Hedging Treasury Risk with Forward Foreign Exchange Contracts Leslie Matthews Šulenta Director International Business Strategies, LLC, Zagreb September,

Hedging Hedging Treasury Risk Treasury Risk with with

Forward Foreign Forward Foreign Exchange ContractsExchange Contracts

Leslie Matthews ŠulentaDirector

International Business Strategies, LLC, Zagreb

September, 2005Croatian Association of Corporate Treasurers

Leslie Šulenta, International Business Strategies, LLC

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Overview

FX forwards: definition, characteristics and features

Uses of FX forwards– Example 1: Hedging with forwards– Example 2: Deriving the forward rate

Problems and risks Accounting for forwards

– Example 3: Marking to market Risk management

FX Forwards: FX Forwards: Definition, Definition,

Characteristics and Characteristics and FeaturesFeatures


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Forward Foreign Exchange Contract

Definition:

An agreement to exchange one currency for

another, where The exchange rate is fixed on the day of the

contract, but

The actual exchange takes place on a pre-

determined date in the future


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Characteristics and Features of FX Forwards

Available daily in major currencies in 30-, 90-, and 180-

day maturities

Forwards are entered into “over the counter”

Deliverable forwards: face amount of currency is

exchanged on settlement date

Non-deliverable forwards: only the gain or loss is

exchanged


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Contract terms specify: – forward exchange rate

– term

– amount

– ‘‘value date’’ (the day the forward contract expires)

– locations for payment and delivery.

The date on which the currency is actually exchanged, the

‘‘settlement date,’’ is generally two days after the value date of the

contract.


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Forward Exchange Rates: “The Iron-Clad Law” Forward exchange rates are different from spot rates, but they are

not a prediction of what the spot rate will be when the deal settles!

The difference between the

forward exchange rate and the spot exchange rate

is the interest differential

between the two currencies

FX Forwards: FX Forwards: UsesUses


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Uses of FX Forwards

(1) Hedge foreign currency risk (2) Arbitrage FX rate discrepancies within and

between markets(3) Speculate on future market movements(4) Profit by acting as market maker

Financial institutions, money managers, corporations, and traders use these instruments for managing currency risk


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Two Types of Hedging

Corporations engaged in international trade

Hedge payments and receipts denominated in foreign currencies. – For example, a Croatian corporation that exports to Germany and

expects payment in Euro (EUR) could sell EUR forward to eliminate the risk of a depreciation of the EUR at the time that the payment arrives.

Hedge the translation of foreign earnings for presentation in financial statements.

Example 1: Hedging With an FX Forward

Hedged Item Company must pay EUR 1,000,000

to a eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK will

depreciate during next 3 months

– Exposure to FX risk: What will be exchange rate

HRK/EUR in three months??

Hedging Instrument Bank buys 1,000,000 EUR

forward at forward rate of 7.3750

– FX risk: Company is protected against large adverse FX rate movements

If FX rate is unfavorable in 3 months (ie, > 7.3750), Company pays just 7.3750


Hedged Item Company must pay EUR 1,000,000 to

a eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK will

depreciate during next 3 months

Advantages of Hedge: Company knows its costs and can

plan its finances accordinglyCost of the hedge is zero -- No money is exchanged at

inception of the forward FX agreement

Hedging Instrument Bank buys 1,000,000 EUR forward at

forward rate of 7.3750

Disadvantage of Hedge: Company is still exposed to FX risk

if the HRK/EUR spot rate is less than 7.3750 in 3 months

Effect of hedge is same as buying EUR today and

holding in an interest-bearing account

(Forward FX agreement is NOT a simple speculation)


Unhedged Company If in 3 months, spot rate

is 7.4500…

– Unhedged Company must pay:

7.45 x 1,000,000 =

HRK 7,450,000

Effect of Hedging Hedged Company has

already bought EUR forward

– Hedged Company will pay:

7.375 x 1,000,000 = HRK 7,375,000

Money saved by hedging: 7,450,000 –

7,375,000 = HRK 75,000


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Example 2: Deriving the Forward Exchange Rate

The spot rate HRK/EUR is 7.3000

A bank today sells a 3-month HRK/EUR forward to a company for a forward exchange rate of 7.3371

How did the bank compute the forward rate?


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Three month interest rates are:

– 1% on the euro

– 3% on the kuna

A company with EUR 1 million and a need for HRK in three months should be indifferent, financially speaking, as to whether it:

– Invests the EUR 1 million for 3 months at 1% and converts the euros (plus interest) into HRK at the end of this time, or

– Sells the EUR 1 million spot for HRK, and invests the HRK at 3% for 3 months


Invest EUR 1 million at 1%for 3 months (91 days)

Interest earned EUR2,493.15

Value after 3 monthsEUR 1,002,493

Sell EUR 1 million spot at 7.30Buy HRK 7.3 million

Invest HRK for 3 months at 3%

Interest earned HRK55,358.33

(7.3 million x 3% x 91/360)

Value after 6 monthsHRK 7,355,358

OPTION 1 OPTION 2

Forward Exchange Rate: 7.3371

FX Forwards: FX Forwards: Problems and RisksProblems and Risks


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Problems with FX Forwards

Finding counterparties who want to take exactly the opposite position:– Most companies (potential counterparties) are

“in the same boat” (i.e., importers from the eurozone)

– One of the parties to the transaction might want to trade a different amount, or have a different settlement date

– Transaction costs can be large (bank’s spread)


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Problems with FX Forwards Liquidity risk: A party in a forward

contract may find it difficult to exit the position. Alternatives:– If counterparty agrees, cancel the forward for

a fee – Assign the contract to another party. This

requires some compensation– If an exact opposite position can be taken,

offset the obligation and suffer only the price differential


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Problems with FX Forwards

Default risk: There is an incentive for the counterparty who lost on the forward contract to default on the agreement– Forwards are a zero sum game. Each

counterparty that gains is balanced by a counterparty who loses the same amount.

FX Forwards: FX Forwards: AccountingAccounting


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Accounting for FX Forwards

IAS 39 applies (Accounting for

Financial Instruments – derivatives

accounting)

– The deal has no immediate value

– Off-balance sheet accounts are used

initially to record the deal on the books


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Accounting for Forwards

Fair value of the forward changes over time with movements in the foreign exchange rate

Unrealized gain (loss) is measured by applying today’s market rates at the forward date


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Example 3: Marking to Market

After one month’s time, the company has to mark-to-market a 3-month forward which is carried in the off-balance sheet accounts

– On the date of the deal, the spot rate was 7.3000– The forward rate for the deal is 7.3371– The spot rate HRK/EUR is now 7.4150

What is the market value of the forward today?


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Example 3: Marking to Market

The company bought EUR against HRK in 90 days. Today, the company could buy EUR 1,000,000 at the

spot rate of 7.4150 and pay HRK 7,415,000. The company is committed to buy EUR 1,000,000 when

the forward matures at 7.3371 and pay only HRK 7,337,100.

Thus, the deal now has value.

Company records an unrealized GAIN of:HRK 7,415,000 – HRK 7,337,100 = HRK 77,900

FX Forwards: FX Forwards: Risk ManagementRisk Management


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Risk Management

Before using any type of derivatives, companies should:

Discuss the potential risks and benefits of derivatives with Management Board and Supervisory Board

Develop appropriate internal controls and limits Prepare derivatives policy and procedures manual; tax

and accounting manuals Host training seminars for management and

employees


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Successful Risk Management

DON’T WORRY, IT MAY MELT BEFORE WE GET THERE!


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WE CAN DECIDE WHAT TO DO, IF AND WHEN WE HIT IT!


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WE NEVER NEEDED TO USE LIFE BOATS BEFORE!!

Thank You.Leslie Matthews Šulenta

+385 98 355 258

[email protected]

www.consulting-mps.com

mailto:[email protected]

mailto:[email protected]

Documents

Hedging Treasury Risk with Forward Foreign Exchange Contracts Leslie Matthews Šulenta Director International Business Strategies, LLC, Zagreb September,