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.

Fixed-price contracts

are an alternative way to effectively shift foreign exchange risk to a supplier.

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.

Foreign exchange forward

is a customized contract that locks in an exchange rate for the purchase or sale of a predetermined amount of currency at a future delivery date.

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

Current spot rate

is compared to the contracted forward rate and a cash payment changes hands

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. Tend to have shorter terms to maturity and have only two exchanges between counterparties.

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. Tend to cover longer periods and involve multiple exchanges between counterparties. Usually have periodic payments between the counterparties for the term of the swap and cover a longer period of time than foreign exchange swaps.

The classic currency swap

involves a change in the currency.

A currency basis (floating-to-floating) swap

involves a change in the currency and the type of floating interest rate (the basis).

CURRENCY FUTURES

are exchange-traded forward contracts to buy or sell a predetermined amount of currency on a future delivery date

CURRENCY FUTURES MARK-TO-MARKET AND MARGIN

Margin is a performance bond, required by both buyers and sellers, to ensure their performance to the contract

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.

Sale of options

can be used to produce option premium income, though not providing a hedge.

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.

call option on francs and a put option on yen

An option that permits the purchase of Swiss francs against Japanese yen

An American-style option

is exercisable at any time before expiry of the option. A European-style option - is exercisable on the expiry date.

European-style option

is exercisable on the expiry date.

An at-the-money option 

permits the option holder to exercise it at a rate equivalent to current market rates (usually the forward rate).

An in-the-money option

has a strike rate that is more favorable exchange than current rates.

An out-of-the-money option

has a strike rate that is worse than current exchange rates. The out-of-the-money option’s value is based on the probability of it being in-the-money before expiry.

BUYING OPTIONS

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

SELLING OPTIONS

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

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.