtain expert opinion, as foreign exchange movement is one of the key causes of business failure.

It does NOT have any DRM protection to enforce copyrights. It is completely printable and allows sharing of foreign exchange risk organization wide. Persons involved in sales and purchase needs to be aware of foreign exchange risks to accept/reject customer orders, selection of suppliers, pricing, credit terms etc.












Copyright © 2012 Murtaza Lanewala. All Rights Reserved | NEWSLETTERS | COMMENT | FORUMS | JOBS

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1 Direct Vs Indirect Quote Foreign exchange rates are quoted in pairs

Example: Dollar to Pound, Franks to Yen, Rupees to Dinar etc.

1.1 Direct Quote

A foreign exchange rate quoted as the home currency per unit of the foreign

currency.

In other words, one unit of foreign currency is measured in home currency.

In Direct quote, exchange rate is represented by home currency symbol.

In Direct quote, home currency is written prior to foreign currency and home

currency symbol is written just before exchange rate.

Example: If home currency is Rupees, then Rupees to Pound Sterling (Rs/£) is expressed

as Rs140/£1. Generally, it is expressed as just Rs140.

If home currency is Pound sterling, then Pound Sterling/Dollars (£/$) is

expressed as £1.556.

In Direct Quote, exchange rate is multiplied by the foreign currency to convert

foreign currency into home currency.

Example: Suppose exchange rate of Rupees to Dollar is Rs140.

If a Pakistani citizen pays ACCA fee £86, then he/she will calculate equivalent

amount in home currency (Rs) as follows:

Direct quote is used when foreign currency is stronger than home currency. It

eases calculating foreign exchange rate by avoiding decimal places. It is used

mostly used in developing countries such as Pakistan and India.













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1.2 Indirect Quote

A foreign exchange rate quoted as the foreign currency per unit of the home

currency.

In other words, one unit of home currency is measured in foreign currency.

In Indirect quote, exchange rate is represented by opposite currency symbol.

In Indirect quote, foreign currency is written prior to home currency and

foreign currency symbol is written just before exchange rate.

Example: If home currency is Pound Sterling, then Dollar to Pound Sterling ($/£) is

expressed as $1.555.

In Indirect quote, exchange rate is divided by the foreign currency to convert

foreign currency into home currency.

Example: Suppose exchange rate of Pound Sterling to Dollar is £1.555.

If a UK citizen pays CFA fees $786, then he/she will calculate equivalent amount

in home currency as follows:

2 Buying & Selling Rate Buying and selling rates are two different rates. Difference between buying

and selling rate is known as spread.

Spread represents the profit to the foreign exchange dealer (broker).

They sell at profit and buy to cause you loss.

Diagram:













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2.1 Direct Quote

In direct quote, buying rate is higher rate and selling rate is lower rate.

2.2 Indirect Quote

In indirect quote, buying rate is lower rate and selling rate is higher rate.

Remember whichever quote you use, you should select an exchange rate for

buying and selling which is loss making to you and profitable to foreign

exchange dealer. Because, foreign exchange dealer is trading for profit and if

they are making profit, then you should definitely be losing money.

Lower rate is written before the higher rate regardless of the type of quote in

use.

Example: Dollar to Pound Sterling rate is $1.554 – $1.557

3 Agreement & Settlement Date

3.1 Agreement Date

Agreement date is the date at which organization enters into contract.

Example: Date at which organization commits for buying or selling of goods to foreign

supplier or customer respectively.

3.2 Settlement Date

Settlement date is the date at which organization expects to receive cash from

foreign customer as per credit term offered or obliged to make payment to

foreign suppliers.

Profit Spread

Higher rate

Lower rate

Buy

Sell

Direct

Sell

Buy

Indirect













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Example: If organization purchases goods on 1/1/2012 on 90 days credit period, then

settlement date will be 30/3/2012.

4 Foreign Exchange Risk Foreign exchange risk is the risk that foreign exchange rate movement will

affect profitability and stability. Ultimately, it will prevent an organization from

achieving its objective of shareholders wealth maximization.

Not-for-profit organization is also subject to foreign exchange risk, which will

prevent an organization from providing particular services (education, health

care, entertainment etc) to its members or society as whole.

5 Types of Foreign Exchange Risk

5.1 Transaction Risk

Transaction risk is short-term risk rises due to particular transaction.

It is the risk that foreign exchange rate will adversely affect organizational

profitability.

It arises due to following conditions being met, if any these conditions do not

exist, then there will no transaction risk:

Receipt and payment in foreign currency rather than home currency.

Payment and receipt (settlement) date against purchase and sale is

different from agreement date of goods or services.

Increase in foreign exchange rate makes foreign purchases more costly.

Movement in foreign exchange rates makes cost of purchases higher and

lower. Cost of purchase for goods cannot be exactly known in home currency

until settlement is made. It is due to timing difference between agreement

date and settlement date. However, purchased goods are already being sold

into market between those dates. If exchange rate moves adversely, then

organization can do nothing to cover increased cost of purchase.

Diagram:













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Selli

ng

pri

ce

$

Time

Net Loss

Net profit

Co

st p

er u

nit

Co

st p

er u

nit

Agreed Settled

Exchange rate Movement













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Example: If a person situated in US has bought a pair of shoes for £30 on 90 days credit

period. Suppose he/she sold his/her shoes for $37 in home market before

settlement date.

If exchange rate US to UK appreciates between these 90 days from $0.876 to

$0.718 for buying, then at the last day of credit period, he/she will require

$41.78 to pay £30 because of strengthening of dollar.

(

)

However, at agreement date, he/she was required $34.24 to pay $30.

(

)

Net foreign exchange transaction loss is $7.54, which turned his profit of $2.76

to loss of $4.78 because of exchange rate movement.

( )

( )

( )

Similarly, increase in foreign exchange rate makes foreign sales less profitable.

Period between which goods are sold and receipt is expected, foreign

exchange movement can decrease the amount of money received in home

currency.

Significant foreign exchange losses can create liquidity problem and in extreme

cases end up in liquidation.

Fortunately, transaction risk can be controlled using appropriate Hedging

techniques.

5.2 Translation Risk

Translation risk does not involve cash flows.













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Investment (land and building) in foreign currency will result in lower amount

in balance sheet prepared in home currency due to depreciation of foreign

currency.

Liability (Bank loans) in foreign currency will result in higher amount in balance

sheet prepared in home currency due to appreciation of foreign currency.

Transaction risk is long-term risk because it is subject to long-term investments

& liabilities.

Translation risk can affect key ratios such as profitability, gearing and investor

ratios.

Translation risk can result in violation of loan covenants about maximum

gearing level, which should not be exceeded. Reduction in assets leads to

reduction in equity resulting in higher gearing ratio.

Moreover, organization may find difficulty raising finance as lenders evaluate

credit risk by calculating gearing ratios.

Similarly, transaction risk can result in reduction in share price and market

capitalization of the organization due to reduction in equity.

ROCE will also increase without any improve in performance of the

organization. Managers will be wrongly rewarded, if ROCE is used for

calculating profit related pay (PRP).

Translation risk can be controlled by organization through careful planning and

using matching principle.

5.3 Economic Risk

Economic risk affects all the organizations regardless of involvement in foreign

trade or investment.

Increase in foreign exchange rate will make imported goods more costly in

home currency terms. Organizations using imported raw material as an input

to the goods or services provided by the organization is exposed to economic

risk.

Increase in the cost of raw materials to the organization will lead to increase in

the cost of goods produced or services provided by the organization.













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Organization may have to raise selling price or reduce profit margin to remain

competitive in the market against suppliers of imported goods from other

foreign countries.

Economic risk is beyond the control of the organization. Organization has to

accept that risk. Government can control economic risk in the long term.

However, in short term, it is uncontrollable even by government. Organization

can use its economic power to influence the actions of government.













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