Fall Semester 09-10 Akila Weerapana

Lecture 4: Hedging on the Foreign Exchange Market

I. INTRODUCTION
In the last lecture, we discussed the myriad reasons that attract buyers and sellers of foreign exchange to the f/x market. In the process, we discovered that one of the main reasons for trading on the foreign exchange market was for the purpose of hedging: protecting yourself against the downside of foreign currency uctuations. The spot market, where foreign currency can be acquired immediately, oers an easy protection because anyone who needs foreign currency for some future transaction can acquire that currency immediately. However, for a variety of reasons that we discuss in todays lecture, this may not be an attractive method of hedging, or even a viable method for some. Instead, people can turn to other types of markets - forward, futures or options - where they can agree on a price today at which the transaction can take place in the future. This provides them with more exibility (because the transaction does not need to take place right now) and remove uncertainty as well (since the price at which the transaction will occur in the future is agreed on now). In todays class, we will look at dierent methods of hedging and discuss the pros and cons of each approach. The bottom line is that dierent circumstances can dictate which method of hedging is best. Your task is to know the basic pros and cons of each approach so you can apply that knowledge to a particular scenario. Consider the following example. You are the owner of a specialty food store in the U.S. that wants to import 5,000,000 cans of mushy peas, each costing 1 from England. Payment of 5 million is due in 90 days. The current spot rate is 2 $/, but exchange rate uctuations could change the cost to the importer by the time the payment date rolls around: if the exchange rate changes from 2 $/ to 2.25 $/ the cost increases from $10 million to $11.25 million. if, on the other hand the exchange rate appreciates to say 1.8 $/ the cost decreases from $10 million to $9 million, as shown in the table below. Lets see how the outcomes from this unhedged approach dier from the various methods of hedging as we discuss them below. $ Depreciates ($2.25/pound) $11.25 million $ Appreciates ($1.8/pound) $9 million

Unhedged (Pay back after 90 days)

II. HEDGING ON THE SPOT MARKET

Consider the following example. You are the owner of a specialty food store in the U.S. that wants to import 5,000,000 cans of mushy peas, each costing 1 from England. Payment of 5 million is due in 90 days. The current spot rate is 2 $/, but exchange rate uctuations could change the cost to the importer by the time the payment date rolls around: if the exchange rate changes from 2 $/ to 2.5 $/ the cost increases from $10 million to $12.5 million.

 Clearly, the importer could have hedged her exposure to currency risk by buying 5 million on the spot market to lock in the dollar price of goods at $ 10 million. She can only do this however if she has access to money today, either her own money or by borrowing from someone else. In either case, acquiring the pounds today and paying o the foreign supplier carries with it a cost. This cost is either the opportunity cost of the foregone interest on $ 10 million (if using your own money) or the explicit borrowing costs in the form of the interest rate charged on the $ 10 million borrowed. Overall, the results from hedging on the spot market, can be compared to the unhedged approach in the table below. $ Depreciates ($2.25/pound) $11.25 million $10 million + interest cost $ Appreciates ($1.8/pound) $9 million $10 million + interest cost

Unhedged (Pay back after 90 days) 1. Hedge on Spot Market (Pay back immediately)

III. HEDGING ON THE FORWARD MARKET

The forward market is a great facilitator of hedging. Stay with the example of a specialty food store in the U.S. that needs to acquire 5 million in 90 days,a nd is concerned about exchange rate uctuations. The importer could have hedged her exposure to currency risk by buying 5 million on the spot market to lock in the dollar price of goods at $ 10 million, but as we discussed earlier, this requires to have the money upfront, and also carries a opportunity/borrowing cost. Instead she can hedge by buying 5 million on the forward market for delivery in 90 days. She can therefore lock in the dollar price of goods today without worrying about payment for another 90 days. Suppose that the forward rate is 2 $/. Note that this is an assumption that is being made here; there is no reason for the forward rate and the spot rate to be equal to one another. In fact, they will rarely be equal to one another. Under this assumed forward rate, the mushy pea buyer can protect herself against exchange rate depreciation by buying 5 million for a cost of $10 million on the forward market. Hedging on the forward market, in this particular case, was better than hedging on the spot market. If she had bought pounds on the spot market she is tying up her dollars in foreign currency. Instead, by locking in the rate on the forward market but not having to put money upfront, she is free to earn interest on the $10 million. Over the 90 day period, even if the dollar depreciated to say 2.5 $/ on the spot market, her cost remains at $10 million - she has successfully hedged against this downside risk. Note that unlike with spot market hedging, hedging on the forward market does not require her to put the $10 million upfront: only the price is agreed on today.

 However, buying on the forward market, while protecting you from downside risk, does not allow you to gain on the upside. Suppose that the dollar appreciated over the 90 day period to 1.75 $/. Then, if the importer had waited for 90 days, her cost would only have been $8.75 million. But she has already agreed to buy on the forward market for 2 $/ so she has to honor that agreement, resulting in a cost of $10 million. She has to honor the forward exchange rate because the transactions on the forward exchange market are in the form of contracts, which the buyer and seller have to honor. Since they will typically meet each other many more times in the same market, the reputational cost of reneging on a forward contract would be very high. The forward market hedging outcomes can be added to the table, as shown below. $ Depreciates ($2.25/pound) $11.25 million $10 million + opp.cost $10 million $ Appreciates ($1.8/pound) $9 million $10 million + opp.cost $10 million

Unhedged (Pay back after 90 days) 1. Hedge on Spot Market (Pay back immediately) 2. Hedge on Forward Market

IV. HEDGING ON THE FUTURES MARKET

As we discussed in the previous lecture, the simplest way to understand a futures contract is as a bet between two parties on the price at which a specic quantity of a commodity (in this case foreign currency) will trade at a specied date in the future. Once the two parties have agreed on the futures contract, if the price of the commodity rises above the price at which the contract was purchased, then the person buying the contract benets at the expense of the seller. If the price of the commodity falls below the price at which the contract was purchased, then the person selling the contract benets at the expense of the buyer. Suppose that on January 1st, the mushy pea importer entered into a futures contract to buy 5 million at an exchange rate of 2 $/ in 90 days time (90 days from January 1st will be April 1st). How does entering into a futures contract allow the mushy pea importer protection against depreciation? Suppose that on April 1st, the spot rate (which is identical on that date to the April 1st futures rate) has reached 2.50 $/. Since it is April 1st, the 90 day futures contract entered into on January 1st has run its course and will be extinguished. The value of her futures contract has increased by 0.50 $/* 5 million = $2.5 million. The importer can acquire the pounds she needs on the spot market at a cost of 5 million *2.5 $/ = $12.5 million. But because she has made a prot on the futures market, her total cost is only $10 million ($12.5 million spot market cost - $2.5 million in prots from futures account). In other words, she has acquired the pounds for the 2 $/ locked in on the futures market.

 What would have happened if the dollar had appreciated so that on April 1st, the spot rate had reached 1.80 $/. Again, since it is April 1st the futures contract will be extinguished since it has run its course. The value of her futures contract has FALLEN by 0.20 $/* 5 million = $1 million. Now the importer can acquire the pounds at a cost of 5 million * 1.8 $/ = $9 million, which seems like a bargain but she has to factor in her losses on the futures market. Her total cost is still $10 million ($9 million spot market cost + $ 1 million in losses from futures account). In other words, she has still acquired the pounds for the 2 $/ locked in on the futures market. Holding a futures contract to maturity, will therefore lock in the exchange rate specied on the futures contract much like a forward contract did. This can be added to our table of hedging outcomes, factoring in the key dierence between the forward and futures contract, which is that the latter requires an upfront deposit (the margin) and thus carries an interest cost (either the cost of borrowing the margin or the opportunity cost of using ones own money). $ Depreciates ($2.25/pound) $11.25 million $10 million + interest cost $10 million $10 million + interest cost of margin $ Appreciates ($1.8/pound) $9 million $10 million + interest cost $10 million $10 million + interest cost of margin

Unhedged (Pay back after 90 days) 1. Hedge on Spot Market (Pay back immediately) 2. Hedge on Forward Market 3. Hedge on Futures Market (Held to maturity)

How does entering into a futures contract allow the mushy pea importer to benet from appreciation? If all the futures market did was lock in the exchange rate to protect against depreciation, then its usefulness would be limited since the forward market aords the same benets without requiring margin deposits. The real advantage of the futures market is that it also allows for benets from appreciation. To see how this works, we have to consider the real advantage of the futures contract - namely that it can be extinguished at ANY point in the process, unlike a forward contract which can only be redeemed on the agreed upon date. Suppose that the mushy pea importer unexpectedly managed to sell all her peas by February 1st. Suppose also that on February 1st, the spot rate has appreciated to 1.8 $/. In this case, she may decide that it is worthwhile to pay o her supplier now for $9 million instead of waiting for 59 more days and paying the supplier at a cost of $10 million. Since she is concluding her transaction at this point, she does not require any further hedging and will extinguish her futures contract as well. The futures account will show either a prot or a loss depending on what has happened in the futures market.

 If the futures account is extinguished on day t then the total cost would be the cost of acquiring the currency on the spot market less the gain on the futures account plus any interest costs. So the total cost at date t (ignoring interest costs) is 5 millionet prot on futures contract at time t 5 millionet 5 million(April 1st futures ratet 2) The interest cost if you choose to extinguish before maturity is complicated. It consists of two sources: the interest cost on the margin account until the date the account is extinguished as well as the interest cost incurred in paying o the supplier on some date t, before the bill is due. You will rarely, if ever, be asked to calculate this value so dont worry too much about it. Adding this to our table, we get the following $ Depreciates ($2.25/pound) $11.25 million $10 million + interest cost $10 million $10 million + interest cost of margin < ($10 million + interest cost of margin) $ Appreciates ($1.8/pound) $9 million $10 million + interest cost $10 million $10 million + interest cost of margin < ($10 million + interest cost of margin)

Unhedged (Pay back after 90 days) 1. Hedge on Spot Market (Pay back immediately) 2. Hedge on Forward Market 3. Hedge on Futures Market (Held to maturity) 4. Hedge on Futures Market (Extinguished before maturity)

Note that since holding the futures contract to maturity is always available as a choice, you would only choose to extinguish on day t if the cost is less than holding it to maturity. This is why the fourth method is presented as being less than the third method. Why would anyone ever buy a forward contract then, given that a futures contract is like a forward contract that has the added benet of a benet from appreciation? There are a couple of reasons: rst, futures contracts are for trading standardized amounts at standardized dates while forward contracts can be tailored to the whatever the needs of the two contracting parties. Second, in order to trade futures contracts, you have to put up a margin deposit, which may have to be supplemented later if your losses mount. These impose an interest cost, as well as the hassle factor of dealing with margin calls and margin requirements, which may be why the forward market is preferred to the futures market in some cases.

V. HEDGING ON THE OPTIONS MARKET

An equally complicated hedging mechanism that oers downside protection and upside gain is an options contract. As we discussed in the last lecture, an options contract provides its owner the right, but not the obligation, to buy or sell a specied amount of foreign currency at a specied price up to a specied date. In order to acquire the option, there is an upfront cost that has to be paid, regardless of whether or not the option is eventually exercised.

 Suppose that our mushy peas importer bought a call option for pounds 30 days from now, and that the exchange rate specied in the option is 2 $/. She has locked in the dollar price at $10 million. If by April 1st the dollar depreciates to 2.25 $/ on the spot market, she is not aected because she owns the right to buy pounds at 2 $/. So her cost will at most be $10 million Thus far it seems similar to a forward contract. However, suppose instead that the dollar appreciated to 1.8 $/ on the spot market on April 1st. Because the option represents a right, and not an obligation, she can ignore her options contract and pay $9 million to buy 5 million on the spot market. To calculate the overall cost we need to factor in the price of the option. Suppose that our mushy pea buyer had to pay an option price of $0.20 / . Then her 5 million option would carry a cost of $ 1 million payable at the time the option was acquired. If the dollar depreciates to 2.25 $/, then she would exercise her option and buy the 5 million at a rate of 2 $/ for a total cost of $11 million (the $1 million option cost + $10 million to buy the currency). If the dollar appreciates to 1.8 $/ then she would not exercise her option and would instead buy on the spot market for $9 million, but would still have to pay $1 million for the option, resulting in a cost of $10 million. You may ask yourself why anyone would oer to sell an option? In this case the seller of the option would stand to gain $ 1 million if the option was not exercised (but would lose money if the option was exercised). So depending on they expect to happen in the foreign exchange market there is incentive for people to want to buy options and others to want to sell them options. We can summarize the outcome in the table below. $ Depreciates ($2.25/pound) $11.25 million $10 million + interest cost $10 million $10 million + interest cost of margin < ($10 million + interest cost of margin) $10 million + option cost $ Appreciates ($1.8/pound) $9 million $10 million + interest cost $10 million $10 million + interest cost of margin < ($10 million + interest cost of margin) $ 9 million + option cost

Unhedged (Pay back after 90 days) 1. Hedge on Spot Market (Pay back immediately) 2. Hedge on Forward Market 3. Hedge on Futures Market (Held to maturity) 4. Hedge on Futures Market (Extinguished before maturity) 5. Hedge on Options Market

IV. COMPARISON OF HEDGING ALTERNATIVES

We have now discussed four dierent hedging mechanisms: the spot market, the forward market, the futures market and the options market. We show how these can be compared for a particular scenario below. To keep things simple, I assumed that the spot rate, the forward

rate, the futures rate and the options rate are all 2 $/, although this certainly does not have to be the case. All ve methods protect against downside exchange rate risk, the last two allow us to benet from appreciation. Comparing the 4th choice to the others is dicult because we would need to know the futures value at every date between January 1st and April 1st, but we can compare the other 4 methods. Of the four methods, the forward market does the best job of protecting against downside risk in THIS PARTICULAR case. Furthermore even if the exchange rate appreciated to $1.8/pound, in this case the forward market remains the best choice. With an option cost exceeding $1 million (the option itself costs $1 million, which has to be paid upfront (thus carrying an interest cost)), the forward contract (which guarantees her a cost of $ 10 million is better than an option, which had a cost that was at best $10 million in the case of appreciation but could have cost more than $11 million in the case of depreciation. Which of these is preferred for another case, depends on a variety of factors including current exchange rates, opportunity costs, option prices and the expected path of exchange rates. It may even be possible that none of them is as good as remaining unhedged.