Foreign Currency Risk Part 1 Mark FieldingPritchard mefielding

Foreign Currency Risk Part 1 Mark Fielding-Pritchard mefielding. com 1

3 Types of Risk Transaction- the risk we don’t receive as much money as we expected or we have to pay more Translation risk- The value of our balance sheet on translation to the operating currency falls- covenants Economic risk- positive NPV projects become negative mefielding. com 2

Transaction Risk Forwards Money Markets Futures Options Swaps mefielding. com 3

Forwards A forward contract is (usually) a contract- an over the counter transaction to exchange an amount of currency at a predetermined date. The amounts and the dates are determined by negotiation. The forward is non transferable In 90%+ of cases the exchange will take place mefielding. com 4

Information Marko is a UK company. Today is 1/1/16, Marko is due to receive US$937500 on 30/6/16 Biggo Bank is offering mefielding. com 5

Biggo Bank Offers to it’s clients on 1/1/16 Forward Spot $/£ 1. 7982 - 1. 8010 6 month forward $/£ 1. 7835 -. 1. 7861 Options £ 62500 Calls Puts March June 1. 80 1. 96 3 3. 17 5. 34 1. 78 2. 91 3. 84 2. 12 4. 20 Futures £ 62500 March 1. 7782 June 1. 7492 Money Market Deposits $ 3 Month 4 - 6% £ 3 Month 4. 4 - 6% $ 6 Month 4. 4 - 5. 8% $ 6 Month 4. 8 - 6. 0% mefielding. com 6

Forwards are OTC Cheap comparatively Easy to organise Low on administration But Irreversible mefielding. com 7

Forwards Marko is due to receive US$937500 on 30/6/16 Therefore enter into a forward Bank offers 6 month forward $/£ 1. 7835 - 1. 7861 Therefore it will take 1. 7861$ to buy 1 pound so we receive £ 524887 Pounds will be delivered into our account directly If spot is below $1. 7861 we have ‘lost’, that is the cost of hedging Assume spot on 30/6/16 is $1. 73 - 1. 75. Forward is a contract if we are late collecting we must still fulfil. Therefore if client doesn’t pay we have to buy $937500 at spot then exchange back at contract price. We buy at 1. 73 with a cost of £ 541908. Then we exchange back at 1. 7861 which gives $524887 so we have a loss of £ 17021 mefielding. com 8

Futures are just forwards for fixed amount of currency on fixed delivery dates Lets assume Marko is due $93750 in some time, his fear is that the dollar rises, so from $1. 50 today to $1. 60 Therefore he enters into a contract to buy dollars today at todays price of 1. 50 When he receives his dollars from his customer he will sell at the rate in force, $1. 60 Today $1. 50 Buy $93750 £ 62500 Future $1. 60 Sell $100000 £ 62500 mefielding. com 9

Futures - Process Marko will not actually change any money at the futures trader, the system works on a margin basis. Assume exchange rate goes from $1. 50 to 1. 60 Future Bought $93750 £ 62500 Sold $100000 £ 62500 Profit $6250 Transaction Actually Receives 93750/1. 60= 58594 Currency Loss (93750/1. 50)- (93750/1. 60) £ 3906 Gain on future $6250/1. 6= £ 3906 mefielding. com Therefore we have hedged perfectly 10

Futures This process is a 2 stage process 1) Set up the hedge today , Which month? Do we buy or sell futures? How many futures? 2) Stage 2 what happens when we receive/pay our money Close out the future, calculate gain or loss Exchange our cash received or to be paid at spot mefielding. com 11

Futures Marko will receive $s Prices quoted are Futures £ 62500 March 1. 7782 June 1. 7492 mefielding. com 12

Futures Using the futures is similar On 1/1/14 we enter into a futures contract. 1) Do we buy or sell? The exchange is in Chicago, the £ is therefore the foreign currency. When the debtor pays $ we want to buy foreign currency (pounds) so we buy futures 2) Which month? A March future would cease trading on about 31 March. This would leave our debt unhedged for 3 months. A June future would therefore be preferred 3) How many futures? Pound futures are denominated in units of £ 62500. On 1 January we are due to receive $937500 and the price of a future is $1. 7492. [(937500/1. 7492)/62500]= 9 mefielding. com 13

Futures Hedging Strategy Therefore on 1 January 2016 we buy 9 June futures At this point in principle no money changes hands We cannot buy fractions so we are over hedged as we need 8. 57 futures Notice that if we were quoted September futures we would still pick June as September futures will have greater basis risk mefielding. com 14

Futures Closing Out On 30 June we receive $937500 On slide 8 we assumed spot on 30/6/16 is $1. 73 - 1. 75. On 30/6 the basis risk in the future will be zero In spot market we receive 937500/1. 75 *As we bought in January we must sell in June £ 535714 Future Bought 1. 7492 Sold* 1. 75 Gain . 08 c x 62500 x 9 =450/1. 75 mefielding. com Total £s received 257 £ 535971 15

Futures Fees & Other Items Initial deposit Margin calls Maintenance margins Price movement caps Which future to choose mefielding. com 16