An Introduction to Currency Risk for Importers and Exporters

Import and export companies face the daunting task of dealing with foreign exchange risk that can easily alter revenues from overseas; with smaller cash reserves, exchange rate fluctuations can be the difference between profits and losses. Although FX volatility has been trending towards multiyear lows for the past few months, the last few years since the financial crisis have seen exceptionally high rates of FX volatility that make it difficult for firms, both large and small alike, to accurately price products sold overseas where a non-domestic currency is used.

NZD-USD Graph

 

For companies in New Zealand, for example, overseas sales are rarely calculated in New Zealand Dollars, considering it is a generally accepted practice that export sales are invoiced in the foreign buyer’s currency. With the New Zealand Dollar’s exchange rate seeing large, rapid swings frequently against major currencies such as the Australian Dollar, the Euro, the Japanese Yen, and the U.S. Dollar, it has often been more difficult for companies dealing with business overseas to accurately forecast revenue streams. This risk to the bottom line – the likelihood that a change in foreign exchange rates will negatively impact revenues – is known as foreign exchange risk, or currency risk.

For exporters, currency risk materializes when exchange rate volatility results in the company repatriating fewer revenues abroad, when the domestic currency strengthens relative to the foreign currency. For importers, this risk is the exact opposite: currency risk materializes when the domestic currency weakens relative to the foreign currency. This is true because of purchasing power parity, the relative equilibrium of exchange rates between two currencies so that an identical good in country A costs the same in country B.

Therefore, if exchange rate fluctuations cause the currency of country A to appreciate relative to the currency of country B, goods produced by country B will become cheaper to consumers in country A. If consumers in country A find that they can get the same product in country B but at a cheaper price due to the exchange rate fluctuation, they will purchase it. But for consumers in country B, whose currency has weakened, they will not consume the identical product from country A, as it would cost more.

Exporters and importers face these same risks. Importers in country A see weakened demand and smaller revenues as a result of the stronger currency; while exporters in country B see strengthened demand and greater revenues as a result of the weaker currency. When a company’s cash flow is negatively impacted by currency risk, it is known as transaction exposure.

In the next blog post, we will discuss the four different types of transaction exposure, and when and why it is appropriate to hedge against currency risk.

Hedging Basics: Hedging Using Interest Rate Futures Risk Reversals

Exposure to the interest rate markets can be hedged with many financial instruments. One of the more flexible is the risk reversal.  A key benefit of the risk reversal is that it does not exposure the hedger to immediate gains or losses (similar to a swap or futures contract) as it allows the hedger to create a range in which their exposure is un-hedged.

Futures Contracts
A futures contract is an obligation between two parties to purchase or sell a physical or financial product as some date in the future.  Interest rate futures are traded on exchanges such as the Chicago Mercantile Exchange and provide a clearing platform for traders that eliminate credit risk.

Hedging
The strategy of a risk reversal for a hedger that is looking to mitigate downside exposure to the interest rate market is to purchase a put on an interest rate futures contract and simultaneously sell a call on an interest rate futures contract.  The strike price of the call and the put are generally a certain percentage away from the current spot price, creating a range above and below the current price where the trader is not hedged.  If the price of the futures contract falls below the put, the trader receives a payout.  If the price of the futures contract rises above the call, the trader needs to make a payment.

Hedging Basics: Swaptions

Interest rate options are excellent tools to use to mitigate interest rate exposure.  One robust structure that is used to reduce exposure to monthly periods of interest rate volatility is the interest rate swaption.  This instrument combines the protection of a swap, with the flexibility of a European style option.

Interest Rate Swap
An interest rate swap is a fixed for floating swap which allows an investor or corporate treasurer to reduce their exposure to interest rates by selling or buying a swap.  A pay fixed swap reduces exposure to climbing interest rates while a pay float swap reduces exposure to declining interest rates.

European Option
A European style option is an option in which the purchaser of the option can only exercise the option on the expiration date.  The option is the right but not the obligation to purchase a financial instrument as a specific date in the future.  The strike price is the price at which the buyer and seller of the option agree to buy/sell the financial product.

Interest Rate Swaption
An interest rate Swaption is the right but not the obligation to purchase an interest rate swap on a specific date.  On the expiration date, the owner of the swaption has the right to purchase the swap at the strike price.  A swaption payout profile is similar to a European option.

Hedging Basics: Currency Swaps

A currency swap locks in a price of a currency pair and is another tool that can be used to manage an organisation’s cash flow. The currency swap pays the fixed-price buyer of a currency pair a payout equal to the difference between the current price and the settlement price of the swap.

Fixed for Float Swap
A (fixed for floating) swap is a financial product which acts as a hedge against an adverse downside movement for an investor or corporate hedger.  The components of a swap are as follows:

  • Reference Index:  A pricing index such as a currency pair future or OTC currency pair
  • Fixed Price is a negotiated price which will be compared to the floating (index) price to determine if the swap is in our out of the money.
  • Floating Price is created from the reference index by averaging the reference prices over the period of the agreed swap.
  • Floating Payment is calculated by multiplying the floating price by the volume of the notional used for the currency pair.

Swap Calculation: The average floating price over the swap period is compared to the fixed price, to determine which way cash will flow.

Swap Pricing Periods: The periods of time that are agreed upon which incorporate the swap.  When the swap period is complete the floating price is examined, and payments are exchanged. Generally monthly periods are used to compute swaps.

Hedging Basics: Average Price Currency Options

Late last year we started a series of educations posts relating to the fundamentals of currency hedging. This latest post covers the basic workings of Average Price Currency Options.

The currency markets are volatile markets in which movements between currency pairs can be swift and choppy, changing the direction during political uncertainty or during statement by central banks on monetary policy.  Many treasurers have significant exposure to the currency markets, and hedging using daily operating currency rates can be a significant help in smoothing a corporation’s cash flows.

Average Price Option
An average price option, which is also known as an Asian option, is a financial instrument in which the payout is calculated based on the average price through a specific period.  The period in question can range from a couple of days to multiple years.  Average price options help a treasurer hedge their exposures to the currency markets on a daily basis, removing the daily volatility associated with currency fluctuations.

Average Price Option Payout
Average price currency options generate a different payout profile when compared to European and American style options.  An average price option is calculated by averaging a specific currency rate either using the end of the day price or a mutually agreed upon point, over the period in which the option is active.  For example, a monthly average price option would use the daily average of the trading days during the month.  This level is compared to the strike price, and the difference when multiplied by the volume generates the payout.