International Finance coursework

353FIN

International Finance

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1. What is currency risk? Critically discuss different hedging techniques that can be used to manage currency risk. Use examples to support your discussion.

Currency risk, commonly referred to as exchange rate risk, is the sensitivity of real domestic currency value of assets, liabilities or operating income to unexpected changes in exchange rates. During lasts years to the present, we are living in an era of floating exchange rates, what has increased currency risk over these years, and these exchange rates have become more volatile.

Regarding currency risk, there are three types: transaction exposure, translation exposure and economic exposure. About the first one, there would be a risk if the exchange rate changes unexpectedly, so the domestic value of these foreign currency cash flows would be deviated from expected values and may result in a transaction loss. In the second one, the risk would appear when organizations will make exchange rate gain or loss when the accounting results of its foreign subsidiaries are translated into the home currency. Finally, in the third one, changes in exchange rates will affect a firm’s future cash flow by altering the competitive or economic position of the firm in the markets within which it operates.

The figure of currency risk is really important for firms and investors; this could be explained because the foreign currency exchange rates could change unexpectedly the firm’s or investor’s total return on a foreign investment, independently on how well the investment went, resulting in lower returns or even losses (InvestingAnswers, n.d.). However, this exchange rate risk can be reduced by hedging. It is a technique designed to avoid market volatility or protect an investment against potential investment risk or los (DifferenceBetween, n.d.).

To develop a hedging strategy it is important that we ask ourselves first few questions, like whether we should hedge or not, in what proportion of risk should we hedge, how our attitude towards risk is... There are some internal techniques which aim is to mitigate exchange rate risk, these are; netting, leading & lagging, matching assets and liabilities, matching receipts and payments and currency of invoice.

Talking about hedging, we can find a financial instrument used in it called derivatives. Basically derivatives are a broad range of instruments whose price is derived from the price of an underlying asset. In other words, derivatives are agreements between two parties to sell or buy an asset in the future with some characteristics or specifications (DifferenceBetween, n.d.). The derivatives can be used to hedge risk, as an insurance, providing a compensation in case of an undesired event or to increase profit but with additional risk, speculating. The most common derivatives used are futures, forwards, options and swaps.

Moreover, an alternative to all these types of derivatives is the money market hedge which involves borrowing and lending money. It is a series of money market transactions, set up to hedge exchange rate risk. It is very important knowing the exchange rates and the interest rate. It requires a somewhat laborious process but in the end it may be worth it. Like in the picture, where we can see that we will receive more money if we enter in a money market hedge.[pic 2]

Focusing on the derivatives, the futures market is a legally binding obligation to buy or sell a standard quantity of a foreign currency at a specified future time at a price agreed now. It is a very liquid instrument. If we buy one contract in May at $1.4434/£, we will gain if at the time of closing out the contract the futures price has moved to $1.4500, when £ appreciates. If £ depreciates, for instance, to $1.4400, we will loss. Exactly the opposite will happen if we sell. Therefore, obtaining benefits will depend on how the exchange rates fluctuate. The future contract as a financial instrument has been negotiated for more than two decades; there are futures on short, medium and long-term interest rates, currency futures and stock futures and on stock indices (Wikipedia, 2018).

Another important derivative that is very used is the forward exchange contract, even though it might seem the same as the future contract, has some differences. It is an agreement between two counterparties; a buyer and seller. The buyer agrees to buy an underlying asset from the other party. The delivery of the asset occurs at a later time, but the price is determined at the time of purchase (Investopedia, n.d.). One of its main advantages is that this forward contract removes downside risk. If we are expecting to receive SFr 2m in 3 months and the current spot rate is 1.6735 SFr/£, would it be worth to use a forward contract at 1.6709 SFr/£? Today: SFr 2,000,000/1.6735 = £1,195,100. In 3 months using the forward contract: SFr 2,000,000/1.6709 = £1,196,960. It would be worth since we are receiving more money. If we are receiving money we will gain if £ depreciates and the opposite will occur if we are buying. Like in the futures market, depending on how do you think the exchange rates are going to move, it will be worth to enter in a forward contract. The most common forwards negotiated in the treasuries are on currencies, metals and fixed income instruments.

The third derivative I am going to talk about is the currency options which are different from the previous. It provides a buyer the right, but not the obligation to buy or sell currency in the future, at a rate agreed today, from or to the seller of the option. There are two types of options: call and put option. The buyer must pay to the seller a premium. Its main advantage is that it preserves upside potential, protects against downside risk. When we expect to receive money and the receipt is hedged by buying an OTC option from the bank, we will exercise if the £ in the spot in 6 months is stronger than the £ in the exercise rate. The opposite happens when we are buying. This one is the best hedging technique, however like everything good, it has a cost and in this case, we have to pay a premium which provides the right to buy or sell. Options contracts are often used in securities, commodities, and real estate transactions (InvestingAnswers, n.d.).

Finally, the last important derivative is the swap, which is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price (Investopedia, 2018). It might have the presence of the bank. There are two main types of swaps; currency swaps and interest rate swaps. Through this arrangement, every party win, in the case of banks, they earn money and in the case of the firms, they save or earn money. Through this derivative we can observe that when two companies establish relationships, they can become stronger and obtain benefits.

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