Foreign Currency Risk Management

FOREX

How to Convert How Currency Types of

Currency
Hedging Methods
Fluctuates Foreign Risk

©ACCA
 Risk Management
 Exchange Rate
1.50 $/£

 Buy $ 5,000  Buy $ 9,000  Buy $ 8,000

Rate 1.50 $/£ Rate 1.20 CAD/$ Rate 1.20 $/€
Answer in £ Answer in CAD : Answer in €
 Exchange rate conversion
Bid Offer/ask
Bank Buy Bank Sell
1.2320 $/£ 1.2324 $/£

Example
Example
Sell 50,000 $
Buy 50,000 $
Rate 1.01-1.03 CAD/$
Rate 1.2520-1.2525 $/£
Answer in CAD
Answer in £

Example
Buy 50,000 $ Example
Rate 1.1220-1.1225 $/€ Sell 60,000 $
Answer in € Rate 1.07-1.08 $/CHF
Answer in CHF
 Foreign Currency Risk Management
- When dealing with converting Foreign currency, it is important to consider the
following points
 Always consider yourself at Adverse Position

In case of Receipt In case of Payments

(Lower Receipt) (Higher Payment)

 In Currency Division Divide with Higher

In case of Receipt, Sell Currency, Exports, Gain or Currency Rate
Income
In case of Payment, Buy Currency, Import, Loss or Divide with Lower
Expense Currency Rate

©ACCA
 Foreign Currency Risk Management
How Currency Fluctuate
• Supply & Demand
• Export and Import
• Foreign Direct Investment (FDI)
• Foreign Currency Loans

©ACCA
 Foreign Currency Risk Management
How Currency Fluctuate
Purchasing Power Parity (PPP)
According to PPP the exchange rate between two currencies can be explained by the difference between
inflation rated in respective countries.
PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country
with a LOW inflation rate has an expectation of increase in its currencies value.
The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by
banks.

Expected spot rate Future Spot rate= current spot rate × ( 1+ inflation of first currency)
(1 + inflation of 2nd currency)

©ACCA
 Foreign Currency Risk Management
How Currency Fluctuate
Interest rate parity (IRP)
This concept says that the difference between 2 currencies worth can be explained by interest rate structure
in the countries of these 2 currencies.
According to IRP a country with a high interest rate structure normally has a currency at discount in relation
to another currency whose country has a low interest rate structure & vice versa.
HIGH INTEREST in country LOWER will be the value of currency
LOWER INTEREST in country HIGHER will be the value of currency

We can predict forward rate between two currencies by using interest rate parity concept as follows;

Forward rate= current spot rate × ( 1+ interest of first currency)

Forward rate (1 + interest of 2nd currency)

©ACCA
 Foreign Currency Risk Management
How Currency Fluctuate
Fisher Effect
This concept tells us the relation between interest rate and inflation.
It assumes that real interest rate between two economies are same and nominal interest rates
are different because of inflation.

 Countries with relatively high rate of inflation will generally have high nominal rates of interest,
partly because high interest rates are a mechanism for reducing inflation.

 USA 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]
 UK 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate]

©ACCA
 Foreign Currency Risk Management
Types of Foreign Exchange Risk
Translation Risk Translation Risk
• Translation risk refers to the hedging
possibility of accounting loss
that could occur because of • Arrange Maximum Borrowing
foreign subsidiary, as a result in Subsidiary Co. currency.
of the conversion of the value • Maintain Surplus Assets in
of assets and liabilities which Parent Co. currency which
are denominated in foreign will reduce the overall
currency, due to movements in exposure of Translation risk.
exchange rate.
• This risk is involved where a
parent company has foreign
subsidiaries in a depreciating
currency environment.

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk

Economic Risk Economic Risk Hedging

• Long-term movement in the • Shift manufacturing to cheaper labor
rate of exchange which puts
areas
the company at some
competitive disadvantage is • Create innovative and differentiate
known as economic risk. units to create brand loyalty
• E.g. if competitor currency • Diversify into new products and into
starts depreciating or our new markets
company currency starts
appreciating.
• It may affect a company’s
performance even if the
company does not have any
foreign currency transactions.

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Transaction Risk - Internal Hedging Method
Transaction Risk
• Transaction risk refers to adverse changes in the exchange rate
before the transaction is finally settled.
• Invoice in Home Currency
Suitability: Monopoly power & customer has no option. Supplier
agrees to invoice in your currency.
• Matching Foreign Currency (Receipts and Payments)
Timing and currencies should be same
• Netting

©ACCA
 Netting
Netting is a process in which all transaction of group companies are converted into the same
currency and then credit balances are netted off against the debit balances, so that only reduced
net amounts remain due to be paid or received.
Step 1 : Convert all transactions of group companies or in case of multilateral netting the other non
group companies in to the same currency ( normally the parent Co currency.
Step 2 : prepare the Transaction matrix ( Netting Table )
Payment Step 3 :
Read down
USA UK Europe Total Companies with negative
Receipts balance will pay the amounts
Receipts USA to companies having positive
Read UK balance.
Across Europe
Total
Payments
Net
Amounts ©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Transaction Risk - External Hedging Method
Forward Contract :
A forward contract is an agreement made today between a buyer and seller to exchange a specified quantity of an
underlying asset at a predetermined future date, at a price agreed upon today.
Example
- Home Currency is British Pound £ , Exports receipts = $ 500,000 after six months
Spot Rate = 1.30 – 1.31 $/£
Six month forward rate = 1.32 – 1.33 $/£
Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940
Adjustment :
3 month forward 1.28 $/£
8 month forward 1.38 $/£
6 month forward ?

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Transaction Risk - External Hedging Method
Money Market Hedging :

Foreign Currency Receipts / Exports

Steps:
a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of
this amount.
Present Value = Foreign Currency amount
(1+ borrowing rate of FCY)
a) Convert that present value into home currency using spot exchange rate.
b) Deposit the home currency at the deposit rate of home currency.
Total receipts= Home currency × ( 1 + lending rate of HCY )

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Foreign Currency Payments / imports

Steps:
a) Calculate present value of foreign currency using lending rate of foreign
currency and deposit that amount.
Present Value = Foreign Currency amount
(1+ lending rate of FCY)
a) Convert that present value into home currency using spot exchange rate.
b) Borrow the home currency at the borrowing rate of home currency.
Total payment= Home currency × ( 1 + borrowing rate of HCY )

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Transaction Risk - External Hedging Method
Derivatives: Over-the-Counter Derivatives Exchange-Traded Derivatives
• Future Settlement Customized Contracts Standardized Contracts

• Initial amount to be paid is nil or low Any Amount Standardized Contract Size (e.g. $
62,500)
• Drive their value from some underlying
Available in any Currency Major Currencies
• Traded in two types of market
Settlement on any date Settlement Date – Mar/Jun/Sept/Dec
(Over the counter Market & Exchange Traded)
No Initial margin requirement Initial Margin Requirement

Gain or Loss settled at maturity Gain or Loss settled on daily basis

using ‘Mark to Market”

High Risk of Default No Risk of Default

Counter Party is another Investor Counter Party is clearing house.

E.G FORWARD CONTRACTS E.G FUTURE CONTACTS

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Transaction Risk - External Hedging Method
Future Contract

• Futures are standardized contracts traded on a regulated exchange to make or take delivery of
a specified quantity of a foreign currency, or a financial instrument at a specified price, with
delivery or settlement at a specified future date.

• They are Exchange Traded derivatives contracts.

• Standardized contract sizes and are available in only major currencies

• There are four settlement dates MAR/JUNE/SEPT/DEC.

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Future Contract
Step 1: Identify the amount of currency to be hedged
Step 2: Decide whether to buy or sell future
If you want to buy currency  Buy that currency future
If you want to sell currency  Sell that currency future
Think according to the contract size currency
Step 3: Identify the settlement date expiring immediately after the payment is due to be paid or received
Step 4: Calculate no of contracts  Transaction Amount/Contract Size
If transaction currency is different from the contract size currency then using future rate convert that transaction amount
currency into the same currency of contract size.
Step 5: Calculate Basis Risk.
BASIS = Current Spot rate – Opening Future Rate
Remaining Basis =( Difference/Total months)* remaining months
Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future rate.
Lock in Rate= opening future rate ± Remaining Basis ( opposite to normal rule )
Convert the foreign currency into home currency using Lock in rate.

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Option Contract
TYPES:
• Currency options give the buyer the right but
not the obligation to buy or sell a specific CALL OPTION  Right to buy at a specified rate
amount of foreign currency at a specific PUT OPTION  Right to sell at a specified rate
exchange rate (the strike price) on or before a
predetermined future date.
OPTION BUYER – OPTION HOLDER  LONG POSITION
• For this protection, the buyer has to pay a
premium. OPTION SELLER – OPTION WRITER  SHORT POISTION
• A currency option may be either a call option
or a put option

• Currency option contracts limit the maximum American Option – can be exercised at anytime before maturity
loss to the premium paid up-front and provide
the buyer with the opportunity to take European Option – can be exercised at maturity only.
advantage of favorable exchange rate
movements.

©ACCA
 Foreign Currency Risk Management
Methods of Hedging FOREX Risk
Option Contract Step 7 :
Step 1: Identify the amount of currency to be hedged NOTE: It is assumed that option will be exercised.
Step 2: Decide whether to buy Call or Put Exercise the option ×××
if you want to buy any currency in future  Call Over or under hedge amount × ××
If you want to sell any currency in future  Put
Premium ×××
Think according to the contract size currency
Step 3: Identify the settlement date expiring immediately after the
payment is due to be paid or received
Net Amount ××
Step 4: Identify the exercise price
Step 5: Calculate the no of contracts =
(Foreign Currency Amount/ Exercise Price) / Contract Size
Step 6: Calculate the premium cost = No of contract x Contract size x
Premium
If premium answer is not in your home currency then using current
spot rate convert it into home currency.

©ACCA