Hedging currency risk

A forward contract fixes today the exchange rate at which a future currency transaction will take place. It is over the counter, so the parties specify the amount, the currency and the maturity date to suit themselves — which means the hedge can cover the exposure exactly.

MBA Co is a Zambian company expecting to receive €500,000 in six months. Rates are quoted against the dollar rather than directly, so the conversion goes through it.

Both legs use the six-month forward rate, because the whole transaction settles in six months. Mixing a spot rate into one leg and a forward into the other is the usual error in a cross-rate question.

The last two lines are the price of certainty. A forward contract does not get the best rate; it gets a known rate, which is a different objective and usually the right one for a company whose business is not currency trading.

A money market hedge removes exchange rate uncertainty by making the exchange today, at the spot rate, instead of in the future. It uses borrowing and depositing to move the cash to the right currency now, and then holds it until the transaction settles.

The principle is the same in both directions: create a position in the foreign currency that offsets the one the trade has created. Which way round depends on whether the company owes or is owed.

For a payable, four steps. Deposit the present value of the amount owed, converting at spot, funded by borrowing at home.

A Zambian importer owes $200,000 in six months. Spot is ZMW16.50 – ZMW16.60 per dollar, the US deposit rate is 4% a year and the company borrows kwacha at 18% a year.

The dollar deposit grows to exactly $200,000 and pays the supplier. The company knows today that the transaction will cost it ZMW3,547,836, whatever the rate does.

For a receivable the whole thing runs backwards: borrow the present value of what is owed to you, convert it at spot, deposit the home currency, and let the customer’s payment clear the foreign loan.

Two details that decide whether the answer is right. Annual rates are pro-rated to the period — six months at 18% is 9%, treated as simple interest. And which side of the quoted spread applies depends on which way the currency is being traded: a company buying dollars pays the bank’s selling rate, a company selling dollars gets its buying rate. The bank is on the better side of both.

Both hedges remove the uncertainty, and they rarely produce the same number. The only way to know which is better is to work both out.

HT Co, a UK company, is negotiating a sale worth $1.4 million on six months’ credit. Spot is $1.8960 – $1.8970 = £1 and the six-month forward is $1.8840 – $1.8860 = £1. UK borrowing is 4% a year and deposits earn 3%; in the US the figures are 8% and 6%.

The forward contract is worth £22,045 more, and it is one line of arithmetic against three. Both fix the receipt today, so HT should take the forward.

Now the third option, which is to do nothing. If the rate moves to $1.8870 – $1.8900 = £1 by settlement, the unhedged receipt is $1,400,000 ÷ 1.8900 = £740,741.

The forward still wins, which will not always be true — but notice that it beats the assumed unhedged outcome as well. Where a hedge is both certain and better than the expected outcome of not hedging, the decision needs no argument about risk appetite at all.

Why is the money market hedge so much worse here? Because HT borrows dollars at 8% and deposits sterling at 3%, losing five points on the round trip. The money market hedge tends to win when the interest rates work the other way, and where interest rate parity holds exactly the two hedges give the same answer — the gap between them is the gap between market rates and parity.

A currency future is an exchange-traded contract fixing the rate at which a currency will be traded on a future date. It does the same job as a forward, standardised — fixed contract sizes, fixed currencies, fixed settlement dates.

Because they are exchange traded, futures require an initial margin when the position is opened and are marked to market daily: gains and losses are settled every day rather than accumulating to maturity.

Most positions are never delivered. A contract is closed out by entering an equal and opposite one, and delivery of the actual currency is the rare case. That ability to close out cheaply at any time is what makes futures attractive, and it is also what makes them demand active management.

That last row matters in this market. Futures exist in the major currency pairs; a Zambian company hedging a kwacha exposure will not find a liquid futures contract for it, and is realistically choosing between a forward and a money market hedge arranged with its bank.

The overall effect of a futures hedge is the same as a forward’s: a gain on the futures position offsets a loss on the underlying transaction, and a loss on the futures offsets a gain on the transaction. The company ends up near the rate it locked in, less whatever the standardisation left uncovered.

An option gives its holder the right, but not the obligation, to buy or sell a currency at a predetermined price on or before a future date. That asymmetry is the whole of what distinguishes it from everything else in this step.

• A call option is an option to buy the underlying currency.
• A put option is an option to sell it.

The holder exercises when the contract price is better than the market — the option is in the money — and lets it lapse when the market is better, which is out of the money. At the money is the case where the two are equal.

The price of an option is the premium, paid up front to the writer who is selling the flexibility. The flexibility belongs entirely to the holder: the writer has an obligation and no choice, which is what they are being paid for.

Options are the expensive way to hedge, and they buy something the other methods cannot. A company that both needs protection against an adverse movement and wants the benefit of a favourable one has no alternative — a forward gives certainty and gives up the upside, and a money market hedge does the same.

That last point is worth carrying into any recommendation. Option premiums are driven by expected volatility, so a currency that is swinging violently — the situation in which a treasurer most wants an option — is the situation in which the option costs most. The choice between a forward and an option is finally a question of whether the upside being preserved is worth what is being paid for it.