Hedging

Hedging Treasury Risk
with
Forward Foreign
Exchange Contracts
Leslie Matthews ulenta
Director
International Business Strategies, LLC, Zagreb

September, 2005
Croatian Association of Corporate Treasurers
Leslie ulenta, International Business
Strategies, LLC
2
Overview
FX forwards: definition, characteristics and
features
Uses of FX forwards
Example 1: Hedging with forwards
Example 2: Deriving the forward rate
Problems and risks
Accounting for forwards
Example 3: Marking to market
Risk management
FX Forwards:
Definition,
Characteristics and
Features
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Forward Foreign Exchange
Contract
Definition:
An agreement to exchange one currency for
another, where
The exchange rate is fixed on the day of the
contract, but
The actual exchange takes place on a pre-
determined date in the future

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Characteristics and Features of FX
Forwards
Available daily in major currencies in 30-, 90-, and 180-
day maturities
Forwards are entered into over the counter
Deliverable forwards: face amount of currency is
exchanged on settlement date
Non-deliverable forwards: only the gain or loss is
exchanged
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Forwards
Contract terms specify:
forward exchange rate
term
amount
value date (the day the forward contract expires)
locations for payment and delivery.

The date on which the currency is actually exchanged, the
settlement date, is generally two days after the value
date of the contract.
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Forwards
Forward Exchange Rates: The Iron-Clad Law
Forward exchange rates are different from spot rates, but they are
not a prediction of what the spot rate will be when the deal settles!

The difference between the
forward exchange rate and the spot exchange rate
is the interest differential
between the two currencies
FX Forwards:
Uses
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Uses of FX Forwards
(1) Hedge foreign currency risk
(2) Arbitrage FX rate discrepancies within and
between markets
(3) Speculate on future market movements
(4) Profit by acting as market maker

Financial institutions, money managers,
corporations, and traders use these instruments
for managing currency risk
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Two Types of Hedging
Corporations engaged in international trade

Hedge payments and receipts denominated in foreign
currencies.
For example, a Croatian corporation that exports to Germany and
expects payment in Euro (EUR) could sell EUR forward to
eliminate the risk of a depreciation of the EUR at the time that the
payment arrives.

Hedge the translation of foreign earnings for presentation
in financial statements.

Example 1: Hedging
With an FX Forward
Hedged Item
Company must pay EUR 1,000,000
to a eurozone supplier in 3 months
Spot rate HRK/EUR: 7.3000.
Treasurer believes HRK will
depreciate during next 3 months

Exposure to FX risk:
What will be exchange rate
HRK/EUR in three months??
Hedging Instrument
Bank buys 1,000,000 EUR
forward at forward rate of 7.3750

FX risk: Company is
protected against large
adverse FX rate movements
I f FX rate is unfavorable in 3
months (ie, >7.3750),
Company pays just 7.3750
Example 1: Hedging
With an FX Forward
Hedged Item
Company must pay EUR 1,000,000 to
a eurozone supplier in 3 months
Spot rate HRK/EUR: 7.3000.
Treasurer believes HRK will
depreciate during next 3 months

Advantages of Hedge:
Company knows its costs and can
plan its finances accordingly
Cost of the hedge is zero --
No money is exchanged at
inception of the forward FX
agreement

Hedging Instrument
Bank buys 1,000,000 EUR forward at
forward rate of 7.3750

Disadvantage of Hedge:
Company is still exposed to FX risk
if the HRK/EUR spot rate is less
than 7.3750 in 3 months

Effect of hedge is same as
buying EUR today and
holding in an interest-bearing
account
(Forward FX agreement is
NOT a simple speculation)
Example 1: Hedging
With an FX Forward
Unhedged Company
If in 3 months, spot rate
is 7.4500

Unhedged Company
must pay:
7.45 x 1,000,000 =
HRK 7,450,000
Effect of Hedging
Hedged Company has
already bought EUR
forward

Hedged Company will pay:
7.375 x 1,000,000 = HRK
7,375,000
Money saved by
hedging: 7,450,000
7,375,000 =
HRK 75,000
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Example 2: Deriving the Forward
Exchange Rate
The spot rate HRK/EUR is 7.3000

A bank today sells a 3-month HRK/EUR
forward to a company for a forward
exchange rate of 7.3371

How did the bank compute the forward
rate?
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Exchange Rate
Three month interest rates are:

1% on the euro
3% on the kuna

A company with EUR 1 million and a need for HRK in three
months should be indifferent, financially speaking, as to whether
it:

Invests the EUR 1 million for 3 months at 1% and converts the
euros (plus interest) into HRK at the end of this time, or
Sells the EUR 1 million spot for HRK, and invests the HRK at 3%
for 3 months
Exchange Rate
Invest EUR 1 million at 1%
for 3 months (91 days)
Interest earned EUR
2,493.15
Value after 3 months
EUR 1,002,493
Sell EUR 1 million spot at 7.30
Buy HRK 7.3 million
Invest HRK for 3 months at 3%
Interest earned HRK
55,358.33
(7.3 million x 3% x 91/360)
Value after 6 months
HRK 7,355,358
OPTION 1 OPTION 2
Forward Exchange Rate: 7.3371
FX Forwards:
Problems and Risks
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Problems with FX Forwards
Finding counterparties who want to take
exactly the opposite position:
Most companies (potential counterparties) are
in the same boat (i.e., importers from the
eurozone)
One of the parties to the transaction might want
to trade a different amount, or have a different
settlement date
Transaction costs can be large (banks spread)
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Liquidity risk: A party in a forward
contract may find it difficult to exit the
position. Alternatives:
If counterparty agrees, cancel the forward for
a fee
Assign the contract to another party. This
requires some compensation
If an exact opposite position can be taken,
offset the obligation and suffer only the price
differential
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Default risk: There is an incentive for
the counterparty who lost on the
forward contract to default on the
agreement
Forwards are a zero sum game. Each
counterparty that gains is balanced by a
counterparty who loses the same amount.
FX Forwards:
Accounting
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Accounting for FX Forwards
IAS 39 applies (Accounting for
Financial Instruments derivatives
accounting)
The deal has no immediate value
Off-balance sheet accounts are used
initially to record the deal on the books
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Accounting for Forwards
Fair value of the forward changes over
time with movements in the foreign
exchange rate

Unrealized gain (loss) is measured by
applying todays market rates at the
forward date
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Example 3: Marking to Market
After one months time, the company has to
mark-to-market a 3-month forward which is
carried in the off-balance sheet accounts

On the date of the deal, the spot rate was 7.3000
The forward rate for the deal is 7.3371
The spot rate HRK/EUR is now 7.4150

What is the market value of the forward today?
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Example 3: Marking to Market
The company bought EUR against HRK in 90 days.
Today, the company could buy EUR 1,000,000 at the spot
rate of 7.4150 and pay HRK 7,415,000.
The company is committed to buy EUR 1,000,000 when
the forward matures at 7.3371 and pay only HRK
7,337,100.
Thus, the deal now has value.

Company records an unrealized GAIN of:
HRK 7,415,000 HRK 7,337,100 = HRK 77,900

FX Forwards:
Risk Management
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Risk Management
Before using any type of derivatives, companies
should:
Discuss the potential risks and benefits of derivatives
with Management Board and Supervisory Board
Develop appropriate internal controls and limits
Prepare derivatives policy and procedures manual; tax
and accounting manuals
Host training seminars for management and
employees
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Successful Risk Management
DONT WORRY, IT
MAY MELT
BEFORE WE GET
THERE!
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WE CAN
DECIDE WHAT
TO DO, IF AND
WHEN WE HIT
IT!
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WE NEVER
NEEDED TO USE
LIFE BOATS
BEFORE!!
Thank You.
Leslie Matthews ulenta
+385 98 355 258
Leslie.sulenta@consulting-
mps.com
www.consulting-mps.com

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Hedging Treasury Risk

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