Foreign Exchange Hedging Strategies : Foreign Exchange Hedging Strategies Mark Frey Head Trader Custom House Global Foreign Exchange
2004 BIS Survey – FX Mkt. : 2004 BIS Survey – FX Mkt. Average daily FX turnover $1.88 trillion USD.
57% increase since 2001.
50% Forwards and Swaps.
33% Spot transactions.
Less than 10% delivered.
USD involved in 89% of trades – almost $1.7 trillion daily.
2004 BIS Survey (cont.) : 2004 BIS Survey (cont.) EURUSD $501B 28%
USDJPY $296B 17%
USDGBP $245B 11%
AUDUSD $90B 4.8%
USDCHF $78B 4.1%
USDCAD $71B 3.8%
EURJPY $51 2.7%
EURGBP $43 2.3%
Why Hedge? : Why Hedge?
Same Story with CAD : Same Story with CAD
Canadian Exporters – One Year Ago : Canadian Exporters – One Year Ago Assume selling 100K USD worth of goods to USD with a cost of 120K CAD.
May 2005 – Sell 100K USD @ 1.27 = 127,000 CAD.
Profit = 127,000 -100,000 = 7,000 CAD (5.5% profit margin).
Canadian Exporter – The Past Year : Canadian Exporter – The Past Year 100K in USD receivables can now be exchanged at a rate of 1.1550.
Yields 115,500 CAD but their cost in CAD terms is still 120,000.
Net result is a loss of 4,500 CAD or 3.9% of revenue.
No change in business model or cost structure but drastically different result in terms of profitability.
Canadian Importers – The Past Year : Canadian Importers – The Past Year Let’s assume you are purchasing 100K USD worth of goods each month.
Payment terms are net 30, meaning that you pay for your goods one month after receipt.
Who needs to hedge, your CAD buys more USD than it did the month before.
Same Story with CAD : Same Story with CAD
Who Needs to Hedge? : Who Needs to Hedge? Every importer in British Columbia becomes an expert currency trader.
Without fail, they buy their USD at a cheaper price each month, simply by waiting until month end.
There is no need for them to raise prices, the CAD’s appreciation does it for them.
There is a risk of falling into a trap where the profitability of the business is based on the exchange rate, not the business itself.
Hedging Products : Hedging Products Currency Futures
Currency Options
Currency Forwards
We’ll examine the basic drawbacks and benefits of each.
Currency Futures : Currency Futures Standardized contracts in terms of value dates and contract size.
Trade on a regulated exchange (vs. the OTC inter-bank market). The exchange is the counter party to all trades – No delivery risk.
May be floor traded (CME pit) or electronic (GLOBEX).
Brokers paid per contract commission rather than off spread.
Currency Futures : Currency Futures Benefits
Very tight bid – ask spread during active trading.
Accessibility and speed of execution.
Transparency – bid-ask spreads, volumes all immediately available in real-time.
Futures Cont’d : Futures Cont’d Drawbacks
Lack of liquidity during off hours.
Fixed dates – may introduce interest rate risk.
Fixed amounts – 1 CAD contract is 100K CAD, 125K for EUR.
Delivery – For hedging only. Still required to do FX for spot to exchange funds.
Currency Options : Currency Options Flexible contracts in terms of value dates and contract size.
Trade on regulated exchanges as well as OTC. Majority of volume is traded OTC.
Pricing is not tremendously transparent, based on independently formulated pricing models.
Options : Options Benefits
Ideal for hedging variable or uncertain FX volumes.
Perfectly flexible – can develop an option or strategy to fit almost any situation.
Can be both deliverable to accommodate exchange of funds or non-deliverable for strictly hedging purposes.
Options Cont’d : Options Cont’d Drawbacks
Lack of transparency – Pricing models can be very complicated, intricate and well guarded.
Costs – Premiums eat into profits or benefits of hedging. No cost collars are really “No Cash Collars.”
Increased risks associated with writing options to offset premium costs.
Forwards : Forwards Drawbacks
A forward is a commitment to buy or sell a foreign currency as opposed to an option.
Once a forward position is initiated, it must be delivered or closed out at or before maturity with a resulting paper gain or loss to be offset by the gain or loss realized on actual goods.
Forwards Cont’d : Forwards Cont’d Benefits – Flexibility in every sense.
Nearly every currency pair.
Can be both deliverable and non-deliverable.
Dates are flexible, not fixed. Can pick any specific date.
Amounts are not fixed, can cover to the exact penny.
Extremely liquid – based from FX spot market which is largest financial market in the world.
No upfront costs or fees.
The Ideal Hedging Mix : The Ideal Hedging Mix A combination of all 3 products.
Futures for immediately executable and non-deliverable requirements. Pure hedging.
Options for uncertain or variable requirements.
Forwards for the bulk of your commitments using specific dates and amounts. We’ll concentrate here next.
Types of Forward Contracts : Types of Forward Contracts Open forwards.
Closed forwards.
Option Dated forwards.
Non-Deliverable forwards.
But first, we need to understand value dates.
Value Dates : Value Dates In FX Markets, a trade settled for anything other than spot is subject to forward points.
Spot Date
Settlement occurs 2 days from the contract date…except.
USDCAD; USDMXN
Forward Date
Settlement occurs on a business date beyond the spot date.
Short Date
Settlement occurs before the spot date.
Forward Contract Pricing : Forward Contract Pricing Open Contract
An “Open” contract means that the forward points are only applied when it is in the seller’s interest to do so.
The purchaser sacrifices any potential benefits from the forward points in return for being able to exercise the contract at any time.
The contract rate is never adjusted regardless of when the contract is drawn down.
Forward Contract Pricing : Forward Contract Pricing Closed Contract (Fixed Dated).
A “Closed” contract means that the forward points, whether discount or premium (in the client’s favor or not) are always priced into the contract from the transaction date to the end value date or last delivery date.
The contract rate will be adjusted for the remaining points when the contract is pre-delivered.
Forward Contract Pricing : Forward Contract Pricing Window Contract (Option Dated).
A “Window” contract means that the contract is initially closed for a period and thereafter open for the remainder of the term.
The forward points are applied up to the end of the closed period if in the clients favor, to the end of the open period if in the seller’s favor.
The contract rate is adjusted on pre-deliveries while the contract is closed.
Non-Deliverable Forwards : Non-Deliverable Forwards Non-deliverable forwards are outright forward transactions which will be reversed prior to settlement. Must be combined with spot deals.
Used to hedge exchange rate risk in currencies subject to exchange controls.
NDF’s are common for CNY, TWD, KRW etc.
NDF’s are always priced as closed contracts.
Forward Points : Forward Points Reflect the interest rate differential between two currencies
Forward Premium
Forward margin or points are positive
Base ccy interest rate < Terms ccy interest rate
Forward Discount
Forward margin or points are negative
Base ccy interest rate > Terms ccy interest rate
If you are buying USD, you want the points to trade at a discount.
If you are selling USD, you want the points to trade at a premium.
Forward Points Illustrated : Forward Points Illustrated You are buying USD for a payable scheduled 6 months into the future.
2 Options – Buy and hold, or book a forward, which are equivalent.
Buy and Hold – Borrow CAD from the bank at the CAD interest rate. Buy USD for spot settlement. Invest USD at U.S. interest rate. Interest earned > interest owing. Therefore need a discount on forward to compensate.
Example of Forward Pricing : Example of Forward Pricing You are selling USD, therefore you want your rate to be as high as possible.
The forward points are negative at this time (U.S. interest rates > CAD interest rates).
The further out into the future you go, the worse the price.
Forward points are always added when originally booking a contract.
Forward Pricing Cont’d : Forward Pricing Cont’d You are buying USD. Forward points are negative and are in your favor. You want your rate as low as possible.
If you book a closed contract, the forward points are subtracted from the spot rate.
If you book an open contract, you forgo the forward points in favor of increased flexibility of execution.
Numerical Example Selling USD : Numerical Example Selling USD USDCAD spot = 1.1500
1 Month forward points = -.0010
1 Month open fwd = 1.1490
1 Month closed fwd = 1.1490
What’s the difference?
If you book a closed contract, and exercise it early, you will get some of the points back.
Deliver 2 weeks later – you receive 5 points back making your rate 1.1495.
Numerical Example Buying USD : Numerical Example Buying USD USDCAD spot = 1.1500
1 Month forward points = -.0010
1 Month open fwd = 1.1500
1 Month closed fwd = 1.1490
You receive a ten pt. discount for booking closed, sacrificing flexibility.
If you exercise the contract two weeks in, you have to give back 5 pts making your rate 1.1495.
Forward Contract Pricing Summary : Forward Contract Pricing Summary USD trades at a forward discount.
Open and Closed Sells priced to last delivery date – full discount points applied.
Open Buys priced to first delivery date – minimum discount points given.
Closed Buys priced to last value date – full discount points applied.
The Moral of the Story : The Moral of the Story Always book closed contracts as opposed to open.
If the points are in your favor, you get a better price up front.
If the points are not in your favor, you can get a refund if you exercise your contract prior to its maturity date.
Forward Contract Strategies : Forward Contract Strategies Working the forward point curve.
Enhancing hedging profits and avoiding high risk situations.
Slide39 : USDCAD
Slide40 : Forward Strategies.
The decision to hedge short-term or long term is purely a question of whether forward points are increasing or falling and has nothing to do with the direction of the spot market or the duration of the forward receivable or payable being hedged.
Slide41 : 2. Rolling short-term contracts can provide the same hedge coverage as a long-term contract and reduces risk by forcing market gains or losses to be realized on a periodic basis. 3. Closed contracts, properly managed, are always preferable to open contracts, from either a profit maximizing or risk minimizing perspective.
Where’s the Loonie headed? : Where’s the Loonie headed? RBC is calling for 1.30
BMO is calling for 1.10
Which is right? Maybe they both are.
Positives: Yield play, strong economy, job growth, commodities, U.S. twin deficits.
Negatives: Yield play? Commodities? Oil, NG and gold are all off highs, BOC sounding dovish.
What do you do if you are advising a business with an FX exposure? : What do you do if you are advising a business with an FX exposure? Cover 50 to 75% of certain requirements with deliverable, closed forward contracts. Cover the remainder on the spot market.
Hedge with laddered forwards – similar to GIC strategy.
Investigate no cost collar options for uncertain requirements.
Questions? : Questions? Mark Frey
Ph: 250-220-1015 ext. 226
mfrey@customhouse.com
Sales Support and Information
Colin W. Dyer
Victoria, B.C.
Ph: 250-412-0466 ext. 248
Cell: 250-213-7274
Fax: 1-800-661-7486
cdyer@customhouse.com