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

2. 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

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

4. 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

5. Information  Marko is a UK company.  Today is 1/1/16, Marko is due to receive US$937500 on 30/6/16  Biggo Bank is offering mefielding.com5

6. Biggo Bank mefielding.com6 Offers to it’s clients on 1/1/16 Forward Spot $/£ 1.7982- 1.8010 6 month forward $/£ 1.7835 -.1.7861 Options £62500 CallsPuts MarchJuneMarchJune 1.801.9633.175.34 1.782.913.842.124.20 Futures £62500 March 1.7782 June 1.7492 Money Market Deposits $ 3 Month 4- 6%£ 3 Month 4.4- 6% $ 6 Month 4.4- 5.8%$ 6 Month 4.8- 6.0%

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

8. F orwards  Marko is due to receive US$937500 on 30/6/16  Therefore enter into a forward  Bank offers 6 month forward $/£ 1.7835 - 1.7861  Therefore it will take 1.7861$ to buy 1 pound so we receive £524887  Pounds will be delivered into our account directly  If spot is below $1.7861 we have ‘lost’, that is the cost of hedging  Assume spot on 30/6/16 is $1.73- 1.75. Forward is a contract if we are late collecting we must still fulfil.  Therefore if client doesn’t pay we have to buy $937500 at spot then exchange back at contract price. We buy at 1.73 with a cost of £541908. Then we exchange back at 1.7861 which gives $524887 so we have a loss of £17021 mefielding.com8

9. 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

10. 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= 58594 Currency Loss(93750/1.50)- (93750/1.60) £3906 Gain on future$6250/1.6=£3906 Therefore we have hedged perfectly

11. 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

12. Futures  Marko will receive $s  Prices quoted are mefielding.com12 Futures £62500 March 1.7782 June 1.7492

13. 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 £62500. On 1 January we are due to receive $937500 and the price of a future is $1.7492. [(937500/1.7492)/62500]= 9 mefielding.com13

14. 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

15. Futures Closing Out  On 30 June we receive $937500  On slide 8 we assumed spot on 30/6/16 is $1.73- 1.75. On 30/6 the basis risk in the future will be zero mefielding.com15 In spot market we receive 937500/1.75£535714 Future Bought1.7492 Sold*1.75 Gain.08c x 62500 x 9 =450/1.75257 Total £s received£535971 *As we bought in January we must sell in June

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