Managing Currency
Rate Movement:
Weighing the Options
Without protections, volatile currency rate movements can
turn a profitable deal into a dead loss - John Price
Reprinted with permission from Export Today, February/March
1992, pages 28-32.
Name an industry and it's a good bet at least some of its
participants use risk management instruments. For relatively
little cost, risk management tools can protect companies against
movements in interest rates and even the prices of essential
materials.
The volatility of currency exchange rates motivates thousands
of U.S. companies to search for protection Without protection,
currency rate movements can turn a profitable sale into a
loss.
A typical situation could be where a U.S exporter sells goods
to a German buyer and agrees to take payment in Deutsche marks
(DM) 90 days out. What's the risk? That the value of the mark
could fall against the dollar in the intervening 90 days,
leaving the seller with a lower margin or even a loss when
the marks are received and converted. Thus, in this example,
the seller has become an unwitting speculator, when all he
wanted to do was sell a product at a predetermined margin.
Many Solutions. The solution? There are
several. Old standbys and recent breakthroughs in the area
of financial risk management can remove much of the risk from
currency rate movements. In addition to protecting against
the down side of rate fluctuations, they can even be designed
to allow exporter to profit from favorable movements.
The range of such products is huge, with increasingly sophisticated
techniques constantly being added. What follows are descriptions
of the four major classes of products used to manage exchange
rate risk: forwards, futures, options, and swaps.
Forward — Tried and True. A forward
rate agreement (FRA) is a contract to buy or sell currency
at an agreed upon exchange rate at a specific date in the
future.
A U.S. exporter who has contracted with a foreign buyer to
be paid in the foreign buyer's currency later, can contract
now to sell this currency to a bank or other financial institution
for a predetermined amount in U.S. dollars.
If the exchange rate has moved against the exporter between
the date of the contract and the settlement date, he is protected.
Conversely, he foregoes the potential windfall of a favorable
exchange rate movement. Thus, forwards allow an exporter to
contract with another party to assume the risk of adverse
currency movements.
FRAs are very straightforward: one settlement at one fixed
date. However, FRAs can be combined in a series to meet a
wide rage of needs. For example, if an exporter is receiving
a stream of currency from customers, FRAs can be fairly thin
and good rates difficult to obtain.
Futures — Exchange-Based Forward.
Futures are similar to forwards except that they're traded
on exchanges which specify settlement dates.
Exporters can eliminate exchange risk ("hedge")
by using a futures contract to offset the risk involved in
receiving foreign currency as payment for an overseas sale.
By taking a short position (that is, contracting to sell foreign
currency on the settlement date), the exporter will make a
profit if the value of the currency falls, which will offset
the currency-related loss on the product sale.
Deutsche mark futures, for example, are traded on the Chicago
Mercantile Exchange (CME) - on which traders currently hold
around 64,000 contracts at DM 125,000. CME DM futures have
settlement dates at three-month intervals for the next year.
Taking a short position in, say, the December 1992 contract
would give you the obligation to sell DM125,000 at that time
at the settlement rate, which is the rate specified on the
day the contract is entered into - just like a forward.
If the exporter receives the foreign currency payment prior
to the settlement date, he can buy out his contract converting
the marks at the market rate for that day and paying the amount
the contract would cost that day in dollars. The amount received
on the open market for the marks would offset any profit or
loss released on settling the futures contract.
There are also futures contracts in Australian dollars, British
pounds, Canadian Dollars, Japanese yen, Swiss francs (SF),
and a U.S. dollar index.
Exchanges require, however, that purchasers of contracts
maintain a margin account, in effect as collateral against
a loss on the futures contract. This is typically a small
percentage of the contract value. Futures contracts are said
to be "marked to market" on a daily basis with adjustments
credited or debited to the exporter's account. If the value
of the contract increases, the exporter's account is credited
accordingly. The opposite happens if the value of the contract
drops.
The advantage of futures are that they are very liquid, and
that there is no risk of default. On the other hand, management
of the margins can be difficult for smaller firms. The limited
number of settlement dates is another drawback. A contract
is also for a set amount of the foreign currency, DM125,000
for example, which unfortunately will rarely exactly match
an exporter's hedge need on a given transaction.
Options — Financial Insurance. There
are two basic types of options, calls and puts.
Purchase of a call grants you the right - but not the obligation
- to buy a specified asset at a particular price at a specified
time in the future. (In one variation the purchase can take
place at any time over the life of the contract).
A put option is identical, except that it replaces the right
to buy with the right to sell. the purchaser of either option
pays a premium to the seller, or writer.
How do options work? In regard to calls, let's suppose the
price of the asset rises above the "strike price,"
the price specified in the contract. The option holder would
then exercise the option and make a profit on the difference
between the final asset price and the strike price.
If, on the other hand, the value of the asset falls to a
level below the strike price, the option holder would do nothing
and the option would expire worthless.
Options are thus akin to insurance policies: For a predetermined
premium a floor is placed under your losses, while your potential
for profit is left wide open.
For example, a U.S. exporter may contract with a Swiss buyer
to sell equipment for SF10 million on 90-day terms. If the
value of the dollar rises over this period, the value of the
sale could be much less than anticipated; if the dollar falls,
the exporter makes a considerable profit. By taking out an
option to sell Swiss francs a an exercise price of, say, the
current rate less 5%, he is protected if the dollar rises
by more than 5% but free to benefit if it falls.
Swaps. A swap is an agreement between two
parties to exchange certain specified cash flows over the
life of a contract. One of the parties is generally a bank.
For example, an exporter with exchange-rate risk can renegotiate
a swap of U.S. dollars for the currency of the country to
which he is selling. The exporter will then be indifferent
to exchange-rate movements. The bank or financial institution
is willing to do this because it can manage its foreign exchange
exposure better than the exporter and use other risk management
tools to hedge its risk.
Other Risk Management Products. Beyond the
four main types of risk management instruments, there are
a number of other products including "swaptions"
(options on swaps); avenging options; yield curve swaps; futures
on spreads; and options on portfolios. Sophisticated mathematical
tools an high-speed computers are needed to calculate the
price of these instruments and to determine their overall
effect on the company.
Babes in Riskland. Exports comprise much
of Mattel Toys' $1.4 billion in yearly sales. "While
all companies welcome growth an profitability, managing seasonal
cash flows and currency risks is always a concern, even in
toyland," said William Stavro, the Mattel assistant treasurer.
Mattel's risk management objects are to strike a balance between
opportunities and risk. According to Stavro, "The company
starts out each year with a 50% forward cover of its annual
currency exposure." This cover is then modified according
to advice from an outside currency manager.
Learning the Ropes. It is important for
a corporate treasurer to understand the basic characteristics
of each type of instrument. A good way to start is to think
of each instrument as a means for either selling risk, or
for exchanging various types of risk.
Examine each class of instrument to see what cash is being
transferred—and what risk is being transferred—in
both directions. Start with examples from the four major classes
as a basis for moving on to the specialized instruments. A
deeper analysis, furthermore, shows that the distribution
of risk over time can be changed and that different types
of risk can be exchanged within the same company.
In the end, an effective risk management strategy keeps levels
and distributions of risk within stipulated boundaries. It
allows manufacturers to focus on manufacturing and selling,
and not worry about fluctuating exchange rates. Greater use
of currency risk management techniques will allow exporters
both predictability in international transactions and the
competitive edge of giving the overseas customer the choice
of currency to which to pay. |