© 2018 Cambridge University Press 3-1
Michala Moravcová
Department of Finance, Masaryk University
International Finance
Transaction Exchange Risk
International Finanace
© 2018 Cambridge University Press 3-2
1. Future Exchange Rates Uncertainty
2. Hedging Transaction Exchange Risk
3. The Forward Foreign Exchange Market
4. Changes in Exchange Rate Volatility
Contents
International Finance
© 2018 Cambridge University Press 3-3
• Transaction exchange risk
• Possibility of taking a loss in foreign exchange transactions because future spot rate not
known with certainty.
• As a financial manager, you must be able to gauge where the exchange rate might head and
how likely such fluctuations may be.
• Who incurs transaction exchange risk?
• Corporations
• Institutional investors
• Individuals
• How to avoid?
• Hedging: protect against losses and remove uncertainty
• Forward foreign exchange market is the market for exchanges of currencies in the future. Its
purpose is to manage foreign exchange risk in general and transaction exchange risk in
particular.
3.1 Transaction Exchange Risk
3International Finance
© 2018 Cambridge University Press 3-4
• Fancy Foods
• FF (US company) has to pay £1,000,000 in 90 days in return for supplies
• The spot rate is $1.50/£ and FF expects the £ to appreciate by 2%
• They can (i) wait and buy £’s on the market or (ii) hedge
• No hedge (Fancy Foods’s expectations are realized and the pound actually appreciates by 2%)
• 𝐶𝑜𝑠𝑡 = 𝑆 𝑡 + 90, $/£ × £1𝑀 = $1.53/£ £1𝑀 = $1.53𝑀
• 𝑆 𝑡 + 90, $/£ = ($1.50/£)x (1 + 0.02) = $1.53/£ .
• Hedge
• Purchase a forward contract and lock in rate (No uncertainty)
• Forward is the market’s best guess as to what the spot will be in 90 days so if the market is right,
you’re only out the bid/ask spread
• If the market is wrong, hedging could be good or bad
• If £ appreciates (takes more $’s to buy a £), hedging would have been better
• If £ depreciates (takes fewer $’s to buy a £), then hedging would have been worse.
Transaction Exchange Risk Example
4International Finance
© 2018 Cambridge University Press 3-5
• Assessing exchange rate uncertainty using historical prices
• Percentage change:
• 𝑠(𝑡) =
! " #!("#%)
!("#%)
• Appreciation if positive
• Depreciation if negative
• Mean and standard deviation
• Normal distribution for major currencies
• Skewed distribution for emerging markets
3.2 Describing Uncertain Future Exchange Rates
5International Finance
© 2018 Cambridge University Press 3-6
Dollar/Pound Monthly
Exchange Rate: 1975–
2014
• Histogram of monthly % changes
in the exchange rate of the U.S.
dollar per British pound.
• Mean: -0.05%
• Std. Dev.: 3.03%
6International Finance
© 2018 Cambridge University Press 3-7
Peso/Dollar Monthly
Exchange Rate: 1994–
2014
Mean: 0.79%
Std dev.: 4.76%
Long right-hand tail (skewed to the
right). Large depreciations or
devaluations of the peso relative to
the dollar have occurred
(“fat tails“).
The absence of a large left-hand tail
indicates there have been no
analogously large appreciations or
revaluations of the peso.
7International Finance
© 2018 Cambridge University Press 3-8
• The probability distribution of future exchange rates (financial managers are also
interested in the probability distribution of future spot exchange rates).
• Depends on all of the information available at time t, so we say it is “conditional”
• Conditional mean/expectation at time t of the future spot exchange rate:
• 𝑆(𝑡)×(1 + 𝜇)
• $1.50/£×(1 + 0.02) = $1.53/£ (possible future spot exchange rate)
• (1 + 𝜇) - percentage change in the exchange rate over the next 90 days
• Conditional volatility (standard deviation = 4%):
• 𝑆(𝑡)×𝜎
• $1.50/£× 0.04 = $0.06/£
• Range (within 1 σ) is therefore: $1.47/£ - $1.59/£
3.2 Describing Uncertain Future Exchange Rates
8International Finance
© 2018 Cambridge University Press 3-9
Probability Distribution
of future exchange rates
in 90 days S(t+90)
• The range of future exchange
rates that encompasses all but
4.55% of the future possible
values of dollar–pound exchange
rates is $1.41/£ to $1.65/£.
9
Within 1 σ
Probability of 68.26%
Within 2 σ
Probability of 95.45%
International Finance
© 2018 Cambridge University Press 3-10
• Assessing the likelihood of particular future exchange rate ranges
• How likely is it that the £ will appreciate in 90 days to $1.60/£?
• $0.07/£ greater than conditional mean of $1.53/£
• (0.07/0.06) = 1.167 standard deviations away, or 12.16% for normal distribution
3.2 Describing Uncertain Future Exchange Rates
10International Finance
© 2018 Cambridge University Press 3-11
• Forward contracts and hedging
• Forward rate
• Forward contract between a bank and a customer calls for delivery, at a fixed future date, of a
specified amount of one currency against payment in another currency (fixed FX rate). The
exchange rate specified in the contract, called the forward rate, is fixed at the time the parties
enter into the contract.
• Eliminates risk/uncertainty
• Usually a large sum of money
• With bank
• Example: Fancy Foods can buy £1,000,000 at $1.53/£
• Which gives them an asset to match the liability
• They will also only have a $ liability ($1,530,000)
• No hedge: (Fancy Foods can wait to transact in 90 days, but it risks losing money if the pound
strengthens against the dollar).
3.3 Hedging Transaction Exchange Risk
11International Finance
© 2018 Cambridge University Press 3-12
Gains and Losses
Associated with Hedged
Versus Unhedged
Strategies
• The 45-degree line represents the
unhedged strategy. Costs/Profits
are unlimited.
• If you hedge by buying a forward
contract today, your cost will be
the same (equal to the forward
rate) no matter what spot
exchange rate is realized in the
future. You bear no risk.
• The forward contract eliminates
your risk of loss, but it does so by
keeping you from participating in
possible gains in the future.
12International Finance
Think of being exporter and importer and also having assets
and liabilities in foreign currency.
© 2018 Cambridge University Press 3-13
• Hedging import payments
• Example: You are US wine store. You are due to pay €4M in 90 days.
• What is the source of your transaction exchange risk, and how much could you lose?
• You are exposed to losses if the euro strengthens relative to the dollar unexpectedly to, say,
$1.12 /€.
• Spot: $1.10/€; 90-day forward: $1.08/€
• Hedged you will pay €4𝑀×$1.08/€ = $4,320,000
• However, if dollar strengthens, you could lose money relative to remaining unhedged
• Hedging export receipts
• Example: You are British manufacturer shipping sweater to Japan. Hedge a ¥500M receivable
to arrive in 30 days
• Spot: ¥176/£; 30-day forward: ¥180/£
• Hedged you will receive ¥500𝑀/(¥180/£) = £2,777,778
• However, if the yen strengthens, you could lose money relative to remaining unhedged
3.3 Hedging Transaction Exchange Risk
13International Finance
© 2018 Cambridge University Press 3-14
• Market organization
• Outright forward contracts (OTC)
• Only 13% of all transactions
• Swap
• Simultaneous purchase and sale of a certain amount of foreign currency for two different dates in
the future
• More than 42% of forex transactions are swaps
3.4 The Forward Foreign Exchange Market
14International Finance
© 2018 Cambridge University Press 3-15
• Forward contract maturities and value dates
• Forward value or settlement date
• Most active maturities are 30, 60, 90, 180 days
• Highly customizable
• Exchange takes place on the forward value date
• Forward bid/ask spreads
• Larger than in spot market (due to lower liquidity and higher uncertainty)
• Spreads higher for contracts with greater maturities
• Less than 0.05% for major currencies
• 90 day: Less than a pip wider than the spot spreads
• As soon as the trader records the forward trade, he may start looking for a counterparty in
the interbank market to close the position by entering into an opposite contract.
3.4 The Forward Foreign Exchange Market
15International Finance
© 2018 Cambridge University Press 3-16
• Net settlement
• Settling a contract by paying or receiving a net settlement that depends on the value of the
contract
• Can be used in the case where the situation differs from the original scenario
• Often used in forex futures market
3.4 The Forward Foreign Exchange Market
16International Finance
© 2018 Cambridge University Press 3-17
• Foreign exchange swap types
• Most common:
• The purchase of foreign currency spot against the sale of foreign currency forward
• The sale of foreign currency spot against the purchase of foreign currency forward
• Others:
• The purchase of foreign currency short-term forward against the sale of foreign currency long-term
forward
• The sale of foreign currency short-term forward against the purchase of foreign currency long-term
forward
• Use:
• Protection against FX risk for portfolio managers who invests in foreign bonds, equities,… (to buy a
foreign equity, these people must first buy the foreign currency in the spot market. To hedge the
currency risk, they sell that currency forward).
• The main reason swaps are so popular is that simultaneous spot and forward transactions in
opposite directions occur quite naturally.
3.4 The Forward Foreign Exchange Market
17International Finance
© 2018 Cambridge University Press 3-18
• How swap prices are quoted
• Spot: ¥/$ 104.30 – 35
• 30-day swap points: 15/20
• Basis points that must be added/subtracted to/from the current spot bid/ask price to yield
the actual 30-day bid/ask forward prices
• ¥104.30/$ spot bid + ¥0.15/$ + = ¥104.45/$ forward bid for dollars
• ¥ 104.35/$ spot ask + ¥0.20/$ = ¥ 104.55/$ forward ask for dollars
• 30-day swap points: 20/15
• ¥104.30/$ spot bid - ¥ 0.20/$ = ¥104.10/$ forward bid for dollars
• ¥1104.35/$ spot ask - ¥ 0.15/$ = ¥104.20/$ forward ask for dollars
• A rule for using swap points
• If first number in swap quote is smaller than the second, you add the points to the bid and
ask prices to get the forward quotes; if larger - subtract
3.4 The Forward Foreign Exchange Market
18International Finance
© 2018 Cambridge University Press 3-19
Cash Flows in a SpotForward
Swap
Nomura quotes:
Spot: ¥ 104.30 /$ - ¥ 104.35 /$
30-day swap points: 20/15
IBM swaps $10,000,000 into yen for 30 days
Future payment:
¥ 104.35 /$ - ¥ 0.15 /$ = ¥104.20/$
$ 10,000,000 x (¥104.20/$) = ¥1,042,000,000
The party that is receiving the high-interestrate
currency pays the party that is receiving
the low-interest-rate currency the difference
in basis points.
19International Finance
© 2018 Cambridge University Press 3-20
• Forward premium
• Occurs when the price of the currency forward contract is higher then the spot rate
• F$/€ > S$/€ (the price of a € is higher for Forward.
• Forward discount
• Occurs when the price of the currency forward contract is lower then the spot rate
• F$/€ < S$/€ (the price of a € is lower for Forward.)
• Calculation (Forward premium and Forward discount expressed as annualized %)
• 𝐴𝑛𝑛. 𝑃𝑒𝑟𝑐𝑒𝑛𝑡 =
!"#$%#& '()"*
()"*
×
+,.
&%/0
×100 , N is the number of days in the forward
contract.
3.5 Forward Premiums and Discounts – related to
interest rates
20International Finance
© 2018 Cambridge University Press 3-21
• Forward premiums and swap points
• Because forward contracts typically trade as part of a swap, the swap points indicate the
premium or discount for the denominator currency
1, USD/JPY: IR USD > IR JPY
• 1st > 2nd (swap points subtracted)
• base currency is the higher interest rate currency. As such, the base currency becomes Forward
discounted currency.
2, USD/JPY: IR USD < IR JPY
• 1st < 2nd (swap points added)
• base currency is the lower interest rate currency. As such, the base currency becomes Forward
premium currency.
3.5 Forward Premiums and Discounts
21International Finance
© 2018 Cambridge University Press 3-22
• Understanding how forex rates move involves more than just means and standard
deviations
• Volatility clustering: When standard deviations (volatility) in forex rate demonstrate a pattern
• i.e., has been high and remains high
• GARCH model
• Developed by Tim Bollerslev (1986)
• V(t) = a + bv(t-1) + ce(t)2
• A = minimum variance if past volatility and news terms = 0
• B = sensitivity of current conditional variance to past volatility
• C = sensitivity to current news
• Other models exist, but none of which have received as much attention
• Clustering of macroeconomic news events, reactions to changes in uncertainty regarding macroeconomic
fundamentals, trading processes
3.6 Changes in Exchange Rate Volatility
22International Finance
© 2018 Cambridge University Press 3-23
Monthly Standard
Deviations of Daily
Rates of Appreciation
23International Finance
© 2018 Cambridge University Press 3-24
• What is a forward exchange rate? When does delivery occur on a 90-day forward
contract?
• If the yen is selling at a premium relative to the euro in the forward market, is the
forward price of EUR per JPY larger or smaller than the spot price of EUR per JPY?
• How much of the probability distribution of future spot rates is between plus or
minus 2 standard deviations?
• If you are a U.S. firm and owe someone ¥10,000,000 in 180 days, what is your
transaction exchange risk?
• What is a spot–forward swap and forward–forward swap?
Questions:
International Finance