Forex Risk Management through forwards, futures, options and swaps
Fahid Fayaz Darangay
The losses that an international financial transaction incurs via currency fluctuations is called the Foreign Exchange risk also named as currency risk., FX risk and exchange-rate risk. This risk usually arises when a company does financial transactions in a currency other than his domestic currency. For example an Indian company does transactions in USD or a Pakistani company does in INR.
The appreciations/depreciations of the base currency or the depreciations/appreciations of the denominated currency affect the cash flows emanating from these international transactions. The bearers of this risk generally are investors, trading international markets, and businesses engaging in the import/export of products or services to multiple countries.
The profit or loss, is denominated in the foreign currency and is need to be converted back to the company’s base currency. Fluctuations in the exchange rate could adversely affects this conversion resulting in a lower than expected amount which gives birth to this Foreign Exchange risk. The risk also originates when a contract between two parties agrees to definite prices for goods or services and the delivery dates.
If a currency’s value fluctuates between when the contract is signed and the delivery date, it could cause a loss for one of the parties. That is why this risk needs to be managed so that both parties can hedge it and make use of Forwards, Futures, Options and Swaps. All the three types of Forex risk transaction risk, translation risk, and economic risk can be managed by the above mentioned contracts.
A small example
An Indian textile company signs a contract to buy 100 meters from an American retailer for $50 per meter, or $5,000 total, with payment due at the time of delivery. The Indian company agrees to this contract at a time when the USD and the INR are of equal value, so $1 = 1INR. Thus, Indian company expects that when they accept delivery of the cloth, they will be obligated to pay the agreed upon amount of $5,000, which at the time of the sale was $5,000.However it will take some time for delivery. In the meantime, due to unforeseen circumstances, the value of the INR depreciates versus the USD to where at the time of delivery $1 = 1.10INR. The contracted price is still $5,000 but now the INR amount is 5,500INR, which is the amount that the Indian textile company will have to pay.
With forward contracts
The foremost instrument used is the forward contract. These contracts are customized agreements between two parties to fix the exchange rate for a future transaction. This simple arrangement easily eliminates exchange rate risk, but it has some shortcomings, particularly getting a counter party who would agree to fix the future rate for the amount and time period in question may not be easy. In many countries bank functions as a counter party. By entering into a forward rate agreement with a bank, the risk gets easily transferred to the bank, which will now have to bear this risk.*
With future contracts
With the need and the difficulty in finding a counter party, the futures market came into existence. The futures market basically solves some of the shortcomings of the forward market. A currency futures contract is an agreement between two parties – a buyer and a seller – to buy or sell a particular currency at a future date, at a particular exchange rate that is fixed or agreed upon today. This sounds a lot like the forward contract. In fact the futures contract is similar to the forward contract but is much more liquid. It is liquid because it is traded in an organized exchange– the futures market (just like the stock market). Futures contracts are standardized contracts and thus are bought and sold just like shares in the stock market. The futures contract is also a legal contract just like the forward, but the obligation can be ‘removed’ before the expiry of the contract by making an opposite transaction. As for hedging with futures, if the risk is an appreciation of value one needs to buy futures and if the risk is depreciation then one needs to sell futures.*
A currency option is a contract between two parties a buyer and a seller where the buyer of the option has the right but not the obligation, to buy or sell a specified currency at a specified exchange rate, at or before a specified date, from the seller of the option. While the buyer of option enjoys a right but not obligation, the seller of the option nevertheless has an obligation in the event the buyer exercises the given right. There are two types of options:
• Call options – gives the buyer the right to buy a specified currency at a specified exchange rate, at or before a specified date.
• Put options – gives the buyer the right to sell a specified currency at a specified exchange rate, at or before a specified date.
Of course the seller of the option needs to be compensated for giving such a right. The compensation is called the price or the premium of the option. Since the seller of the option is being compensated with the premium for giving the right, the seller thus has an obligation in the event the right is exercised by the buyer.*
With currency swaps
Currency swaps are a way to help hedge against that type of currency risk by swapping cash flows in the foreign currency with domestic at a pre-determined rate. Currency swaps are not required by law to be shown on a company’s balance sheet the same way a forward or options contract would. Many currency-hedged ETFs and mutual funds now exist to give investors access to foreign investments without worrying about currency risk.
In the currency swap, or FX swap, the counter-parties exchange given amounts in the two currencies. For example, one party might receive 100 million USD, while the other receives 125 million INR. This implies a USD/INR exchange rate of 1.25. At the end of the agreement, they will swap again at either the original exchange rate or another pre-agreed rate, closing out the deal.
Swaps last for years, depending on the individual agreement, so the spot market’s exchange rate between the two currencies in question can change often during the life of the trade. This is why big institutions use currency swaps. They know exactly how much money they will receive and have to pay back in the future. If they need to borrow money in a particular currency, and they expect that currency to strengthen significantly in coming years, a swap will help limit their cost in repaying that borrowed currency.
If you have a portfolio heavily weighted towards United Kingdom stocks, for instance, you’re exposed to currency risk: The value of your holdings can decline due to changes in the exchange rate between the British pound and the U.S. dollar. You need to hedge your currency risk to benefit from owning your fund over the long term.
(The author is currently pursuing Masters in Financial Economics from Madras School of Economics, Chennai)