Exchange Rate Risk

CFA Level III
#1

Exporter, Inc is US based. Exporting GBP 6 mn of goods. Spot rate is 1.40 per GBP and forward rate is 1.45 per GBP.

Importer, Inc is US based. Importing GBP 6 mn of goods. Spot rate is GBP 0.85 per and forward rate is GBP 0.90 per .

To hedge the exchange rate risk > should Exporter, Inc and Importer, Inc short or long the mention contracts ??

thanks!!

#2

Exporter Inc is long GBP , so he should short the forward USD-GBP contract.

Importer Inc is short GBP, so he would go long the fwd contract

#3

Hi

thanks for your response!

I understood your explanation. My query is in particuar to these contracts, because (I think) in case of Importer Inc, the contract is written on dollars. So, should not the Importer Inc actually short the particular contract in question??

yea in case of Exporter Inc, the contract is written on GBP, hence shorting would hedge the risk. Here I am on line with you !!

#4

If Importer Inc. has a contract written in dollars , in exchange for clothes or something , then he has nothing to worry about hedging. All his transactions ( buying or selling ) are in USD . The rate for convertig the GBP to USD is already set and written into the contract and he can allocate dollars for delivery . It is the other party that should hedge .

So no need to hedge anything for Importer Inc.

#5

http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91318250

some excellent explanations in this thread. I still find this tricky but I try to reason it out:

  1. what does the company need to protect themselves against? For Exporter this is a depreciation of the pound, for importer it is an appreciation of the pound.

  2. which way do the quotes have to ‘move’ for the futures to be profitable? For Exporter, it is quoted as USD per pound so the Exporter wants a position that benefits if the number of USD units gets smaller. (eg to $1.25 USD per pound.) Short positions gain when things decline in value. Conclusion: he needs to be short this contract.

For the Importer, It is quoted as GBP per dollar and he needs a position that benefits if the pound appreciates. In case that would mean the ‘unit’ this quote is expressed in would decrease (same as above). So I *think* he needs to be short this contract too. (ie Long pounds, but because this contract is expressed in dollars, he needs to short it).

I really hope this is right but I wouldn’t bet my life on it :slight_smile: anyone else care to weigh in?

#6

Let us say the contract is for importing $10 million of goods. today $10 million is equal to 8.5 million GBP. He has no clue what the GBP will be when he takes delivery . If the GBP has appreciated , he pays $10 million , if the GBP has depreciated he pays $10 million . Either way he pays $10 million .

His own currency is USD. He has to arrange $10 million when he takes delivery . Maybe he needs money from a bank then and he wants to lock in a loan at the time so he buys an interest rate cap , but doesn’t need to hedge anything.

So why should he hedge anything?

Question appears to be flawed or a trick.

#7

Janakisri, I think your answer is slightly off. He won’t pay $10mm regardless. If the GBP has appreciated, he actually pays more than $10mm because he will now need more than $10mm to pay 8.5 GBP bc the dollar has depreciated.

I think the overarching understanding is that hedging (using a futures contract) locks in the amount you pay - you won’t gain nor will you lose. Any loss is offset by the gain in the futures and vice versa. Just know that if you owe money (the payer) then you should go long the futures. If you are the receiver/exporter, then you short the futures.

This is only a problem if you’re domestic currency is different than the currency you receive or are paying. If what you pay and receive is the same currency than, than there’s no exchange rate risk. For the same reason you don’t worry about exchange rates when you go down the street and buy something from Walmart or when you receive a paycheck - the currency is the same.

#8

If this is a schweser q , I don’t have it and can’t refer . But psahni says, and I quote:

in case of Importer Inc, the contract is written on dollars

end quote. So where do you see GBP at all , when you say that:

If the GBP has appreciated, he actually pays more than $10mm because he will now need more than $10mm to pay 8.5 GBP bc the dollar has depreciated.

Where do you need GBP at all? You need only dollars and a certain amount that is given in the contract to buy the stuff . What am I missing?

#9

You’re correct and I agree if its written in dollars, then don’t need any GBP.

let me ask you, a Schweser problem says you’re the importer and owe 8 mm euros ($10mm) when the spot is .8 euro per dollar. The forward rate is .799 euro per dollar. You go long the future which means you buy 8mm euros in the future for $10,012,516. In this case it still cost you more than $10mm, so how did the future work if you’re paying more than the original $10mm?

my only thinking is that you should’ve invested the $10mm at the risk free rate for the time period to get $10,012,516 by the time the future expires and the 8mm euros are due. By doing this you don’t lose anything. Is that correct.

#10

Psahni meant the future or forward contract is expressed in dollar units, I think. The importer needs 6 million pounds to pay for the goods.

I think the real question being asked here is: does the ‘paying foreign currency – short contract/buying foreign currency – long contract’ rule only work if the contract is in the foreign currency? (by this i mean domestic currency PER foreign currency unit, as in the Exporter example). If it’s the reverse (foreign currency per domestic currency, as in the Importer example) do you have to flip it?

#11

Bmiller12 , that strategy will work , but you have to commit the entire 10 mm today to just pay for delivery in he future, you also have the option of converting _less_ than 10 million to Euro immediately and investing in Euro bond to get 8mm Euro on delivery day .

Say the rate for Euro bonds for 1 year is 5% .

So you need 8mm/1.05 Euro now or 10m/1.05 $ now .

#12

Kiakaha , yes you can flip the fx rate back and forth to express a conversion from 1 to another currency

#13

A couple takeaway questions from the forwards/futures strategies reading:

1). For the basic hedging strategy formula, how do you know when the current portfolio value in the numerator is the current value or should be the future value of the portfolio? Some of the problems use the true current value and other times its the future value (using (1+r)^n). Also for preinvesting do you not have to worry about the time value difference between now and when the money is received?

2). Do you ways use duration=0 or beta =0 when referring to cash?

3). It seems odd that as the receiver that the exchange rate can change in your favor (foreign appreciates) but you still lose if it didnt appreciate as much as what the hedge/future called for, in which case you should’ve still hedged. I guess that’s fine, I just use to think that if the foreign appreciated than youd be better off not hedging at all but that’s not always the case, correct?

thanks for your help!!

#14

Hi guys, I am sorry for the confusion. My original question was that “the Importer, Inc forward contract is quoted on dollars, as seen by the quote ‘GBP 0.85 per $’ and hence should not he actually take a short position on this contract to gain the hedge”. I understand that, for an Importer to hedge the currency risk, he needs to long the forward contract written on foreign currency or simply long the foreign currency.

The only confusion is that the quote ‘GBP 0.85 per $’ signifies that the forward contract is written on dollars, and hence should be shorted to gain the hedge. This confusion arose because in SCH, Book 4, Pg 157 the same question has been answered by “long the forward contract”.

@Kiakaha- I am in line with your explanation and you caught my question rightly !! :slight_smile:

#15

Can you clarify what it means for a contract to be written on a currency…how do we know which currency is being bought or delivered/sold? Is it best to think of it from the perspective of your situation and which currency you’re trying to hedge?

#16 

**As per my understanding,** if the quote notation is 'GBP 0.85 per $' - a direct quote for $, the underlying currency is $. By saying 'written on $' - I mean the underlying ccy is $.

Shorting forward contract which quotes 'GBP 0.85 per $' means longing the forward contract which quotes '$ 1.18 per GBP'

'GBP 0.85 per $' - the underlying is $ here

'$ 1.18 per GBP' - the underlying is GBP here

????
#17

So if you say you’re long the forward contract that is 1.18 per GBP, does that mean you are buying GBP and delivering the ?

Likewise if you short a forward that is 1.18 per GBP, does that mean you delivering the GBP and receiving ?

#18

If you’re long the forward contract that is $95.22 per _ barrel of oil _, does that mean that you are buying _ barrels of oil _ and delivering dollars?

Likewise, if you are short a forward that is $95.22 per _ barrel of oil _, does that mean you’re delivering the _ barrels of oil _ and receiving dollars?

#19

Are you confirming my questions, that is - are they accurate? Sorry, I see your point its

just that currencies always seem to muddy things up in my mind. Thanks

#20

Yes.

That’s why I always think of currencies as commodities; it makes it clearer for me.

My pleasure.