Foreign Currency Risk Part 1 Mark Fielding-Pritchard mefielding.com1

3 Types of Risk  Transaction- the risk we don’t receive as much money as we expected or we have to pay more  Translation risk- The value of our balance sheet on translation to the operating currency falls- covenants  Economic risk- positive NPV projects become negative mefielding.com2

Transaction Risk  Forwards  Money Markets  Futures  Options  Swaps mefielding.com3

Forwards  A forward contract is (usually) a contract- an over the counter transaction to exchange an amount of currency at a predetermined date. The amounts and the dates are determined by negotiation.  The forward is non transferable  In 90%+ of cases the exchange will take place mefielding.com4

Information  Marko is a UK company.  Today is 1/1/16, Marko is due to receive US$ on 30/6/16  Biggo Bank is offering mefielding.com5

Biggo Bank mefielding.com6 Offers to it’s clients on 1/1/16 Forward Spot $/£ month forward $/£ Options £62500 CallsPuts MarchJuneMarchJune Futures £62500 March June Money Market Deposits $ 3 Month 4- 6%£ 3 Month % $ 6 Month %$ 6 Month %

Forwards  Forwards are  OTC  Cheap comparatively  Easy to organise  Low on administration  But  Irreversible mefielding.com7

F orwards  Marko is due to receive US$ on 30/6/16  Therefore enter into a forward  Bank offers 6 month forward $/£  Therefore it will take $ to buy 1 pound so we receive £  Pounds will be delivered into our account directly  If spot is below $ we have ‘lost’, that is the cost of hedging  Assume spot on 30/6/16 is $ Forward is a contract if we are late collecting we must still fulfil.  Therefore if client doesn’t pay we have to buy $ at spot then exchange back at contract price. We buy at 1.73 with a cost of £ Then we exchange back at which gives $ so we have a loss of £17021 mefielding.com8

Futures  Futures are just forwards for fixed amount of currency on fixed delivery dates  Lets assume Marko is due $93750 in some time, his fear is that the dollar rises, so from $1.50 today to $1.60  Therefore he enters into a contract to buy dollars today at todays price of 1.50  When he receives his dollars from his customer he will sell at the rate in force, $1.60 mefielding.com9 Today $1.50Buy$93750£62500 Future $1.60Sell$100000£62500

Futures - Process  Marko will not actually change any money at the futures trader, the system works on a margin basis. Assume exchange rate goes from $1.50 to 1.60 mefielding.com10 Future Bought$93750£62500 Sold$100000£62500 Profit$6250 Transaction Actually Receives93750/1.60= Currency Loss(93750/1.50)- (93750/1.60) £3906 Gain on future$6250/1.6=£3906 Therefore we have hedged perfectly

Futures  This process is a 2 stage process  1) Set up the hedge today,  Which month?  Do we buy or sell futures?  How many futures?  2) Stage 2 what happens when we receive/pay our money  Close out the future, calculate gain or loss  Exchange our cash received or to be paid at spot mefielding.com11

Futures  Marko will receive $s  Prices quoted are mefielding.com12 Futures £62500 March June

Futures  Using the futures is similar  On 1/1/14 we enter into a futures contract.  1) Do we buy or sell? The exchange is in Chicago, the £ is therefore the foreign currency. When the debtor pays $ we want to buy foreign currency (pounds) so we buy futures  2) Which month? A March future would cease trading on about 31 March. This would leave our debt unhedged for 3 months. A June future would therefore be preferred  3) How many futures? Pound futures are denominated in units of £ On 1 January we are due to receive $ and the price of a future is $ [(937500/1.7492)/62500]= 9 mefielding.com13

Futures Hedging Strategy  Therefore on 1 January 2016 we buy 9 June futures  At this point in principle no money changes hands  We cannot buy fractions so we are over hedged as we need 8.57 futures  Notice that if we were quoted September futures we would still pick June as September futures will have greater basis risk mefielding.com14

Futures Closing Out  On 30 June we receive $  On slide 8 we assumed spot on 30/6/16 is $ On 30/6 the basis risk in the future will be zero mefielding.com15 In spot market we receive /1.75£ Future Bought Sold*1.75 Gain.08c x x 9 =450/ Total £s received£ *As we bought in January we must sell in June

Futures Fees & Other Items  Initial deposit  Margin calls  Maintenance margins  Price movement caps  Which future to choose mefielding.com16