Lecture notes on foreign exchange hedging strategies including hedging in physical markets such as forward and money markets; and derivative markets such as currency futures and options markts, with added detail and worked examples.
Accounting & Finance
Financial Analysis, Information and Markets
FX Hedging Strategies
Managing Transaction Risk
As mentioned in the FX lecture, transaction risk is the FX risk which affects importers
and exporters who take or give trade credit, and this is something which can be hedged
to reduce or eliminate risk.
Furthermore, on the date that a company receives an export order or places an import
order, it can either:
Take no action and accept the FX transaction risk – this is effectively
speculation in the unpredictable and volatile FX market and provides an
organisation with no degree of certainty to the profit (if any) that they will make
from importing and exporting. Speculating or guessing FX rates is not a core
competency of the financial manager and is something which simply cannot be
guessed – the amount an importer will pay and an exporter will receive could be
anything, which is not how sensible businesses should operate.
Take action to reduce or eliminate the FX transaction risk by using:
Internal strategies; and/or
Hedging strategies
Internal Strategies
There are two types of internal strategy to reduce or eliminate FX transaction risk.
The first of which is to request settlement in the domestic currency, whether that is
an importer, paying for their goods or services; or an exporter, receiving payment for
their goods or services. This transfers all of the FX transaction risk to the other party
and there is no transactions costs. However, this is only possible for the domestic
importer or exporter if they have high bargaining power, as there is no advantage for the
foreign party to oblige. In addition, it is likely to be difficult to agree on a fair exchange
rate.
The second type of internal strategy is known as matching and netting. Matching and
netting only works when a company is a regular importer and exporter of similar values.
The matching aspect requires the organisation to match the settlement days at which it
is obliged to pay for its imports and receive payment for its exports. Once settlement
dates are matched, the currency receipts and payment amounts should be netted
(totalled). The net amount requires no further action as risk is eliminated by settlements
, for payments and receipt of payments cancelling each other out. The net exposure
should then be hedged. An example of this would be if an organisation matched $900k
of payments for imports with $700k of receipts from exports – here the net exposure
would be equal to $200k, which cannot be matched. The $200k of import payment
should then be hedged to reduce or eliminate the transaction risk.
Hedging Strategies
FX transaction risk can be hedged in 4 markets, as below:
Physical Markets:
Forward market
Money market
Derivative Markets: (where prices derive from the prices of assets in the physical
markets)
Currency futures market
Currency options market
All of the hedging strategies/markets can reduce risk, but there are a number of criterion
which the strategies/markets should be assessed against, as below:
1. Availability – can the exposure be hedged using the strategy? For forward
markets exposure can always be hedged; for money markets exposure can
usually be hedged; and for futures and options markets exposure can possibly be
hedged, but this is less likely that for forward and money markets.
2. Cost – costs can either be implicit or explicit. Implicit costs are the costs of
making the payment or receipt of payment (different markets have different
costs). Explicit costs are the hedge set-up costs
3. Flexibility – can the hedge be altered in the future if required (perhaps due to
diminishing value/significant change in FX)?
4. Efficiency – this refers to whether a perfect hedge can be achieved, which
matches the amount and date of the exposure. A perfect hedge is where we can
completely eliminate the FX transaction risk regardless of the size of increases
and decreases in FX rates. An imperfect hedge is where transaction risk is
reduced but not eliminated, so we either pay or receive more or less than
planned but not to the same extent as if we didn’t hedge at all.
5. Complexity – different markets are more complex than others, i.e. the pricing
mechanisms in derivative markets are more complex than those in physical
markets. This is because the prices of derivatives are dependent on a number of
variables additionally to the price of the asset in the physical market that it
derives from.
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