Managing Financial Risk, Smithson & Smith
Chapter 7
Using Forwards to Manage Financial Price Risks
by: Mark Glitto
Forwards vs On-Balance Sheet Hedges
I. Off-Balance Sheet Forward
Example, a corporation with negative DM FX Risk transfers its
foreign exchange risk to the seller of the forward contract. The
corporation off sets its exposure when it buys or goes long on
the DM forward.
II. On-Balance Sheet Create Long Position "Synthetically" by borrowing dollars, buying DM on the spot market and investing in a DM denominated financial asset.
Forward-Rate Agreement (FRA)
to Manage Business Risk
Gobibank
Facts
Gobibank, threw a syndication, made a 200 million fix rate loan for 2 years. Its assets increase by 200 million.
This new loan is currently funded with overnight Fed funds which is expensive way to borrow money to increase liabilities.
An opportunity to place 6 month fixed CD with the state pension fund.
Problem
there is now a mismatched maturity, a negative Gap. The problem for Gobibank is that it is exposed to interest rate risk. If interest rates increase Gobibank must pay out the higher rate while it is only receiving the same fixed rate on the 200 million original syndication. What the bank wants to do is to manage its interest rate risk.
Solutions
On balance sheet solution: issue extra CDs now before interest rates increase. This poses its own problem in that it will increase or "blow up" Gobi's balance sheet by an extra 200 million. Banking regulations which require capital adequacy would require Gobi to add an additional 15 million to its capital.
There is a better solution, of using off balance sheet derivative. Use a FRA to lock in Gobi's borrowing costs three months in the future.
Forward to Lock in Windfall
Profits
BMW Automobiles
Economic Facts
BMW imports cars into the US and sells them for $. They in turn exchange these dollars for DMs.
At the exchange rate of $1 = 2.84 DM BMW makes 20% profit as long as it sells at least 50,000 cars.
The dollar strengthened further against the DM so that $1 = 3.0 DM. Now BMW has a 30% profit at sales of 50,000 cars.
Transaction Facts
The CEO instructs the treasurer to lock in the profits with a FX, DM/USD forward. But the transaction is delayed by various implementation decisions.
- amount of the forward
- Number of forwards
- 8, 10, 11 month contracts are not standard
- Credit rating of BMW
In the interim the dollar advances further against the DM. Note that if the dollar had retreated against the DM during the time it took to put the hedge together BMW would have lost out and the treasurer would have been fired.
Questions Management may ask
· Which way will (FX rates, interest rates) go?
· Should we cash out and realize profits now?
*What if there had been a loss would the CEO want to unwind the hedge and realize the loss?
*Unwinding the transaction means you are now unhedged.
*If the dollar retreats and goes below the original level BMW will not be hedged and will lose out. To keep its profit margins it will have to raise the price of its cars.
*Taxes on the capital gains.
*Extra dividends to the shareholders?
*Shareholders may want to cash out, they hold an option and may want volatility whereas bondholders may want stability.
Current News: Coffee Futures
at an All Time High
Starbucks Coffee Shops
Starbucks has had to raise coffee prices twice in the last three months. There has been a freeze in South America and coffee prices have gone from a dollar a pound to three dollars in the last months. Coffee is at a historical high, its highest since the mid 1970s.
*If you can raise the price of coffee why hedge? You can pass the risk on to the consumer. *But what if your competition was hedged?
*How long could you hedge?
*What if the increase in prices was demand driven not supply driven?