CITY UNIVERSITY OF HONG KONG

DEPARTMENT OF ACCOUNTANCY

Foreign Exchange Risk Management

1 Introduction
1.1 Purchasing Power Parity
1.2 Interest Rate Parity
1.3 Background to Foreign Exchange Trading
2 Foreign Exchange Risk Management
2.1 Foreign Exchange Risk
2.2 Hedging Foreign Exchange Risk

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1 INTRODUCTION

The unique feature of international financial management is that you need to deal with more
than one currency. So we need to know:
(1) How foreign exchange markets operate?
(2) Why exchange rates change?
(3) How to protect yourself against exchange risk?

Also, interest rate differs from country to country. So to finance overseas operations, you
have to consider where to borrow your fund and hedge against the possible foreign exchange
risk.

In recent years, we observed extreme volatility in exchange rates. This is evident by looking
at exchange rates for the world’s major currencies. In 1999, the exchange rate for the newly
established EURO against the US dollar was 1 EUR = 1.19 USD. Over the next few years,
the EURO depreciated to around 1 EURO = 0.80 USD, a fall in value of around one third.
Subsequently, the EURO recovered and at the beginning of 2011, the spot rate is about 1
EURO = 1.36 USD. In October 2015, 1 EURO = 1.10 USD.

Changes in exchange rates result from changes in the demand for and supply of the currency.
These changes may occur for a variety of reasons:

(1) Changes in Trade

(a) Demand for imports represents a demand for foreign currency.

(b) Overseas demand for exports represents a supply of foreign currency.

(2) Capital Movements between economies

(a) Changes in interest rates: rising (falling) interest rates in foreign country will
attract a capital inflow (outflow) and a demand (supply) for foreign currency.
(b) Inflation: asset holders will not wish to hold financial assets in a currency
whose value is falling because of inflation.

1.1 Purchasing Power Parity

Purchasing power parity claims that the rate of exchange between two currencies
depends on the relative inflation rates within the respective countries. It is based on
the law of one price. By which, in equilibrium, identical goods must cost the same,
regardless of the currency in which they are sold.

For example, suppose the spot rate is 1.5 USD = 1 GBP and an item cost $300 in
USA, then the equilibrium price in UK should be 300/1.5 = 200 GBP. Now, if
inflation rate is 5% annually in US and 10% in UK. Then after one year, the price in
US will be $300 x 1.05 = $315 and the price in UK will be 200 x 1.10 = 220. In
equilibrium, the expected exchange rate 1 year later should be such that $315 equals
to 220 GBP. In other words, the expected exchange rate one year later should be
315/220, i.e. 1.4318 USD = 1 GBP. Purchasing power parity predicts that the
currency of the country with higher inflation will be weaken against the currency of
the country with lower inflation.

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 In formula, we have

Expected spot rate = Spot rate x (1 + inflation rateUS)/(1 + inflation rateUK)

Expected spot rate = 1.5 x (1 + 5%)/(1 + 10%) = 1.4318

1.2 Interest Rate Parity

Interest rate parity claims that the difference between the spot rate and the forward
rates is equal to the differential between interest rates available in the two currencies.
Where the forward rate is a future exchange rate agreed now, for buying or selling an
amount of currency on an agreed future date.

For example, suppose a US investor invests in a one-year US bond with a 4% interest

rate that has similar risk to a UK bonds offering 6% interest rate and the spot rate is
1.5 USD = 1 GBP. Assume the investor has 1 million GBP, he has two alternatives to
investment. The first is to exchange the GBP for USD now and invest the money in
the US bond. The amount of USD he will get back in one year later is 1 million x 1.5
x (1 + 4%). Alternatively, he can invest the 1 million GBP in the UK bond and enter
into a forward agreement with a bank to sell the GBP to get the USD at the forward
rate. In other words, after one year we get 1 million x (1 + 6%) x forward rate USD.
The two alternatives should give the same amount of USD, otherwise an arbitrage
opportunity arises. Forward rate then equals to 1.5 x (1.04)/(1.06) = 1.4717. Interest
rate parity predicts that the currency of the country with higher interest rate will be
weaken against the currency of the country with lower interest rate.

In formula, we have

Forward rate = Spot rate x (1 + iUS)/(1 + iUK)

When we deal with forward rate for less than a year, the interest rates should be
adjusted to the corresponding periodic rates.

For example, if we want to find the forward rate for 3-months, then

Forward rate (3 months) = 1.5 x (1 + 4%/4)/(1 + 6%/4) = 1.4926.

1.3 Background to Foreign Exchange Trading

(1) Quoting Exchange Rates

In quoting the price of a currency we may quote in terms of the number of units of
foreign currency bought for one unit of home currency. For example, in UK market,
USD/GBP is 1.4970 means that one pound is equivalent to 1.4970 US dollar (i.e.
1.4970USD/GBP). This method of quotation is termed the indirect quote. When we
quote the home currency price each foreign currency is worth, it is called direct quote.
So the direct quote for the price of US dollar, i.e. GBP/USD is 1/1.4970 = 0.6680
when we consider British pound as home currency.

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(2) Spot Rates

Exchange rates are quoted as “spot” or “forward”. A spot rate is the rate of exchange
applied when immediate exchange of one currency for another is required. By
convention, the settlement occurs two business days later (value date).

Banks quote two prices: the rate at which they are prepared to sell a currency and that
at which they are prepared to buy. The difference is the spread, which is one of the
potential sources of profits. The smaller rate is always termed the bid rate and the
higher is called the offer rate.

For example a UK bank has the following quote:

USD/GBP 1.4725 - 1.4735

The first of this quote is the rate at which the bank will buy the home currency (sell
the other currency). That is, the bank will sell dollars at 1.4725 to the pound. The
second rate is the rate at which the bank will sell the home currency (buy the other
currency). The bank will buy low and sell high to earn the differential to cover
operating cost and earn profit. You should always remember when you buy or sell
currency, you get the unfavourable rate.

(3) Forward Rates

Forward exchange rates are applied when the exchange of one currency for another is
required more than two business days away. Forward rates are commonly quoted for
settlement in one month, three months and six months but other periods are available.
The forward rate is calculated by adding or subtracting a margin to the spot rate. The
size of the margin and whether it is to be added or subtracted depends upon the period
of time before settlement and the prevailing rates of interest in the two countries in
question.

Using the examples in illustrating the interest rate parity, we have the following spot
rate, forward rate for 3 months and forward rate for 12 months:

USD/GBP
Spot 1.5000
Three months forward 1.4926
Twelve months forward 1.4717

When a currency is worth more in the forward market than it is in the spot market, we
say that the forward rate is at a premium. Conversely, when the currency is worth less
for forward delivery than for spot delivery, the forward is at a discount. In this
example, the GBP is at a discount, a margin is subtracted to the spot rate. A larger
margin is subtracted for the twelve months forward than the three months forward as
interest rate is higher in UK.

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2 FOREIGN EXCHANGE RISK MANAGEMENT

2.1 Foreign Exchange Risk

Since the major currencies have been free to “float” there have been significant and
unpredictable (direction and magnitude) swings in foreign exchange (FX) rates.
Businesses that have trade with firms operating in countries with different currencies
and have net assets or net liabilities denominated in foreign currencies, are subject to
exchange rate movements against domestic currency, have a foreign exchange risk.
This risk is commonly grouped into three different types as follows:

(1) Transaction Risk - arises where there is a possibility for a movement in the rate of
exchange between the initiation and completion of a transaction. For example, a
Hong Kong importer of Swiss watches components would have a SFR exposure from
the date of entering the contract until date of payment. Other examples include sales
that give rise to foreign currency receivables and foreign currency borrowings or
investment. These transactions will ultimately require an exchange between the HKD
and the foreign currency and so will have an impact on the firm’s cash flows if the
rate of exchange varies between initiation and completion of the contract.

(2) Translation Risk - arises from the translation into domestic currency of a company’s
foreign subsidiary or branch operations in order to prepare group accounts in the
domestic currency. This is often referred to as an “accounting” risk as translation of
accounts does not necessitate a foreign currency transaction. That is, there is no
immediate cash effect and FX gains and losses may never be realised. Moreover, the
amount of any foreign currency translation gain or loss (for a given shift in the rate of
exchange) is dependent upon the translation method used. Where, as is commonly the
case, accounting standards permit foreign currency translation gains or losses to be
taken to a reserve account, rather than impacting upon reported profit, managerial
concerns with respect to this form of risk have been largely dissipated.

(3) Economic Risk - arises from the variation in the value of the business (i.e. the present
value of future cash flows) due to unexpected changes in exchange rates. It is the
long-term version of transaction risk. For example, if your firm’s home currency
strengthens, then foreign competitors are able to gain business at your expense
because your products have become more expensive in the eyes of customers both
abroad and at home. Such exposures are frequently too complex to even identify let
alone measure or manage.

2.2 Hedging Foreign Exchange Risk

(1) Natural hedging techniques

These techniques may provide an effective hedge against exchange rate risk and
may be cheaper and more easily managed. Examples of natural hedges include:

• An exporter with a significant proportion of cash inflows and/or assets

denominated in a foreign currency may hedge, fully or partially, by

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 borrowing in that currency. Such a hedge may have some timing
mismatches but in the longer term usually proves to be an effective hedge.

• Early settlement on foreign currency trade receivables or payables may be

feasible especially if a discount can be negotiated.

• There is considerable scope to hedge intra-group receivables and payables

through settlement procedures and by instructing group companies to lead
and lag payments in line with exchange rate forecasts.

(2) Transactional hedging techniques.

A variety of FX risk exposure management instruments are available to the

corporate treasurer.

(a) Forward Contracts

These involve the buying or selling of foreign currencies for future
settlement at a price determined today. For example, a UK importer of US
motor vehicles may be concerned that the USD will appreciate against the
GBP before its payment of USD 2m is due in ninety days’ time.

A UK bank has the following quote:

USD per GBP

Spot 1.4725 – 1.4735
Three months forward 1.4581 – 1.4601

The UK importer will hedge by buying 2m USD and selling GBP at the rate
1.4581. The GBP payment amount will be 2m/1.4581 = 1,371,648.

(b) Foreign Currency Futures

A currency futures contract represents an obligation to make or take delivery
of a specified quantity of a foreign currency at a specified future date at a
price agreed/when the contract originates.

Foreign currency futures perform the same function as forward contracts in

that they allow hedgers to lock into an exchange rate today, by buying or
selling a futures contract, for settlement at some future point in time.
Exchange traded futures contracts have an advantage over forward contracts
in that they can be closed out if so desired by taking an opposite position in
the market to the original. However, this advantage is offset by the fact that
exchange traded futures are standardised with respect to amount and timing
of delivery dates and are, therefore, not as flexible as forward contracts.

Currency futures are available in AUD, SFR, JPY, FER, GBP, against the
USD on at least one futures exchange (not Hong Kong). In the above
example the importer wishing to hedge against a USD appreciation against
the GBP could sell 22 GBP futures contracts on, say, the International
Money Market of the Chicago Mercantile Exchange. The calculation is
based on the contract size of sterling futures being GBP 62,500 and the

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 assumption that the futures price is 1.4581. Number of contract =
2m/(1.4581x62,500) ≈ 22.

(c) Money market hedge

The money market are markets for lending and borrowing. Many companies
are able to borrow or deposit funds through their bank in the money markets.
Instead of hedging a currency exposure with a forward contract, a company
could use the money markets to lend or borrow, and achieve a similar result.

If you are hedging a future payment, you should (1) buy the present value of
the foreign currency amount today at the spot rate and placed on deposit and
earned interest to settle the future payment in foreign currency, (2) borrow
the local currency to buy the present value of the foreign currency, the
amount of the borrowing together with the interest paid is the payment in
local currency.

Example: Hedging a future payment

PQR Ltd. is a UK company with import trade with the USA. The following transactions, in
USD, cash payment of $450,000 is due within the next 3 months’ time.

Data relating to exchange rates, interest rates are as follows:

Exchange rates (London market):

USD per GBP

Spot 1.7000 – 1.7040
Three months forward 1.6902 – 1.6944

Interest rates Borrow (%) Deposit (%)

GBP 7.5 6.0
USD 6.5 5.0

Hedging using the money market requires deposit USD

450,000/(1 + 0.05/4) = 444,444

This is acquired at the spot rate where you have to buy USD and sell GBP. The bank
will buy low and sell high, as the bank buy GBP from you, the lower rate 1.7000 apply:

444,444/1.7000 = GBP 261,438

The GBP has to be borrowed for three months and the cost is:

261,438 x (1 + 0.075/4) = GBP 266,340

Hedging using the forward contract

450,000/1.6902 = GBP 266,241

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 Using forward is better.

(d) Foreign currency options

The buyer of a currency call (put) option has the right to buy (sell) a
predetermined amount of one currency in exchange for a predetermined
amount of another currency on (or before) a predetermined date. Exchange
traded options with standardised specifications are available on currency
futures (for example, Index and Options Market of Chicago Mercantile
Exchange) and spot currencies (Philadelphia Stock Exchange). Currency
options are also widely available on an “Over the Counter” basis from
financial institutions. The latter are more popular for hedging purposes as
they can be tailored to the option buyer’s specific needs with respect to
amount, exercise price and expiration date, are available in a wider range of
currencies and may be better for longer and/or larger transactions.

Advantages of currency options relative to other hedging techniques are that:

- There is no obligation to exercise so the holder may benefit from unanticipated

opposite movements in the foreign currency;

- They offer a range of strike (exercise) prices which afford greater flexibility than
forwards or futures which deal only at the forward price;

- They are preferable for exercising contingent cash flows (e.g. from tenders) as there is
no obligation to exercise.