Education Course Notes [Session 9]
ACCA P4
Advanced Financial Management
Education Class 5
Session 9
Patrick Lui
Chapter 14 Hedging Foreign Exchange Risk
1. Discuss the operation of the derivatives market, including:
(a) The relative advantages and disadvantages of exchange traded versus OTC agreements
(b) Key features, such as standard contracts, tick sizes, margin requirements and margin trading
(c) The source of basis risk and how it can be minimised
2. Assess the impact on an organization to exposure in translation, transaction and economic risks and how these can be managed.
3. Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:
(a) The use of the forward exchange market and the creation of a money market hedge
(b) Synthetic foreign exchange agreements (SAFE’s)
(c) Exchange-traded currency futures contracts
(d) Currency swaps
(e) FOREX swaps
(f) Currency options
4. Advise on the use of bilateral and multilateral netting and matching as tools for minimizing FOREX transactions costs and the management of market barriers to the free movement of capital and other remittances.
1. Exchange Rates
1.1 Direct and indirect currency quotes
1.1.1 A direct quote is the amount of domestic currency which is equal to one foreign currency unit.
1.1.2 An indirect quote is the amount of foreign currency which is equal to one domestic currency unit.
1.1.3 In the UK, indirect quotes are invariably used but, in most countries, direct quotes are more common.
1.2 Bid and offer prices
1.2.1 The bid price is the rate at which the bank is willing to buy the currency.
1.2.2 The offer (or ask) price is the rate at which the bank is willing to sell the currency.
Example 1 – Bid and offer pricesCalculate how many dollars an exporter would receive or how many dollars an importer would pay, ignoring the bank’s commission, in each of the following situations, if they were to exchange currency at the spot rate.
(a) A US exporter receives a payment from a Danish customer of 150,000 kroner
(b) A US importer buys goods from a Japanese supplier and pays 1 million yen
Spot rates are as follows.
Bank sells (offer) / Bank buys (bid)
Danish Kr/$ / 9.4340 / 9.5380
Japanese Yen/$ / 203.650 / 205.781
Solution:
(a) The bank is being asked to buy the Danish kroners and will give the exporter:
(b) The bank is being asked to sell the yen to the importer and will charge for the currency
1.3 Spread
1.3.1 The difference between bid price and the offer price, covering dealers’ costs and profit, is called the spread. The spread can be quoted in different ways.
£/$0.6500 +/– 0.0005 or £/$0.6495 – 0.6505
Example 2 – SpreadABC Inc, a US based company, is engaged in both import and export activities. During a particular month, ABC sells goods to Posh plc, a UK company, and receives £5 million. In the same month, ABC imports goods from a UK supplier, which cost £5 million.
If the exchange rates were £/$0.5075 +/– 0.0003, calculate the dollar values of the sterling receipt and payment.
(a) As an exporter, ABC will pay a high rate to buy dollars (sell pounds) – that is, they will be quoted a rate of 0.5075 + 0.0003 = 0.5078. ABC Inc will therefore receive
£5 million/0.5078 = $9,846,396
(b) As an importer, ABC will receive a low rate to sell dollars (buy pounds) – that is, a rate of 0.5075 – 0.0003 = 0.5072. ABC Inc will therefore pay £5 million/0.5072 = $9,858,044
2. Internal Hedging Techniques
2.1 Invoice in home currency
2.1.1 One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.
2.1.2 However the exchange rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.
2.1.3 Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.
2.2 Do nothing
2.2.1 In the long run, the company would “win some, lose some”. This method
(a) works for small occasional transactions
(b) saves in transaction costs
(c) is dangerous.
2.3 Leading and lagging
2.3.1 Leading involves accelerating payments to avoid potential additional costs due to currency rate movements.
2.3.2 Lagging is the practice of delaying payments if currency rate movements are expected to make the later payment cheaper.
Example 3 – Leading and laggingWilliams Inc – a company based in the US – imports goods from the UK. The company is due to make a payment of £500,000 to a UK supplier in one month’s time. The current exchange rate is as follows:
£0.6450 = $1
(a) If the dollar is expected to appreciate against sterling by 2% in the next month and by a further 1% in the second month what would be Williams Inc’s strategy in terms of leading and lagging and by how much would the company benefit from this strategy?
(b) If the dollar was to depreciate against sterling by 2% in the next month and by a further 1% in the second month, how would Williams Inc’s strategy probably change and what would the resulting benefit be?
Solution:
(a) Dollar appreciating against sterling
If the dollar appreciates against sterling, this means that the dollar value of payments will be smaller in two months’ time than if payment was made when due. Williams Inc will therefore adopt a ‘lagging’ approach to its payment – that is it will delay payment by an extra month to reduce the dollar cost.
Payment to UK supplier
One month’s time / Two month’s time
Exchange rate / £0.6450 × 1.02 = £0.6579 / £0.6579 × 1.01 = £0.6645
$ value of payment / £500,000/0.6579 = $759,994 / £500,000/0.6645 = $752,445
By delaying the payment by an extra month Williams Inc will save $7,549.
(b) Dollar depreciating against sterling
The opposite strategy should now be adopted. As the dollar depreciates, there is an incentive for Williams Inc to pay as soon as possible. The dollar value of sterling payments will increase as the dollar depreciates therefore to save money the company will want to pay on time.
Payment to UK supplier
One month’s time / Two month’s time
Exchange rate / £0.6450 × 0.98 = £0.6321 / £0.6321 × 0.99 = £0.6258
$ value of payment / £500,000/0.6321 = $791,014 / £500,000/0.6258 = $798,977
By paying on time Williams Inc will save $7,963.
Companies should be aware of the potential finance costs associated with paying early. This is the interest cost on the money used to make the payment, but early settlement discounts may be available. Before deciding on a strategy of making advanced payments, the company should compare how much they save in terms of currency with the finance costs of making early payment.
By delaying payments there may be a loss of goodwill from the supplier which may result in tighter credit terms in the future. Whilst savings may have been made by paying late, the company must compare these savings with potential future costs resulting from, for example, withdrawal of favourable credit terms or early settlement discounts.
2.4 Matching
2.4.1 When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other. It is then only necessary to deal on the foreign exchange (forex) markets for the unmatched portion of the total transactions.
Suppose that ABC Co has the following receipts and payments in three months time:
2.5 Netting
(Jun 13, Dec 15)
2.5.1 The terms netting and matching are often used interchangeably but strictly speaking they are different:
(a) Netting refers to netting off group receipts and payments.
(b) Matching extends this concept to include third parties such as external suppliers and customers.
2.5.2 In the case of bilateral netting, only two companies are involved. The lower balance is netted off against the higher balance and the difference is the amount remaining to be paid.
2.5.3 Multilateral netting is a more complex procedure in which the debts of more than two group companies are netted off against each other. The arrangement might be coordinated by the company’s central treasury or alternatively by the company’s bankers.
2.5.4 Multilateral netting involves minimizing the number of transactions taking place through each country’s banks. This limits the fees that these banks receive for undertaking the transactions and therefore some governments do not allow multilateral netting in order to maximize the fees their local banks receive.
2.5.5 On the other hand, some other governments allow multilateral netting in the belief that this will be make companies more willing to operate from those countries and any banking fees lost will be more than compensated by the extra business these companies and their subsidiaries bring into the country.
2.5.6 Tabular method (transaction matrix)
Step 1: Set up a table with the name of each company down the side and across the top.
Step 2: Input all the amounts owing from one company to another into the table and convert them into a common (base) currency (at spot rate).
Step 3: By adding across and down the table, identify the total amount payable and the total amount receivable by each company.
Step 4: Compute the net payable or receivable, and convert back into the original currency.
Example 4 – Multilateral nettingP is the parent company of a group that contains 3 subsidiaries: Q (based in Europe), R (based in the USA) and S based in Canada. The following cash flows are due in 2 months’ time between P and its subsidiaries:
Owed by / Owed to / Amount
P / S / CAN$ 3 million
P / R / US$ 5 million
Q / R / US$ 4 million
Q / S / CAN$ 7 million
R / S / CAN$ 2 million
R / P / US$ 6 million
S / Q / EUR 12 million
S / P / CAN$ 5 million
Mid rate exchange rates in two months’ time are expected to be:
£1 = US$1.60
£1 = EUR 1.20
£1 = CAN$ 1.50
Required:
Calculate, using a tabular format (transaction matrix), the impact of undertaking multilateral netting by P and its three subsidiary companies for the cash flows due in two months.
Solution:
Note that all foreign currency amounts have been translated into £ using the given mid rates.
In £ million / Paid by
Paid to / P / Q / R / S / Total
P / 3.750 / 3.333 / 7.083
Q / 10.000 / 10.000
R / 3.125 / 2.500 / 5.625
S / 2.000 / 4.667 / 1.333 / 8.000
Total payment / (5.125) / (7.167) / (5.083) / (13.333)
Total receipt / 7.083 / 10.000 / 5.625 / 8.000
Net receipt/(payment) / 1.958 / 2.833 / 0.542 / (5.333)
So overall, S needs to pay amounts equivalent to the above figures to each of P, Q and R in two months’ time.
Question 1
X, Y and Z are three companies within the same UK based international group. W is a company outside of the group. The following liabilities have been identified for the forthcoming year:
Owed by / Owed to / Amount (millions)
X / Y / €39
Y / X / £10
Y / W / $20
Z / X / ￥200
Z / Y / €15
W / X / $15
W / Z / ￥100
Mid-market spot rates are:
£1 = $2.00
£1 = €1.50
£1 = ￥250
Required:
Establish the net indebtedness that would require external hedging.
3. Managing Transaction Risk – Forward Contracts
(Jun 11, Dec 12, Jun 13, Jun 14)
3.1 Characteristics of forward contracts
3.1.1 A forward contract allows a business to buy or sell a currency on a fixed future date at a predetermined rate, i.e. the forward rate of exchange.
3.1.2 A forward exchange contract is:
(a) An immediately firm and binding contract, e.g. between a bank and its customer.
(b) For the purchase or sale of a specified quantity of a stated foreign currency.
(c) At a rate of exchange fixed at the time the contract is made.
(d) For performance (delivery of the currency and payment for it) at a future time which is agreed when making the contract (this future time will be either a specified date, or any time between two specified dates).
3.1.3 The rule for adding or subtracting discounts and premiums
Forward rate cheaper => Quoted at discount => added to the spot rateForward rate more expensive => Quoted at premium => subtracted from the spot rate
3.1.4 Quotation of forward rates
Banks will quote a spread based on the forward bid and offer prices. For example the $/€ 3-month forward rate might be quoted as: