Lets talk about Hedging. So what exactly is Hedging? Hedging is the process of dealing with foreign exchange so that the owner gets maximum benefit. Example, an Education loan for International studies is at a Foreign Exchange risk. Imagine an Indian student taking a study loan of 20lakhs in Rupees in May 2008 and pays the same in Sep 2008. There would be a huge forex problem as Dollar was strengthened artificially and $ became equivalent to 46INR from 41.xx INR. This is a considerable loss. Now following are some of the hedging concepts.
Forward Contract: You agree to either buy or sell an amount of currency (or whatever else it is) in the future at a price decided upon today.
Spot Rate 3-Month Forward Contract Rate 3-Month Forward Forecasted Rate
1AUD = 1050MNT 1 AUD = 1000MNT 1 AUD = 1100MNT
1 AUD = 110 KZT 1 AUD = 105 KZT 1 AUD = 100 KZT
1 AUD = 5 BWP 1 AUD = 5 BWP 1 AUD = 5 BWP
1 AUD = 2 SRD 1 AUD = 4 SRD 1 AUD = 6 SRD
Anytime the 3-month contract rate yields more AUD than the 3-month forecasted rates, get a
forward contract. In this case, the Cat Empire will want to be in the short position for Forward Contracts
for the MNT and the SRD. To be safe, the Cat Empire may also want to use a Forward Contract for the
BWP as well.
Foreign Currency Futures: An agreement to deliver to another a given amount of a standardized
commodity or financial instrument at a designated future date. This is the same thing as a forward contract, but a futures contract can only be in a set increment (kind of like a bank note), such as $100,000 (which is the most common denomination). So you can buy, say, 5 futures contracts worth $500,000.
Henry Avery, a pirate that has spenth is life pillaging and plunderingt he westernh emisphere,w ants to
retire and buy a condominium in Bangalore in I year. The anticipated price on the condominium is
expected to be INR 3 million. The 1 year future price is IUSD = INR 40. The cost of a round turn per
contracti s usD 75. Each Indian Rupeef uture contractr epresentsIN R 500,000.
How many USD will Henry need if he were to secure this position?
Condo’s worth USD: INR 3,000,000 / 40 (spot) = $75,000
Round Turn Cost = No of Round turns * Cost of each contract = 3000000/500000 = 6 x $75 = $450
Total Cost = $75450
Foreign Currency Options: You pay money to be guaranteed the right to buy something at a certain price in the future. You don't have to buy it, but you could if you wanted to.
• Exercise price: price at which you can buy the underlying security
• Call Option: Right to buy a financial instrument at a specific price. (Call me the money!)
• Put Option: Right to sell a financial instrument at a specific price. (Put the money away!)
• American Option: May exercise at anytime,( but you usually don't)
• European Option: Exercise only at a specific date
• Long position: You have the currency you need to do something with. You got money.
• Short position: You don't have the currency you need to do something with. You don't got money.
• Writer: Must stand behind obligation bound if buyer demands.
Tunnel Forwards: This is essentially a forward contract, but instead of negotiate a range of where your exchange rate could fall.
Foreign Currency Loan: You take out a loan in a foreign currency and convert it to your currency today. you have to pay the loan back with interest in the future.
Kumar Sangakkara, a cricket player from Sri Lanka, has been offered a new job during the off-season as a little-league cricket coach in India. The job lasts for three months, but he won't get paid his 500,000
Rupees until the end of his contract. To pay for his living expenses during those three months, Kumar is
considering taking out a foreign currency loan. The loan could be made at 3% above the present Indian
prime rate of 8% plus an arrangement fee of .2%. The Sri Lankan prime rate is currently 10%, and
Kumar will not pay a spread above that or an arrangement fee because he is a superstar in Sri Lanka. If
the spot rate is currently 1 Sri Lankan Rupee (SLR) = .35 Indian Rupees (INR) and the 3-month forward
rate is 1 Sri Lankan Rupee= .30 Indian Rupees should Kumar take the foreign currency loan?
Answer: No! Kumar's best choice would be to convert enough SLR to bring 500,000 INR with him to
India - when he gets paid in 3 months, his contract will be worth more than he paid for the 500,000 INR,
Thanks to depreciation of the INR against the SLR. His second best choice would be to take out a loan in
Sri Lanka for enough SLR to bring 500,000 INR and then pay back the interest when he returns to Sri
Lanka - again, depreciation of the INR against the SLR makes the 500,000 INR contract worth a lot more
in three months. It would be better not to pay a loan back in INR.
Step One: How much is the 500,000I NR worth to Kumar today? 500,000* 11.35= 1,428,571 SLR
Step Two: How much will the 500,000 INR be worth in 3 months? 500,000 * ll .3 = I.666.666 SLR
Step Three: what are the costs associated with the foreign currency loan?
Total Interest Paid: 500,000 x (.08 + .03) = 55,960 INR
Total Arrangement Fee: 500,000 * .002 = 1,000 INR
Amount that Kumar would receive today: 500,000- (55,000+ 1,000=) 444,000INR
What is this worth in SLR: 444000 * 1/.35 = 1268571 SLR
Total Paid in 3 Months: 1,428,517 * 1.1 = 1,571,428 SLR
Pre-sale of a Foreign Contract:
You're expecting to collect on a contract in the future. Instead of waiting for your money,
you sell your contract to a third party and get your money today.
Mike - the MBA blogger
