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8 Money market hedging 12/08, 6/12, 6/13, 6/15

# 8 Money market hedging 12/08, 6/12, 6/13, 6/15

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Step 4

When the time comes to pay the company:
(a)
(b)

Pay the supplier out of the franc bank account.
Repay the sterling loan.

The effect is exactly the same as using a forward contract, and will usually cost almost exactly the same
amount. If the results from a money market hedge were very different from a forward hedge, speculators
could make money without taking a risk. Market forces therefore ensure that the two hedges produce very
similar results.
This transaction is called a money market hedge because the company is borrowing and investing in the
money markets to create the currency hedge.

4.8.2 Example: Money market hedge (1)
A UK company owes a Danish supplier Kr3,500,000 which is payable in three months' time. The spot
exchange rate is Kr7.5509 – Kr7.5548 per £1. The company can borrow in sterling for three months at
8.60% per annum and can deposit kroner for three months at 10% per annum. What is the cost in pounds
with a money market hedge and what effective forward rate would this represent?

Solution
The interest rates for three months are 2.15% (= 8.60%/4) to borrow in pounds and 2.5% (= 10%/4) to
deposit in kroner. The company needs to deposit enough kroner now so that the total including interest
will be Kr3,500,000 in three months' time. This means depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634.
These kroner will cost £452,215 (spot rate Kr7.5509 = £1). The company must borrow this amount and,
with three months' interest at 2.15%, will have to repay:
£452,215  (1 + 0.0215) = £461,938.
Thus, in three months, the Danish supplier will be paid out of the Danish bank account and the company
will effectively be paying £461,938 to satisfy this debt. The effective forward rate which the company has
'manufactured' is 3,500,000/461,938 = Kr7.5768 = £1. This effective forward rate shows the krone at a
discount to sterling because the krone interest rate is higher than the sterling rate.

£
Now:

Borrow
£452,215

Convert
7.5509

Interest
paid: 2.15%

Kr
Deposit
Kr3,414,634

Interest
earned: 2.5%

3 months' time:

£461,938
The foreign currency asset hedges the foreign currency liability.

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19: Foreign currency risk  Part G Risk management

Kr3,500,000

4.8.3 Setting up a money market hedge for a foreign currency receipt
A similar technique can be used to cover a foreign currency receipt from a trade receivable. To
manufacture a forward exchange rate, follow the steps below.

Step 1
Step 2
Step 3
Step 4

Borrow an appropriate amount in the foreign currency today.
Convert it immediately to home currency at the spot rate.
Place this on deposit in the home currency.
When the receivable's cash is received:
(a)
Repay the foreign currency loan.
(b)
Take the cash from the home currency deposit account.

4.8.4 Example: Money market hedge (2)
A UK company is owed SFr 2,500,000, receivable in 3 months' time from a Swiss company. The spot
exchange rate is SFr1.4498 – SFr1.4510 per £1. The company can deposit in sterling for 3 months at
8.00% per annum and can borrow Swiss francs for 3 months at 7.00% per annum. What is the receipt in
sterling with a money market hedge and what effective forward rate would this represent?

Solution
The interest rates for 3 months are 2.00% to deposit in sterling and 1.75% to borrow in Swiss francs. The
company should borrow SFr2,500,000/1.0175 = SFr 2,457,002 today. After 3 months, SFr 2,500,000 will
be repayable, including interest.
These Swiss francs will be converted to £ at 2,457,002/1.4510 = £1,693,316. The company must deposit
this amount for 3 months, when it will have increased in value with interest (2% for the three months) to:
£1,693,316 × 1.02 = £1,727,182
Thus, in 3 months, the loan will be repaid out of the proceeds from the trade receivable and the company
will receive £1,727,182. The effective forward rate which the company has 'manufactured' is
2,500,000/1,727,182 = SFr1.4474 = £1. This effective forward rate shows the Swiss franc at a premium to
the pound because the Swiss franc interest rate is lower than the sterling rate.
SFr
£
Now:

Borrow
SFr 2,457,002

Interest
paid: 1.75%

3 months' time:

SFr
2,500,000

Convert
2.2510

Deposit
£1,091,516

Interest
earned: 2.0%

£1,113,346

4.9 Choosing between a forward contract and a money market hedge
FAST FORWARD

The choice between a forward contract and a money market hedge is generally made on the basis of which
method is cheaper, with other factors being of limited significance.

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389

4.9.1 Choosing the hedging method
When a company expects to receive or pay a sum of foreign currency in the next few months, it can
choose between using the forward exchange market and the money market to hedge against the foreign
exchange risk. Other methods may also be possible, such as making lead payments. The cheapest
method available is the one that ought to be chosen.
Often, the costs of using a forward contract and money market hedge are very similar. In such cases,
transaction costs must be considered.

4.9.2 Example: Choosing the cheapest method
Trumpton plc has bought goods from a US supplier, and must pay \$4,000,000 for them in three months'
time. The company's finance director wishes to hedge against the foreign exchange risk, and the three
methods which the company usually considers are:

Using forward exchange contracts
Using money market borrowing or lending

The following annual interest rates and exchange rates are currently available.

1 month
3 months

US dollar
Deposit rate
Borrowing rate
%
%
7
10.25
7
10.75

Spot
1 month forward
3 months forward

Deposit rate
%
10.75
11.00

Sterling
Borrowing rate
%
14.00
14.25

Exchange rate per £1
\$1.8625 – \$1.8635
\$1.8565 – \$1.8577
\$1.8445 – \$1.8460

Which is the cheapest method for Trumpton plc? Ignore commission costs (the bank charges for
arranging a forward contract or a loan).

Solution
The three choices must be compared on a similar basis, which means working out the cost of each to
Trumpton either now or in three months' time. In the following paragraphs, the cost to Trumpton now will
be determined.

Choice 1: The forward exchange market
Trumpton must buy dollars in order to pay the US supplier. The exchange rate in a forward exchange
contract to buy \$4,000,000 in 3 months' time (bank sells) is \$1.8445 = £1.
The cost of the \$4,000,000 to Trumpton in 3 months' time will be:
\$4,000,000
= £2,168,609.38
1.8445
This is the cost in three months. To work out the cost now, we could say that by deferring payment for
three months, the company is:

Saving having to borrow money now at 14.25% a year to make the payment now; or
Avoiding the loss of interest on cash on deposit, earning 11% a year.

The choice depends on whether Trumpton plc (a) needs to borrow to make any current payment or (b) is
cash rich. Here, assumption (a) is selected, but (b) might in fact apply.

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19: Foreign currency risk  Part G Risk management

At an annual interest rate of 14.25% the rate for 3 months is 14.25/4 = 3.5625%. The 'present cost' of
£2,168,609.38 in 3 months' time is:
£2,168,609.38
= £2,094,010.26
1.035625

Choice 2: The money markets
Using the money markets involves:
(a)

Borrowing in the foreign currency, if the company will eventually receive the currency

(b)

Lending in the foreign currency, if the company will eventually pay the currency. Here, Trumpton
will pay \$4,000,000 and so it would lend US dollars.

It would lend enough US dollars for 3 months, so that the principal repaid in 3 months' time plus interest
will amount to the payment due of \$4,000,000.
(a)

Since the US dollar deposit rate is 7%, the rate for 3 months is approximately 7/4 = 1.75%.

(b)

To earn \$4,000,000 in 3 months' time at 1.75% interest, Trumpton would have to lend now:
\$4,000,000
 \$3,931,203.93
1.0175

These dollars would have to be purchased now at the spot rate of (bank sells) \$1.8625 = £1. The cost
would be:
\$3,931,203.93
 £2,110,713.52
1.8625
By lending US dollars for three months, Trumpton is matching eventual receipts and payments in US
dollars, and so has hedged against foreign exchange risk.

Lead payments should be considered when the currency of payment is expected to strengthen over time,
and is quoted forward at a premium on the foreign exchange market. Here, the cost of a lead payment
(paying \$4,000,000 now) would be \$4,000,000 ÷ 1.8625 = £2,147,651.01.
Summary

Forward exchange contract
Currency lending

Exam focus
point

£
2,094,010.26 (cheapest)
2,110,713.52
2,147,651.01

If the exam question includes payments and receipts in the same foreign currency at the same time, the
payments and receipts can be netted off against each other.

5 Foreign currency derivatives
FAST FORWARD

Foreign currency derivatives can be used to hedge foreign currency risk. Futures contracts, options and
swaps are types of derivative.

5.1 Currency futures
FAST FORWARD

Currency futures are standardised contracts for the sale or purchase at a set future date of a set quantity
of currency.

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391

Currency futures can be used to hedge currency risk in the same way as forward contracts. Futures are
exchange-traded instruments whereas forward contracts are over the counter transactions. Forward
contracts are used much more extensively than currency futures.

Key term

A currency future is a standardised, market-traded contract to buy or sell a specified quantity of foreign
currency.
The following table summarises the differences between currency futures and forward contracts.
Currency futures

Forward contracts

Standard contracts

Bespoke contracts

Traded on the open market (futures exchange)

Contract price in US dollars

Contract price in any currency offered by the bank

Flexible close out dates

Fixed date of settlement

Underlying transactions take place at the spot rate;
the difference between the spot rate and futures
rate is settled between two parties

Underlying transactions take place at the forward
rate

Cheaper than forwards

A futures market is an exchange-traded market for the purchase or sale of a standard quantity of an
underlying item, such as currencies, commodities or shares, for settlement at a future date and at an
agreed price.

The contract size is the fixed minimum quantity of commodity which can be bought or sold using a
futures contract. In general, dealing on futures markets must be in a whole number of contracts.
The contract price is the price at which the futures contract can be bought or sold. For all currency futures
the contract price is in US dollars. The contract price is the figure which is traded on the futures exchange.
It changes continuously and is the basis for computing gains or losses.
The settlement date (or delivery date, or expiry date) is the date when trading on a particular futures
contract stops and all accounts are settled. On the International Monetary Market (IMM), the settlement
dates for all currency futures are at the end of March, June, September and December.
A future's price may be different from the spot price, and this difference is the basis.
Basis = Spot price – Futures price

One tick is the smallest measured movement in the contract price. For currency futures this is a
movement in the fourth decimal place.
Market traders will compute gains or losses on their futures positions by reference to the number of ticks
by which the contract price has moved.

5.1.1 Example: Futures contract
Exam focus
point

You will not be expected to do futures calculations in the exam but the following example will help you to
understand how they work.
A US company buys goods worth €720,000 from a German company payable in 30 days. The US
company wants to hedge against the € strengthening against the dollar.
Current spot is \$0.9215 – \$0.9221 per €1 and the € futures rate is \$0.9245 per €1.
The standard size of a three-month € futures contract is €125,000.
In 30 days' time the spot is \$0.9345 – \$0.9351 per €1.
Closing futures price will be \$0.9367 per €1.
Evaluate the hedge.

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19: Foreign currency risk  Part G Risk management

Solution

Step 1

Setup

(a)

Which contract?

We assume that the three month contract is the best available.
(b)

Type of contract

We need to buy € or sell \$.
As the futures contract is in €, we need to buy futures.
(c)

Number of contracts

720,000
= 5.76, say 6 contracts
125,000
(d)

Tick size

Minimum price movement  contract size = 0.0001  125,000 = \$12.50

Step 2

Closing futures price

We're told it will be 0.9367.

Step 3

Hedge outcome

(a)

Outcome in futures market

Opening futures price
Closing futures price
Movement in ticks
Futures profit/loss
(b)

0.9245
0.9367
122 ticks
122  \$12.50  6 contracts = \$9,150

Net outcome

Spot market payment (720,000  0.9351 \$/£)
Futures market profit

Sell at high price
Profit

\$
673,272
(9,150)
664,122

(a)

Transaction costs should be lower than other hedging methods.

(b)

Futures are tradeable and can be bought and sold on a secondary market so there is pricing
transparency, unlike forward contracts where prices are set by financial institutions.

(c)

The exact date of receipt or payment of the currency does not have to be known, because the
futures contract does not have to be closed out until the actual cash receipt or payment is made.

(a)

The contracts cannot be tailored to the user's exact requirements.

(b)

Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis
risk (the risk that the futures contract price may move by a different amount from the price of the
underlying currency or commodity).

(c)

Only a limited number of currencies are the subject of futures contracts (although the number of
currencies is growing, especially with the rapid development of Asian economies).

(d)

Unlike options (see below), they do not allow a company to take advantage of favourable currency
movements.

Part G Risk management  19: Foreign currency risk

393

5.2 Currency options
FAST FORWARD

Key term

Currency options protect against adverse exchange rate movements while allowing the investor to take
advantage of favourable exchange rate movements. They are particularly useful in situations where the
cash flow is not certain to occur (eg when tendering for overseas contracts).

A currency option is a right of an option holder to buy (call) or sell (put) a quantity of one currency in
exchange for another, at a specific exchange rate (the exercise rate, exercise price or strike price) on or
before a future expiry date. If a buyer exercises the option, the option seller must sell or buy at this rate.
If an option is not exercised, it lapses at the expiry date.
The exercise price for the option may be the same as the current spot rate, or it may be more favourable
or less favourable to the option holder than the current spot rate.
Companies can choose whether to buy:
(a)

A tailor-made currency option from a bank, suited to the company's specific needs. These are over
the counter (OTC) or negotiated options; or

(b)

A standard option, in certain currencies only, from an options exchange. Such options are traded

Because of the flexibility offered by currency options – the holder can exercise the option at any point, or
choose to sell the option – it allows the holder to enjoy the upside without a risk of suffering the downside.
is a cost of using an option. It is the most the buyer of the option can lose by hedging an exposure to
currency risk with an option: this maximum loss occurs if the option is not exercised, but is allowed to
lapse.

5.2.1 Example: Currency options
Currency options will be exercised by the option holder only if the exercise rate in the option is more
favourable than the spot rate at the exercise date for the option.
For example, a company may buy a currency call option, giving it the right to buy US\$6,000,000 in 2
months' time in exchange for sterling at an exercise rate of \$1.5000. Buying the dollars at this rate would
cost £4,000,000.
(a)

If the spot exchange rate at the exercise date is \$1.60, the option holder will let the option lapse
and will buy the dollars at the spot rate for £3,750,000.

(b)

If the spot exchange rate at the exercise date is \$1.40, the option holder will exercise the option
and will buy the dollars at the exercise rate of \$1.50. (Buying at the spot rate would cost
£4,285,714.)

Similarly, a company may buy a currency put option, giving it the right to sell US\$2,800,000 in 2 months'
time in exchange for sterling at an exercise rate of \$1.4000. The dollars could be sold at this rate for
£2,000,000.
(a)

If the spot exchange rate at the exercise date is \$1.35, the option holder will let the option lapse
and will sell the dollars at the spot rate for £2,074,074.

(b)

If the spot exchange rate at the exercise date is \$1.45, the option holder will exercise the option
and will sell the dollars at the exercise rate of \$1.40. (Selling at the spot rate would earn
£1,931,034.)

5.2.2 The purposes of currency options
The purpose of currency options is to reduce or eliminate exposure to currency risks, and they are
particularly useful for companies in the following situations.

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19: Foreign currency risk  Part G Risk management

(a)

Where there is uncertainty about foreign currency receipts or payments, either in timing or
amount. Should the foreign exchange transaction not materialise, the option can be sold on the
market (if it has any value) or exercised if this would make a profit.

(b)

To support the tender for an overseas contract by a company, priced in a foreign currency. The
option would be to sell the currency earned from the contract. If the company does not win the
contract, it can let the option lapse (or make a profit on a favourable movement in the spot rate). In
this situation, an option would be preferable to a binding forward contract, because it does not
know whether or not it will need to sell any currency.

(c)

To allow the publication of price lists for its goods in a foreign currency. A company can arrange
a number of currency options to sell a quantity of the foreign currency in exchange for its domestic
currency, covering the time period for which the price list remains valid.

In both situations (b) and (c), the company would not know whether it had won any export sales or would
have any foreign currency income at the time that it announces its selling prices. It cannot make a forward
exchange contract to sell foreign currency without becoming exposed in the currency.

5.2.3 Drawbacks of currency options

They have a cost (the 'option premium'). The cost depends on the expected volatility of the
exchange rate, the choice of exercise rate and the length of time to the expiry date for the
option.
Options must be paid for as soon as they are bought.
Tailor-made options (arranged over the counter with a bank) lack negotiability.
Traded options are not available in every currency.

5.3 Currency swaps
FAST FORWARD

Currency swaps effectively involve the exchange of debt from one currency to another.

Currency swaps can provide a hedge against exchange rate movements for longer periods than the
forward market, and can be a means of obtaining finance from new countries.

Key term

A swap is a formal agreement whereby two organisations contractually agree to exchange payments on
different terms, eg in different currencies, or one at a fixed rate and the other at a floating rate.
In a currency swap, the parties agree to swap equivalent amounts of currency for a period. This effectively
involves the exchange of debt from one currency to another. Liability on the main debt (the principal) is
not transferred and the parties are liable to counterparty risk: if the other party defaults on the agreement
to pay interest, the original borrower remains liable to the lender.
Consider a UK company X with a subsidiary Y in France which owns vineyards. Assume a spot rate of £1 =
1.6 euros. Suppose the parent company X wishes to raise a loan of 1.6 million euros for the purpose of
buying another French wine company. At the same time, the French subsidiary Y wishes to raise £1 million
to pay for new up to date capital equipment imported from the UK. The UK parent company X could
borrow the £1 million sterling and the French subsidiary Y could borrow the 1.6 million euros, each
effectively borrowing on the other's behalf. They would then swap currencies.

5.3.1 Benefits of currency swaps
(a)

Swaps are easy to arrange and are flexible since they can be arranged in any size.

(b)

Transaction costs are low, only amounting to legal fees, since there is no commission or premium
to be paid.

(c)

The parties can obtain the currency they require without subjecting themselves to the
uncertainties of the spot foreign exchange markets.

Part G Risk management  19: Foreign currency risk

395

(d)

The company can gain access to debt finance in another country and currency where it is little
known, and consequently has a poorer credit rating, than in its home country. It can therefore take
advantage of lower interest rates than it could obtain if it arranged the currency loan itself.

(e)

Currency swaps may be used to restructure the currency base of the company's liabilities. This
may be important where the company is trading overseas and receiving revenues in foreign
currencies, but its borrowings are denominated in the currency of its home country. Currency
swaps therefore provide a means of reducing exchange rate exposure.

(f)

A currency swap could be used to absorb excess liquidity in one currency which is not needed
immediately in order to create funds in another where there is a need.

In practice, most currency swaps are conducted between banks and their customers. An agreement
should only be necessary if the swap were for longer than, say, one year. For shorter periods, a forward
exchange contract should be arranged if a currency hedge is required.

5.3.2 Example: Currency swap

Step 1

Edted, a UK company, wishes to invest in Germany. It borrows £20 million from its bank
and pays interest at 5%. To invest in Germany, the £20 million will be converted into euros
at a spot rate of £1 = €1.50. The earnings from the German investment will be in euros, but
Edted will have to pay interest on the swap. The company arranges to swap the £20 million
for €30 million with Gordonbear, a company in the euro currency zone. Gordonbear is thus
the counterparty in this transaction. Interest of 6% is payable on the €30 million. Edted can
use the €30 million it receives to invest in Germany.

Step 2

Each year when interest is due:

Step 3

396

(a)

Edted receives from its German investment cash remittances of €1.8 million (€30
million × 6%).

(b)

Edted passes this €1.8 million to Gordonbear so that Gordonbear can settle its
interest liability.

(c)

Gordonbear passes to Edted £1 million (£20 million × 5%).

(d)

Edted settles its interest liability of £1 million with its lender.

At the end of the useful life of the investment the original payments are reversed with Edted
paying back the €30 million it originally received and receiving back from Gordonbear the
£20 million. Edted uses this £20 million to repay the loan it originally received from its UK
lender.

19: Foreign currency risk  Part G Risk management

Chapter Roundup

Currency risk is the risk of changes in an exchange rate or in the foreign exchange value of a currency. It
is a two-way risk.

Currency risk occurs in three forms: transaction exposure (short-term), economic exposure (effect on
present value of longer-term cash flows) and translation exposure (book gains or losses).

Factors influencing the exchange rate include the comparative rates of inflation in different countries
(purchasing power parity), comparative interest rates in different countries (interest rate parity), the
underlying balance of payments, speculation and government policy on managing or fixing exchange rates.

Foreign currency risk can be managed, in order to reduce or eliminate the risk. Measures to reduce
currency risk are known as 'hedging'.
Basic methods of hedging risk include matching receipts and payments, invoicing in own currency, and
leading and lagging the times that cash is received and paid. Other common hedging methods are the
use of forward exchange contracts and money market hedging.

A forward exchange contract is a contract made now for the purchase or sale of a quantity of currency in
exchange for another currency, for settlement at a future date, and at a rate of exchange that is fixed in the
contract.
A forward contract therefore fixes in advance the rate at which a specified quantity of currency will be
bought and sold.

Money market hedging involves borrowing in one currency, converting the money borrowed into another
currency and putting the money on deposit until the time the transaction is completed, hoping to take
advantage of favourable exchange rate movements.

The choice between a forward contract and a money market hedge is generally made on the basis of which
method is cheaper, with other factors being of limited significance.

Foreign currency derivatives can be used to hedge foreign currency risk. Futures contracts, options and
swaps are types of derivative.

Currency futures are standardised contracts for the sale or purchase at a set future date of a set quantity
of currency.

Currency options protect against adverse exchange rate movements while allowing the investor to take
advantage of favourable exchange rate movements. They are particularly useful in situations where the
cash flow is not certain to occur (eg when tendering for overseas contracts).

Currency swaps effectively involve the exchange of debt from one currency to another.

Currency swaps can provide a hedge against exchange rate movements for longer periods than the
forward market, and can be a means of obtaining finance from new countries.

Part G Risk management  19: Foreign currency risk

397

Quick Quiz
1

Identify the three types of currency risk.

2

Define a 'forward exchange rate'.

3

The principle of purchasing power parity must always hold.
True
False

4

398

Fill in the blanks.
(a)

Forward rate higher than spot rate is quoted at a ______________________

(b)

Forward rate lower than spot rate is quoted at a ______________________

5

Name three methods of foreign currency risk management.

6

Name three types of foreign currency derivative used to hedge foreign currency risk.

19: Foreign currency risk  Part G Risk management