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.