19.3 Managing Currency Exposure

Exchange rate fluctuations is one of the very important risks trade organizations face. Once this risk is identified, it is even more important to take care of it — by finding ways to reduce its impact on company’s operations and profitability. There are many ways exist to manage and mitigate currency exposure, some methods are discussed below.

Hedging

Hedging allows companies to mitigate currency risk by entering into future and forward contracts. A future contract is an agreement to trade an asset on some future date at a price locked in today. A company that knows that it will need Korean won later this year to purchase raw materials from a South Korean supplier, for example, can purchase a futures contract for Korean won.

While futures contracts allow companies to lock in prices today for a future commitment, these contracts are not flexible enough to meet the risk management needs of all companies. Futures contracts are standardized contracts. This means that the contracts have set sizes and maturity dates. For example, futures contracts for Korean won have a contract size of 125 million won. A company that needs 200 million won later this year would need to either purchase one futures contract hedging only a portion of its needs, or purchase two futures contracts, hedging more than it needs. Either way, the company has some currency risk that they were unable to manage.

A forward contract can be useful here as company will be able to meet its specific need by using it. A forward contract is simply a contractual agreement between two parties to exchange a specified amount of currencies at a future date. Let’s say the company needs 200 million Korean won after 90 days. It can approach its bank saying that it will need to purchase 200 million Korean won on the 90th day. The bank will quote a forward rate — a rate specified today for the sale of currency on a future date. The company and its bank then can enter into a forward contract to exchange dollars for 200 million Korean won at the quoted rate on the specified future date. This contract is similar to you booking a room for three nights at $200 per night with a hotel. You are agreeing today to show up at the hotel on a future (specified) date and pay the quoted price when you arrive. The hotel agrees to provide you the room on that specified future date and cannot change the price of the room when you arrive.

The forward contract is an individualized contract between the buyer and the seller; they are both under a contractual obligation to honor the contract. Because this contract is not standardized like the futures contract (so that it can be traded on an exchange), it can be tailored to the needs of the two parties. While the forward contract has the advantage of being fine-tuned to meet the company’s needs, it has a risk, known as counterparty risk, that the futures contract does not have. The forward contract is only as good as the promise of the counterparty. If the company enters into a forward contract to purchase 200 million Korean won on March 1 from its bank and the bank goes out of business before March 1, the company will not be able to make the exchange with a nonexistent bank. The exchanges on which futures contracts are traded guard the purchaser of a futures contract from this type of risk by guaranteeing the contract.

Natural Hedges

A natural hedge occurs when a business can offset its risk simply through its own operations. With a natural hedge, when a risk occurs that would decrease the value of a company, an offsetting event occurs within the firm that increases the value of the company.

As an example, consider a British-based travel agency. One of the major tours the company offers is a tour of Italy. The company arranges for transportation, lodging, meals, and sightseeing for Britishers to visit the highlights of Rome, Florence, and Venice. Because the company charges customers in British pounds but must pay the bus companies, hotels, and other service providers in Italy in euros, the travel agency faces significant transaction exposure. If the value of the British pound depreciates after the company sets the price it will charge for the tour but before it pays the Italian suppliers, the company will be harmed.

The company could create a natural hedge by offering tours of London to individuals living in the European Union. The travel agency could charge people who live in Germany, Italy, Spain, or any other country that has the euro as its currency for a travel package to London. Then the agency would pay British restaurants, tour guides, hotels, and bus companies in British pounds. This segment of the business also has currency risk. If the British pound depreciates, the company gains because the euros it collects from its EU customers will purchase more British pounds than before.

Thus, the company has created a situation in which if the British pound depreciates, the decrease in value of its tours of Italy is exactly offset by the increase in value of its tours of London. If the British pound appreciates, the opposite occurs: The company experiences a gain in its division that charges British pounds for tourists travelling to Italy and an offsetting loss in its division that charges euros for tourists travelling to London.

Options

A financial option gives the owner the right, but not the obligation, to purchase or sell an asset for a specified price at some future date. Options are considered derivative securities because the value of a derivative is derived from, or comes from, the value of another asset.

In trade finance, options have specific terminology.

• If the owner of an option decides to purchase or sell the asset according to the terms of the options contract, the owner is said to be exercising the option.
• The price the option holder pays if purchasing the asset or receives if selling the asset is known as the strike price or exercise price.
• The price the owner of the option paid for the option is known as the premium.

An option contract has an expiration date. The most common kinds of options are American options, which allow the holder to exercise the option at any time up to and including the expiration date. Holders of European options may exercise their options only on the expiration date. Both American and European options are traded worldwide, so can be confusing sometimes.

Option contracts are written for a variety of assets. The most common option contracts are options on shares of stock. Options are traded for U.S. Treasury securities, currencies, gold, and oil. There are also options on agricultural products such as wheat, soybeans, cotton, and orange juice. Thus, options can be used by financial managers to hedge many types of risk, including currency risk, interest rate risk, and the risk that arises from fluctuations in the prices of raw materials.

Options are divided into two main categories, call options and put options. A call option gives the owner of the option the right, but not the obligation, to buy the underlying asset. A put option gives the owner the right, but not the obligation, to sell the underlying asset. Call option and Put Option has a buyer as well as seller of a call. Table 19.1 gives a summary of Option contracts and outlines the positions that the parties who enter into options contract are in.

Swap-based Hedging

As the name suggests, a swap involves two parties agreeing to swap, or exchange, something. A Swap is a financial instrument that allows two parties to exchange a series of payments in one currency for a series of payments in another currency (Mehta, 2024). Generally, the two parties, known as counterparties, are swapping obligations to make specified payment streams. Currency swaps can also help in managing Translation exposure by exchanging cash flows in different currencies over a specific time period (Danani, 2024).

References

Danani, R. (2024). Translation exposure. WallStreetOasis. https://www.wallstreetoasis.com/resources/skills/accounting/translation-exposure

Mehta, K. (2024). Transaction exposure. WallStreetMojo. https://www.wallstreetmojo.com/transaction-exposure/

Attribution

“Chapter 19: Exchange Rate Risk Management” is an adaptation of “20.3 Exchange Rates and Risk” from Principles of Finance by Julie Dahlquist & Rainford Knight, published by OpenStax – Rice University and licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted. Access “Principles of Finance” for free.