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Hedging Currency Risk Using Currency Forwards and Futures

This document provides an overview of hedging currency risk using currency forwards and futures. It discusses how companies face currency risk from transactions, translations, investments, and economic factors. To address this risk, companies can choose to hedge or not hedge their currency exposure. The main methods of hedging discussed are using financial contracts like forwards, options, and swaps. The document also provides examples of how large companies like IOC and TT Textiles employ currency hedging strategies using these methods to mitigate their transaction risk from international business dealings.

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Naman Jain
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30 views52 pages

Hedging Currency Risk Using Currency Forwards and Futures

This document provides an overview of hedging currency risk using currency forwards and futures. It discusses how companies face currency risk from transactions, translations, investments, and economic factors. To address this risk, companies can choose to hedge or not hedge their currency exposure. The main methods of hedging discussed are using financial contracts like forwards, options, and swaps. The document also provides examples of how large companies like IOC and TT Textiles employ currency hedging strategies using these methods to mitigate their transaction risk from international business dealings.

Uploaded by

Naman Jain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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HEDGING CURRENCY RISK USING CURRENCY

FORWARDS AND FUTURES

Session 6
3rd August, 2020
SESSION PLAN
▷ INTRODUCTION CONCEPTS

▷ CURRENCY RISK-AN OVERVIEW

▷ HOW DO COMPANIES ADDRESS CURRENCY


RISK

▷ WHAT IS CURRENCY RISK HEDGING

▷ METHODOLOGY OF RISK HEDGING

▷ CURRENCY HEDGING BY COMPANIES: TT AND


MCDONALD
INTRODUCTION
FOREX BASICS
▷ DIRECT QUOTATION

PRICE ONE UNIT OF FOREIGN CURRENCY IN HOME


CURRENCY

USD 1= 74.8100

▷ INDIRECT QUOTATION

RS. 100 = USD 1.3367


FOREX BASICS
▷ INTER BANK RATE / MERCHANT RATES

FEDAI
▷ BUYING AND SELLING RATES

▷ SPOT AND FORWARD RATES


FOREX BASICS
▷ APPRECIATION AND DEPRECIATION

IN 2005-06 USD/INR DIRECT QUOTE WAS SAY 45


IN 07-08 IT WAS 39
IN 20-21 IT IS 74-77

WHEN LESS DOMESTIC CURRENCY REQUIRED TO BUY 1 UNIT


OF FOREIGN CURRENCY
– APPRECIATION

MORE REQUIRED TO BUY 1 UNIT IS


-DEPRECIATION
CASE RELATED CONCEPTS
▷ CURRENCY SWAPS

▷ KNOCK-INS / KNOCK-OUTS
AN OPTION THAT COMES ALIVE KNOCK-IN
BREACHING A ASSET PRICE BARRIER KNOCK OUT

▷ PARTIAL BARRIER
A TYPE OF DERIVATIVE WHERE THE PAYOFF DEPENDS ON IF
THE UNDERLYING HAS REACHED OR EXCEEDED A
PREDETERMINED PRICE
RISK AND TREASURY
▷ RISK MANAGEMENT WAS ASSOCIATED WITH
BUYING INSURANCE TO PROTECT
ORGANISATIONS FROM BEARING LOSSES
ASSOCIATED WITH ACCIDENTS

▷ POST WORLD WAR 2 AND ESPECIALLY SINCE


1970s AND EMERGENCE OF DERIVATIVES
BECAME WIDE-SPREAD.
RISK MANAGEMENT
▷ BUSINESS COMPLEXITY
▷ SHARE HOLDER ACTIVISM
▷ REGULATORY COMPLIANCES
▷ COMPLEX ACCOUNTING
▷ INTEREST RATES
▷ FX
▷ SCALABILITY
ENTERPRISE RM FRAMEWORK
COMPONENTS OF RISK MANAGEMENT
▷ RISK APPETITE

▷ RISK MANAGEMENT STRATEGY


CURRENCY RISK : OVERVIEW
ABC COMPANY PACKAGING AND SELLING PREMIUM
COFFE BEANS IN US. BUY COFEE BEANS IN
COLUMBIA, PACKAGE IN CALIFORNIA, SELL AROUND
THE WORLD.
RISKS FACED BY ABC
1. POLITICAL TURMOIL IN COLUMBIA

2. VOLATILITY IN DOLLAR-PESO

3. PLANT LOCATION AND UNIONISED LABOUR

4. COMPETITION FROM LARGE PLAYERS

5. DEMAND FOR COFFEE EBBING

6. HEALTH CONCERNS OF CAFFEINE CONSUMPTION


SOURCES OF CURRENCY RISK
▷ 1. TRANSACTION RISK

▷ 2. TRANSLATION RISK

▷ 3. INVESTMENT RISK

▷ 4. ECONOMIC RISK
TRANSACTION RISK
▷ BUYING IN COLUMBIA AND PACKAGING AND
SELLING IN US
TRANSLATION RISK
▷ ACCOUNTING FOR SALE / PURCHASE
INVESTMENT RISK
▷ INVESTING OVERSEAS

1. VARIATION IN RETURN DUE TO FOREX

2. FOREIGN INVESTMENT MAY YIELD MORE OR LESS HOME


CURRENCY THAN EXPECTED

3. A FOREIGN INVESTMENT IS SIMULTANEOUSLY AN


INVESTMENT IN ASSETS OVERSEAS AND FOREIGN CURRENCY
EXAMPLE
▷ INVEST 1 MILLION DOLLARS SAY 700 LAKHS

ROI 20%
TOTAL INVESTED VALUE OF CAPITAL
INCREASES TO RS. $1.2 MILLION

SCENARIO 1 RUPEE DEPRECIATES


USD/INR IS 75
ROI IS 28.57%

SCENARIO 2 RUPEE APPRECIATES


USD/INR IS 64
ROI IS 9.71%
ECONOMIC RISK
▷ INVESTING IN A SPECIFIC COUNTRY
LAST 20 IN FORBES
▷ VENEZUELA

▷ ZIMBABWE

▷ BURUNDI

▷ GUINEA

▷ YEMEN

▷ LIBYA
ADDRESSING CURRENCY RISK
WHICH RISK?
▷ MOST IMPORTANT RISK THAT IMPACTS
BUSINESS IS TRANSACTION RISK
DO NOT HEDGE
▷ THIS LEAVES YOU EXPOSED TO THE RISK

▷ YOU MAY GAIN OR LOSE OUT IN TERMS OF


HOME CURRENCY

▷ MAY BE SUITABLE FOR SMALL, IRREGULAR


TRANSACTIONS AND FOR THOSE WHO CAN
LIVE WITH UNCERTAINTY AND ITS
CONSEQUENCES
HEDGE
▷ THIS REMOVES MOST OR ALL OF THE FOREX
RISK

▷ WILL HAVE BETTER VISIBILITY OVER CASH


RECEIPTS AND PAYMENTS

▷ SUITS LARGE/REGULAR TRANSACTIONS PLUS


ANYONE WHO CANNOT AFFORD TO TAKE
FOREX RISK
CURRENCY RISK HEDGING
HEDGING
▷ A transaction designed to neutralize the risk as far as
possible. A perfect hedge is that completely
eliminates the risk.
CURRENCY HEDGING
▷ A METHOD OF STRATEGICALLY USING
FINANCIAL INSTRUMENTS TO OFFSET THE
RISK OF ADVERSE CURRENCY PRICE
MOVEMENT
CONTINGENT FOREX RISK
▷ AN AMERICAN FIRM BIDDING FOR A
CONTRACT TO CONSTRUCT SPORTS
COMPLEX AT LONDON. BID IS IN POUNDS. SAY
25 MILLION POUNDS, AT FORWARD RATE
USD/GBP 1.4370, PROJECT BID IS USD35.925
MILLION. IF GBP WEAKENS, FIRM WILL
RECEIVE FEWER USD.

▷ PUT IS A BETTER HEDGE COMPARED TO


FORWARD
CONTINGENT RISK
▷ SCENARIO 1 BID SUCCESSFUL AND (POUND
DEPRECIATES)

SELL POUNDS FORWARD 1.437


POUND DEPRECIATES (HIGHER POUNDS PER DOLLAR),
1.457
LOSS IN FORWARD
GAIN IN VALUE RECEIVED

PUT WILL EXPIRE WORTHLESS


CONTINGENT RISK
▷ SCENARIO 2 BID SUCCESSFUL AND (POUND
APPRECIATES)

SELL POUNDS FORWARD 1.437


POUND DEPRECIATES (HIGHER POUNDS PER DOLLAR),
1.417
GAIN IN FORWARD
LOSS IN VALUE RECEIVED

PUT WILL BE WORTH MORE OR LESS EQUAL


METHODOLOGY OF CURRENCY
RISK HEDGING
CURRENCY HEDGING
▷ 1. FINANCIAL CONTRACTS
FORWARDS
OPTIONS
SWAP

▷ 2. FINANCIAL TRANSACTION

BORROWING IS EQUIVALENT TO LONG


INVESTING IN A FOREIGN COUNTRY TO HEDGE AGAINST SHORT

▷ 3. OPERATIONAL TECHNIQUES
GEOGRAPHICAL DIVERSIFICATION
CURRENCY CONTRACTS
▷ USD INR/USD
▷ EUR INR/EUR
▷ GBP INR/GBP
▷ JPY INR/JPY

▷ OPTCUR INR/USD EUROPEAN


CURRENCY HEDGING
▷ A LARGE PART IS OTC
A COMPREHENSIVE APPROACH
▷ 1. DETERMINING SPECIFIC COUNTRY EXPOSURE BY
CURRENCY AND AMOUNT.
▷ 2. EXCHANGE RATE FORECASTING: DETERMINE
THE LIKELIHOOD OF ADVERSE MOVEMENTS
▷ 3. ASSESSING IMPACT OF 2 ON EARNINGS, CASH
FLOW AND LIABILITIES
▷ 4. DECIDING WHETHER TO HEDGE OR NOT TO
HEDGE
CURRENCY HEDGING BY INDIAN
COMPANIES
IOCL
▷ FORTUNE 500 COMPANY
▷ EXPOSED TO COMMODITY AND FOREX RISK

▷ MARGIN HEDGING, INVENTORY HEDGING AND


CRUDE OIL PRICE HEDGING THROUGH SWAPS,
OPTIONS AND FUTURES IN THE OTC MARKET AS
WELL AS THE EXCHANGES TO MITIGATE THE RISK
WITHIN THE APPROVED LIMITS.
FX HEDGING IOCL

▷ IT MANAGES ITS FOREX RISK THROUGH A


COMBINATION OF NATURAL HEDGING, MANDATORY
HEDGING AND HEDGING UNDERTAKEN ON
OCCURANCE OF PRE-DETERMINED TRIGGERS. THE
HEDGING IS MOSTLY UNDERTAKEN THROUGH
FORWARD CONTRACTS.

IOCL ANNUAL REPORT 17-18


TT CURRENCY HEDGE
TT FOREX HEDGE
TT TEXILES CASE
CURRENCY HEDGING

PAYOFF MATRIX

22,50,00,000.00 TOTAL CONTRACT VALUE


CHF CHF/USD INR/USD DOLLARS INR LIABILITY Profit/ Loss
LIABILITY LIABILITY 225000000
49,65,791.22 USD
63,06,554.84 CHF 63,06,554.84 1.04 45.31 60,63,995.04 27,47,59,615.37 -4,97,59,615.37
45.31 EXCHANGE RATE 63,06,554.84 1.04 46.25 60,63,995.04 28,04,59,770.71 -5,54,59,770.71
63,06,554.84 1.27 46.25 49,65,791.22 22,96,67,843.73 -46,67,843.73
1.27 EXCHANGE RATE 63,06,554.84 1.27 45.00 49,65,791.22 22,34,60,604.71 15,39,395.29
1.77% INTEREST
3.54% ANNUL OPTIONS

80 LAKHS CREDIT LIMIT 45 AND 46.25 USD


19-10-2006 START DATE 1.04 AND 1.27 CHF
15-10-2009 EXPIRY
19-10-2009 DELIVERY DATE

CHF: SWISS FRANC


“
▷ KEY IS CHOOSING RIGHT HEDGING
MECHANISM. FOR CONTINGENCY
FOREX RISK OPTION MAY BE A
BETTER BET THAN FORWARDS FOR
HEDGING
CONCEPT FOR THE DAY

▷ SWAPS AND OPTIONS


Thanks for Your time
and Attention!

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