Organizational Framework
Every business before getting into the nitty gritty of
hedging, must put in place a frame work for foreign exchange risk management,
so that all in the organization understand their role vis-à-vis forex risk
management and discharge their responsibilities effectively. The frame work
could be built on the lines of: The Board - Being the highest authority, the
board should set the hedging strategy and policies that define a firm’s actions
and thus constitute the most important element of risk management framework. It
shall be responsible to set the objectives of risk management:
- Whether to be aggressive or conservative;
- Minimization of translation exposure;
- Minimization of earnings fluctuations owing to forex risk;
- Minimization of transaction exposure;
- Minimization of economic exposure; and
- Hedging at a minimum cost.
The leadership should explicitly articulate its hedging
objectives with the staff down the line and make them own up the proposed
action. It should monitor the functions of senior executives under exchange
risk management vis-à-vis the laid down objectives/strategies and policies, and
suggest corrective action wherever warranted. It should also ensure that the
employees entrusted with the task of exchange risk management do exhibit a
“sense of accountability”. Senior Executives – To be effective, companies must
articulate a policy for foreign exchange risk management before their board and
seek its approval for implementation. The policy framework should encompass the
following points:
- Identify the roots of exchange risk
- Understand the specific implications
- Define company’s attitude to risk
- Lay down the hedging strategy
- Define the instruments to be used for hedging
- Decide how risk management activity will be organized in the firm
Once the board approves the risk management policy, its
implementation becomes the responsibility of senior executives. They should put
in place an infrastructure that facilitates:
- Assessment of foreign exchange risk
- Control of forex risk as it arises
- Periodical measurement and reporting of performance to the board
- Ensuring overall compliance with the board’s strategy and policies.
Independent Assessors – Besides the hierarchy, there must
be an independent team of experts within the risk management framework to
independently undertake the assessment of the firm’s foreign exchange exposure,
assess the tools and techniques used by the linestaff in measuring, monitoring
and managing foreign exchange risk, assess the compliance of the hierarchy with
the prescribed policies and strategies of the board and give feedback to the
board about the outcome under the risk measuring framework.
Employees – It is the employees who ultimately implement
the board’s strategy and risk management polices and administer deals that are
necessary to manage the foreign risk. In that context, it becomes critical to
identify the right kind of employees to manage risk. Once identified, their
roles and responsibilities must be defined and communicated to them. The lines
of communication must also be clearly drawn and made understood by all the
concerned.
Essentially, foreign exchange risk is managed through two
means: one, internal – use of tools which are internal to the firm such as
netting, matching etc., and two, external techniques – use of contractual means
such as forward contracts, futures, options, etc., to insure against potential
exchange losses. The usage of internal techniques is also known as passive hedging,
while the latter is known as active hedging. Usage of internal tools among the
group companies may at times be difficult to practice owing to local exchange
control regulations. Nevertheless, they are worth implementing for they do not
involve extra payouts while being significantly effective in minimizing the
forex exposure.
Here, it is essential to understand the difference
between forex exposure and forex risk. Foreign exchange exposure is the
sensitivity to changes in the real domestic currency value of assets,
liabilities, or operating incomes to unanticipated changes in exchange rates.
Foreign exchange risk exposure is quite often used interchangeably with the
term ‘foreign exchange risk’, although they are conceptually quite different.
Foreign exchange risk is defined in terms of the variance of unanticipated
changes in exchange rates. It is measured by the variance of the domestic
currency value of an asset, liability, or operating income that is attributable
to unanticipated changes in exchange rates.
1.1 Internal Hedging Techniques
Companies having subsidiaries in different countries or
the parent company having subsidiaries across the globe can effectively
practice internal techniques to minimize foreign exchange exposure and the
eventual need for its active hedging. We shall now take a look at some such
important tools:
1.1.1 Netting
It is possible to net the payments and receipts among the
associated companies which trade with one another. It involves mere settlement
of inter-affiliate indebtedness for the net amount owing. One of the simplest
ways of netting is bilateral netting: it involves pairs of companies. It
basically reduces the number of inter-company payments and receipts that pass
over the foreign exchanges.
However, it poses a problem: which currency is to be used
for settlement? Multilateral netting is a little complex phenomenon though
similar to bilateral netting. It involves more than two associated companies
and their debt. Hence it calls for the services of a group’s centralized
treasury. Multilateral netting results in considerable savings, since it
eliminates exchange and transfer costs. Besides reducing costs, it enables the
central office to exercise control over inter-company settlements.
1.1.2 Matching
Netting or matching are frequently used interchangeably.
But there is a subtle difference: netting refers to potential flows within the
group companies, while matching extends from group companies to third party
companies too. It basically matches a company’s foreign currency inflows with
its foreign currency outflows in respect of both time and amount of flow.
Receipts in a particular currency are used to make payments in that currency
alone, and thereby eliminate the need to go through exchange markets for such
conversions.
However, to practice this technique, there must be a
two-way cash flow in the same foreign currency within the group companies. For
all practical purposes matching is akin to multilateral netting and hence calls
for centralized group finance function. It is of course likely to pose
problems: uncertain timings of third party receipts and payments can delay
payments but the central treasury shall endeavor to streamline the collection
of information and processing thereof.
1.1.3 Leading and Lagging
Leading means paying an obligation in advance of the due
date and lagging means delaying payment of an obligation beyond its due date.
It basically refers to credit terms and payments between associate companies
within a group. In forex market where exchange rates are constantly
fluctuating, the leading and lagging tactics come handy to take advantage of
the expected rise/fall in exchange rates. For instance, company ‘a’, a
subsidiary of company ‘A’ located in India,
owes money to a subsidiary ‘c’ in Canada. The bill is invoiced in US
dollars and due for payment in three months’ time. Assume that rupee is likely
to devalue in three months’ time by around 20 per cent. In such a situation, it
makes great sense to lead the payment to Canadian company in dollars, so that
it needs to part with less units of rupees today than after three months. Thus,
leading becomes pretty tempting and the converse holds good for lagging.
However, it is quite essential for companies to factor the impact of relative
interest rates; expected currency movements, and after tax effects into leading
and lagging decisions.
While practicing leading and lagging the management must
realize that the performance measurement of those subsidiaries which were asked
to ‘lead’ payments may suffer as they incur loses on interest receivable and
incurs interest charges on the funds ‘led’. At times, lead and lag techniques
may also be constrained by local exchange control regulations. Practicing of
leading and lagging techniques indeed goes beyond the realm of risk
minimization. It amounts to taking aggressive stances on financing vis-à-vis
anticipated movements in exchange rates. For instance, an expected devaluation
of a host country’s currency may make an international company borrow locally
and repay the foreign currency denominated borrowings.
1.1.4 Price Variation
It involves increasing selling prices to counter exchange
rate fluctuations. But the question is whether a firm can raise its price in
tandem with anticipated exchange rate movements. This is only possible when the
selling company is a market leader. In some South American countries, price
increase is the only legally tenable tactic of foreign exchange exposure
management.
Inter company trade transfer price variations can also be
effected as a foreign exposure risk management tool. There is of course a
danger here: unless the firm maintains arm’s length price, taxation and customs
authorities may question such variations in transfer prices. Nevertheless, it
is common knowledge that multinationals attempt to maximize after-tax group
cash flows by transfer pricing with the objective of minimizing tax liability
and moving funds around the world.
1.1.5 Invoicing in Foreign Currency
Exporters and importers of goods always face a dilemma in
deciding the currency in which the goods are to be invoiced. It is obvious that
sellers always prefer to invoice in their domestic currency or the currency in
which they incur cost, so that it avoids foreign exchange exposure. On the
other hand, buyers will have their own preferences for a particular currency.
In the buyers’ market, a seller hardly has any choice to invoice in his desired
currency. At least, in such situations, one should choose only the major
currency in which forward markets are pretty active. Currencies that are of
limited convertibility and with a weak forward market must be shunned.
1.1.6 Asset-Liability
Management
It is used to manage balance sheet, income statement or
cash flow exposures by aggressively shifting cash inflows into currencies
expected to be strong or increase exposed cash outflows denominated in weak
currencies. Alternatively, a firm may practice defensive approach: matching of
cash inflows and outflows according to currency denomination, irrespective of
whether they are in strong or weak currencies.
As a part of aggressive financing policy, companies may
prefer to increase their exposure under cash flows, debts and receivables in
strong currencies and increase borrowings and trade creditors in weak
currencies. Simultaneously, they reduce exposed borrowings and trade creditors
in strong currencies.
Box 3: Alternative Currency Translation Methods
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· Current/Non-current method – functions under
the principle of maturity: current items on closing rate basis and long term
items on historical rate basis; income statement is translated at the average
exchange rate of the period; many American multinationals are known to widely
employ this method.
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2 External Hedging Techniques
External techniques which are also known as active
hedging techniques, essentially involve contractual relationship with outside
agencies. Hedging is a method whereby one can reduce the financial exposure
faced in an underlying asset due to volatility in prices by taking an opposite
position in the derivatives market in order to offset the losses in the cash
market by a corresponding gain in the derivatives market. Constructing a hedge
essentially involves:
- Identification of the exposure one is facing;
- Measurement of that exposure; and
- Construction of another position with the opposite exposure.
Construction of an exact opposite position to the
existing risk exposure results in a perfect hedge. Such opposing positions,
when they come together, automatically offset each other. But, there is always
a problem: how to strike a balance between uncertainty and the risk of
opportunity loss.
The problem of
setting an effective hedge ratio has two dimensions:
- Uncertainty – if a firm does not hedge the transaction, it cannot know with certainty at what rate of exchange it can exchange its dollar export proceeds for rupees - it could be at a better rate or a worse rate.
- Opportunity – if firms enter into a hedge transaction such as a forward contract they would, of course, be certain of the rate at which they would be exchanging the export proceeds. But now they have taken an infinite risk of ‘opportunity loss’.
During 1984, Lufthansa, a German airline, signed a
contract to buy $3 billion – worth of aircraft from an American company –
Boeing. At that time, dollar was strong and market held an opinion that it was
sure to get even stronger. In that context the CFO of Lufthansa hedged the
company’s exposure to dollar by buying a forward contract for $1.5 billion. The
central idea behind this hedging is: if the dollar strengthens, it would lose
on its aircraft contracts but gain on the forward contract. There is another
interesting dimension to this hedge: Lufthansa’s cash flow was also in effect
dollar denominated and thus had a fair level of ‘natural hedge’. In this
episode, dollar weakened by around 30% during 1985 and thus the forward
contract inflicted heavy losses on the company. The moral is: deciding to hedge
is one thing, and getting it right is quite another.
There is yet another dimension to hedging: hedging has a
cost. If a depreciation/devaluation of it is unlikely, hedging will prove an
ineffective way of doing business. All these complexities associated with
hedging thorough derivatives pose a great challenge to arrive at a right hedge
ratio.
The true purpose of hedging is to reduce the volatility
of earnings and cash flows by setting pre-defined limits on any loses. The
first step under hedging through derivatives is to estimate the size of the
short position that must be held in the derivatives market – say, futures
market, as a proportion of the long position held in the spot market that
maximizes the firm’s expected utility, defined over the risk and expected
return of the hedge portfolio. This is the problem of estimating the Optimal
Hedge Ratio. OHR is the hedge ratio that equates the agent’s marginal rate of
substitution between the expected return and the standard deviation of the
hedged portfolio with the slope of this feasible set (Cecchetti, Cumby and
Figlewski, 1988).
Box 4: Estimation of the Optimal Hedge Ratio
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Hedging using
futures involves taking a position in the futures market that is opposite to
the position held in the spot market. For a long position in the spot market,
the return of a hedged portfolio is given by
xt = st - hft (1)
Where, st
is the return in the spot market at time t,
ft is the return in a
futures market at time t and
h is the hedge ratio.
The Optimal Hedge Ratio (OHR) is the
value of h that maximizes the investor’s expected utility, defined over the
expected return and risk of the hedged portfolio. In the mean-variance
framework, risk is defined by the variance of the return of the hedged
portfolio, which is given by
var(xt) = var(st - hft) (2)
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Source: Robust
Estimation of the Optimal Hedge Ratio, Richard D.F. Harris and Jian Shen; School of Business
and Economics, University
of Exeter, July 2002
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2.1 Hedging through Forward Contracts
Forward contracts obligate one party to buy the
underlying at a fixed price at a certain time in the future from a counter
party who is obligated to sell the underlying at that fixed price. These are
one of the oldest and commonest hedging tools of the forex market. Consider an
Indian exporter who expects to receive US $1 million in six months. Suppose
that the price of the dollar is Rs.43.60 now. If the price of the dollar falls
by 10 per cent, the exporter loses Rs.43 lakhs. But by selling dollars forward
the exporter locks in the current forward rate of Rs.43.65 which means even
after dollar depreciating by 10 percent in the next 6 months, the exporter
would still get Rs.43.65 per dollar. Thus, the exporter has fully hedged
himself i.e. he took a financial position to reduce his exposure to exchange
rates.
2.2 Hedging through Futures
Futures contract is an agreement to buy or sell a
standard quantity of a specific financial
instrument at a future date and at a price agreed between the parties
through open outcry on the flow of an organized financial futures exchange. The
terms under the contract such as amount, maturity date, range of price movement
are all standardized. A buyer of the futures contract has the right and
obligation under the contract. Under a futures contract, there will always be a
buyer and seller, whose obligation is not to each other but to a clearing
house. After a transaction is recorded, the clearing house substitutes itself
for the other party. Thus credit risk is eliminated. Financial futures provide
a means of hedging for those who wish to lock in exchange rates on future
transactions.
Hedging through futures contract is almost akin to
hedging with forward contract. An exporter having a receivable can hedge by
selling a futures while a payable is hedged by buying a futures contract.
However, as the amounts and delivery dates for futures are standardized, a
perfect hedge through futures is not possible. There is another difference
between hedging through futures and forward contracts: there are intermediate
cashflows under futures contracts owing to ‘markto- market’ mechanism. Such
cashflows could be positive or negative.
2.3 Hedging through Options
Options provide hedging characteristics different from
forward or futures contracts. Option contract allows the buyer to participate
in the good side of the risk, while insuring against the bad side of the risk.
An option has a right but no obligation to perform. Thus, an importer who
purchased a call option will have a right to buy the underlying i.e. dollar at
the agreed price, even if the current spot price is par above the price under
option. On the other hand, if the spot price is much less than the price under
option, the option holder can ignore the option and acquire dollars from the
spot market.
Options are more suited to hedge uncertain cashflows. For
instance, assume that an Indian company is bidding for a project in a foreign
country. Its forex flows will materialize only if the bid is successful.
Similarly, if an Indian investor who invested in foreign stock market and
assumes that due to falling dollar is portfolio value may decline. In all such
cashflows that are contingent upon happening a even than better be hedged
through options.
2.4 Hedging through Swaps
Swap is a contract to exchange cash flows over the life
of the contract. Swap is simply a portfolio of forward contracts. As in the
case of forward contracts, the market’s assessment of the present value of the
cash flows of a swap is zero at the initiation of the contract. Swaps could
involve currencies or interest rates. They help the corporate treasurer to
manage his portfolio of liabilities. Swaps also help businesses to arbitrage on
market imperfections and thereby raise finance at rates below market rates,
otherwise available.
Whilst on hedging one should always remember that forward
hedging of contractual exposures does not remove a firm’s forex exposure. It
merely removes the uncertainty regarding the home currency value of that
particular cashflow and nothing beyond. In other words such hedging only
stabilizes the firm’s cashflows or profits.
3. Hedging
through Money Market
In imperfect markets there is always room for covered
interest arbitrage opportunities. Similarly, absence of covered interest
arbitrage opportunities does not necessarily imply that forward cover and money
market cover would be same. In fact, money market hedge may sometimes prove to
be a better alternative to hedge foreign exchange risk. However, this is only
possible to firms, which have access to international money markets/Euro
markets for short-term borrowings or investments where forward premiums and
interest rates are strikingly low. For instance, assume an Indian exporter is
having a receivable in dollar due for payments three months henceforth. If the
exporter had access to Euro market, he/she can borrow dollars equivalent to the
receivable amount and convert them into Indian rupees at the current Re/$ spot
rate 43.4950/4850 and use it for domestic payments or for lending in the
domestic market. Subsequently, the amount due under the export bill/receivable
can be used to pay off the Euro loan. Such money market coverage can at times
result in gain, particularly when the differences in interest rates/forward
premiums are high.
Thanks for sharing this useful information about Forex Risks, this may helpful for beginners.
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