1. Foreign exchange risk management 2
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2. Background
 Growing world trade over the past 25 years
 Companies involved in transactions involving foreign
currencies
 about 22% of sales in FTSE 350 companies directly
exposed to the US
 further 11% in regions tied to the dollar
 Pike & Neale, chapter 21
 Foreign exchange rate exposure of increasing
importance
 Companies need to insure against adverse
movements in exchange rates
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3. Scenario
 A UK company expects to receive $300,000 in 3
months time. It is concerned that the pound will
appreciate relative to the dollar and decides to
hedge the transaction risk
 Current exchange rate is $1.50
 How much is $300,000 worth currently?
 How much would it be worth in three months time if
the exchange rate moved to $1.60?
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4. Scenario
 A UK company expects to receive $300,000 in 3
months time.
 Current exchange rate is $1.50
 How much is $300,000 worth currently?
 $300,000/1.50 = £200,000
 How much would it be worth in three months time if
the exchange rate was $1.60?
 $300,000/1.60 = £187,500
 Unhedged, this is a LOSS to the company
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5. Futures
A financial futures contract is an agreement to buy or sell,
through an organised exchange
 a standard amount of a financial instrument
 for delivery at a specified date in the future
 at a price which is agreed on the trade date
 Only members of the exchange can trade
 Chicago Mercantile Exchange (CME); Euronext.liffe
 Contracts are standardised in terms of contract amounts,
dealing dates and size
 Delivery in the future at a price agreed today
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6. Futures - background
 Commodity futures have been traded for more than
100 years in the US
 Financial futures are similar to commodity futures
 However, the underlying asset is a financial
instrument, not wheat, soya beans or another crop
 Only a small percentage of futures reach final
delivery
 Speculators dominate the market
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7. Jargon
 Holding futures contract – long position
 Selling futures contract – short position
 Party and counterparty
 Clearing house
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8. Example using Futures
(adapted from Watson and Head)
A UK company expects to receive $300,000 in 3
months time. It is concerned that the pound will
appreciate relative to the dollar and decides to use
futures to hedge its transaction risk
Delivery in the future at a price agreed today
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9. Using futures contracts
 Holding a futures contract means delivery at a
specified date in the future of a pre-agreed amount
of foreign currency
 The company will buy sterling futures
 This means it will take delivery of sterling and pay
with the dollars it expects to receive
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10. Example using Futures
CME rates at 1 Jan
Spot rate: $1.54 - $1.55
£ futures price (Apr): $1.535
Standard contract size: £62,500
CME : the Chicago Mercantile Exchange
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11. Futures contract
Spot rate: $1.54 - $1.55
£ futures price (Apr): $1.535
Standard contract size: £62,500
The futures price quoted is the amount of dollars
needed to buy one unit of foreign currency (one
pound)
To work out the number of contracts needed, divide
the sterling amount by the standard contract size
Each contract will cost £62,500 x $1.535 = $95,937.50
i.e. to take delivery of £62,500 in three months time,
will cost $95,937.50
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12. Using futures contracts
How many contracts?
 divide amount in dollars by sterling futures price
 $300,000/1.535 = £195,440
 now divide sterling amount by standard contract size
£195,440/£ 62,500 = 3.13, or 3
Three contracts will provide £187,500 in three months time
This will cost the company $287,813 = 187,500 x1.535
The difference (300,000 – 287,813) is unhedged
(could be sold spot in 3 months or a forward contract
arranged)
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13. What has happened?
The UK company
 expects dollars in the future and wants to fix the
exchange rate now
 buys 3 futures contracts now
 receives a known amount of sterling in the future
(from the contracts)
 settles in dollars from its dollar payment
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14. Differences between forwards and
futures contracts
Forward Contracts Futures Contracts
 Over-the-counter  Traded on an exchange
 Each contract is tailor -made  Standardised contracts
 The market is operated by  Formal margin requirements
the banks and is self  The contract is marked-to-
regulatory market on a daily basis
 90% contracts are carried out  Requires a brokerage fee
 Cost of the forward contract  The exchange is the
counterparty
is based on the bid-ask
spread  Less than 1% of futures
contracts are carried out →
 No margin is required liquid market
 High transaction costs  Speculation as well as hedging
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15. Less than 1% of contracts are carried out
means….
 Liquid market in contracts
 Euronext.liffe has an average daily volume of around
3 million contracts worth hundreds of billions of
pounds
 Standardised legal agreements
 Wide market appeal
 It is the contracts that are bought and sold, not the
commodity
 Liquidity is good
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16. Options
 An option gives the owner the right but not the
obligation to take delivery of a physical asset at or
before a pre-agreed date
 Examples of options
 share options
 currency options
 The physical asset is called the underlying asset
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17. Currency Options
 The right to buy/sell currency
 at a given price
 at a given date
 CALL option - the right to buy
 PUT option - the right to sell
 Types of options
 American
 European
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18. What are you buying?
 Buying a currency option - a call - gives you the
right, but not the obligation, to buy currency at a pre-
agreed exchange rate at or before a pre-agreed time
 The pre-agreed exchange rate is called the strike
 The pre-agreed date is called the exercise date or
the expiry
 The price you pay is called the premium
 If you do not trade at or before the exercise date,
then the option expires worthless
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19. Option terminology
 In-the-money - profitable at the current exchange
rate
 Out-of-the-money - not profitable at the current
exchange rate
 At-the-money - exercise price = spot rate
 Intrinsic value – the value the holder of the option
could realise if the option traded today
 positive if option in-the-money
 otherwise zero
 For the buyer of options, loss is limited to
premium, potential gain is unlimited
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20. Example using options
(adapted from Watson and Head)
A UK company expects to receive $1m in 3 months
and decides to hedge its transaction risk with
currency options.
Currently $1.63/£.
£ is the foreign currency (on CME) and so company
buys £ call options, strike price $1.65/£
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21. Using options
 The company will buy CME sterling currency options
 The underlying is a futures contract
 Contract size is £62,500
 Sterling is the foreign currency
 The company will buy call options
 This gives the company the right but not the
obligation to sell dollars and buy sterling at a pre-
agreed exchange rate
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22. Example using options
CME contract
Strike $1.65
Standard contract size: £62,500
Premium 7cents
Each contract costs $4,375
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23. Using options
How many contracts?
 divide amount in dollars by strike
 $1,000,000/1.65 = £606,060
 now divide sterling amount by standard contract size
£606,060/£ 62,500 = 9.7
Company can buy 9 contracts or 10 contracts
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24. Decision
 10 contracts
 cost: $43,750
 amount hedged: $1,031,250 (=62,500x10x1.65)
 9 contracts
 cost : $39,375
 amount hedged: $928,125 (=62,500x9x1.65)
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25. Mechanism
In 3 months time
if the spot rate is below $1.65
 the company will allow the option to expire
 it will exchange its dollars in the spot market
if the spot rate is above $1.65
 it will exercise the option
 1,000,000/1.65 = £606,061 AT-THE-MONEY
 1,000,000/1.75 = £571,428 IN-THE-MONEY
 1,000,000/1.60 = £625,000 OUT-OF-THE-
MONEY
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26. Buying a call option
Profit
Strike Underlying Price
0
P P = premium
Loss
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27. Buying a put option
Profit
0 Strike Underlying Price
P
Loss
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28. The difference between options and
futures
 An option confers the right not the obligation to trade
 A premium is payable
 The seller (writer) of the option is obliged to honour
the contract
 Options: one party purchases all the rights; the other
has all the obligations
 Futures: commit both parties to obligations
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29. Risk Management
Pros Cons
 Maintaining  Complexity of
competitiveness instruments
 Costs
 Reduction of bankruptcy
risk  Complex fin reporting
and tax
 Reduction in volatility of
cash flows
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30. Key Points: currency risk
 Considered use of futures and options to hedge
forex risk
 Differences between forward/futures plus
options/futures discussed
 Forex exposure management strategies discussed
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31. Reading
 Watson, D. & Head, A. Corporate Finance
Principles and Practice, Chapter 12
 Arnold, G. Corporate Financial Management,
Chapter 24
 Pike, R. & Neale, B. Corporate Finance and
Investment, Chapter 21
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