Revision 1 Case Questions

Revision 4 Treasury and Advanced Risk Management Techniques

Chapter 14 Hedging Foreign Exchange Risk

Answer 1

(a)

KYT can hedge using futures as follows:

1. Buy futures, since it wishes to acquire Yen to pay the supplier, and the futures contracts are in Yen.

2. Number of contracts = = 11.2 contracts ≈ 11 contracts

3. Use September futures, since these expire soon after 1 September, price of = 125.23 ¥/$

4. Tick size = 0.000001 × 12.5m = $12.50

(b)

Basis risk arises from the fact the price of a futures contract may not move as expected in relation to the value of the instrument being hedged. Basis changes do occur and thus represent potential profits/losses to investors. Typically, this risk is much smaller than the risk of remaining unhedged.

Basis risk is the difference between the spot and futures prices.

(c)

Futures outcome

Net outcome

Hedge efficiency

Hedge efficiency

= = 76%

This hedge is not perfect because there is not an exact match between the exposure and the number of contracts, and because the spot price has moved more than the futures price due to the reduction in basis. The actual outcome is likely to differ since basis risk does not decline uniformly in the real world.

(d)

Interest rate futures

Hedging

A future is an agreement on the future price of a variable. Hedging with futures offers protection against adverse movements in the underlying asset; if these occur they will more or less be offset by a gain on the futures market. The person hedging may be worried about basis risk, the risk that the futures price may move by a different amount from the underlying asset being hedged.

Terms

The terms, sums involved and periods are standardised and hedge inefficiencies will be caused by either having too many contracts or too few, and having to consider what to do with the unhedged amount.

Deposit

Futures require the payment of a small deposit; this transaction cost is likely to be lower than the premium for a tailored forward rate agreement or any type of option.

Timescale

The majority of futures are taken out to hedge borrowing or lending for short periods.

Interest rate options

Guaranteed amounts

The main advantage of options is that the buyer cannot lose on the interest rate and can take advantage of any favourable rate movements. An interest rate option provides the right to borrow a specified amount at a guaranteed rate of interest. On the date of expiry of the option the buyer must decide whether or not to exercise his right to borrow. He will only exercise the option if actual interest rates have risen above the option rate.

Premium cost

However a premium must be paid regardless of whether or not the option is exercised, and the premium cost can be quite high, high enough not to make an option worthwhile if interest rate movements are expected to be marginal.

Types of option

Options can be negotiated directly with the bank (over the counter, OTC) or traded in a standardised form on the LIFFE. OTC options will be preferable if the buyers require an option tailored to their needs in terms of maturity date, contract size, currency or nature of interest. OTC options are also generally more appropriate if the buyer requires a long time to maturity or a large contract size. Traded options will be more appropriate if the buyers are looking for options that can be exercised at any time, are looking for a quick, straightforward deal, or might want to sell the options before the expiry date if they are not required.

(c)

Foreign exchange exposure risks resulting from overseas subsidiary

If a wholly owned subsidiary is established overseas then KYT Inc will face exposure to foreign exchange risk. The magnitude of the resulting risk can, if not properly managed, eliminate any financial benefits we would be hoping to achieve by setting up the overseas subsidiary.

The foreign exchange risks resulting from a wholly owned overseas subsidiary are as follows:

Transaction risk

This is the risk of adverse exchange rate movements occurring in the course of normal trading transactions. This would typically arise as a result of exchange rate fluctuations between the date when the price is agreed and the date when the cash is paid.

This form of exposure can give rise to real cash flow gains and losses. It would be necessary to set up a treasury management function whose role would be to assess and manage this risk through various hedging techniques.

Translation risk

This arises from fluctuations in the exchange rate used to convert any foreign denominated assets or liabilities, or foreign denominated income or expenses when reporting back to the head office and thereby impacting on the investment performance.

This type of risk has no direct cash flow implications as they typically arise when the results of the subsidiary denominated in a foreign currency are translated into the home currency for consolidation purposes. Although there is no direct impact on cash flows, it could influence investors' and lenders' attitudes to the financial worth and creditworthiness of the company. Given that translation risk is effectively an accounting measure and not reflected in actual cash flows normal hedging techniques are not normally relevant. However, given the possible impact the translated results have on the overall group's performance and the possible influence on any potential investment decision making process it is imperative that such risks are reduced by balancing assets and liabilities as far as possible.

Answer 2

(a)

Money market hedge

Calculate two month forward rate

Two month forward rate is the average of one month and three month rates

= = 1.6199 SFr/€

Exposure to transaction risk could be eliminated by entering into a forward contract to purchase Swiss francs at a rate of SFr/€1.6199 – that is, you would purchase SFr1.6199 × 1.5 million = SFr2.4299 million.

Use interest rate parity formula to calculate lowest acceptable Swiss borrowing or lending rate.

Interest rate parity:

If Asteroid Systems can borrow at less than 2.0529% in the Swiss market, the money market hedge will be preferable to selling Swiss francs in the forward market.

(b)

Relative advantages and disadvantages of a money market hedge versus exchange traded derivatives

Money market hedge

The main problems with a money market hedge are that it is difficult to reverse and it can be relatively expensive. It is not always possible to construct a money market hedge depending on the currencies with which you are dealing, as you may not be able to get access to the short-term money market in the overseas country.

Exchanged traded derivatives

Exchange traded derivates such as futures and options can be set up quickly and closed out easily.

Futures, for example, are normally closed out before maturity with the profit/loss being used to offset the gain or loss in the underlying. These derivatives tend to have relatively low costs for small deals and they are marked-to-market, they offer relatively low risk.

Options offer flexibility in that the holder is not obliged to exercise the option on maturity if the market position is such that it would be more profitable not to do so.

However exchange traded derivatives are only available for certain currencies and offer few maturity dates. They are also only available in fixed amounts which may mean an inexact hedge.

In the case of futures, there can also be cash flow problems as marking-to-market requires any daily shortfalls to be paid immediately.

With exchange traded options, there will be a premium to be paid which could prove to be expensive for the privilege of flexibility.

Conclusion

For small, infrequent hedges the forward market may be more suitable for hedging risk. However you must take the costs of setting up loans and deposits into consideration before making a decision.

(c)

Currency hedging and cost of capital

Cost of equity

l  As hedging reduces a firm's exposure to foreign currency risk, there should be a favourable impact on the company's beta value and hence its cost of equity.

l  The extent of the impact will depend on the size and importance of the potential foreign currency exposure and the correlation of the currency with the market.

l  If the currency and the company have the same correlations with the market then the removal of currency risk would have little or no effect on the company's cost of capital, as the company's exposure to market risk would not change.

l  The reverse would be true for different correlations with the market and the company's cost of equity would be affected by changes in levels of foreign currency risk.

Cost of debt

l  The reduction in foreign currency risk may have a favourable impact on the company's exposure to default risk.

l  The risk of defaulting on debt payments is closely related to the volatility of the company's cash flows – the greater the volatility the greater will be the default risk.

l  Reduction in foreign currency risk will have a smoothing effect on the company's cash flows which will therefore reduce the risk of defaulting on debt. This should have a downward impact on the cost of debt and hence the overall cost of capital.

Answer 3

(a)

Netting

There are several ways in which this question could be approached. We have shown what we believe to be the most straightforward approach – using a transactions matrix.

All settlements are to be made in Euros – the first step is therefore to convert all amounts owed to Euros.

The next step is to determine how much is paid by (and paid to) each company and net the results off:

Multidrop (Europe) pays the US, UK and Malaysian business €4·06 million, €0·40 million, and €0·39 million respectively, and receives from Singapore €14·47 million. The net income is €9·62 million to Multidrop (Europe).

(b)

Advantages and disadvantages of netting arrangements

Advantages

Netting reduces foreign exchange exposure as balances are offset between countries. This limits the number of foreign currency exchange transactions and thus reduces the transactions costs involved.

Transaction risks (and transaction costs) are also reduced as a result of fewer foreign currency exchanges and this will enable the group to focus their hedging activities on a smaller number of transactions. Fewer hedging activities mean lower hedging costs (such as arrangement costs, premiums, etc).

If exchange controls are in place (that limit cross-border currency flows), netting allows balances to be offset which minimises total exposure and helps to keep such currency flows to a legally acceptable level.

Disadvantages

One of the main issues with netting arrangements is making netting contracts legally enforceable. A netting system cannot operate effectively without resolving the legal status of contracts in numerous jurisdictions. As well as cross-border issues, there may be taxation problems to resolve before the netting arrangements can be approved.

There is also the issue of liabilities being accepted. This is a particular issue when external parties (in this case, Alposong and NewRing) are involved. The success of the netting arrangement depends on acceptance of liabilities by all parties, both internal and external to the group.

Costs in establishing the netting system have to be considered and compared with the savings. If there are no net benefits to be gained from the system then it should be abandoned.

Where third parties are involved, the netting arrangement may involve re-invoicing for the net amount or, in some cases, a completely new contract may be required.

Answer 4

(a)

Only transactions between Kenduri Co and Lakama Co are relevant, which are:

Net payment in US$ = US$4.5m – US$2.1m = US$2.4m

The hedging options are: using the forward market, money market hedging and currency options.

Forward market

= = £1,500,375 payment

Money market hedge

Options hedge

Kenduri would buy sterling put options to protect against a depreciating £

Both these hedges are worse than the hedge using forward or money markets. This is due to the premiums payable to let the option lapse if the prices move in Kenduri Co’s favour. Options have an advantage over forwards and money markets because the prices are not fixed and the option buyer can let the option lapse if the rates move favourably. Hence options have an unlimited upside but a limited downside. With forwards and money markets, Kenduri Co cannot take advantage of the US$ weakening against the £.

Conclusion

The forward market minimises the payment and is therefore recommended over the money market. However, options give Kenduri Co the choice of an unlimited upside, although the cost is higher. Therefore the choice between the forward market and the option market depends on the risk preference of the company.