By Tristan Van Iersel.
As we live in an era of volatile exchange rates in which companies are involved in export/import of goods and services and/or have overseas investments or loans, companies must manage their currency risk exposure.
This article defines the types of foreign exchange exposure that firms face and how these exposures arise and how they can be hedged.
Definitions
Risk is born because of randomness, i.e. unexpected variations in exchange rates.
Currency risk can be identified with statistical techniques and quantities which summarize the probability that the actual domestic purchasing power of home or foreign currency on a given future date will differ from its originally anticipated value.
Currency exposure can be defined as the value at risk due to changes in exchange rates. That is the amount of foreign currencies which represent the sensitivity of the future market value of any physical of financial asset to unexpected exchange rate variations in the future domestic purchasing powers of these foreign currencies.
Hedges are the amounts of the foreign currency financial transactions (i.e. forward contracts or its equivalent) required to render the future, real, domestic currency market value of an exposed position statistically independent of unanticipated, random variations in the future domestic purchasing powers of these foreign currencies.
Major Types of Foreign Exchange Exposure
Foreign exchange exposure of firms can be classified under three categories:
Transaction exposure: it is the possibility of incurring gains or losses, upon settlement at a future date, on transactions already entered into and denominated in a foreign currency. Therefore the amount of cash flows involved in exchange transactions of the firm are exposed to currency rate fluctuations.
Translation exposure: it arises when, for reporting and consolidation purposes, the results of foreign operations are converted from local currencies to the home currency of the parent. Fluctuations in foreign exchange rates expose the value of the firm as measured according to accounting conventions.
Economic exposure: it relates to the impact of foreign exchange rate movements on the net present value of the firm’s future after tax cash flows, which also link directly to the value of the firm.
We have to note that all three types of exposure (translation, transaction and economic) should not be thought as discrete measures of risk. Indeed, they are overlapping and are interrelated parts of currency risk.
In the next sections, our focus will be on transaction exposure.
Transaction Exposure
A transaction exposure arises when a firm contractual obligation exists to sell or purchase goods or services, or to receive or pay interest, royalties or other items, where the payment is denominated in a foreign currency.
The transaction exposure is eliminated when the exposure is hedged by a matching sale/purchase of the amount of currency to be received/paid for the same value as the receipt/payment.
Any transaction exposure has four basic elements:
- Position: either a ‘long’ or a ‘short’ position. For example, a US exporter expecting Euro payments from a French company is ‘long’ in Euro. On the other hand, a US importer who is going to pay a French company in Euro has a future liability and is said to be ‘short ’ in Euro.
Currency of exposure.
Amount of exposure (denominated in the foreign currency).
Timing of future payment or receipt.
Hedging Transaction Exposure
A hedge for a currency exposure is the creation of another exposure identical as to currency, amount and timing to the first exposure, but with the opposite position: if the original exposure was long, the hedge would be a short position, and if the original was short, the hedge would be a long position.
It is important to realise that a hedge is not perfect unless it is identical in respect of currency, amount and timing. A common error is to believe that creation of an opposite exposure, identical in currency and amount, but not timing, constitutes a perfect hedge. In fact it only eliminates part of the relevant risk; it constitutes what is called a partial hedge.
Thus, a partial hedge is said to be created when the position of hedge is opposite to the original exposure, but there is a difference in one or more of the other three constituents of exposure, currency amount and timing.
We have to underline that it may be difficult or impossible to hedge exposures in certain currencies, as a result of exchange control or other banking restrictions, and a partial hedge, using a third currency as a ‘proxy’ for the exposure, may be better than no hedge at all. Such a partial hedge, using different but in some ways linked, currencies, is frequently referred to as a parallel hedge or cross-hedging.
Hedging Techniques – Currency of Invoicing
Determining the appropriate currency of denomination for receivables and payable will have a large effect on a company’s exposure profile. The rule of thumb is to invoice in currencies trading at a premium to the corporation’s base currency. Conversely, companies should try to pay in a discount currency.
There are two drawbacks to this strategy: first, it is difficult to do it in the real world, and second, it may not be the best thing for the company as a whole. More importantly, if the company’s aim is to avoid the foreign exchange risk, then it should use the currency in which it incurs costs, or if the company is an importer, the currency in which it sells the imported goods.
Hedging Techniques – Forward Foreign Exchange Contracts
Forward contracts are the most popular hedging instrument. A forward contract is an agreement between a bank and a firm to exchange one currency for another at some future date. The rate at which the exchange has to be made, the delivery date, and the amounts involved are fixed at the time of the agreement.
The delivery date of a forward contract can be anything from three days to over five years from the contract date. However, in practice, the delivery dates of the vast volume of forward contracts are for between seven days and one year ahead. Forward contracts are a very suitable method of providing the perfect hedge for transaction exposure, since they can be written for most currencies in most amounts for delivery at most future dates, and taken out exactly to match the position of the original exposure.
Another possibility is to use option date forward contract when the ‘timing’ of the exposure is uncertain. The option date forward contract extends this idea to allow the customer to call for settlement of the contract on two days’ notice at any time in an ‘option period’ agreed with the bank on the day the deal was struck.
Hedging Techniques – Currency Borrowing
Borrowing the currency concerned is an alternative to covering the currency risk in the foreign exchange market. The principle is that the exporter borrows an amount of currency that exactly matches his receivables in amount. The currency borrowed is immediately sold for domestic currency and the domestic currency used to pay domestic debt. However, it is important to remember that the amount of the hedge provided by the borrowing is the principal and the interest on the borrowing.
In this case the exporter has done two things:
Hedging its exposure
Financing its receivables
Hedging Techniques – Currency Futures
The purpose of the financial futures markets is to enable companies and individuals to fix in advance interest and exchange rates variability which might otherwise adversely impact them. The prime purpose, then, is to hedge business against adverse movements in interest or exchange rates. The futures exchange itself provides a place where future buying and selling may be conducted and so provides a means to set prices for these transactions. The commodity being bought and sold in such a market is a ‘Financial Future’.
A currency future is a standard contract between buyer and seller, in which the buyer has a binding obligation to buy:
A fixed amount (the contract size)
At a fixed price (the futures price)
On a fixed date (the delivery date)
Of a currency
The futures exchange lays down a detailed contract specification which defines precisely what is contracted to be bought or sold.
Companies are comparatively small users of the currency futures markets. They can invariably achieve cover more easily, more cheaply and more effectively via the forward market.
Unlike the futures market, the forward market does not require any up-front payments.
Hedging Techniques – Currency Options
A foreign exchange option gives the holder the right to buy (call option) or sell (put option) a currency at a given price but creates no obligation to do so.
Two main advantages of options are:
- Option buyers know what the ‘worst case’ will be. They pay their premium and no further expense is possible.
Since there is no obligation to exercise an option, options are ideal for hedging contingent cash flows which may or may not materialise
Disadvantages of options:
Compared to ordinary forward cover, options are expensive, especially when commissions are taken into account.
Only a limited range of currencies is available.
Conclusion
A company may follow different strategies for hedging its risk exposure:
No hedging: the company accepts the risk.
Partial hedging: involves hedging a pre-determined percentage of exposures, leaving the remainder unhedged.
Full hedging: using one of the techniques described above to eliminate the risk.
Hedging techniques help to reduce the currency risk exposure, however in the aim to be effective, the company shall need to set up accurate measurement systems that will represent additional costs. Therefore, a company must determine the costs and benefits of setting up a hedging strategy before implementing one.
Article written by Tristan Van Iersel
Source: I. Ertürk & M. Cavus (2012), Treasury, Foreign Exchange and Financialization, Manchester Business School, Study Guide and Workbook.
For more information on hedging techniques and currency exposure theory, you may read: D.K. Eiteman, A.I. Stonehill & M.H. Moffet (2012), Multinational Business Finance, Prentice Hall (13th Ed.).
