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

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Presentation on theme: "Hedging Treasury Risk with Forward Foreign Exchange Contracts Leslie Matthews Šulenta Director International Business Strategies, LLC, Zagreb September,"— Presentation transcript:

1 Hedging Treasury Risk with Forward Foreign Exchange Contracts Leslie Matthews Šulenta Director International Business Strategies, LLC, Zagreb September, 2005 Croatian Association of Corporate Treasurers

2 Leslie Šulenta, International Business Strategies, LLC 2 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

3 FX Forwards: Definition, Characteristics and Features

4 Leslie Šulenta, International Business Strategies, LLC 4 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

5 Leslie Šulenta, International Business Strategies, LLC 5 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

6 Leslie Šulenta, International Business Strategies, LLC 6 Characteristics and Features of FX Forwards 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.

7 Leslie Šulenta, International Business Strategies, LLC 7 Characteristics and Features of FX Forwards 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

8 FX Forwards: Uses

9 Leslie Šulenta, International Business Strategies, LLC 9 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

10 Leslie Šulenta, International Business Strategies, LLC 10 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.

11 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: 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 – FX risk: Company is protected against large adverse FX rate movements If FX rate is unfavorable in 3 months (ie, > ), Company pays just

12 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: Treasurer believes HRK will depreciate during next 3 months Advantages of Hedge: Company knows its costs and can plan its finances accordingly Cost 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 Disadvantage of Hedge: Company is still exposed to FX risk if the HRK/EUR spot rate is less than 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)

13 Example 1: Hedging With an FX Forward Unhedged Company If in 3 months, spot rate is … – 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: x 1,000,000 = HRK 7,375,000 Money saved by hedging: 7,450,000 – 7,375,000 = HRK 75,000

14 Leslie Šulenta, International Business Strategies, LLC 14 Example 2: Deriving the Forward Exchange Rate The spot rate HRK/EUR is A bank today sells a 3-month HRK/EUR forward to a company for a forward exchange rate of How did the bank compute the forward rate?

15 Leslie Šulenta, International Business Strategies, LLC 15 Example 2: Deriving the Forward Exchange Rate 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

16 Example 2: Deriving the Forward Exchange Rate Invest EUR 1 million at 1% for 3 months (91 days) Interest earned EUR 2, Value after 3 months EUR 1,002,493 Sell EUR 1 million spot at 7.30 Buy HRK 7.3 million Invest HRK for 3 months at 3% Interest earned HRK 55, (7.3 million x 3% x 91/360) Value after 6 months HRK 7,355,358 OPTION 1OPTION 2 Forward Exchange Rate:

17 FX Forwards: Problems and Risks

18 Leslie Šulenta, International Business Strategies, LLC 18 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 (banks spread)

19 Leslie Šulenta, International Business Strategies, LLC 19 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

20 Leslie Šulenta, International Business Strategies, LLC 20 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.

21 FX Forwards: Accounting

22 Leslie Šulenta, International Business Strategies, LLC 22 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

23 Leslie Šulenta, International Business Strategies, LLC 23 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 todays market rates at the forward date

24 Leslie Šulenta, International Business Strategies, LLC 24 Example 3: Marking to Market After one months 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 – The forward rate for the deal is – The spot rate HRK/EUR is now What is the market value of the forward today?

25 Leslie Šulenta, International Business Strategies, LLC 25 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 and pay HRK 7,415,000. The company is committed to buy EUR 1,000,000 when the forward matures at 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

26 FX Forwards: Risk Management

27 Leslie Šulenta, International Business Strategies, LLC 27 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

28 Leslie Šulenta, International Business Strategies, LLC 28 Successful Risk Management DONT WORRY, IT MAY MELT BEFORE WE GET THERE!

29 Leslie Šulenta, International Business Strategies, LLC 29 Successful Risk Management WE CAN DECIDE WHAT TO DO, IF AND WHEN WE HIT IT!

30 Leslie Šulenta, International Business Strategies, LLC 30 Successful Risk Management WE NEVER NEEDED TO USE LIFE BOATS BEFORE!!

31 Thank You. Leslie Matthews Šulenta mps.com


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