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APPLICATION. Hedging Foreign Exchange Risk

As we discussed in Chapter 1, foreign exchange rates have been highly volatile in recent years. The large fluctuations in exchange rates subject financial institutions and other businesses to significant foreign exchange risk because they generate substantial gains and losses. Luckily for financial institution managers, the financial derivatives discussed in this chapter—forward and financial futures contracts—can be used to hedge foreign exchange risk.

To understand how financial institution managers manage foreign exchange risk, let's suppose that in January, the First National Bank's customer Frivolous Luxuries, Inc., is due a payment of 10 million euros in two months for $10 million worth of goods it has just sold in Germany. Frivolous Luxuries is concerned that if the value of the euro falls substantially from its current value of $1, the company might suffer a large loss because the 10 million euro payment will no longer be worth $10 million. So Sam, the CEO of Frivolous Luxuries, calls up his friend Mona, the manager of the First National Bank, and asks her to hedge this foreign exchange risk for his company. Let's see how the bank manager does this using forward and financial futures contracts.

Hedging Foreign Exchange Risk with Forward Contracts

Forward markets in foreign exchange have been highly developed by commercial banks and investment banking operations that engage in extensive foreign exchange trading and are widely used to hedge foreign exchange risk. Mona knows that she can use this market to hedge the foreign exchange risk for Frivolous Luxuries. Such a hedge is quite straightforward for her to execute. Because the payment of euros in two months means that at that time Sam would hold a long position in euros, Mona knows that the basic principle of hedging indicates that she should offset this long position by a short position. Thus she just enters a forward contract that obligates her to sell 10 million euros two months from now in exchange for dollars at the current forward rate of $1 per euro.4 In two months, when her customer receives the 10 million euros, the forward contract ensures that it is exchanged for dollars at an exchange rate of $1 per euro, thus yielding $10 million. No matter what happens to future exchange rates, Frivolous Luxuries will be guaranteed $10 million for the goods it sold in Germany. Mona calls up her friend Sam to let him know that his company is now protected from any foreign exchange movements, and he thanks her for her help.

Hedging Foreign Exchange Risk with Futures Contracts

As an alternative, Mona could have used the currency futures market to hedge the foreign exchange risk. In this case, she would see that the Chicago Mercantile Exchange has a euro contract with a contract amount of 125,000 euros and a price of $1 per euro. To do the hedge, Mona must sell euros as with the forward contract, to the tune of 10 million euros of the March futures. How many of the Chicago Mercantile Exchange March euro contracts must Mona sell to hedge the 10 million euro payment due in March? Using Equation 1 with VA = 10 million euros and VC = 125,000 euros,

NC = 10 million/125,000 = 80

Thus Mona does the hedge by selling 80 of the CME euro contracts. Given the $1-per-euro price, the sale of the contract yields 80 X 125,000 euros = $10 million. This futures hedge enables her to lock in the exchange rate for Frivolous Luxuries so that it gets its payment of $10 million.

One advantage of using the futures market is that the contract size of 125,000 euros, worth $125,000, is quite a bit smaller than the minimum size of a forward contract, which is usually $1 million or more. However, in this case, the bank manager is making a large enough transaction that she can use either the forward or the futures market. Her choice depends on whether the transaction costs are lower in one market than in the other. If the First National Bank is active in the forward market, that market would probably have the lower transaction costs. If First National rarely deals in foreign exchange forward contracts, the bank manager may do better by sticking with the futures market.

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