SUMMARY NOTES
BY
BY DR.STEPHEN
Chapter 13: Hedging foreign exchange risk
Chapter learning Objectives
Upon completion of this chapter you will be able to:
explain the characteristics of the following and calculate the financial
position after their use as hedging tools:
o forward contracts
o money market hedges
o exchange-traded currency futures contracts
o FOREX swaps
o currency swaps
o currency options
explain the characteristics of synthetic foreign exchange agreements
(Safe€™s)
explain how bilateral and multilateral netting and matching tools work to
minimize FOREX transactions costs and manage the market barriers to the
free movement of capital and other remittances
Calculate the required payments for a party to a bilateral or multilateral net
settlement system.
Many aspects of forex risk management were met in F9. These are recapped
briefly for completeness. In P4 the range of techniques considered is extended.
Page 1 of 40
,1 Introduction
Types of forex risk
Firms may be exposed to three types of foreign exchange risk:
Transaction risk
The risk of an exchange rate changing between the transaction date and the
subsequent settlement date on an individual transaction.
I.e. it is the gain or loss arising on conversion.
Associated with exports/imports.
Hedge using a variety of financial products/methods –see below.
Economic risk
Includes the longer-term effects of changes in exchange rates on the market
value of a company (PV of future cash flows).
Looks at how changes in exchange rates affect competitiveness, directly or
indirectly.
Reduce by geographic diversification.
Page 2 of 40
,Translation risk
How changes in exchange rates affect the translated value of foreign assets
and liabilities (e.g. foreign subsidiaries).
Can hedge by borrowing in local currency to fund investment.
Gains/losses usually unrealized so many firms do not hedge.
Types of foreign exchange risk
Transaction risk
Is the risk of an exchange rate changing between the transaction date and the
subsequent settlement date, i.e. it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company
exports goods on credit then it has a figure for debtors in its accounts. The amount
it will finally receive depends on the foreign exchange movement from the
transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of accompany, most
companies choose to hedge against such exposure. Measuring and monitoring
transaction risk is normally an important component of treasury management.
The degree of exposure involved, which is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is
acceptable. This will probably be dependent on whether the Treasury Department
is been established as a cost or profit Centre.
Economic risk
Transaction exposure focuses on relatively short-term cash flows effects; economic
exposure encompasses these plus the longer-term effects of changes in exchange
Page 3 of 40
, rates on the market value of a company. Basically this means a change in the
present value of the future after-tax cash flows due to changes in exchange rates.
There are two ways in which a company is exposed to economic risk.
Directly: If your firm home currency strengthens then foreign competitors are able
to gain sales at your expense because your products have become more expensive
(or you have reduced your margins) in the eyes of customers both abroad and at
home.
Indirectly: Even if your home currency does not moves your customers currency
you may lose competitive position.For example suppose a South African firm is
selling into Hong Kong audits main competitor is a New Zealand firm. If the New
Zealand dollar weakens against the Hong Kong dollar the South African firm has
lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy is to diversify
internationally, in terms of sales, location of production facilities, raw materials
and financing. Such diversification is likely to significantly reduce the impact of
economic exposure relative to a purely domestic company, and provide much
greater flexibility to react to real exchange rate changes.
Page 4 of 40
BY
BY DR.STEPHEN
Chapter 13: Hedging foreign exchange risk
Chapter learning Objectives
Upon completion of this chapter you will be able to:
explain the characteristics of the following and calculate the financial
position after their use as hedging tools:
o forward contracts
o money market hedges
o exchange-traded currency futures contracts
o FOREX swaps
o currency swaps
o currency options
explain the characteristics of synthetic foreign exchange agreements
(Safe€™s)
explain how bilateral and multilateral netting and matching tools work to
minimize FOREX transactions costs and manage the market barriers to the
free movement of capital and other remittances
Calculate the required payments for a party to a bilateral or multilateral net
settlement system.
Many aspects of forex risk management were met in F9. These are recapped
briefly for completeness. In P4 the range of techniques considered is extended.
Page 1 of 40
,1 Introduction
Types of forex risk
Firms may be exposed to three types of foreign exchange risk:
Transaction risk
The risk of an exchange rate changing between the transaction date and the
subsequent settlement date on an individual transaction.
I.e. it is the gain or loss arising on conversion.
Associated with exports/imports.
Hedge using a variety of financial products/methods –see below.
Economic risk
Includes the longer-term effects of changes in exchange rates on the market
value of a company (PV of future cash flows).
Looks at how changes in exchange rates affect competitiveness, directly or
indirectly.
Reduce by geographic diversification.
Page 2 of 40
,Translation risk
How changes in exchange rates affect the translated value of foreign assets
and liabilities (e.g. foreign subsidiaries).
Can hedge by borrowing in local currency to fund investment.
Gains/losses usually unrealized so many firms do not hedge.
Types of foreign exchange risk
Transaction risk
Is the risk of an exchange rate changing between the transaction date and the
subsequent settlement date, i.e. it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company
exports goods on credit then it has a figure for debtors in its accounts. The amount
it will finally receive depends on the foreign exchange movement from the
transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of accompany, most
companies choose to hedge against such exposure. Measuring and monitoring
transaction risk is normally an important component of treasury management.
The degree of exposure involved, which is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is
acceptable. This will probably be dependent on whether the Treasury Department
is been established as a cost or profit Centre.
Economic risk
Transaction exposure focuses on relatively short-term cash flows effects; economic
exposure encompasses these plus the longer-term effects of changes in exchange
Page 3 of 40
, rates on the market value of a company. Basically this means a change in the
present value of the future after-tax cash flows due to changes in exchange rates.
There are two ways in which a company is exposed to economic risk.
Directly: If your firm home currency strengthens then foreign competitors are able
to gain sales at your expense because your products have become more expensive
(or you have reduced your margins) in the eyes of customers both abroad and at
home.
Indirectly: Even if your home currency does not moves your customers currency
you may lose competitive position.For example suppose a South African firm is
selling into Hong Kong audits main competitor is a New Zealand firm. If the New
Zealand dollar weakens against the Hong Kong dollar the South African firm has
lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy is to diversify
internationally, in terms of sales, location of production facilities, raw materials
and financing. Such diversification is likely to significantly reduce the impact of
economic exposure relative to a purely domestic company, and provide much
greater flexibility to react to real exchange rate changes.
Page 4 of 40
