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Managing FX Exposure in

Bid-to-Award Situation

Presentation to XYZ Co.

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How does the FX Exposure arise Ways to hedge FX Exposure

• Spot• Forward• Option• Compound Options

Alternative to reduce hedging cost Conclusion

Outline

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XYZ is Bidding for a project in India Project bid in Indian Rupee Revenue after 1 year, Bid Award known after 1 month Significant costs in USD or EUR Pricing sensitive to landed INR cost variations Current Rate to buy USD sell INR 1 year later (Forward

Rate) = 45.75 INR per 1USD Current Rate to buy EUR sell INR 1 year later (Forward

Rate) = 56.60 INR per I EUR

How does the FX Exposure Arise

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One month from now, bid is awarded. No USD/INR hedge done

Forward @ 46.50o Variation from earlier estimate=(46.50-

45.75)= 0.75po Increment Cost= (0.75/45.75)=1.64%

Forward @ 45.00o Variation from earlier estimate=(45.00-

45.75)= -0.75po Cost Savings= (0.75/45.75)=1.64%

How does the FX Exposure Arise -cont

One month from now, bid is awarded. No EUR/INR hedge done

Forward @ 58.00o Variation from earlier estimate=(58.00-

56.60)= 1.40po Incremental Cost= (1.40/56.60)=3.00%

Forward @ 55.20o Variation from earlier estimate=(55.20-

56.60)= -1.40po Cost Savings= (1.40/56.60)=3.00%

There are two variables-USD/INR and EUR/USD

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• Spot= Buy USD against INR. Buy EUR against USD.

When?oAt Bid Stage?

What if the bid is not awarded? Unwanted Position. Exposed to movement in USD/INR and EUR/USD

oAt Award Stage? Spot Rate may be different from rate at which the tender was priced What if the spot rate on revenue receipt date is different Don’t have INR, need to borrow INR, Cost of borrowing?

o At actual time when import need to be paid for? What if the rate is different from the rate the tender was priced

Ways to Hedge- Spot

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Buy USD against INR, Buy EUR against USD for the actual date of payment

When?oAt Bid Stage?

What if the bid is not awarded? Unwanted Position.

oAt Award Stage? Rate may be different from rate at which the tender

was priced What if the spot rate on payment date is different ?

Opportunity Loss

Ways to Hedge- Forward

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• Buy EUR Call USD Put Strike (FWD Rate) expiry 1 Year Gives you right to buy EUR sell USD at a rate of (Current Forward Rate

=1.2370.) It is a right, not an obligation Cost 3.50% of EUR Notional.

• Buy USD Call INR Put Strike (FWD Rate) expiry 1 Year Gives you right to buy USD sell INR at a rate of (Current Forward Rate

=45.75) It is a right, not an obligation Cost 1.65% of USD Notional.

Ways to Hedge-Option

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If the bid is awarded If spot at end of 1 year is above

45.75, exercise the option, buy USD sell INR at a rate of 45.75

If spot at end of 1 year is below 45.75, buy USD sell INR in the spot market at a better rate

If the bid is not awarded

Long a USD call INR Put Sell back the option to recover

some cost Hold the option position to

potential gains later

Ways to Hedge-Option(cont)

If the bid is awarded If spot at end of 1 year is above

1.2370, exercise the option, buy EUR sell USD at a rate of 1.2370

If spot at end of 1 year is below 1.2370, buy EUR sell USD in the spot market at a better rate

If the bid is not awarded

Long a EUR call USD Put Sell back the option to recover

some cost Hold the option position to

potential gains later

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• Buy a right to buy an option Buy a right to buy EUR Call USD Put strike 1.2370 for expiry 1

year from now by paying a cost of 6% on Bid-Award Date. Pay 1% cost today. Option does not come alive unless you pay 6% on Bid-Award Date

Total potential cost= 7%

Ways to hedge- Compound Option

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If Bid is awarded Exercise the compound option by paying 6% Buy another hedge- spot, forward or another option if it is

cheaper

If Bid is not awarded Walk away from compound option. Loss only 1%, the

initial premium paid Exercise the compound option by paying 6% if the option

is worth more. The option can be sold for gains.

Ways to Hedge- Compound Option (Cont)

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• Total premium tends to be expensive• Initial premium can be chosen (typically low).

Lower initial premium would lead to a higher final premium

• Not available in all currency pairs, so USD/INR not mentioned.

Ways to Hedge- Compound Option (Cont)

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Hedging with Options

Right to Buy or Sell Unlimited Profit Potential Offsets Loss on Exposure Limited Loss Potential Allows Profit on Exposure Premium Cost Known upfront

Options Vs. Forwards: A Summary

Hedging with Forwards

Obligation to Buy or Sell Unlimited Profit Potential Offsets Loss on Exposure Unlimited Loss Potential Offsets Profit on Exposure Opportunity Cost initially

Unknown

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• Options carry a cost because they limit the downside and offer unlimited upside

• To reduce cost, consider having some downside(risk reversal) give up some gains on upside (spread) Or do both ! (seagull)

Alternatives to reducing cost of options

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Buy EUR Call USD Put Strike 1.2670 Right to buy EUR sell USD at 1.2670 USD per 1 EUR

Sell EUR Put USD Call Strike 1.2120 Obligation to buy EUR sell USD at 1.2120 USD per 1 EUR

Zero Cost Scenario at expiry Rate above 1.2670 : Buy EUR at 1.2670, no

worse Rate between 1.2120-1.2670 : Buy EUR in the market Rate below 1.2120 : Buy EUR at 1.2120, no

better

Risk Reversal

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Price the Tender at 1.2370 If the bid is awarded

Keep the options as a hedge

If the bid is lost Sell of the option position. There is potential for unlimited gains and losses but less severe than in

case of a forward.

Risk Reversal(cont)

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Buy EUR Call USD Put Strike 1.2670 Right to buy EUR sell USD at 1.2670 USD per 1 EUR

Sell EUR Call Put USD Strike 1.3070 Obligation to Sell EUR buy USD at 1.3070

Cost 1% of Notional Scenario at expiry Rate below 1.2670 : Buy EUR from Market Rate between 1.2670-1.3070 : Buy EUR at 1.2670 Rate above 1.3070 : Buy EUR at 1.2670, sell USD at 1.3070,

net receive 0.0400 USD per 1 EUR. Buy

EUR from market for own use.

Spread

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• Price tender at 1.2370• If the bid is awarded

Keep the options as a hedge• If the bid is lost

Sell of the option position to reduce expenditure

Spread (cont)

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• Buy EUR Call USD Put Strike 1.2470 Right to buy EUR sell USD at 1.2470 USD per 1EUR

• Sell EUR Call USD Put Strike 1.3170 Obligation to sell EUR Sell USD at 1.3170

• Sell EUR Put USD Cal Strike 1.1970 Obligation to buy EUR sell USD at 1.1970

• Zero Cost

Seagull

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• Scenario at expiry Spot below 1.1970 : Buy EUR sell USD at 1.1970 Spot between 1.1970-1.2470 : Buy EUR in the market Spot between 1.2470-1.3170 : Buy EUR at 1.2470 Spot between 1.3170 : Buy EUR at 1.24700, sell EUR at

1.3170, net receive 0.0700 USD per 1 EUR. Buy EUR from market for

own requirement

Seagull (cont)

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• Price tender at 1.2370• If the bid is awarded

Keep the options as a hedge• If the bid is lost

Sell of the option position to reduce expenditure. There is potential for unlimited losses and gains but less severe than forward

Seagull (cont)

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• Bidding in currencies other than cost currency give rise to potential to loss or gain because of the movement in FX rates

• Hedging the exposure before the bid to award date may have cause unwanted positions in case the bid is not awarded

• But a hedge is still required as not hedging can result in less revenue

• Options offer flexibility and are better suited for hedging such situations

Conclusion