Hedge your bets

Sunil Bhandari explains the best way to tackle questions on foreign currency hedging

Foreign currency hedging is included in ACCA FM as well as AFM. As you would expect, there is more to cover in the latter compared with the former. The forward contract and money market hedging methods are regularly tested in both exams.

This article will explain and demonstrate how to present these hedges with the aid of an example.

Example: Lads Co

Lads Co is a UK-based company that regularly trades with companies in the USA. Several large transactions are due in three months’ time. These are shown below. The transactions are in ‘000’ units of the currencies shown.

Assume that it is now 1 June. Exports to:

Exchange rates: $US/£

Spot Rate 1.9156-1.9210

3 months forward1.9066-1.9120

1 year forward1.8901-1.8945

Annual interest rates available to Lads Co from: relevant rate.

To ensure you choose the correct value between the bid (left) or the offer (right), there are two ways to think about this.

From first principles, the banks in this case are trading the £. That’s their product. Like any business, they will purchase the product at a low price (bid). They then add a profit and sell the product at a high price (offer).

Lads Co is looking to dispose of £’s in exchange for $’s. They can then cover the net payment. This means that the bank will buy the £’s from Lads. The bank dictates the price. They will use the low value, the bid price, the one on the left.

This is a lot to think about in the heat of the exam room. So, I have a simple process to learn and use.

1. Check the presentation of the rates are indirect format.

2. You have a receipt or net receipt of foreign currency.

3. Divide (2) by the right-hand rate.

I call this the ‘R&R’ rule. A Receiver of FX divides by the Right-hand rate. If the transaction is a foreign currency payment or net payment, simply divide by the left-hand rate.

I accept that in ACCA AFM the exchange rates could be presented in the ‘direct’ format, but let’s leave that for a future article.

Forward Contract Hedge

Now, we can complete this regularly tested hedge:

3-month forward rate ($/£)1.90663 month forward bid (left hand) rate Transaction at forward rate (£’000)

Money Market Hedge (MMH)

The MMH is different to the other hedges as it is not a derivative. The objective is to accelerate the exchange from the transaction date to today. As the current spot rate is known and certain, the FX transaction risk is removed.

The MMH requires the use of money market accounts for deposits and loans in the respective currencies. These accounts follow the simple interest rules.

Money Market Hedge

The first step is to net off the $ transactions expected in three months’ time:

The amount of £ needed to pay the $’s for the deposit

The £’s needed will be funded by a short-term loan

Based purely on the numbers above, the forward contract will be chosen as the sterling value in 3 months’ time is more favourable.

However, as an ACCA AFM student, you will need elaborate a little more to earn the professional skills marks, in particular acumen. Additional comments that could be made in this case include the following.

There are transaction costs involved when converting at the spot or the forward rates. The latter are likely to be marginally higher.

Both methods of hedging remove the chance of making a transaction risk gain should the value of sterling rise over the next three months. However, the data provided in the question indicates that this is unlikely to happen.

As Lads Co is based in the UK and it’s home currency is sterling, the two transactions in £’s can be ignored.

Understanding the FX Rates

Before we prepare the two types of hedges, let’s take a careful look at the exchange rates: $US/£

Spot Rate 1.9156-1.9210

3 months forward1.9066-1.9120

1 year forward1.8901-1.8945

This is known as the ‘indirect’ presentation of the bid-offer rates for the £. The home currency (£) is locked at one and is being valued in $’s. To convert from $’s to £’s, the dollar payment will need to be divided by the

The forward rates are an indicator of the potential change in future spot rates. They are showing a decline in the value of sterling.

Then take the money market interest rates. These are nominal values and reflect the respective inflation rates of each country. The dollar rates are clearly below the sterling values. Hence, if the spot rates were forecast using the Purchasing Power Parity Theory (PPPT), sterling would be predicted to fall.

Conclusion

In this article, I have looked at the two most popular FX hedging methods tested in ACCA FM and AFM. However, in the latter the calculations extend to cover FX Futures and Options. These will be looked at in future articles.

• Sunil Bhandari is an ACCA AFM tutor with FME Learn Online. See www. SunilBhandari.com

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