using forward exchange markets and money market hedging

Using Forward Exchange Markets and Money Market Hedging

International Finance ManagementTeam 4: Sneha & Sonja

09-09-10

IGTC-Bangalore, IFM Team 4 2

Forward Contract

09/09/2010

Contract agreement

Forward Options Swap

Derivative

Future


• Negotiated agreement between two parties on:– A particular good– At a set price– At a future date (unknown)

• Forward rate• Spot rate

09/09/2010

The Forward Contract


The Forward Contract

09/09/2010


Forward exchange market

• Market for contracts • Ensure the future delivery of – a foreign currency – at a specified exchange rate

• Forward contracts can be used to – hedge or cover exposure to foreign exchange risk

09/09/2010


Money market

• Component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames

• Treasury bills, commercial papers, banker´s acceptances, certificates of deposit, federal funds, and short-lived mortgage and asset-backed securities

09/09/2010


Forward Exchange Contract

09/09/2010


What are the pros and cons?

Pros Cons

Allows you to manage the risk of exchange rate movements between the currency of your export contract payments and Australian dollars

If your buyer doesn’t pay you on time under your export contract, your bank will still expect you to fulfil the forward exchange contract by exchanging the amount of the export contract payment for Australian dollars on the agreed date

09/09/2010


Money Market Hedging

• Internal hedging technique• Borrowing and lending in multiple currencies• Eliminate currency risk by locking in the value

of a foreign currency transaction in one's own country's currency.

09/09/2010


Example• UK company with a 1 year receivable of $1,000,000. If the Spot FX rate is

2.000 and US interest rates were 4% and UK interest rates were 5%. The company would borrow $1,000,000 discounted by 4% ($1,000,000/1.04) = $961,538.46, then convert it into Sterling at 2.000 = £480,769.23. The Sterling would then be placed on deposit at 5% (£480,769.23*1.05 = £504,807.69). In one year's time the company receives the expected $1,000,000 and repays the $ loan in full. Therefore the company has hedged the foreign exposure and has enjoyed the Sterling equivalent for the full period. The calculation for the effective Foreign Exchange Forward Outright is $1,000,000/£504,807.69 = 1.98.

• Forward Outright formula - [Spot-(((1+ih)/(1+if)-1)*Spot)] or [2-(((1.05)/(1.04))-1)*2]

• Spot=Current FX rate • ih=Interest in Home country • if=Interest in foreign country

09/09/2010


Non-transferability and Reversal of Forward Contracts

• Exchange rate is locked in• Informal arrangement• Final settlement at delivery• Not transferable and not reversible

09/09/2010


What is Hedging??

• Hedging refers to managing risk to an extent that makes it bearable.

09/09/2010


Forex Hedging strategy

• Analyze risk: Trader must identify what the implications

could be of taking on the risk un-hedged, and determine whether the risk is high or low in the current forex currency market.

09/09/2010


Determine risk tolerance:

• The trader uses their own risk tolerance levels, to determine how much of the position's risk needs to be hedged.

• No trade will ever have zero risk• It is up to the trader to determine the level of

risk they are willing to take, and how much they are willing to pay to remove the excess risks.

09/09/2010


• Determine forex hedging strategy: If using foreign currency options to hedge the

risk of the currency trade, the trader must determine which strategy is the most cost effective.

• Implement and monitor the strategy: By making sure that the strategy works the

way it should, risk will stay minimized.

09/09/2010


Forwards in Hedging

• Forward contracts can also be used to hedge currency risk.

• Forward contracts are superior to futures in terms of their overall risk reduction, there is no central market for forward contracts, which contributes to higher transaction costs and lower liquidity, as well as counterparty risk (i.e. the risk that the contract will not be honoured at expiration).

09/09/2010


Example:

09/09/2010

Assume that a Malaysian construction company, Bumiways just won a contract to build a stretch of road in India. The contract is signed for 10,000,000 Rupees and would be paid for after the completion of the work. This amount is consistent with Bumiways minimum revenue of RM1,000,000 at the exchange rate of RM0.10 per Rupee. However, since the exchange rate could fluctuate and end with a possible depreciation of Rupees, Bumiways enters into a forward agreement with First State Bank of India to fix the exchange rate at RM0.10 per Rupee. The forward contract is a legal agreement, and therefore constitutes an obligation on both sides.

By entering into a forward contract Bumiways is guaranteed of an exchange rate of RM0.10 per Rupee in the future irrespective of what happens to the spot Rupee exchange rate. If Rupee were to actually depreciate, Bumiways would be protected. However, if it were to appreciate, then Bumiways would have to forego this favourable movement and hence bear some implied losses. Even though this favourable movement is still a potential loss, Bumiways proceeds with the hedging since it knows an exchange rate of RM0.10 per Rupee is consistent with a profitable venture.


Speculation

09/09/2010

• Speculating is the assumption of risk in anticipation of gain but recognizing a higher than average possibility of loss

• The term speculation implies that a business or investment risk can be analyzed and measured, and its distinction from the term Investment is one of degree of risk.

• Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. This creates a positive feedback loop in which prices rise dramatically above the underlying value or worth of the items.


• Speculation is no gambling because here the investors invest through informed decisions and the outcomes are not random in nature. Speculators generally rely on the technical analysis.

• Speculation supplies the necessary liquidity to the Stock market. Now a days, it is not a purely risky venture after the invention of many sophisticated investment tools (such as futures, options, short selling, stop loss orders, etc.), which help the speculators to hedge the risk.

09/09/2010


How Speculation Yields Returns

• A bubble is a phenomenon during which the value of an investment (such as real estate, stock, foreign exchange and petroleum futures) rises substantially. Most of the investments are overpriced in such a scenario, yielding high returns.

09/09/2010


Speculation: Dangers

• A speculative buying spree, devoid of analytical calculation, aggravates the element of risk. Any downturn in prices can cause panic and excessive selling, resulting in a dramatic plummeting of prices and eventually a market crash. The stock market crisis of 2008 can be attributed to consecutive periods of speculative buying, followed by panic and speculative selling.

09/09/2010


How Speculation Helps the Market

• Speculation can be a blessing for the economy. This is because speculators inject capital in the market, thereby increasing liquidity. Speculative investments also minimize the risk for arbitrageurs and hedgers.

09/09/2010


Forwards in Arbitrage• Forex arbitrage takes advantage of the difference in the prices of

currencies by striking deals that capitalize on this imbalance. The profit is the difference between the currency prices. Traders who practice this process are called forex arbitrageurs.

• Forex arbitrage allows forex traders to make profits from the opportunities arising from inefficiencies in pricing the currencies. The faster a trader acts, the more he gains till the pricing inefficiency is corrected. Forex arbitrage is practiced by purchasing and selling two or more currencies that have pricing inefficiencies.

• To execute the forex arbitrage strategy, a trader needs to have the: 1) real-time quotes of currencies 2) ability to make decisions quickly

09/09/2010


Forex Arbitrage: How it Works

• The two-currency arbitrage is the most popular form of forex arbitrage. It involves trading in two currencies, with two different brokers offering different spreads. One of the prices in the spread (bid price or ask price) would be different, while the other is the same.

• A forex arbitrage move involving more than two currencies would require the trader to have an in-depth knowledge of the currencies involved and the exchange rates. If the exchange rate of a currency, when compared to that of other currencies,

1)follows a set ratio or 2)shows definite fluctuation 3)it creates opportunities for profitable forex arbitrage.

09/09/2010


Forex Arbitrage: Dangers

Forex arbitrage is one of the safest strategies followed by traders on the forex market. Also, it can help earn large profits within a short span of time. However, one should be careful while practicing this strategy:

• Traders can exploit a trend taking place between two currency pairs. They need to be cautious as once the pricing loopholes are fixed, the traders may find themselves on the losing side.

• While the forex arbitrage strategy yields high returns, it does that at a cost. To be on the safe side, one should keep forex arbitrage as a part of the trading strategy and diversify.

09/09/2010


Long Dated Forwards

• A type of forward contract commonly used in foreign currency transactions. Long dated forward refers to contracts that typically involve positions that have settlement dates longer than a year away. Long dated forward contracts are sometimes used by companies to hedge certain currency exposures.

09/09/2010

using forward exchange markets and money market hedging

Documents