Protection Against Exchange Rate Risks

Shifting the Risk to Third Parties

• It is pertinent to underscore some salient points about hedging in foreign exchange markets:

1. Hedging is not always the most appropriate technique to limit foreign exchange risks
2. Hedging does not protect long-term cash flows
3. Forward market hedges are available in a very limited number of currencies
4. Hedging should not be used for individual transactions

• Types of Hedges:

Spot and Forward Market Hedge	a spot transaction is one in which foreign currencies are purchased and sold for immediate delivery, that is, within two business days following the agreed- upon exchange date.	Want to see an example of forward  currency rates? Click on the link below. http://futures.tradingcharts.com/marketquotes/EC.html
	Unlike hedging in the spot market, forward market hedging does not require borrowing or tying up a certain amount of money for a period of time. This is because the firm agrees to buy or sell the agreed amount of currency at a determinable future date, and actual delivery does not take place before the stipulated date.
Swap	A swap transaction is a simultaneous purchase and sale of a certain amount of foreign currency for two different value dates. The central feature of this transaction is that the bank arranges the swap as a single transaction, usually between two partners. Swaps are used to move out of one currency and into another for a limited period of time without the exchange risk of an open position.	How Forex Swaps Work?  http://www.bis.org/publ/qtrpdf/r_qt0803z.htm This chart illustrates the fund flows involved in a euro/US dollar swap as an example. At the start of the contract, A borrows X·S USD from, and lends X EUR to, B, where S is the FX spot rate. When the contract expires, A returns X·F USD to B, and B returns X EUR to A, where F is the FX forward rate as of the start. FX swaps are often employed to raise foreign currencies, both for financial institutions and their customers, including exporters and importers, and for institutional investors to hedge their positions.

Shifting risk to the other party

Invoicing in One’s Own Currency	Risks accompany all transactions involving a future remittance or payment in foreign currency If the payment or receipt for a transaction is in one's own currency, the risk arising from currency fluctuations is shifted to the other party.
Invoicing in Foreign Currency	In the event that the agreement stipulates that payment is to be made in foreign currency, it is important for the exporter to require inclusion of a provision that protects the value of its receipts from currency devaluation.

 

Sample Multiple Choice Questions

 

	True	False
Graphed alongside are Euro/Dollar (EUR/USD) and British Pound/Dollar (GBP/USD) exchange rates. The mean and standard deviation values are -0.06% and 0.61%, respectively, for the day-to-day changes  in EUR/USD rate. The corresponding numbers for the GBP/USD data are -0.02% (mean) and 0.35% (standard deviation). Based on these, and assuming that the efficient market hypothesis is valid (i.e., rates fluctuate randomly as in the normal or Guassian distribution model), could we claim that ...
1.			the GBP/USD rates have clearly fluctuated more widely in this period than the EUR/USD rates?
2.			as USD has depreciated faster against EUR than against GBP, GBP too has depreciated against EUR?

		True	False
What Does Foreign-Exchange Risk Mean?	3.			The drop in an investment's value due to changes in the currency exchange rate.
	4.			Export-import firms are vulnerable to foreign exchange risks whenever they enter into an obligation to accept or deliver a specified amount of foreign currency at a future point in time.
Why do many people argue that changes in the foreign exchange rate support the efficient market hypothesis?	5.			Exchange rate fluctuations can have a profound effect on international trade
	6.			Daily changes in the exchange rates fluctuate randomly.

	True	False
7.			The UK is not a member-country that participates in the Euro, and has its own currency, the British Pound, instead.
8.			The typical characteristic of a swap transaction is that the bank arranges the swap as a double transaction between the two partners, so that the Bank gets its commission first at the initial stage and then at the maturity of the contract.

		True	False
The futures market is quoting  €1 = $1.4120 for current delivery and €1 = $1.4011 for delivery in December 2011. Do you think the market expects the dollar to continue with its current decline against the euro or reverse this trend?	9.			USD is expected to continue declining against the Euro.
	10.			USD is expected to stop its current decline and start rising against the Euro.

Talking-Points for the Review Questions

 

1. Differentiate between spot and forward exchange rate. How can a U.S. import firm use the forward market to protect itself from the adverse effect of exchange rate fluctuations?
   
   The spot rate is the exchange rate between two currencies for their immediate trade for delivery within two business days. The forward rate is the cost today for a commitment to buy or sell an agreed amount of a currency at a fixed (usually a 30, 60, 90, or 180 day basis), future date. The U.S. import firm can purchase its future payment in U.K. pounds at the percent spot rate and leave it until payment is due (if the future pound will be higher than today’s spot rate).
    

2. What does it mean when a currency is trading at a discount to the U.S. dollar in the spot market?
   
   If the forward rate is below the present spot rate (in relation to the dollar), the foreign currency is said to be at a forward discount.
    

3. Why do export-import firms enter the foreign exchange market?
   
   To reduce exchange risks involving payments or receipts in foreign currency.
    

4. Hedging is not always the most appropriate technique to limit foreign exchange risks. Discuss.
   
   In view of fees associated with hedging, export-import firms should consider using this technique when a high proportion of their cash flow is vulnerable to exchange rate fluctuations.
    

5. If a Canadian exporter accepts payments in foreign currency from buyers in the United States, which party bears the currency fluctuation risk? Explain.
   
   The Canadian exporter. If the value of the Canadian dollar appreciates in terms of the U.S. dollar, the Canadian exporter’s receipts in local currency will be reduced.

The euro has now replaced twelve national currencies. What are the implications of this development to companies exporting to the European Union? Eliminates exchange rate volatility as well as the need to exchange currencies among EU–area members.

As of January 1, 2011, the Euro is the currency of following 17 European Union countries: Austria Belgium Cyprus (since 1 January 2008) Estonia (since 1 January 2011) Finland France Germany Greece Ireland Italy Luxembourg Malta (since 1 January 2008) The Netherlands Portugal Slovakia (since 1 January 2009) Slovenia (since 1 January 2007) Spain

7. Suppose that the spot rate of the U.K. pound today is $2.00 while the six-month forward rate is $2.05. How can a U.S. importer who has to pay 30,000 U.K. pounds in six months hedge his or her foreign exchange risk?
   
   The U.S. importer can hedge by buying 30,000 U.K. pounds today at the spot rate ($2.00 per pound). It will deposit the pounds in the bank until the payment date in six months and earn interest.

    

8. In reference to question 7, what happens if the U.S. importer does not hedge and the spot rate of the pound goes up to $2.10?
   
   If the importer does not hedge, he or she has to pay more than if he had hedged.

    

9. Suppose the spot rate of the yen today is $0.0084 while the threemonth forward rate is $0.0076. (1) How can a U.S. exporter who is to receive 350,000 yen in three months hedge his/her foreign exchange risk? (2) What happens if the exporter does not hedge and the spot rate of the yen in three months is $0.0078?
   
   The U.S. exporter can hedge by selling 350,000 yen today for delivery in three months at today’s three month forward rate. After three months, the exporter receives $2,660 for 350,000 yen, regardless of the spot rate of the yen. If the U.S. exporter does not hedge, he or she gets $2,730, or $70 more than if he or she had hedged.
    

10. Do you think the U.S. dollar will continue to maintain its key currency status? Explain.

    Yes. Strong U.S. economic growth, large and open credit market, diversified financial institutions, and independent central bank.