Hedging

1
Hedging Speculation

• HEDGING refers to the avoidance of foreign
  exchange risk, or the covering of an open
  position.
• Consider the importer in the previous example
  could borrow 100,000 at the present spot rate
  SR2/1 and leave this sum on a deposit in a
  bank to earn interest for three months.
  Therefore, he could avoid the risk that the SR in
  three months will be higher than todays SR and
  that he would have to pay more than 200,000 for
  his imports. Cost of insuring against the foreign
  exchange risk is the positive difference between
  borrowing rate (interest paid on loan) and
  deposit interest rate (low interest rate earns on
  deposit).
• What the exporter could do? Borrow 100,000
  exchange for 200,000 at todays SR and deposit
  in a bank to earn interest. After 3 months
  payback the loan with 100,000 he receives.

2

• Disadvantage of covering foreign exchange risk in
  Spot Market
• Must borrow or tie up own funds for three
  months. To avoid this, hedging usually takes
  place in the forward market no borrowing or
  tying up of own funds required.
• Importer could buy for delivery and payment in
  three months at todays three-month forward rate.
  If is at 3 month FP of 4 per year, he will
  have to pay 202,000 in three months for the
  100,000 needs to pay for imports. Hedging cost
  is 2,000, 1 of 200,000 for 3 months.
• Exporter could sell forward for delivery and
  payment in three months at todays three-month
  forward rate, anticipating receipt of 100,000
  for exports. No transfer of funds necessary/
  takes place until three months have passed. If
  is at 3 month FD of 4 or FP of 4, what would
  happen?

3

• A foreign exchange risk can be hedge (an open
  position avoided) in futures or options markets.
• Example
• An importer knows it must pay 100,000 in three
  months and 3 month forward rate of FR2/1. He
  could either purchase 100,000 forward, pay
  200,000 in three months and receive 100,000
• OR
• Purchase an option to purchase 100,000 in three
  months, say at 2/1, and pay the premium say 1
  (2,000 on 200,000 option). If in 3 months SR of
  , SR1.95/1, importer would have to pay
  200,000 with the forward contract, but could let
  option expire and get 100,000 at the cost of
  only 195,000 on the spot market. 2,000 premium
  can be regarded as an insurance policy he will
  save 3,000 over the forward contract.

4

• In the presence of foreign exchange uncertainty,
  hedging facilitates international trade and
  investments. Without hedging, there would be
  smaller international capital flows, less trade
  and specialization in production, and smaller
  benefits from trade.
• Large multinational corporation (receive and make
  a large number of payments in the same foreign
  currencies at the same time in the future) need
  only hedge its net open position.
• A bank has an open position only for its net
  balance on contracted future payments and
  receipts in each foreign currency at each future
  date. The bank closes as much of its open
  positions as possible by dealing with other
  banks, through foreign exchange brokers.

5

• SPECULATION opposite of hedging. A hedger seeks
  to cover a foreign exchange risk. A speculator
  accepts and even seeks out a foreign exchange
  risk (an open position) to make a profit. If he
  correctly anticipates future changes in SR, he
  makes a profit. Speculation can also take place
  spot, forward, futures, and option markets.
• If a speculator believes that SR of a foreign
  currency will rise, he could purchase the
  currency now and hold it in on deposit in a bank
  for resale later. If he is correct, he earns a
  profit on each unit of foreign currency equal to
  the spread between buying rate and selling rate.
  If he is wrong, he incurs a loss.
• If a speculator believes that SR will fall,
  borrows the foreign currency for three months,
  immediately exchange for domestic currency at
  prevailing SR, deposits in a bank to earn
  interest. After three months, if SR is lower as
  anticipated, he earns a profit by purchasing
  currency to repay his foreign exchange loan and
  earns a profit.
• What, if he is wrong?

6

• These examples, the speculators operated in the
  Spot market. To avoid shortcoming when operating
  in Spot market, Speculation usually take place in
  the forward market.
• If a speculator believes that the SR of a
  foreign currency will be higher in 3 months than
  its present 3 month forward rate, he purchases a
  specified amount of that currency forward for
  future delivery and payment in 3 months. After 3
  months if he is correct, he receives foreign
  currency at lower agreed rate and immediately
  resells it at the higher SR.

7

• What would happened if three-month forward rate
  on is FR2.02/1 and the speculator believes
  that the SR in 3 months will be SR1.98/1?
• Alternatively, if he believes that the will
  depreciate could have purchased an option to sell
  in 3 months at 2.02/1. If he is correct and
  SR in 3 months is SR1.98/1 as anticipated, he
  will exercise his option, buy in spot market
  and receive 2.02/1 by exercising option.
• What is the different between forward contract
  and option in the above case? Option price
  (premium) may exceed the commission on forward
  contract, net profit with the option may be a
  little less. If he is wrong, he will let his
  option contract expire unexercised and incur the
  cost of premium or option price. With forward
  contract, he would have to honour his commitment
  and incur a much larger loss.

8
Speculation can be stabilizing or destabilizing

• Stabilizing speculation refers to the purchase of
  a foreign currency when domestic price of the
  foreign currency falls or is low, in the
  expectation that it will rise soon, thus leading
  to a profit, or sale of foreign currency when the
  exchange rate rises or is high, in the
  expectation that will fall soon.
• Destabilizing speculation refers to the sale of a
  foreign currency when the exchange rate falls or
  is low, in the expectation that it will fall even
  lower in the future, or the purchase of a foreign
  currency when the exchange rate is rising or is
  high, in the expectation that it will rise even
  higher in the futures.
• Stabilizing speculation moderates fluctuations,
  whereas Destabilizing speculation magnifies
  fluctuations and can prove very disruptive

9

• When a speculator buys a foreign exchange (spot,
  forward, futures or option) in the expectation of
  reselling at a higher future SR, he is taking a
  long position.
• When he borrows or sells forward a foreign
  currency in the expectation of buying it at a
  future lower price to repay his foreign exchange
  loan or honour his forward sale contract or
  option, he is said to take a short position.

10
Interest rate and exchange rate

• Interest Arbitrage international flow of
  short-term liquid capital to earn higher returns
  abroad. It can be covered or uncovered.
• Uncovered Interest Arbitrage Transfer of funds
  abroad to take advantage of higher interest rates
  in foreign monetary centres involves the
  conversion of domestic currency to make the
  investment. And, then subsequent re-conversion of
  the funds plus interest earned from foreign
  currency to the domestic currency at the time of
  maturity.
• This may involve a foreign exchange risk due to
  the possible depreciation of the foreign currency
  during the period of the investment. If such
  foreign exchange risk is covered, we have covered
  interest arbitrage.

11

• e.g. interest rate on 3-month treasury bills is
  10 p.a. in New York and 14 in London. US
  investor can earn 1 extra interest for 3 months
  by exchanging for at the current SR and
  purchase British treasury bills. At the maturity,
  US investor may want to exchange he invested
  plus interest he earned back into . By that date
  may have depreciated, so he would get back
  fewer per than he paid. If depreciates by ½
  of 1 during 3 months of his investment, US
  investor nets only about ½ of 1 from his
  investment (extra 1 interest he earns minus ½ of
  1 losses from depreciation). If depreciates by
  1 during 3 months, he gets nothing, and if
  depreciates by more than 1, US investor losses.
  If appreciates, he gains both from the extra
  interest he earns and from the appreciation of .

12

• Covered Interest Arbitrage As investors of
  short-term funds overseas generally want to avoid
  foreign exchange risk, interest arbitrage is
  usually covered.
• When investor exchanges the domestic currency for
  the foreign currency at the current SR in order
  to purchase the foreign treasury bills, at the
  same time he sells forward the amount of foreign
  currency he is investing plus the interest he
  will earn to coincide with the maturity of his
  foreign investment. Therefore, CIA refers to the
  spot purchase of foreign currency to make the
  investment and the offsetting simultaneous
  forward sale (swap) of foreign currency to cover
  the foreign exchange risk.

13

• Currency with higher interest is usually at a
  forward discount, the net return on the
  investment is roughly equal to the positive
  interest differential earned overseas minus the
  forward discount on the foreign currency.
• This reduction in earnings is the cost of
  insurance against the foreign exchange risk.
• e.g. Using previous example, suppose is at a
  three-month forward discount of 1 p.a. To engage
  in CIA, US must first exchange for at the
  current SR to purchase British bills, and at the
  same time sell forward initial investment plus
  interest earn at the prevailing forward rate. US
  investor losses ¼ of 1 on the foreign exchange
  transaction to cover his foreign exchange risk
  for 3 months. His net gain is extra 1 interest
  earns for the three months minus ¼ of 1 he
  losses on the foreign exchange transaction, or
  of .

14

• With covered interest arbitrage, the possibility
  of gains diminishes until it is completely wiped
  out.
• This happens for two reasons
• As funds are transferred from New York to London,
  interest rate rises in New York and falls in
  London. As a result, the positive interest
  differential in favour of London diminishes.
• Purchase of in spot market increases SR, and
  sale of in the forward market reduces the
  forward rate. Thus, forward discount on ( the
  positive difference between SR and FR) rises.
• With positive interest differential in favour of
  London diminishing and FD on rising, the net
  gain falls for both reason until it becomes zero.
  Then, is said to be at INTEREST PARITY the
  positive interest differential in favour of
  foreign monetary centre is equal to the equal to
  the forward discount on the foreign currency
  (expressed on per annum basis).

15

• In the real world, a net gain of at least ¼ per
  year is normally required to induce funds to move
  internationally under CIA.
• If is at a forward premium, the net gain will
  equal extra interest earned for 3 months plus FP
  on for 3 months. However, as CIA continues, the
  positive interest differential diminishes and so
  does the FP on until it becomes a FD and all of
  the gains are wiped-out. Therefore, SR and FR on
  a currency are closely related through CIA.
• In the real world significant CIA margins (CIAM)
  are often observed for long periods.
• Formula for CIAM
• K amount of capital, i domestic interest rate
  p.a., i foreign interest rate p.a. , SR spot
  rate and FR forward rate.