Download companies step up fx hedging after big moves in

ARTICLE SERIES
PANTONE 2925
C80 M30 Y0 K0
R0 G142 B214
HEX: 008ED6
PANTONE 340
C90 M0 Y65 K3
R90 G153 B102
HEX: 009966
PANTONE 2718
C70 M50 Y0 K0
R91 G119 B204
HEX: 5B77CC
PANTONE 109
C0 M9 Y100 K0
R255 G209 B0
HEX: FFD100
COMPANIES STEP UP FX
HEDGING AFTER BIG
MOVES IN EMERGING
MARKET EXCHANGE RATES
PANTONE 368
C65 M0 Y100 K0
R120 G190 B32
HEX: 78BE20
PANTONE 306
C75 M0 Y5 K0
R0 G181 B226
HEX: 00B5E2
PANTONE 293
C100 M69 Y0 K4
R0 G61 B165
HEX: 003DA5
PANTONE 2597
C80 M99 Y0 K0
R92 G6 B140
HEX: 5C068C
COOL GRAY 6
C16 M11 Y11 K27
R167 G168 B170
HEX: A7A8AA
COOL GRAY 10
C10 M10 Y5 K55
R119 G119 B119
HEX: 777777
COOL GRAY 11
C0 M0 Y0 K80
R89 G90 B83
HEX: 595a53
White
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R255 G255 B255
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In October 2013, Reuters ran the following report: “After months of volatility
in emerging market currencies and deep uncertainty over the outlook for
the dollar, bruised companies have stepped up hedging of their foreign
exchange exposure. Providers of protection against big moves in currencies,
which can wreak havoc with budget plans and eat into corporate profits,
say business is up.”
But what does this really mean?
In today’s global economy, almost every company is
exposed to foreign exchange (FX) rates, be they cash
flows from an overseas subsidiary or the impact of
exporting sales or importing inputs and raw materials.
Hedging (covered in Module 3 of the CFA Institute
Investment FoundationsTM course of study) is a common
risk management strategy used to limit exposure to
fluctuations in the exchange rates.
Foreign exchange transactions take place in the spot
market or in the forward market.
•The
spot market is where currencies are traded now
and delivered immediately. The exchange rate for the
transaction is called the spot exchange rate or spot rate.
•In
contrast, the forward market is where currencies
are traded now but delivered at some future date. In
the forward market, the exchange rate for the
transaction is called the forward exchange rate or
forward rate, and there are as many forward rates as
there are delivery dates:
•a
•
one-month forward rate for delivery in one month
a two-month forward rate for delivery in two months
•a
three-month forward rate for delivery in three months
A Supermarket Example
A French supermarket chain imports dairy products today
from the UK for £100,000 and has one month to pay the
invoice. The exchange rate quotes are as follows:
•
Spot rate = €1.20/£1
•
Forward rate, delivery in one month = €1.22/£1
If the French supermarket chain paid the British
producers today on delivery, it would use the spot market
and spot rate. Therefore, the French supermarket chain
would convert euro immediately at the spot rate of
€1.20/£1 to get the £100,000 to pay the British suppliers;
so it would have to pay €120,000.
However, in reality most businesses offer their customers
a time to pay their invoices. So now let’s say the French
supermarket chain has one month to pay the invoice,
allowing it to sell the goods and realize the cash to
pay the invoice. It faces currency risk because the
supermarket will raise euros by selling the goods but
will have to pay the invoice in pounds in one month’s time
and the exchange rate between the euro and the pound
is likely to fluctuate within the next month.
In order to hedge the currency risk, the French
supermarket chain can use the forward market. It would
take the following steps:
For more information, please go to cfa.is/InvFound.
•Enter
today into a forward contract with a bank or
currency dealer. The forward contract specifies the
exchange rate for the transaction in one month. This
exchange rate is the forward rate with delivery in one
month (i.e., €1.22/£1). No actual movement of money
takes place today.
•In
one month, the French supermarket chain converts
euros into pound sterling at the agreed exchange
rate of €1.22/£1. Thus, it pays €122,000 [£100,000 ×
(€1.22/£1)] no matter what the spot rate is on that day.
Therefore, the French supermarket chain knows for sure
how much the import will cost (€122,000) and can price
its goods accordingly in euros today.
Note that if the spot rate the day of the transaction is
more advantageous than the agreed exchange rate, say
€1.21/£1, the French supermarket chain cannot benefit
from it because it has committed to convert at €1.22/£1;
therefore, it must provide €122,000 to the bank or
currency trader, and it will still get £100,000 in exchange.
Our Lesson In Clarity: Hedging
Hedging is not about trying to make a profit out of
currency fluctuations but about obtaining certainty
around the cash flows of running a company. Today,
companies import goods from around the world and
export sales to overseas customers; therefore, it is often
vital to limit exposure to volatile exchange rates that can
impact the volatility of their earnings. Understanding the
spot rate and the forward rate helps companies protect
their assets and mitigate risk.
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