Using derivatives for hedging currency volatility risk.Hedging currency risk.Hedge is the way to reduce risk or volatility. Formally, hedging can be expressed as the taking of a position, acquiring a cash flow, an asset, or a contract that will rise in value and offset a fall in the value of an existing position. (Eiteman, David K, et al. 2007)And the way of hedge is quite similar in even different principals such as stocks, indices, commodities, etc.In the case of currency, the risk of exchange rate can be defined as the variance in expected cash flows arising from unexpected exchange rate changes.There are a few kinds of ways to hedge currency risk. These are forward(futures) contracts, options, and swap.I will show how to hedge with these financial derivatives technically.Assume that a U.S. firm has receivables dominated in British pounds in 3 months. It might be the result of exports from U.S firm to U.K importer. The value of receivable is ￡1,000,000. The spot exchange rate is $1/￡ on the date of contract.At the very moment of setting a contract to export and receiving receivables, currency risk starts to expose.The exposure position of U.S. firm is as follows. This is unhedged status. If the exchange rate should not change in 3 month, then the cash flow of U.S. firm would be $1,000,000. But, If the exchange rate rose to $1.1/￡, then the U.S. firm would get $1,100,000. It means 10% extra profit more than original contract, due to exchange rate change. If the exchange rate decreased to $0.9/￡, then the U.S. firm would receive $900,000. It is 10% loss for the exchange rate change.Figure 1 Unhedged PositionForward hedgeAssume that exchange rate futures of 3 month maturity is $1.0/￡. Selling currency futures of the value of $1,000,000 at $1.0/￡ on the date of export contract would be a complete hedge.This currency futures position will off set any directions of exchange rate change. If exchange rate rose to $1.1/￡ in 3 month, the money of the U.S. firm to receive would be $1,100,000. There would be $100,000 profit due to the exchange rate change. But, currency futures contract would lose $100,000, which would off set the profit of spot exchange rate change.On the contrary, if exchange rate decreased to $0.9/￡ in 3 month, the U.S. firm would receive $900,000, losing $100,000 due to the exchange rate change. The loss from unexpected exchange rate change will be off set by the profit of currency futures contract exactly same amount.Final payoff figure of this contract is as follows. This means the pay off by the exchange rate change is zero regardless of exchange rate in 3 month.Figure 2 Forward hedge payoffOptions HedgeOptions can be used for currency hedge. This hedge has a little different pay off structure from forward hedge.Let’s assume the price of option at the money is $20,000, being other things equal. To hedge original position, U.S. firm can buy a 3 month put option. The pay off of this hedge strategy is as follow figure.Option hedge give an up-side unlimited profit potential and down-side limited loss possibility. The Strong point of this strategy is you don’t need to forgive up-side possibility of profit in case that exchange rate rise. If exchange rate went down, maximum loss is the price of put option.The shape of payoff looks like call option of long position. The proceeds when put option was exercised is $1,000,000. Minimum net proceeds is $980,000. Maximum net proceeds is unlimited. If spot rate rose higher than $1.02/￡, option hedge strategy is superior to forward hedge. If spot rate decrease lower than $0.98/￡, option hedge strategy is better than unhedged position.Depending on currency forecasting, exercise price of put option can be chosen differently.Figure 3 Options hedge payoffThe Reason why firms hedge currency risks only partially or not at all.At first glance, currency hedge looks like ‘common sense’ for the firm which has currency exposure. But there are many reliable reasons not to hedge or partially.One reason is that effect of exchange rate fluctuation might offset each other over a long time. In reality, managers in listed company care about short term result, because they are judged by quarterly report. In these cases, the cost of hedging might outweigh the potential benefits.A second reason is that simply lack of information about hedge and derivatives. Even when the firm knows well about derivatives, using derivative instruments could be disastrous if it were misused. For instance, Sumitomo Corporation lost $3,500million in 1996 because of Copper Futures. Dealing with derivative instruments is very sensitive. This sensitivity might be a huddle for a firm to use derivatives as a hedging tool.A third reason is that the firm may want to speculate on currency volatility.A fourth reason has ground on the idea that the firm’s activity is done for the shareholder’s interest. The shareholders (stock investor) can decide their investment on the firm based on currency exposure. If the firm’s currency risk is too high for the investor, shareholder can decrease their holdings on the firm and increase the other firms that have low correlation with that currency risk.The most important purpose of hedging is management of volatility in cash flows. (Ahmed El-Masry, 2003) It means that when there was a conflict between managing volatility in cash flows and the firm’s market value, shareholder’s best interest, hedging with derivatives might be applied in part or not at all.The other reasons are that the firm concern about disclosures of derivatives activity required under FASB rules, and the firm concerns about the perceptions of derivatives use by investors, regulators, analysts or the public.According to the research by Ahmed El-Masry(2003), the firms, using derivatives as a hedging instruments, concerns lack of knowledge about derivatives, pricing and valuing derivatives positions, liquidity risk, and perceptions by investors, regulators, analysts, and the public about derivatives use.These concerns might prevent the firms from using derivatives instrument for FX hedging in full or at least in part.Firm’s size also matter when deciding to use derivative instruments as a hedging tool, A large company might have concentrated risk management team, calculating value at risk about the derivatives positions. But, a small company, which can not afford to hire risk managing specialist, derivatives specialist, etc., might have a difficulty to dealing with derivatives for a currency hedge.Firms with greater growth opportunities and tighter financial constraints are more likely to use currency derivatives.Approximately 41 percent of respondents out of Fortune 500 firms use currency swaps, forwards, futures, options, or combinations of these instruments (Geczy, CC, BA Minton, and CM Schrand, 1997)There are also substitutes of derivatives for currency hedging. One of these is incurring foreign currency denominated debt. In this way, matching the amount of foreign denominated asset and debt, of course the debt and asset should be the same currency, any change in foreign currency will offset in debt and asset. It is called money market hedge.If the firm used the borrowed money to profitable general business or investment, the money market hedge would be superior to derivative hedge due to the return from the general business of profitable investment.Here comes one numerical example.Let me assume a US firm which has account receivable of ￡1,000,000 which is due in three month and spot exchange rate of $/￡ is 1.764. To do the money market hedge, borrow ￡975,610 today, based on the borrowing rate of 10% per annum, or 2.5% for three month.Then balance sheet is matched exactly with ￡1,000,000 asset and ￡975,710 loan principal and ￡24,390 interest payable.Transferring borrowed pound into dollar, it becomes $1,720,976 at spot exchange rate.After three month, the US firm repay ￡975,610 loan plus ￡24,390 interest with the cash which was originated form account receivable of ￡1,000,000. And the $1,720,976 might have been invested in general business or profitable investment.IF the profitable investment rate were superior to forward proceeds then the money market hedge is better than derivative hedge. So, when there is better investment opportunity in home than forward rate, the money market hedge can be a good strategy.The other way is to buy a foreign firm whose business is to export their product to home country. This will offset exchange rate effect at least partially. It is called natural hedge for operational currency risk. Natural hedge is for operational risk not for a specific contract that is the difference between derivative hedge and money market hedge that I explained until now.Empirical evidence of firms’ behaviour.Geczy, CC, BA Minton, and CM Schrand (1997) tested hedging with derivatives in an econometric method. In this report, Geczy (1997) used pre-research of Smith and Stulz(1985), Froot, Scharfstein, and Steim (1993), and DeMarzo and Duffie (1991), testing reliability of other researcher’s predictions,They considered three factors affecting a firm’s derivatives decision: the incentives to use derivatives, the exposure to foreign exchange-rate risk, and the costs of implementing derivatives.Among variables in incentives for derivatives use are managerial wealth, managerial option ownership, interest coverage ration, long-term debt ratio, R&D expenses/sales, plant, property, and equipment investment expenditures/SIZE, book to market ratio, convertible debt/SIZE, preferred stock/SIZE, quick ratio, dividend yield, tax-loss carry forwards/total assets, institutional ownership, number of analyst firms.Firms with greater variation in cash flows or accounting earnings resulting from expenditure to foreign exchange rate risk have greater potential benefits of using currency derivatives. To test these aspect, Geczy measured the ratio of pretax foreign net income to total sales, the ratio of foreign sales to total sales, the ratio of foreign assets to total assets, the dollar equivalent amount of foreign denominated long and short-term debt, whether the firm has quantifiable foreign-denominated long or short-term debt, or makes a qualitative, but not quantitative, disclosure about the existence of foreign denominated debt, and the percentage of imports in a firm’s four digit standard industrial classification industry relative to total industry output.Costs also play a role in a firm’s decision to use currency derivatives and in its choice among derivatives strategies. These costs include liquidity costs, transactions costs of customization, and costs associated with basis risk and counterparty default risk.To measure connectivity of cost with hedging by derivatives, Geczy used variables such as pretax foreign income, foreign denominated debt, whether a firm uses other types of derivatives in addition to currency based derivatives, and finally firm size.Bigger firms used currency derivatives more than smaller firms. The percentage of 4th quartile in size among sample firms used currency derivatives is 75.3%. The 1st quartile is 17.2%.Among industry groupings, which used currency derivatives more than 50%, are beverages, food, pharmaceuticals, computers, office equipment, scientific, photographic, and control equipment, petroleum refining, toys, sporting goods, building materials, glass, industrial and farm equipment, lastly transportation equipment.Geczy statistically tested upper valuables whether it is significantly different between currency derivatives users and non-users. Based on that analysis, some valuables are significantly lager for currency derivatives users. These are managerial option ownership, R&D expenditures/sales, institutional ownership, number of analyst firms, firm SIZE, pretax foreign income/total sales, foreign & export sales/total sales, foreign long-term debt/total assets, percentage of imports in 4-digit SIC industry.Plant, property, and equipment investment expenditures/SIZE and book to market ration are the valuables that have smaller value for currency derivative users than non-users.Other valuables such as managerial wealth, interest coverage ratio, long term debt ratio, convertible debt/SIZE, preferred stock/SIZE, quick ratio, dividend yield, tax-loss carry forwards/total assets, identifiable foreign assets/total assets, foreign short term debt/total assets are not statistically significant between currency derivative users and non-users.This statistical study’s result is, in short, that firms with a combination of high growth opportunities but low accessibility to internal and external financing are most likely to use currency derivatives.So, 59% of the firm in upper study did not use currency derivatives to hedge currency exposure even though all tested 372 large US firms have currency exposure.According to Allayannis et al (2001), East Asian nonfinancial firms using currency derivatives had distinctive characteristics, such as lager size and foreign debt exposure.But the relation between currency derivatives and liquidity constrain with greater growth opportunities is weak.East Asian firms used foreign earnings as a substitute for hedging with derivatives. There was no evidence that East Asian firms eliminated their foreign exchange risk by using derivatives during Asian currency crisis.ReferencesAllayannis, G, GW Brown and L Klapper (2001) ‘Exchange rate risk management: evidence form East Asia’, World Bank Policy Research Working Paper 2606, May.Eiteman, David K., Arthur I. Stonehill and Michael H. Moffett (2007) Multinational Business, Finance 11th edition, Boston MA: Pearson/ Addison Wesley.El-Masry, Ahmed A (2003) ‘Derivatives Use by UK Nonfinancial Companies: A Survey Evidence’, Manchester Business School Working Paper 455, MarchGeczy, CC, BA Minton, and CM Schrand (1997) ‘Why firms use currency derivatives’, Journal of Finance, Vol 52, No 4: 1323-54sThis article is assignment 2 for ‘Finance in the Global Market’ at CeFiMS | SOAS | University of London