International

Finance
ECON3007
Nadia Grant-Reid
Department of Economics
UWI Mona, WJC

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FOREIGN EXCHANGE RISKS,
HEDGING, AND
SPECULATION
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Preview

The meaning of foreign

exchange risk
How foreign exchange risk can
be avoided
Examine how speculators earn
profits

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Foreign Exchange Risks, Hedging, and
Speculation

Whenever a future payment must be made or

received in foreign currency, a foreign
exchange risk is involved because spot rates
vary over time.

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FIGURE1ExchangeRatesoftheG7CountriesrelativetotheUSDollar,1970
2012.
Foreign Exchange Risks, Hedging, and
Speculation

Contracted future foreign currency payments may

become more expensive if the domestic currency
falls in value.
Example:
A contract requires a 100,000 payment in three

months time.
If the exchange rate is currently $1/1, the

expected dollar cost is $100,000.

If the exchange rate changes to $1.10/ 1 in the

intervening months, the dollar cost rises to

$110,000.

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Foreign Exchange Risks, Hedging, and
Speculation

Contracted future foreign currency receipts may

fall in value if the domestic currency increases in
value.
Example:
A producer expects to receive a payment of

100,000 in three months time.

If the exchange rate is currently $1/1, the

expected dollar receipt is $100,000.

If the exchange rate changes to $0.90/ 1 in the

intervening months, the dollar receipt falls to

$90,000.

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 Types Of Risk

Translation Risk or Accounting Risk

(exposure)

Transaction Risk (exposure)

Economic Risk (exposure)

 Translation Risk or Accounting Risk
(exposure)
The risk that a company's equities, assets,
liabilitiesor incomewill change in value as a
result of exchange rate changes. This
occurswhen a firm denominates a portion
ofits equities, assets, liabilities or incomein a
foreign currency.
 Transaction Risk (exposure)
The risk, faced by individuals or companies
involved in international trade, that currency
exchange rates will change after the parties
have already entered into financial
obligations. Such exposure to fluctuating
exchange rates can lead to major losses.
Foreign Exchange Risks- Hedging

Ways of Hedging Against Exchange Rate

Risk
The forward, futures, or options market.
Invoicing in the domestic currency.
Speeding (slowing) payments of currencies
expected to appreciate (depreciate).
Speeding (slowing) collection of currencies
expected to depreciate (appreciate).

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 Economic Risk (exposure)
An exposure to fluctuating exchange rates,
which affects a company's earnings, cash flow
and foreign investments. The extent to which
a company is affected by economic exposure
depends on the specific characteristics of
thecompany and its industry
Foreign Exchange Risks, Hedging, and
Speculation

Hedging is the avoidance of foreign exchange risk.

Options:
1. Buy at the current spot rate and deposit the
receipts in an interest earning account until the
funds are needed.
2. Buy a forward contract
Typically entails paying a forward premium,
increasing the cost of the transaction.
3. Buy a call option
If not exercised, the premium is lost.

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Foreign Exchange Risks- Hedging (Spot
Market)

Hedging refers to the avoidance of a foreign exchange

risk, or the covering of an open position.
For example, An importer orders goods and is required
to pay in three months, he could borrow 100,000 at the
present spot rate of SR = $1/ 1 and leave this sum on
deposit in a bank (to earn interest) for three months,
when payment is due.
The importer is avoiding an increase in the cost of
importing due to changes in the exchange rate

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Foreign Exchange Risks- Hedging (Forward
Market)

Hedging usually takes place in the forward

market
Example If the euro is at a three-month forward
premium of 4 percent per year, the importer
will have to pay $101,000 in three months for
the 100,000 needed to pay for the imports.
Therefore, the hedging cost will be $1,000 (1
percent of $100,000 for the three months).

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Foreign Exchange Risks- Hedging (Options
Market)

Hedging can take place in the futures and

options market
For example, suppose that an importer knows
that she must pay 100,000 in three months and
the three-month forward rate of the euro is FR =
$1/ 1. The importer could buy a call option
contract for 100,000 in three months, at $1/
1, and pay premium of, 1 percent (or $1,000 on
the $100,000 option).

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Foreign Exchange Risks- Hedging (Options
Market)

Parallel to a Call option

Suppose that you went shopping during a sale for a
Sony camcorder, selling for $700 and the store had run
out of this item. Then the store might issue you with a
rain-check which would permit you to go back to the
store within a month and buy the camcorder for $700.
Suppose the day you went back to the store
camcorders were selling for $680 then would you use
your rain-check? No the rain-check would be worthless
and you would just throw it away

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Foreign Exchange Risks- Hedging (Options
Market)

Hedging can take place in the futures and

options market
If in three months the spot rate of the pound is
SR = $0.98/1, the importer would have to pay
$100,000 with the forward contract, but could
let the option expire unexercised and get the
100,000 at the cost of only $98,000 on the spot
market.

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Foreign Exchange Risks- Hedging

The ability of traders and investors to hedge

greatly facilitates the international flow of
trade and investments.
Benefits of hedging
Greater international capital flows,
More trade
Greater specialization in production,
Greater benefits from trade.

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Foreign Exchange Risks- Hedging (Exercise)

Assume that SR = $2/1 and the three-month

FR = $1.96/1. How can an importer who will
have to pay 10,000 in three months hedge the
foreign exchange risk?

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Foreign Exchange Risks- Speculation (Forward
market)

Speculation, the opposite of hedging, is the

acceptance of foreign exchange risk in the hope of
making a profit.
Example:
If the speculator expects the spot rate in three

months time to be $1/1, she may sell euros at

a current three month forward rate of $1.01/1
with the expectation that she will be able to buy
euros to cover her sale at the lower spot rate.

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Foreign Exchange Risks- Speculation (Options
market)

Alternatively, the speculator (who believes that the

euro will depreciate) could have purchased an option
to sell a specific amount of euros in three months at
the rate of, say, $1.01/1.
If the speculator is correct and the spot rate of the
euro in three months is $0.99/ 1, she will exercise
the option, buy euros in the spot market at $0.99/ 1,
and receive $1.01/ 1 by exercising the option.

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Foreign Exchange Risks- Speculation (Options
market)

When a speculator buys a foreign currency on the

spot, forward, or futures market, or buys an option to
purchase a foreign currency in the expectation of
reselling it at a higher future spot rate, he or she is
said to take a long position in the currency.
When the speculator borrows or sells forward a
foreign currency in the expectation of buying it at a
future lower price to repay the foreign exchange loan
or honour the forward sale contract or option, the
speculator is said to take a short position

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Foreign Exchange Risks- Speculation
(Exercise)

Assume that the three month FR = $2.00/1

and a speculator believes that the spot rate in
three months will be SR = $2.05/1.
How can a person speculate in the forward
market?
How much will the speculator earn if he or
she is correct?

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Foreign Exchange Risks, Hedging, and
Speculation

Stabilizing Speculation
The purchase of a foreign currency when the
domestic price falls or is low, in the expectation
that it will soon rise, leading to a profit, OR
The sale of a foreign currency when the domestic
price rises, in the expectation that it will fall.

Stabilizing speculation moderates fluctuations in

exchange rates over time, serving a useful
function.

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Foreign Exchange Risks, Hedging, and
Speculation

Destabilizing Speculation
The sale of a foreign currency when the domestic
price falls or is low, in the expectation that it will fall
even lower, OR
The purchase of a foreign currency when the domestic
price rises, in the expectation that it will rise even
higher.

Destabilizing speculation magnifies fluctuations in

exchange rates over time, and can be very
disruptive to international flow of trade and
investments.
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 Does an efficient foreign
exchange market rule out all
opportunities for speculative
profits?
 What is an Efficient Market?
A market is said to be efficient if prices reflect
all available information.

With an efficient market, the forward rate will

differ from the expected future spot rate by
only a risk premium.
The foreign exchange risk premium is the difference
between the forward rate and the expected future
spot rate.
 Efficient Market

Modern finance theory implies that prices in

the foreign exchange market should move
over time in a manner that leaves no un
exploited profit opportunities for the traders.
Therefore no trader should develop trading
rules that consistently deliver profits.
 Does this rule out all opportunities for
speculative profits?

With an efficient market it is an on going

process of price adjustments in response to
new information that rules out any certain
profits from speculation. However the fact
that the future will bring unexpected events
ensures that profits and losses will result
from foreign exchange speculation.
 Does this rule out all opportunities for
speculative profits?

Although an efficient foreign exchange trading

market prevents certain profits, there are still
gains to be made from speculating. However
there is also the possibility of incurring losses.

Speculators will always be around seeking profit

making opportunities whether the markets are
efficient or not.

An efficient market does not rule out the

opportunity for speculative profit.
END

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