FIN209 CA2

Assignment on Hedging Strategies

currency pair:

EUR/USD
(Euro - US Dollar)

Submitted on:
April 05, 2020.

Submitted by:
Hrishabh Satankar 11711153
Husen Ali Musalman 11717512
Shishir Das 11711385

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Table of contents

Introduction to Currency Pairs 03

EUR/USD 04
Contract Specifications 05
Foreign Exchange risk 06
Instruments of Hedging 07
Currency Futures as hedging tool 08
Long Hegde 09
Short Hedge 11

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What Is a Currency Pair?
A currency pair is the quotation of two different currencies, with the value of one currency
being quoted against the other. The first listed currency of a currency pair is called the base
currency, and the second currency is called the quote currency.
Currency pairs compare the value of one currency to another—the base currency (or the first
one) versus the second, or the quote currency. It indicates how much of the quote currency is
needed to purchase one unit of the base currency. Currencies are identified by an ISO currency
code, or the three-letter alphabetic code they are associated with on the international market.
So, for the U.S. dollar, the ISO code would be USD.

Base Currency
In the forex market, currency unit prices are quoted as currency pairs. The base currency – also
called the transaction currency - is the first currency appearing in a currency pair quotation,
followed by the second part of the quotation, called the quote currency or the counter currency.
For accounting purposes, a firm may use the base currency as the domestic currency
or accounting currency to represent all profits and losses.

Quote Currency
The quote currency, commonly known as "counter currency," is the second currency in both a
direct and indirect currency pair and is used to value the base currency.
In a direct quote, the quote currency is the foreign currency, while in an indirect quote, the
quote currency is the domestic currency. As the rate in a currency pair increases, the value of
the quote currency is falling, whether the pair is direct or indirect.

Basics of Currency Pairs

Trading of currency pairs are conducted in the foreign exchange market, also known as the
forex market. It is the largest and most liquid market in the financial world. This market allows
for the buying, selling, exchanging and speculation of currencies. It also enables conversion of
currencies for international trade and investment. The forex market is open 24 hours a day, five
days a week (except holidays), and sees a huge amount of trading volume.
All forex trades involve the simultaneous purchase of one currency and sale of another, but the
currency pair itself can be thought of as a single unit—an instrument that is bought or sold. If
you buy a currency pair, you buy the base currency and implicitly sell the quoted currency.
The bid (buy price) represents how much of the quote currency you need to get one unit of the
base currency.
Conversely, when you sell the currency pair, you sell the base currency and receive the quote
currency. The ask (sell price) for the currency pair represents how much you will get in the
quote currency for selling one unit of base currency.

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Currency Pair: EUR/USD (Euro/U.S. Dollar)

The Currency Pair EUR/USD is the shortened term for the euro against U.S. dollar pair, or
cross for the currencies of the European Union (EU) and the United States (USD). The currency
pair indicates how many U.S. dollars (the quote currency) are needed to purchase one euro (the
base currency). Trading the EUR/USD currency pair is also known as trading the "euro." The
value of the EUR/USD pair is quoted as 1 euro per x U.S. dollars.
For example, if the pair is trading at 1.50, it means it takes 1.5 U.S. dollars to buy 1 euro.

The EUR/USD pair has become the most widely-traded pair in the world because it represents
a combination of two of the biggest economies in the world. It is affected by factors that
influence the value of the euro and/or the U.S. dollar in relation to each other and to other
currencies. For this reason, the interest rate differential between the European Central Bank
(ECB) and the Federal Reserve (Fed) affects the value of these currencies when compared to
each other. For example, when the Fed intervenes in open market activities to make the U.S.
dollar stronger, the value of the EUR/USD cross could decline due to a strengthening of the
U.S. dollar compared to the euro. Along the same lines, bad news from the EU economy has
an adverse effect on prices for the EUR/USD pair. News of the government debt crisis and
immigrant influx in Italy and Greece resulted in a euro selloff, prompting the pair's exchange
rate to plunge.

History of Euro Currency

The euro currency originated on 1992 as a result of the Maastricht Treaty. It was originally
introduced as an accounting currency in 1999. On Jan. 1, 2002, the euro began circulating in
member countries of the EU, and over the course of several years, it became the accepted
currency of the European Union and ultimately replaced the currencies of many of its members.
Consequently, the euro integrates and represents a large number of European economies. This
serves to stabilize currency exchange rates and volatility for all members of the European
Union. It also makes the euro one of the most heavily traded currencies in the forex market,
second only to the U.S. dollar.

As of March 26, 2018, 19 of the 28 member countries of the European Union use the euro.
According to the ECB, as of January 1, 2017, more than €1 trillion are in circulation in the
world.

In EUR/USD currency pair,

➢ EUR (euro) is the base currency.
➢ USD (US dollars) is the quote currency.
➢ It’s one of the most traded currency, thus it’s a direct quote.

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Cross Currency contract specifications:

Symbol EURUSD
Market Type N
Instrument Type FUTCUR
Unit of trading 1 - 1 unit denotes 1000 EURO.
Underlying / Order Quotation The contract would be quote in USD. The
outstanding positions would be in EURO
terms
Tick size 0.0025
Trading hours Monday to Friday
9:00 a.m. to 5:00 p.m. IST
Contract trading cycle 12 serial monthly contracts.
Calendar spreads Spread Combinations available for trading
would be

M1 - M2, M1 - M3, M1 - M4, M2 - M3, M2-

M4, M3 - M4

All spread orders shall be placed in terms of

price difference only.
Expiry/Last trading day Two working days prior to the last business
day of the expiry month at 12:30 pm. If last
trading day is a trading holiday, then the last
trading day shall be the previous trading day
Quantity Freeze 10,001 or greater
Price operating Tenure upto 6 +/-3 % of base price.
range months
Tenure greater than +/- 5% of base price.
6 months
Base price Theoretical price on the 1st day of the
contract.
On all other days, DSP of the contract.

source: website NSE India

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Foreign Exchange Risk
When companies conduct business across borders, they must deal in foreign currencies.
Companies must exchange foreign currencies for home currencies when dealing with
receivables, and vice versa for payables. This is done at the current exchange rate between the
two countries. Foreign exchange risk is the risk that the exchange rate will change unfavourably
before payment is made or received in the currency.

Effect of changes in exchange rates

Exchange rate movements impact returns when a change in the value of one currency against
another currency leads to a rise or fall in the value of an asset. When an investor buys a domestic
asset, the only variable is whether that asset increases in value. But if they invest abroad, they
will have to consider the impact of an exchange rate too. The basic function of this is relatively
simple: when a local currency depreciates, it can buy less of a foreign currency, decreasing its
purchasing power. And when a local currency appreciates, it can buy more of a foreign
currency, increasing its purchasing power.
For example,

let’s say one wants to invest in a (fictitious) French clothing company, Paris Prints. Shares of
the company are trading at €50 – so at the (assumed) current EUR/USD exchange rate of
0.9004, you’d be paying $45.02 (50 x 0.9004) for the stock. If you bought 100 shares, your
initial outlay would be $4502.

However, you don’t execute your order for two days. Although the share price of Paris Prints
has remained the same, a sensitive political announcement caused the dollar to depreciate
against the euro. So, at the new exchange rate of 0.9250, you’d be buying the shares at a higher
price of $46.25, giving you an outlay of $4625.

Currency Hedging
In very simple terms, Currency Hedging is the act of entering into a financial contract in order
to protect against unexpected, expected or anticipated changes in currency exchange rates.
Currency hedging is used by financial investors and businesses to eliminate risks they
encounter when conducting business internationally. Hedging can be likened to an insurance
policy that limits the impact of foreign exchange risk.

Hedging can be accomplished by purchasing or booking different types of contracts that are
designed to achieve specific goals. These goals are based on the level of risk the customer is
exposed to and seeking protection from and allow the individual to lock in future rates without
affecting, to a great extent, their liquidity.

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Ways / Instruments of Hedging Currency (Forex) Risk

1. Hedging currency risk with specialised ETFs

While less conventional, one way to hedge foreign exchange risk is by investing in a specialised
currency exchange traded fund (ETF). In principle, a currency ETF functions just like any other
ETF, but rather than holding stocks or bonds, it holds currency cash deposits or derivative
instruments tied to an underlying currency, which mirror its movements.
A trader can go long or short on these ETFs, depending on the required hedge, to protect the
value of an investment or cash flow from a currency’s (or multiple currencies’) volatility.

2. Hedging currency risk with CFDs

A contract for difference (CFD) is a derivative that can be used to hedge foreign exchange risk
– to open a CFD position, the trader is not required to own the underlying currency. A CFD
hedge works because you are agreeing to exchange the difference in price of an asset – in this
case currency – from when the position is opened, to when it is closed. If the market moves in
the direction the trader predicted, they would profit and if it moved against them, they would
lose.
A CFD position can be used to offset the currency exposure of the asset being hedged. Because
CFDs are a leveraged product, only a small amount of capital is required to enter the hedge.
Furthermore, the hedge can be closed via cash settlement, limiting the potential financial outlay
of the trade.
3. Hedging currency risk with Futures contracts

A future exchange contract is a derivative that enables an individual to lock in an exchange rate
in the present for a predetermined date in the future. The benefit of a forward is that it can
protect an individual’s assets from exchange rate movements by locking in a precise value now.
The cost or benefit of buying a future is known at its purchase, with the future exchange rate
calculated by discounting the spot rate using interest rate differentials.
4. Hedging currency risk with options

An option gives the right, but not the obligation, to exchange currencies at a pre-determined
rate on a pre-determined date. There are two types of options: puts and calls. A put option
protects an option buyer from a fall in a currency, while a call option protects an option from a
rally in the currency. The benefit of such a strategy is that, for a premium, an individual can
protect themselves from adverse movements.

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Hedging Strategies using Currency Futures
What Are Currency Futures?

Currency futures are an exchange-traded futures contract that specify the price in one currency
at which another currency can be bought or sold at a future date. Currency futures contracts are
legally binding and counterparties that are still holding the contracts on the expiration
date must deliver the currency amount at the specified price on the specified delivery date.
Currency futures can be used to hedge other trades or currency risks, or to speculate on price
movements in currencies.

Currency Futures Example

Assume hypothetical company XYZ, which is based in the United States, is heavily exposed
to foreign exchange risk and wishes to hedge against its projected receipt of 125 million euros
in September. Prior to September, the company could sell futures contracts on the euros they
will be receiving. Euro FX futures have a contract unit of 125,000 euros. They sell euro
futures because they are a US company, and don't need the euros. Therefore, since they know
they will receive euros, they can sell them now and lock in a rate at which those euros can be
exchanged for US dollars.
Company XYZ sells 1,000 futures contracts on the euro to hedge its projected receipt.
Consequently, if the euro depreciates against the US dollar, the company's projected receipt is
protected. They locked in their rate, so they get to sell their euros at the rate they locked
in. However, the company forfeits any benefits that would occur if the euro appreciates. They
are still forced to sell their euros at the price of the futures contract, which means giving up the
gain (relative to the price in August) they would have had if they had not sold the contracts.

Futures as a Hedging instrument

Futures can very well be used for hedging purposes. Since futures are derivative products, they
derive their current value from the underlying asset, in this case, from currency exchange rates.
It can very well be used in different ways to minimize the risk of changes in exchange rates.

Two major approaches of hedging using futures are:

1. Long Hedge
2. Short Hedge

These two ways are used in different appropriate situations.

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Hedging Strategies

Long Hedge
Long Hedge means hedging the risk with buying futures. This approach is taken when a
company or person is expected to make a payment in the future.
How it works:

Consider a company has to make a payment in the foreign currency in the future, associated
with any transaction. But the company is unsure about the exchange rate movements of that
currency. Since the transaction has already been accepted as a contract, the company now has
a fixed amount of foreign currency cost that they have to pay in the future as decided in the
contract. If the company choose to let it be on its own and pay the payment at that time in
future, the company might incur significant losses if their home currency depreciates against
the foreign currency in which payment has to be made. However, if the company decides to
hedge it at the time of entering into the contract of transaction itself, i.e, buys future contracts
of the currency, now the company will be able to make the payment with the same exchange
rate as at the time of contract making, despite whatever the spot rate will be at that time in
future. However, this also makes the company to lose out on the chances of cutting the cost in
case of their home currency appreciated against the foreign currency. But that is never the
motive with hedging and thus is not taken into consideration.

Example:
An importer has ordered certain cars from abroad and has to make a payment of EUR 200,000
after 3 months. The spot exchange rate as well as 3 months future exchange rate is 1.1000. If
the spot exchange rate after 3 months remains unchanged the importer will have to pay USD
220,000 to buy the required EUR to pay for the import contract. If the exchange rate rises to
1.2000, then the importer will have to pay more USD 20,000 after 3 months to acquire EUR.
However, if exchange rate falls to 1.0500, then the importer will have to pay less 10,000.
Importer is exposed to currency risk, which can be hedged by taking a long position in the
future market. By taking long position in 20 future contracts, importer can lock in the exchange
rate after 3 months at 1.1000. Whatever may be the exchange rate after 3 months, importer will
be sure of getting the 2 lakh EUR by paying an amount of USD 220,000. A loss in the spot
market will be compensated by the profit in the future contract and vice versa.
Here,

Payment to be made: 200000 EUR

Current rate: 1.1000

Current cost in USD: 220000 USD

Contract size: 10,000

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If USD Strengthens and the exchange rate If USD weakens and the exchange rate
becomes EUR/USD 1.0500 becomes EUR/USD 1.2000

Spot Market: Importer has to pay more USD Spot Market: It will cost the importer USD
210,000 for buying 200,000 EUR in the spot 20,000 more, totalling at $240,000 for buying
market. 200,000 EUR in the sport market.

This in a way is profitable for the company, but This will take company to losses of $20000.
with no certainty.
Future Market: given 20 Futures were bought Future Market: given 20 Futures were bought at
at 1.1000 rate, company will still be paying 1.1000 rate, company will still be paying
$220000, which is the same as cost. $220000, which is the same as cost, to buy EUR
200000. However, the spot market would have
cost $20000 more.
The cost for buying required EUR currency is The cost would have increased by $20000 but the
same as at the time of the contract. long hedge saves the company from losses.

An importer can thus hedge itself from the currency risk, by taking a long position in the future
market. The importer become immune from exchange rate movement.

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Short Hedge
Long Hedge means hedging the risk with buying futures. This approach is taken when a
company or person is expected to receive a payment in the future.
How it works:
Consider a company has to receive a payment from the foreign currency in the future,
associated with any transaction. But the company is unsure about the exchange rate movements
of that currency. Since the transaction has already been accepted as a contract, the company
now has a fixed amount of foreign currency accrued that they will receive in the future as
decided in the contract. If the company choose to let it be on its own and receive the payment
at that time in future, the company might incur significant losses if their home currency
depreciates against the foreign currency in which payment has to be made. However, if the
company decides to hedge it at the time of entering into the contract of transaction itself, i.e,
sells future contracts of the currency, now the company will be able to receive the same amount
of payment as per the rate at the time of entering into the contract, despite whatever the spot
rate will be at that time in future. However, this also makes the company to lose out on the
chances of cutting the cost in case of their home currency appreciated against the foreign
currency. But that is never the motive with hedging and thus is not taken into consideration.
Example:

An exporter has sold certain cars to abroad and has to receive a payment of USD 200,000 after
3 months. The spot exchange rate as well as 3 months future exchange rate is 1.1000. If the
spot exchange rate after 3 months remains unchanged the importer will be receiving USD
220,000 from the buyer. If the exchange rate rises to 1.2000, then the exporter will receive
$20000 more in exchange of the received payment. However, if exchange rate falls to 1.0500,
then the exporter will get $10,000 lesser than expected, thus will have the loss.

Importer is exposed to currency risk, which can be hedged by taking a short position in the
future market. By taking short position in 20 future contracts, importer can lock in the exchange
rate after 3 months at 1.1000. Whatever may be the exchange rate after 3 months, importer will
be sure of getting the 220000 USD in exchange of the EUR payment. A loss in the spot market
will be compensated by the profit in the future contract and vice versa.

Here,
Payment to be received: 200000 EUR

Current rate: 1.1000

Current accrued sum in USD: 220000 USD

Contract size: 10,000

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If USD Strengthens and the exchange rate
becomes EUR/USD 1.0500
Spot Market: Exporter will get $210000 for
the exchange of EUR payment received in the
spot market, which will take the exporter into
$10000 loss, since the expected payment was of
$220000.
Future Market: given 20 Futures were sold at
1.1000 rate, company will still be getting
$220000, which is the same as the expected
payment.
Profit in selling futures as compared to spot
market = $10000
Payment received in EUR and exchanged at spot
rate = $210000
Net received payment removing loss
= $210000 + $10000 = $220000
The payment received could have decreased by
$10000 but the short hedge saves the company
from losses.
An exporter can thus hedge itself from the currency risk, by taking a short position in the future
market. The exporter become immune from exchange rate movement.
If USD weakens and the exchange rate
becomes EUR/USD 1.2000
Spot Market: It will give the exporter USD
20,000 more, totalling at $240,000 for selling the
200,000 EUR in the sport market.
This can be in a way profit of $20000 but with no
certainty.
Future Market: given 20 Futures were sold at
1.1000 rate, company will still be getting $220000
for exchanging the currency, which is the same as
the expected payment.
Loss in future selling as compared to spot market
= $20,000.
Payment received in EUR and exchanged at spot
rate = $240000
Net received payment removing loss
= $240000-$20000 = $220000
The company ultimately receives the same
amount of money as expected at the time of
transaction.
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