Foreign Exchange Rate Risk Management

ACCA Director Author

Foreign Exchange Rate Risk Management

Foreign Exchange Rate Risk Management

Sketch

Foreign currency transactions take place in a global OTC (Over the Counter) market, mainly dealing with banks. London has the largest foreign exchange market, and most transactions in currency trading are for speculative purposes.

In the foreign exchange rate market:

• Market makers – usually banks quoting bid and offer prices
• Marker takers – all other participants such as individuals and entities

Foreign exchange rate quotation

Case study – Direct and indirect quotes

Indirect quote is where one domestic currency could be exchanged into a variable amount of foreign currencies.

Direct quote is where one foreign currency could be exchanged into a variable amount of domestic currencies.

Higher value currencies such as UK pounds and US dollar usually use indirect quote where lower value currencies usually use direct quote.

For example, USD/RMB 6.840:

• To the USD, this is the indirect quote as one domestic currency (USD) could be exchanged into variable amount of foreign currencies (RMB 6.840).
• To the RMB, this is the direct quote as one foreign currency (USD) could be exchanged into variable amount of domestic currencies (RMB 6.840).

Foreign exchange rate quotation with bid and offer prices:

• Banks usually quote foreign exchange rate with a spread, ie difference between bid and offer price to make a profit.
• Bid price is the price that banks buy from the entity. Offer price is the price that banks sell to the entity. Bid price is lower than the offer price, ie bank buys low and sells high.
• However, we often interpret the above quotation standing from our (entity’s) perspective. Focusing on the base currency (USD), if we need (buy) USD, we choose a higher price (offer price). If we sell USD and get CHF, we choose a lower price (bid price).
• The rule is – ‘We always lose and the bank always wins’.

Further complications:

• In the exam, it is usually recommended to convert the quotation GBP/USD into $/￡to simplify the calculation.
• The rule – We always pay more and receive less.

Case study – Common SWIFT Currency codes

Case study – Charts of foreign exchange rates

Below is an example of a foreign exchange rate of USD/CHF where USD is the base currency.

Increase – USD appreciates against CHF as one US dollar can be converted into more CHF.

Decrease – USD depreciates against CFH as one US dollar can be converted into less CHF.

Source: https://markets.businessinsider.com/

Exchange rate systems

1. Fixed (Pegged) exchange rate system:

This is where the value of country currency is fixed against another currency, a basket of currencies or value of gold.

To achieve the fixed or pegged rate, the central bank is committed at all times to buy and sell currencies through Open Market Mechanisms using its reserves (ie USD) and issuing domestic money:

• If demand for foreign currency is high (depreciation of domestic currency), central bank sells foreign currency using its reserve and buys domestic currency, ie to increase demand for domestic currency.
• If demand for foreign currency is low (appreciation of domestic currency), central bank buys foreign currency by adding domestic currency in the market, ie to increase supply for domestic currency.

Comment about this system:

• The system provides currency stability as it is fixed with a pegged rate.
• It avoids inflation if it is fixed with a popular currency such as USD, ie if US economy grows, its currency grows.
• However, this system may attract speculators (see case study later), and there should be enough foreign currency reserves in place to make this system work.

Case study – Hong Kong (SAR) pegged exchange rate system and HKMA

Banks with authority to print HK dollars include HSBC, Standard Chartered and Bank of China, however, before they are allowed to print HK dollars, there must be extra foreign currency coming in first.

This is like in a casino where gamblers want to have casino tokens, they need to pay for it first, ie with their real money to be exchanged for those tokens. As tokens (HK dollar) could be printed by banks as much as they can, and if they are all released in the casino whereas real money is not in place, the value of tokens goes down against the value of real money.

Therefore, in Hong Kong (SAR), there is an automatic system for central bank (Hong Kong Monetary Authority (HKMA)) to play a role to maintain the stability of exchange rate. It fixes the HK dollar to US dollar. There must be US dollar coming in before extra HK dollar could be introduced to maintain the fixed exchange rate.

Case study – Hong Kong (SAR) financial crisis and George Soros

George Soros is the founder of The Open Society Foundations and he is a well known short seller who broke the fixed exchange rate systems in many Asian countries. In 1997 and 1998, he tried to break the Hong Kong (SAR)’s fixed exchange rate system and here is how it worked:

1. He led a group of institutional investors to borrow HK dollar from most HK commercial banks and paid interests.
2. They shorted Hang Seng index futures contact, ie expecting share price to fall.
3. They then start shorted (sold) HK dollars and exchange them into US dollars, ie more HK dollars in the market with less US dollar pushing HK dollar to depreciate against US dollar.
4. As there were lots of HK dollars in the market (banks), interest rate is inflated to withdraw HK dollars into the central bank (HKMA). The overnight interest rate was risen by 300% at that time.
5. As interest rate surged, stock price and Hang Seng index dropped significantly. Hong Kong (SAR) residents and foreign investors sold their HK dollar denominated assets including properties as they expected the value would continue to fall. The HK dollar was then further converted into US dollar leading to a further decrease in HK dollar value.
6. This tactic was successfully used in the UK and Thailand to beat their central bank and government. However, it did not work in Hong Kong (SAR).
7. At that time, government spent huge amount of cash to buy companies in the Hang Seng index pushing up the share price and index again – when Soros’ s futures contract should be exercised, Soros did not make a fortune from it.
8. At the same time, government used its 96 billion US dollar reserve to buy HK dollars back, stabilising its exchange rate.
9. Finally, Hong Kong (SAR) won the war.

Case study – Fixed exchange rate in different countries

Source: IMF (2019)

Basket of currencies that Chinese Yuan (RMB) is pegged:

Source: hkex

Case study – Fixed exchange rate per value of gold

Before 1944, country currencies are pegged to an ounce of gold. In the 1944 Bretton Woods Agreement – to restore economy in different countries after the second world war, countries agreed to fix all currencies to the US dollar as dollar could be more liquid in the market than gold to restore the economy. At the same time, the World Bank and International Monetary Fund (IMF) were also established.

This means the US government agreed to redeem dollars for gold, ie if a country wants gold, the country could sell its dollar. However, due to unlimited issue of US dollar by the government, up until 1971, the US president Nixon suspended the US dollar off the gold standard, ie one US dollar could not be converted into the fixed amount of gold any more.

Since 1969, the IMF created Special Drawing Rights (SDR) with deposits of golds and currencies by member countries to be loaned and invested by countries with financial difficulties. This is a response to the limitation of gold and US dollar as a way to international settlement. The SDR includes a basket of currencies, USD, UK Pounds, EURO, Japanese Yen and RMB.

2. Freely floating exchange rate system (clean float):

This is where the value of country currency is allowed to change based on demand and supply of the currency in response to changes in market events.

Comment about this system:

• There is no need for central bank to intervene in the foreign currency market.
• However, the exchange rate becomes more volatile under this system.

Case study – The failure of freely floating exchange rate system

During 1974 to 1983, Hong Kong (SAR) adopted the freely floating exchange rate system. However, HK relied heavily on import from other countries and the HK dollar was depreciated against US dollar as there were lots of speculative attacks on HK dollars at that time and the confidence about the future of HK reduced. As many transactions took place in Hong Kong (SAR) were quoted as USD when the US is a major partner with HK, a continuous HK dollar depreciation finally pushes government to peg its exchange rate with the US dollar again.

Case study – Country currencies using freely floating exchange rate

• Australia (AUD)
• Canada (CAD)
• Chile (CLP)
• Japan (JPY)
• Mexico (MXN)
• Norway (NOK)
• Poland (PLN)
• Sweden (SEK)
• United Kingdom (GBP)
• Morocco (MAD)
• European Union (EUR)
• United States (USD)
• Russia (RUB)

Source: Wikipedia

3. Managed floating exchange rate system (dirty rate):

This system lies between fixed and freely floating exchange rate systems where the exchange rate is allowed to fluctuate daily. However, central banks will attempt to affect the rate using the following methods:

1. Open Market Mechanisms by using its foreign currency reserves to buy and sell domestic currency – the same as in fixed exchange rate system.
2. Monetary policy by increasing or decreasing the interest rate to appreciate or depreciate its currency value against another.
3. Foreign exchange controls by limiting the amount of foreign investments (appreciate own currency) or expanding foreign investments (depreciate own currency).

Countries like China and Singapore use this system. However, unlike fixed exchange rate system (such as HK dollar), the exchange rate is moved between USD/HKD 7.75 – 7.85, under the managed floating exchange rate system, the rate may fluctuate a lot more.

Comment about this system:

• There will be less volatility in foreign exchange rate movements as government controls play a vital role in this system.
• However, countries may deliberately devalue its currency to gain a competitive advantage, ie export, which is unfair to other countries.

Case study – Renminbi using managed floating exchange rate system:

Renminbi is pegged against a basket of currencies including the United States dollar, euro, Japanese yen and South Korean won, with a smaller proportion made up of the British pound, Thai baht, Russian ruble, Australian dollar, Canadian dollar and Singapore dollar.

The trading price of USD/RMB is allowed to float from each day’s midpoint published by China’s central bank within a narrow band of 2%.

Types of foreign currency risks

Foreign currency risks include translation, economic and transaction risks.

Translation risks:

• This occurs when company has a foreign branch or subsidiary where the foreign exchange rate adversely moves.

• The foreign exchange losses occur as a result of the foreign branch or subsidiary is consolidated leading to a reduction in equity value.
• However, it does not cause cash outflows, and therefore, this risk is not usually hedged against by management as there might be unnecessary hedging costs leading to a reduction in shareholders’ wealth.
• This risk can be reduced by matching assets such as properties with debts denominated in foreign currency, ie when exchange rate changes, assets and liabilities value go up or down at the same time keeping equity value unchanged.

Economic risk:

This is the risk that continuous movements in foreign exchange rates reduce a company’s international competitiveness, ie the present value of its future cash flows might be reduced.

• A continuous domestic currency weakening against foreign currency increases the import price.
• A continuous domestic currency strengthening against foreign currency reduces foreign receipts.

The continuous long term movements in exchange rates could be due to:

• Exchange rate system – speculators involved in the freely floating and fixed exchange rate system.
• Country economy – impairment in country credit ratings, increase in inflation.
• One-off event – terrorist attacks, stock market crash

To hedge economic risks:

1. Diversify supply chain, ie use different foreign suppliers and having wider customer base located in more foreign countries.
2. Diversify business operations, ie having operations in more foreign countries.
3. Change prices, ie if there is a continuous adverse exchange rate movements, selling prices could be adjusted to ensure the same amount of cash flows could be received. However, sales demand may be affected.

Transaction risk:

This is the risk of adverse foreign exchange rate movements taking place during usually international trading transactions, ie import and export. Businesses may receive less or pay more as a result of suffering from this risk.

Internal and external hedging techniques could be used to reduce this risk.

Internal techniques

1. Invoice in home currency:

This is to invoice foreign customers in home currency, ie to eliminate all foreign currency risks.

2. Leading or lagging:

• Leading – to advance payment.
• Lagging – to delay payment.

3. Matching:

• This is to match foreign currency receipts and payments to reduce the foreign exchange rate risk exposures.
• There should be one or more foreign currency bank accounts so that the foreign currency receipts could be paid into the account which is then used to settle the foreign currency payments.
• From a longer-term view, foreign currency income could be financed by the foreign currency debt so that income and expenses denominated in the same currency could be offset with each other.

4. Netting:

• This is a process where invoices among companies in a group are net off so that the reduced net amounts are subject to foreign exchange rate risks.
• If there are two companies involved, the process is known as bilateral netting.
• If there are three or more companies involved, the process is known as multilateral netting.

Case study – Legislation in netting

Instead of many transactions taking place among banks, with netting, there might be only one transaction taking place, ie the profits earned from banks may reduce. There are different legislations of netting in different countries. For example, Brazil, Malaysia, South Korea, Chile and India allow netting but only in the local currency. Some countries also require cross-border transactions be verified against the original sales contracts and invoices because with netting, one party may have received the goods, but the payment is cancelled (netted) which may cause doubts to its tax authorities.

Categories: : Financial Management (FM)