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C h a p t e r 1 4 G lo b al F i n a n c i al M a n ageme n t
LO-2 Describe different ways to hedge exchange rate risk.
14-2 Hedging Forex Risk with Derivatives
hedging
Firms and investors exposed to short- and long-term foreign exchange (forex) risks can hedge them using various derivative contracts. Hedging intends to reduce potential transaction, translation, and economic risks of currency movements that could lead to volatile cash flows and losses. It is important to note that speculation is the opposite of hedging. Speculators attempt to earn profits from trading in currencies or currency derivatives. Speculators can be instrumental in aggressively pricing currency contracts that makes the forex market efficient when prices reflect all available information. Unlike speculators, hedgers seek to reduce forex risk and, therefore, are not engaged in efficiently pricing currency contracts. Hedges are similar to insurance contracts where a premium is paid to protect against potential losses. Forex risks can be hedged through the use of several different contracts including futures, forwards, options, and swaps.
speculators
14-2-1 Futures Contracts
currency futures contracts
Currency futures contracts are standardized agreements to buy or sell a specified amount of currency on a particular date in the future at a predetermined price. They are similar to debt, equity, and commodity futures contracts. The buyer agrees to take delivery of a set amount of the currency on the future date at the set price and is considered to be in a long position due to profiting on an increase in the value of the currency. The seller agrees to make delivery of the currency according to the agreed terms and is considered to be in a short position due to profiting on a decrease in the value of the currency. Organized exchanges, such as the Chicago Mercantile Exchange (CME), trade selected futures contracts in major currencies, for example:
using currency derivatives to reduce potential transaction, translation, and economic risks of currency movements that could lead to losses for a firm or investor attempts in currencies and currency derivatives to earn profits from trading them and help to make prices efficient
standardized agreements to buy or sell a specified amount of currency at a date in the future at a predetermined price
long position
buying a currency in a currency futures contract and profiting on an increase in the value of the currency over time
short position
selling a currency in a currency futures contract and profiting on a decrease in the value of the currency over time
organized exchanges
the trading of futures contracts in major currencies and offering price transparency and efficiency in addition to elimination of counterparty risk due to guaranteed payments on contacts
marked-to-market
futures contracts in which gains (losses) are earned (paid) in cash at the end of each trading day
margin
small commitment fee needed to purchase a futures contract
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EUR (quoted as the number of U.S. dollars per one euro, EUR-to-USD) GBP (U.S. dollars per British pound) CHF (U.S. dollars per Swiss franc) AUD (U.S. dollars per Australian dollar) CAD (U.S. dollars per Canadian dollar) RP (British pounds per euro) RF (Swiss francs per euro)
Other important forex derivative markets are the pan-European Euronext and Tokyo Financial Exchange.2 There are some common rules in trading currency futures contracts. For example, forex derivatives specify the third Wednesday in March, June, September, and December as the expiration dates for contracts. Futures contracts are marked-to-market daily, which means that gains and losses in futures positions are reconciled at the close of trading each day by the exchange organization. At that time, buyers and sellers must pay them immediately in cash. Another interesting feature of futures contracts is that buyers and sellers can close them at any time prior to the delivery date. The flexibility to unwind forex hedges when they are no longer needed is a convenient advantage. Organized exchanges offer the further advantages of price transparency and efficiency, as well as the elimination of counterparty credit risk (e.g., the possibility that a buyer will not buy a security later that you sold at a previously agreed upon price). The exchange clearinghouse manages all gains and losses and guarantees payments on contracts related to counterparty credit risk. Finally, contracts can be purchased for a small commitment fee known as the margin. This low cost of futures contracts makes them very affordable to use as a way to manage exchange rate and other market risks. If losses occur causing a market
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