The use of financial derivatives to hedge against forex risk. The use of financial derivatives to hedge against forex risk hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure: vi) Currency options They protect against adverse movements in the actual exchange rate but allow favourable ones!

The use of financial derivatives to hedge against forex risk

Chapter 7 PPT Hedging of Foreign Exchange Risks

The use of financial derivatives to hedge against forex risk. This section compares and contrasts the use of derivatives — forwards, futures and options — and the gold dinar for hedging foreign exchange risk. It also argues why a gold dinar system is likely to introduce efficiency into the market while reducing the cost of hedging against foreign exchange risk.

The use of financial derivatives to hedge against forex risk


The speculative attacks on the ringgit for example, almost devastated the economy if not for the quick and bold counter actions taken by the Malaysian government, particularly in checking the offshore ringgit transactions.

It also made apparent the need for firms to manage foreign exchange risk. Many individuals, firms and businesses found themselves helpless in the wake of drastic exchange rate movements. Malaysia being among the most open countries in the world, in terms of international trade, was exposed to significant foreign exchange risk[1]. Foreign exchange risk refers to the uncertainties faced due to fluctuating exchange rates.

For example, a Malaysian trader who exports palm oil to India for future payments to be received in rupees, faces the risk of rupees depreciating against the ringgit at the time the payment is made. This is because if the rupee depreciates, a smaller amount of ringgit will be received when the rupees are exchanged into ringgit. Therefore, what originally seemed a profitable venture could turn out to be a loss due to exchange rate fluctuations. Such risks are common in international trade and finance.

A significant number of international investments, trades and dealings are shelved due to the unwillingness of parties concerned to bear foreign exchange risk. Hence it is important for businesses to manage this foreign exchange risk so that they may concentrate on what they are good at and eliminate or minimize a risk that is not their trade. Unfortunately, however, in the case of most developing nations including Malaysia, tools available for managing foreign exchange risk are minimal.

Traditionally, the forward rates, currency futures and options have been used for this purpose. The futures and options markets are also known as derivative markets. However, in many nations, including Malaysia, futures and options on currencies are not available. Even in countries where currency derivative markets exist, however, for example the Philadelphia Stock Exchange in the United States, not all derivatives on all currencies are traded.

Derivatives are available only on select major world currencies. While the existence of these markets assists in risk management, speculation and arbitrage also thrive in them. This section compares and contrasts the use of derivatives — forwards, futures and options — and the gold dinar for hedging foreign exchange risk. It also argues why a gold dinar system is likely to introduce efficiency into the market while reducing the cost of hedging against foreign exchange risk, compared with the derivatives.

Hedging refers to managing risk to an extent that it is bearable. In international trade and dealings foreign exchange plays an important role. Fluctuations in foreign exchange rates can have significant implications on business decisions and outcomes.

Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Historically, the foremost instrument used for managing exchange rate risk is the forward rate. Forward rates are custom agreements between two parties to fix the exchange rate for a future transaction.

This simple arrangement easily eliminates exchange rate risk, however, it has some shortcomings, particularly the difficulty in getting a counter party who would agree to fix the future rate for the amount and at the time period in question. In Malaysia many businesses are not even aware that some banks do provide forward rate arrangements as a service to their customers. By entering into a forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk.

Of course, the bank, in turn, may have to make some other arrangement to manage this risk. Forward contracts are somewhat less familiar, probably because no formal trading facility, building or even regulating body exists. Now is July and the contract signed for 10,, rupees, would be paid for in September. Nonetheless, fluctuating exchange rates could end with a possible depreciation of rupees and thus render the project unworthy.

The forward contract is a legal agreement and, therefore, constitutes obligations on both sides. The First Bank may have to find a counter party for this transaction — either a party that wants to hedge against an appreciation of 10,, rupees expiring at the same time or a party that wishes to speculate on an upward trend in rupees.

If the bank itself plays the counter party, then the risk would be borne by the bank. The existence of speculators increases the probability of finding a counter party. If the rupee were to actually depreciate, ABC would then be protected.

However, if it were to appreciate, then ABC would have to forego this favourable movement and hence bear some implied losses. The futures market came into existence as an answer for the shortcomings inherent in the forward market.

The futures market solves some of the shortcomings of the forward market, particularly the need and the difficulty in finding a counter party. A currency futures contract is an agreement between two parties to buy or sell a particular currency at a future date, at a particular exchange rate that is fixed or agreed upon upfront. 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 — i. Futures contracts are standardized contracts and thus are bought and sold just like shares in a stock market. When hedging with futures, if the risk is an appreciation in value, then one needs to buy futures, whereas if the risk is a depreciation then one needs to sell futures.

Consider our earlier example, instead of using forwards, ABC could have thus sold rupee futures to hedge against a rupee depreciation. Hence the size of the contract is RM1,, Now assume that the rupee depreciates to RM0. ABC would then close the futures contract by buying back the contract at this new rate. This gives a futures profit of RM, [ RM0.

With perfect hedging the cash flow would always be RM1 million no matter what happens to the exchange rate in the spot market. One advantage of using futures for hedging is that ABC can release itself from the futures obligation by buying back the contract anytime before the expiry of the contract.

To enter into a futures contract a trader, however, needs to pay a deposit called an initial margin first. Then his position will be tracked on a daily basis so much so that whenever his account makes a loss for the day, the trader will receive a margin call also known as variation margin , requiring him to pay up the losses. Unlike the forward contract, the futures contract has a number of features that have been standardized.

These standard features increase the liquidity in the market, i. In the practical world, traders are faced with diverse conditions that need diverse actions like the need to hedge different amounts of currency at different points of time in the future such that matching transactions can be difficult.

By standardizing the contract sizes i. Some of the standardized features include the expiry date, contract month, contract size, position limits i. Nevertheless, these standardized features introduce some hedging imperfections. In our earlier example, assuming the size of each rupee futures contract to be 2,,, then 5 contracts need to be sold for a contract size of 10,, rupees. However, if the size of each contract is 3,, for instance, then only 3 contracts can be sold, leaving 1,, rupees unhedged.

Therefore, with standardization, some part of the spot position can go unhedged. Some advantages and disadvantages of hedging using futures are summarized below:. The above shortcomings of the futures contract, particularly it being a legal obligation, with margin requirements and the need to forego favourable movements, prompted the development and establishment of the options markets that deal in more flexible instruments, i. A currency option may be defined as a contract between two parties — a buyer and a seller — whereby 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 an option enjoys a right but not an 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:. The seller of the option, of course, needs to be compensated for giving the right. The compensation is called the price or the premium of the option. The seller thus has an obligation in the event the right is exercised by the buyer. For example, assume that a trader buys a September RM0.

This means that the trader has the right to buy rupees for RM0. The trader pays a premium of RM0. If the rupee appreciates over RM0. If, however, the rupee were to depreciate below RM0. In this case, if he needs physical rupee, he may just buy it in the spot market at the new lower rate. In hedging using options, calls are used if the risk is an upward trend in price, while puts are used if the risk is a downward trend.

If rupees were to depreciate at the time ABC receives its rupee revenue, then ABC would exercise its right and thereby effectively obtain a higher exchange rate. If, however, rupees were to appreciate instead, ABC would then just let the contract expire and exchange its rupees in the spot market at the higher exchange rate. Therefore, the options market allows traders to enjoy unlimited favourable movements while limiting losses.

This feature is unique to options, unlike the forward or futures contracts where the trader has to forego favourable movements and there are also no limits to losses. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. When a firm bids for a project overseas, which involves foreign exchange risk, the options market allows it to quote its bid price and at the same time protect itself from the exchange rate fluctuations in the event the bid is won.

In the case of hedging with forwards or futures, the firm would be automatically placed in a speculative position in the event of an unsuccessful bid, without any limit to its downside losses.

Consider our ABC Corp. In this instance, ABC would face the exchange rate risk only upon winning the bid. Options fare better as a hedging tool here compared with forwards or futures due to the uncertainty in getting the contract. Assume that it is now July and the results of the bidding will be known only in September, and that the following September options quotes are available today:. Assume that the size of each rupee contract is 2,, rupees.

The following is how ABC could make its hedging strategy:. In September, ABC would have known the outcome of the bid and by then the spot rupee rate might have appreciated or depreciated. Table 5 shows the four outcomes possible and their cash flow implications. The above example illustrates how options can be used to guarantee a minimum cash flow on contingent claims. In the case the bid is won, a minimum cash flow of RM1,, is guaranteed while allowing one to still enjoy a favourable movement if that does take place.

If the bid is lost, the maximum loss possible is the premium paid. An example for hedging with the call option is when a firm bids to buy a property e.


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