Lecture International finance: An analytical approach (3/e): Chapter 13 - Imad A. Moosa
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Chapter 13
Foreign Exchange Risk
Management
Objectives
• To explain why there is concern about FX risk
• To illustrate how to manage transaction, economic
and translation exposure
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-2
Hedging
• Hedging, which is the core risk management
operation, is a process whereby a firm can protect
itself from unanticipated changes in exchange rates
and other sources of risk
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-3
Hedging (cont.)
• The decision to hedge or not to hedge an uncovered
or open foreign currency position is basically a
speculative decision
• It all depends on the expected exchange rate or the
movement of the exchange rate between the point in
time when the decision is taken and when its effect
materialises
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-4
Why is there no need to worry
about FX risk?
• If international parity conditions hold, FX risk will not
arise
• If it is possible to forecast exchange rates accurately,
FX risk can be controlled
• Shareholders are naturally hedged though
diversification
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-5
Why worry about FX risk?
• International parity conditions do not hold
• Forecasting exchange rates is rather difficult
• Hedging produces a more stable income stream
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-6
Benefits of hedging
• Hedging has a positive effect on the value of the firm
• It produces a more stable corporate income stream
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-7
Managing short-term transaction
exposure (financial hedging)
•
•
•
•
Forward hedging
Money market hedging
Futures hedging
Option hedging
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-8
Financial hedging
• By taking an affecting position on a hedging
instrument (forward, etc), the profit/loss on the
unhedged position is offset by the loss/profit on the
hedging instrument
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-9
Forward hedging
• Forward hedging entails locking in the exchange rate
at which payables and receivables are converted
from the domestic currency into a foreign currency,
and vice versa
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-10
Forward hedging (cont.)
V
KS1 (nohedge)
KS0 (hedge)
S0
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
S 1
13-11
Offsetting profit/loss on payables
+
Long forward
S0
S1
F0
Payables
–
(a) (par)
F0 S0
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-12
Offsetting profit/loss on payables
(cont.)
+
Long forward
S0
F0
S1
Payables
–
(b) (premium)
F0 S0
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-13
Offsetting profit/loss on payables
(cont.)
+
Long forward
F0
S1
S0
Payables
–
(c) (discount)
F0 S0
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-14
Introducing the bid-offer spread
Hedge
No-Hedge
Payables
KFa 0
KS a1
Receivables
KFb 0
KSb1
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-15
Futures hedging
• Futures hedging results may differ quantitatively from
those of forward hedging
• Because of the standardisation of contracts, it may
not be possible to hedge the exact amount
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-16
Futures hedging (cont.)
• The due date may not coincide with the settlement
date
• Marking-to-market introduces some variation
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-17
Money market hedging
• A money market hedge amounts to taking a money
market position to cover expected payables or
receivables
• By borrowing and lending, a synthetic forward
contract is created
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-18
Money market hedging of payables
Payables
(K)
Borrowing
domestic
currency
KS 0
(1 i )
Converting
at spot rate
Loan
Repayment
K
(1 i )
Investing at
foreign rate
KS 0 (1 i )
(1 i )
K
Implicit forward rate
S 0 (1 i )
(1 i )
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-19
Money market hedging of
receivables
Receivables
(K)
Borrowing
foreign
currency
(1
K
i )
Converting
at spot rate
Loan
Repayment
KS 0
(1 i )
Investing at
domestic rate
KS 0 (1 i )
(1 i )
K
Implicit forward rate
S 0 (1 i )
(1 i )
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-20
Money market hedging of payables
with
bid-offer spreads
Payables
(K)
Borrowing
domestic
currency
KS a 0
(1 ib )
Converting
at spot rate
Loan
Repayment
K
(1 ib )
Investing at
foreign rate
KS a 0 (1 ia )
(1 ib )
K
Implicit forward rate
S a 0 (1 ia )
(1 ib )
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-21
Money market hedging as a pricing
mechanism
• When the banker quotes a forward rate for a future
delivery of a particular currency, the banker will be
exposed to the risk arising from possible
appreciation of the underlying currency
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-22
Money market hedging as a pricing
mechanism (cont.)
• The banker can protect himself by hedging the
forward position in the money market, so that he
receives the amount of the underlying currency to be
delivered on the maturity date
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-23
Money market hedging as a pricing
mechanism (cont.)
• The minimum forward rate that the banker can
quote, therefore, is the cost of money market
hedging, which is the forward rate implicit in the
synthetic forward contract created by the hedge
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
(cont.
)
13-24
Money market hedging as a pricing
mechanism (cont.)
• The bid and offer forward rates quoted by the banker
are
Fb
Fa
S b0
1 ib
*
1 ia
S a0
1 ia
*
1 ib
Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
13-25
