LESSON 4: FOREIGN EXCHANGE RISK

CURRENCY NETTING

When an organization has foreign currency cash inflows and outflows, a cash forecast for each currency assists in identifying currency exposures.

Proxy hedging

is a strategy that introduces basis risk intentionally.

FOREIGN CURRENCY DEBT

Lower foreign interest rates might be seen as a way to reduce funding costs. Foreign currency debt may be required to finance an overseas expansion or investment in foreign plant and operations.

CHANGES TO PURCHASING / PROCESSING

A company with foreign currency sales might use a supplier whose products are priced in the same currency.

TRANSFER EXCHANGE RATE RISK

Changes may be made to pricing methodology to better reflect exchange rates. In some industries, surcharges help to offset exchange rate risk and pass it on to the final customer.

FORWARD CONTRACTS

Hedging foreign exchange exposure with derivatives such as forward contracts replaces exposure to exchange rates with exposure to the performance of contractual counterparties.

FORWARD PRICING

reflects the difference in interest rates between the two currencies over the period of time covered by the forward. o This is based on the spot exchange rate, plus or minus a forward spread (forward points).

FLEXIBLE FORWARDS

A variation on a standard forward contract, and permits the forward to be used on a date of the hedger’s choice within an allowable date range.

NONDELIVERABLE FORWARDS

Contractual agreements where delivery of the currency does not occur

SWAPS

Although they are similar, there are some significant differences between foreign exchange and currency swaps.

FOREIGN EXCHANGE SWAPS

Used extensively by financial institutions to manage cash balances and exposures in various currencies

Currency swaps

enable swap counterparties to exchange payments in different currencies, changing the effective nature of an asset or liability without altering the underlying exposure.

Currency futures

are exchange

CURRENCY FUTURES MARK

TO

FOREIGN EXCHANGE OPTIONS

Purchase of options can reduce the risk of an adverse currency movement, while maintaining the ability to profit from favorable exchange rate changes.

A put option

gives the option buyer the right to sell the underlying currency at the strike rate. When exercised, the option seller has the obligation to accept the currency at the strike rate.

A call option

gives its buyer the right to purchase the underlying currency at the strike rate. When exercised, the option seller has the obligation to deliver the currency at the strike rate.

An American

style option

European

style options

An at

the

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An out

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BUYING OPTIONS

An option buyer achieves protection against adverse exchange rates beyond the strike rate.

Sale of options

entails significantly more risk than the purchase of options. The seller receives option premium and is obligated to the terms of the option.

FOREIGN EXCHANGE COLLAR

A collar combines the purchase of a call option and the sale of a put option with the same expiry date on the same currency pair.

AVERAGE RATE OPTIONS

Average rate or Asian options have a payoff that depends on the average exchange rate over the option’s term to expiry. At expiry of the option, the average rate is calculated from the periodic fixings made during the term and compared with the strike price.

BARRIER OPTIONS

are a type of exotic option in which payout depends on whether the option has reached or exceeded a pre

COMPOUND OPTIONS

are options on options. Normally Europeanstyle, they give the option buyer the right, but not the obligation, to buy or sell an option contract at the compound option’s expiry date at a predetermined option premium.