FX risk management solutions

As every firm with exposure to FX risk is bombarded with offer of forwards, fx options and option strategies, you probably have heard of them.

In this article, we will explain what they are, what are the advantages and disadvantages of respective solutions. One step at a time.

Hedging or speculation

Forward transaction is often perceived as a speculative one by companies, yet when we enter into forward FX transaction we fix the margin on a business transaction with a trading partner from abroad, whose base currency is different from our base currency. This obvious benefit is easy to grasp for a business owner, while not always so a financial director. If financial director enters into forward transaction that turns out to be profitable, the director probably will not be rewarded for this while he may be fired if the hedging transaction is unprofitable, regardless of the fact that the forward contract fixed the margin and reduced the FX risk on a transaction that his company entered into. This asymmetric relationship between risk and reward for a financial director is the reason why their standpoint is often different from that of the shareholder and this “rock” of negativity has to “bored” by “water” of education and developing the perspective that transactions in foreign currency do not have to be so risky and that it is advisable to fix margin on cross currency business deals and remove the fx risk altogether.

Forward – fixed term fx transaction

The first choice for a firm is often a forward transaction, entering into a contract to purchase currency at specified time in the future at a rate that is fixed today (because we know today’s price of that currency) plus some time-value-of-money element. The specified time could be the moment when some invoice in foreign currency falls due. This private transaction is similar to better known futures contracts that are traded on public exchanges. In case of a future contract, we enter into standardised transaction that has standardised expiry term and payoff, but the margin deposited is a fraction of a “notional” value of a trade – the value of a payoff once future contract expires. Private forward contract is a lot more flexible as we can decide what precise notional value we want to fix – for example the amount of the invoice or the amount of a monthly turnover in another currency regardless of whether this is 17,500 EUR or 185,123 EUR.

What do I need to start with forward contracts

If you went to a banking or non-banking FX solution provider Your company risk needs to be assessed by the provider. They will decide on limits of the exposure to your firm that they are willing to assume. The mechanism are somehow analogous to credit limit – the bank analyst takes a look at your financial statement and your business and proposes a figure. It usually takes between a week and three weeks. Minimum value of a forward for a financial solution provider usually falls between EUR 1000 and 5000.

What’s the future rate of a forward

Future rate is basically spot or today’s rate (known to us) adjusted for interest rates in both currencies plus a margin that financial provider charges for the service. Let’s have a look at two examples:

Example one

You are importer in need of EUR 50,000 EUR in 30 days’ time

The exchange rate is 4,1850 in so-called interbank market – the market in which banks trade currencies wholesale among themselves.

If you enter into forward through a bank, a bank buys for you that EUR 50,000, selling for you PLN 209,250 (4.1850 x 50,000 EUR). Then the bank deposits the EUR 50,000 at a (money market) interest rate of 0,1%. At the same time, if the bank still had PLNs that the bank gave to you, the bank could deposit them at 1%. Hence:

The bank will earn 4.17 EUR (50,000 EUR * 0.1% / 12 months) on a deposit in EUR. If a bank had PLNs, it would have earned respectively 174,38 PLN. Therefore, plugging both deposits into equation:

(209 250 + 174.38) / (50 000 + 4.17) = 209 424.38 / 50 004.17 = 4.1881 PLN.

 

That’s in theory. In practice, the bank will increase the rate in its favour and the company will be offered for example 4.1950 PLN.

 

What about if you were an exporter

The situation in analogous inasmuch that the bank sells the other currency in order to have PLNs for you. Then, the bank deposits PLN’s at 1% (in money market). The interbank exchange rate will again be 4,1881 PLN for 1 EUR, yet the rate that you will be quoted by the bank will be lower, the difference being the bank’s margin on the forward.

 

The above examples are simplified for the purpose of illustration of the mechanics of a forward transaction. In real world, the exchange rate will vary depending on whether we are long currency (buying) or short currency (selling it). In addition, banks margin depends on volume of a bank and if the bank makes enough transaction so that some of them net to zero in term of amount and time (i.e. bank’s market exposure is zero), a bank is able not to hedge some positions externally and give up on some of the price as it’s margin is intact.

In case of short currency position, future exchange rate can be higher only when base currency (first in quoted pair EURPLN) has lower interest rate than quoted one (PLN)

Forwards’ benefits summarized

  • We know the margin on a business deal upfront.
  • We do not freeze the whole amount (notional value)
  • In case of exporter: We actually make a gain on basis point in time

 

What if the business deal isn’t realised?

When a business deal gets problematic – if the partner does not pay or informs us that his payment will be delayed – we can ask the bank to postpone the termination of the forward. The rate should be slightly better off for the exporter and slightly worse off for the importer. If it turns out that business deal falls apart altogether, we can close the forward and any gain/loss on a currency will be added or subtracted to/from our bank account.

 

Currency Options

In case of forward contract, you have an obligation to settle the contact. However, if you purchase an option you buy a right, not an obligation to settle the contract, hence the name “option”. For instance, if exchange rate of euro to zloty improves (and you are an exporter) you can forego the execution of the option contract (selling the currency at specified rate) and sell currency at more favourable price in the spot market.

 

Purchase of an option contract can be compared to purchase of insurance. It is nice to have, but better not to be in the position where it is more favourable for us to call on the counterparty. As in case of car insurance, you have to pay for it, but once you purchase it, you feel safer. That’s the whole point – safety

There are two types of option. Apart from the Call Option described above, giving us the right to purchase (call on the counterparty), there is also a Put Option, giving us the right to sell currency to counterparty.

 

An example

You are an importer, you need to buy EUR 20,000 in 30 days’ time. The spot price of EUR is PLN 4.1850. The price of option (premium) is for example PLN 1000. In 30 days’ time, you will have the right to purchase EUR 20.000 at the rate of 4.1850. If then the spot price will be higher you will want to execute the right and buy at lower price. However, if the spot price will be 4.1000 – you will buy currency in the spot market, and your contract will expire unexecuted. The only cost – PLN 1000 that you already have paid earlier – cost (premium) of an option.

 

Options’ Benefits summarized

  • In case of option contract, you have the right, but not an obligation to execute the transaction, but there is upfront cost attached to this type of contract.
  • You cannot modify the termination date, as in case of a forward contract
  • To buy an option you do not need a limit nor risk assessment from a bank

Option strategies

Things are getting even more complex. In case of using option strategies, you have not just a right, but an obligation to transact at contract termination (as in case of forward contract). At the same time, you can benefit (to some degree) from beneficial changes in market price.

One of such strategies is called Corridor, where as an importer (you buy currency) you buy call option with upper limit at which you will have to buy currency and at the same time you write (sell) put option at a level or so-called strike price at which you will be able to buy currency. If today’s price is 4.1850, you can enter into Corridor with “strike” prices of 4.1690 – 4.1955. So to a degree you participate in favourable moves in the market (not lower than 4.1690), but at the same time you risk paying for currency more than in case if you entered into forward contract.

Another strategy is Participator, where two options – one purchased (long), the other written/sold (i.e. short position) are at the same level but the second one has lower notional value. In this particular strategy and in case of falling market, if you are an importer you will be able to purchase part of your currency at market or spot price, and other part at favourable price stemming from the fact of you having entered into this combination of options. If the spot market went through 4.1850 from the example above, your maximum price would be 4.1850.

There are numerous examples of options strategies, it is best to consult an external expert to match one with company needs and preferences.

Options strategies’ Benefits summarized

  • In the opposite of single option contract, you have the obligation to execute the transaction.
  • You cannot modify the termination date, as in case of a forward contract
  • In the opposite of single option contract, you need a limit nor risk assessment from a bank

 

Toxic Options – what were they about?

Two things actually – Cross Currency Interest Rate Swap (CIRS) contracts, where banks convinced companies to enter into speculative transaction swapping price changes and interest rates, in which companies were earning money as long as zloty was strengthening versus hard currencies. The other thing was complex option strategies, where in low volatility environment company was gaining another income, yet in case of rise of volatility of the exchange rate the company risked large, asymmetric loss. We definitely not recommend it.

 

How to start hedging?

First move for a company willing to start mitigating risk in financial market is to get LEI (Legal Entity Identifier) number. For more info on LEI follow this link www.lei.kdpw.pl

As next step, for forward hedging transactions contact your Business Advisor (or Dealer) to discuss your limit for derivative transactions and start processing application.

It probably makes sense to ask for pricing in more than one bank, thanks to which you will be able to obtain better price.

If not hedging then what?

If you believe that hedging financial market risk is not for you, but still want to de-risk your business, you may want to concentrate on your budgeted exchange rate. It is good to treat any currency gains as a cushion against currency losses that may come about, and not as extraordinary gains. Then, if a trend in currency market reverses, the gain to date can be used to finance client discount and temporary financial loss. This way, the client gets stable price.

If you wanted to discuss hedging instruments, negotiating exchange rates or strategies created specifically to suit your business – get in touch with us.

If you have any questions, please contact us, sign up for trainings or test our tools.

Radosław Wierzbicki
Founder & CEO
FXMANAGO

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