Using Forward Exchange Markets

and Money Market Hedging

International Finance Management

Team 4: Sneha & Sonja
09-09-10
 Forward Contract
Contract agreement

Derivative

Forward Future Options Swap

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 The Forward Contract
• Negotiated agreement between two parties
on:
– A particular good
– At a set price
– At a future date (unknown)
• Forward rate
• Spot rate

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 The Forward Contract

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 Forward exchange market
• Market for contracts
• Ensure the future delivery of
– a foreign currency
– at a specified exchange rate
• Forward contracts can be used to
– hedge or cover exposure to foreign exchange risk

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 Money market
• Component of the financial markets for assets
involved in short-term borrowing and lending
with original maturities of one year or shorter
time frames
• Treasury bills, commercial papers, banker´s
acceptances, certificates of deposit, federal
funds, and short-lived mortgage and asset-
backed securities

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 Forward Exchange Contract

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 What are the pros and cons?

Pros Cons

If your buyer doesn’t pay you on time

Allows you to manage the risk of
exchange rate movements between the
currency of your export contract
payments and Australian dollars
under your export contract, your bank
will still expect you to fulfil the forward
exchange contract by exchanging the
amount of the export contract payment
for Australian dollars on the agreed date

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 Money Market Hedging
• Internal hedging technique
• Borrowing and lending in multiple currencies
• Eliminate currency risk by locking in the value
of a foreign currency transaction in one's own
country's currency.

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 Example
• UK company with a 1 year receivable of $1,000,000. If the Spot FX rate is 2.000
and US interest rates were 4% and UK interest rates were 5%. The company
would borrow $1,000,000 discounted by 4% ($1,000,000/1.04) = $961,538.46,
then convert it into Sterling at 2.000 = £480,769.23. The Sterling would then be
placed on deposit at 5% (£480,769.23*1.05 = £504,807.69). In one year's time
the company receives the expected $1,000,000 and repays the $ loan in full.
Therefore the company has hedged the foreign exposure and has enjoyed the
Sterling equivalent for the full period. The calculation for the effective Foreign
Exchange Forward Outright is $1,000,000/£504,807.69 = 1.98.
• Forward Outright formula - [Spot-(((1+ih)/(1+if)-1)*Spot)] or [2-(((1.05)/(1.04))-
1)*2]
• Spot=Current FX rate
• ih=Interest in Home country
• if=Interest in foreign country

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 Non-transferability and Reversal of Forward
Contracts
• Exchange rate is locked in
• Informal arrangement
• Final settlement at delivery
• Not transferable and not reversible

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 What is Hedging??
• Hedging refers to managing risk to an extent
that makes it bearable.

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 Forex Hedging strategy
• Analyze risk:
 Trader must identify what the implications
could be of taking on the risk un-hedged, and
determine whether the risk is high or low in
the current forex currency market.

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 Determine risk tolerance:

• The trader uses their own risk tolerance levels,

to determine how much of the position's risk
needs to be hedged.
• No trade will ever have zero risk
• It is up to the trader to determine the level of
risk they are willing to take, and how much
they are willing to pay to remove the excess
risks.

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• Determine forex hedging strategy:
If using foreign currency options to hedge the
risk of the currency trade, the trader must
determine which strategy is the most cost
effective.
• Implement and monitor the strategy:
By making sure that the strategy works the
way it should, risk will stay minimized.

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 Forwards in Hedging
• Forward contracts can also be used to hedge
currency risk.
• Forward contracts are superior to futures in
terms of their overall risk reduction, there is no
central market for forward contracts, which
contributes to higher transaction costs and
lower liquidity, as well as counterparty risk (i.e.
the risk that the contract will not be honoured
at expiration).
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 Example:
Assume that a Malaysian construction company, Bumiways just won a
contract to build a stretch of road in India. The contract is signed for
10,000,000 Rupees and would be paid for after the completion of the
work. This amount is consistent with Bumiways minimum revenue of
RM1,000,000 at the exchange rate of RM0.10 per Rupee. However, since
the exchange rate could fluctuate and end with a possible depreciation of
Rupees, Bumiways enters into a forward agreement with First State Bank
of India to fix the exchange rate at RM0.10 per Rupee. The forward
contract is a legal agreement, and therefore constitutes an obligation on
both sides.
By entering into a forward contract Bumiways is guaranteed of an
exchange rate of RM0.10 per Rupee in the future irrespective of what
happens to the spot Rupee exchange rate. If Rupee were to actually
depreciate, Bumiways would be protected. However, if it were to
appreciate, then Bumiways would have to forego this favourable
movement and hence bear some implied losses. Even though this
favourable movement is still a potential loss, Bumiways proceeds with the
hedging since it knows an exchange rate of RM0.10 per Rupee is
consistent with a profitable venture.
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 Speculation
• Speculating is the assumption of risk in anticipation of gain
but recognizing a higher than average possibility of loss
• The term speculation implies that a business or investment
risk can be analyzed and measured, and its distinction from
the term Investment is one of degree of risk.
• Speculation can also cause prices to deviate from their
intrinsic value if speculators trade on misinformation, or if
they are just plain wrong. This creates a positive feedback 
loop in which prices rise dramatically above the underlying
value or worth of the items.

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• Speculation is no gambling because here the investors invest
through informed decisions and the outcomes are not
random in nature. Speculators generally rely on the technical
analysis.
• Speculation supplies the necessary liquidity to the Stock
market. Now a days, it is not a purely risky venture after the
invention of many sophisticated investment tools (such as
futures, options, short selling, stop loss orders, etc.), which
help the speculators to hedge the risk.

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 How Speculation Yields Returns

• A bubble is a phenomenon during which the

value of an investment (such as real estate,
stock, foreign exchange and petroleum
futures) rises substantially. Most of the
investments are overpriced in such a scenario,
yielding high returns.

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 Speculation: Dangers

• A speculative buying spree, devoid of analytical

calculation, aggravates the element of risk. Any
downturn in prices can cause panic and excessive
selling, resulting in a dramatic plummeting of prices
and eventually a market crash. The stock market
crisis of 2008 can be attributed to consecutive
periods of speculative buying, followed by panic and
speculative selling.

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 How Speculation Helps the Market

• Speculation can be a blessing for the economy. This is because

speculators inject capital in the market, thereby increasing
liquidity. Speculative investments also minimize the risk for
arbitrageurs and hedgers.

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 Forwards in Arbitrage
• Forex arbitrage takes advantage of the difference in the prices of
currencies by striking deals that capitalize on this imbalance. The
profit is the difference between the currency prices. Traders who
practice this process are called forex arbitrageurs.
• Forex arbitrage allows forex traders to make profits from the
opportunities arising from inefficiencies in pricing the currencies.
The faster a trader acts, the more he gains till the pricing
inefficiency is corrected. Forex arbitrage is practiced by purchasing
and selling two or more currencies that have pricing inefficiencies.
• To execute the forex arbitrage strategy, a trader needs to have the:
1) real-time quotes of currencies
2) ability to make decisions quickly  

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 Forex Arbitrage: How it Works  

• The two-currency arbitrage is the most popular form of forex

arbitrage. It involves trading in two currencies, with two different
brokers offering different spreads. One of the prices in the spread (bid
price or ask price) would be different, while the other is the same.
•  A forex arbitrage move involving more than two currencies would
require the trader to have an in-depth knowledge of the currencies
involved and the exchange rates. If the exchange rate of a currency,
when compared to that of other currencies,
1)follows a set ratio or
2)shows definite fluctuation
3)it creates opportunities for profitable forex arbitrage.
 

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 Forex Arbitrage: Dangers 

Forex arbitrage is one of the safest strategies followed by

traders on the forex market. Also, it can help earn large profits
within a short span of time. However, one should be careful
while practicing this strategy:
• Traders can exploit a trend taking place between two currency
pairs. They need to be cautious as once the pricing loopholes
are fixed, the traders may find themselves on the losing side.
• While the forex arbitrage strategy yields high returns, it does
that at a cost. To be on the safe side, one should keep forex
arbitrage as a part of the trading strategy and diversify.

 
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 Long Dated Forwards
• A type of forward contract commonly used in foreign currency
transactions. Long dated forward refers to contracts
that typically involve positions that have settlement
dates longer than a year away. Long dated forward contracts
are sometimes used by companies to hedge certain currency
exposures.

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