Exchange Rate Risks Evaluation - Essay Example

Exchange Rate Risk When we are dealing with currency risks, we need to make sure that we take appropriate steps to mitigate our risks or we might end up losing the bulk of our investment (P. COLLIER, 2012). Currency risk can broadly be divided in to three further categories, namely transaction risk (or transaction exposure), translation risk (or translation exposure) and economic risk (or economic exposure) (BJORN DOHRING, 2008). Below we will discuss each of these three types of risks in detail and determine the nature of the risk faced by the importer in question. Transaction risk occurs over a period of time. For instance, let’s say goods are sold by a vendor in United Kingdom to a customer in United States on the first of January, and the customer has promised to make a payment in the next three months. In this case, the risk in question is that the price of dollar to the pound may change over the time period. This change may be on either side, resulting in an exchange gain to one party and loss to the other. Transaction risk often occurs in cases of sales/purchase of goods on credit with payment to be made at a later date, upon receipt of dividend from foreign investments and from borrowing and/or investing in foreign currencies. Transaction risk can be protected against by the use of various hedging instrument (DAVID WINSTONE, 1995). The other kind of risk that we discussed above is translation risk. It occurs when a company has various subsidiaries abroad and needs to consolidate its financial position for reporting purposes. It is pretty much possible that the various currencies in question (that of the subsidiary’s country and the home country) might not be performing well in relation to the host county’s currency and therefore show a very deteriorating position on the consolidated financial statements (PRACHI DEUSKAR, 2007). The best way to counter the impact of translation risk is to get involved in balance sheet hedging. The best way of doing so is making the foreign assets and liabilities equal so as to cut down the impact of any change that might occur in the exchange rates. The third and final case of currency risk mentioned above is economic risk. This risk overall affects the value of the firm in question. It refers to how the change in exchange rates affects the competitiveness of a business on an international scale. To make it simpler to understand, it’s not only the appreciation -or depreciation of a foreign currency to the home currency that affects a company’s operations, but also how a competitor country’s currency performs in response to the home currency (GUNTER FRANKE, 2005). Now let’s consider the case in question and try to determine the nature of exchange risk that is faced by the importer. The importer in the United Kingdom is to pay in another currency, namely the American Dollar, in a three months’ time. This is a clear cut case of the transaction risk. Here the risk that the importer faces is that the dollar may go expensive after three months, in comparison to the current rate, and that would mean he would actually have to pay more pounds in order get the same amount of dollars, then he would have had to pay to three months back. This risk needs to be mitigated so as to save the customer from bearing any unnecessary loss. It is very essential to manage the risk otherwise it can have disastrous consequences. There are various strategies available to manage the transaction risk that the importer in this case, and each of them would be discussed in detail below. However let’s start by listing down the possible hedging strategies before we can go on and discuss them in detail. The following strategies can be deployed to hedge the transaction risk of the importer (H.R. MACHIRAJU, 2007): Forwards Futures Swaps Options Hedge using money market Each of the above mentions options will now be discussed in detail and we shall consider how they would be able to help the importer in hedging his currency risk. Forwards: The best method of hedging a currency risk is to hedge by entering into forward contracts or forwards as they are better known. Forward contracts however, are often not made available to small business entities. In such a case, banks often come in to play. What they do is that they quote a rate to such small businesses, which are often less favorable then rates under the forward contract. The is because in this case the bank bears the risk in case the business is unable to honor its commitment on forward contracts when they fall due (GREGORY P. HOPPER, 1995). The working of forward contacts is very simple. It is an exchange rate contact to buy or sell a particular amount of foreign currency at a certain time in future but at a rate that would be fixed today. However, when discussing forwards it needs to be kept in mind that currency forwards are functionally the same as lending and borrowing in a foreign currency (GREGORY P. HOPPER, 1995). While discussing forwards, it of essence to note that such contracts are dealt with “over the counter” with different maturities and amounts (JING-ZHI, HUANG, 1996). In the given case, the importer is sitting in the UK and has to make a payment in United States dollars in a period of three months. What this importer can do to hedge his risk is that he can enter into a contract to purchase US dollar forwards equivalent to 10 million dollars. In such a case, the rate of buying the US dollar, or selling the pound, would be fixed today, whereas the conversion will take place in the future, i.e. after three months. Now even if the price of the dollar goes up subsequently, the importer wouldn’t have to worry about it since he already has a fixed quote owing to the forward contract he has entered in. Also, it needs to be mentioned here that forward contracts have no “margin requirements” like futures do. Futures: Futures are somewhat similar to forwards in some aspects, while they differ in other features. In very simple and rough terms, the standardized version of forwards is known as futures. They are also traded on regulated exchanges unlike forwards which are usually dealt with over the counter. Moreover, with futures there are some standard terms and conditions which don’t exist in forwards. Forwards, once entered into, need to be settled upon maturity. However futures can also be bought or sold prior to their maturity on regulated exchanges (ANURAG GUPTA, 2004). Futures are standardized and mature upon fix timings only, usually on March, June, September and December. This cycle is also often referred to as the March Quarterly Cycle. Another point of concern is that futures have a fixed contract size, 62,500 for trade in British futures. So for instance if a person wants to hedge an exposure of 125,000, he would have to enter into 2 contracts (125000 / 62500). The situation gets more complex when the amount that needs to be hedged is not a fixed amount. For instance if one wants to hedge an exposure of 105000, then he would have to enter into 8.4 future contracts. However there is nothing such as 1.68 contracts, and there either has to be 1 contract or 2. In such a case, over or under hedging may occur, and there may remain some amount which might not be covered by the future hedge. In the given case, the importer is looking to make a payment of American ten million dollars in a period of three months. He can buy currency futures to minimize his exposure against the US dollars. He would have to enter into 10,000,000 / 62,500 = 160 future contracts. However, the importer needs to know that with futures, he is facing a two side risk. If the market price of the US dollar to the Pound rises above the pre decided contract rate, then he would benefit as he would be paid the difference in the two prices by the forward dealer. However, he also needs to make sure that if the price further falls down, he would still end up buying the currency at a predecided rate and would face a loss. One more thing with futures is that they have a margin requirement. The margin requirement is in place to ensure that when the price of the future goes up or down, the person dealing with the futures is liquid enough to honor his commitment. Currency Options: Options give the holder of such an option a right, but not an obligation, to exercise the option on a particular quantity of foreign currency at a pre-arranged price (also known as the strike price) on or before the date of expiry of the contract. For instance and as in the given case, if the option were to buy US dollars, then the strike price in this case would be quoted as pounds per dollar (JOHN W. LABUSZEWSKI, 2010). Options lapse on a particular date which is known as the expiration date. As options give the holder a right, to exercise them when they’re beneficial and let them lapse when they’re not in favor, all this doesn’t come for free. Option holders have to pay an upfront premium to be able to acquire an option. A call option on a currency allows the holder to be able to buy that currency, whereas a put option gives the holder to sell that particular currency if he feels like it (JOHN W. LABUSZEWSKI, 2010). One more thing that needs to be considered here is what kinds of options we are dealing with. American options can be exercised anytime up to the maturity of such contracts, whereas with European options, their holders can only exercise them upon expiry and not before. In the give case, the option can either buy a call on US dollars or a put on British pounds. However, he will need to keep an active eye on the market rates of the currency and exercise the contracts whenever they give a beneficial result. Also, options minimize the downside risk, as if the option holder, the importer in our case, feels like there is no need to utlize the options, he can always let them lapse without suffering any loss whatsoever. This is possible because unlike forwards, there is no real commitment involved in options. Also, the holder of the option will have to pay an option premium which is going to be a fixed cost. So it is up to the importer himself to see what option is better for him. Conclusion: We have discussed the different types of hedging strategies that are available to the English exporter to minimize his exposure against the US dollars. Now it is up to the importer to decide himself what’s better for him. However, this brief summary would help the importer decide what’s better for him: He should go with forwards if he believes that the price of the dollar to the pound won’t change a lot over the time period. Forwards require no margin or upfront cost, and with little variation in the rates, forwards would be the cheapest possible hedging strategy. He should go with options if he wants to completely cut down the downside risk. They are the best measure when the exchange rates are fluctuating a lot. However, they are expensive as they involve premiums. Futures should be bought if the market is volatile and the importer wants to play a risky game. However, margin requirements would have to be maintained in this case and might prove to be a risky gamble. References Anurag Gupta (2004) Pricing and hedging interest rate options: Evidence from cap–floor markets, Journal of Banking & Finance: volume 29, page 701–733 Bjorn Dohring (2008) Hedging and invoicing strategies to reduce exchange rate exposure: a euro-area perspective, Economic and Financial Affairs, Economic Papers 299. David Winstone (1995) Financial Derivatives: Hedging With Futures, Forwards, Options and Swaps, Thomson Learning: pages 304. Gunter Franke (2005) Incremental Risk Vulnerability, Journal of Economic Literature Classification Numbers: volume 52, page 81. Gregory P. Hopper (1995) A Premier on Currency Derivatives, Federal Reserve Bank of Philadelphia. H.R. Machiraju (2007) International Financial Markets And India, New Age International: pages 340. Jing-zhi Huang (1996) Pricing and Hedging American Options: A Recursive Integration Method, Review of Financial Studies: volume 9, pages 277-300. John W. Labuszewski (2010) Managing Currency Risks with Futures, Chicago Mercantile Exchange Inc. P. Collier (2010) The Management of Currency Transaction Risk by UK Multi-national Companies, Accounting and Business Research: volume 15, page 327-334. Prachi Deuskar (2007) The Economic Determinants of Interest Rate Option Smiles, Journal of Banking and Finance: March issue. Read More