You surely have heard the words “Hedgefund”, and you always wonder what the hell this is. Actually, Hedgefund idea is not that hard to understand! Hedgefund techniques are a way to manage currency exposure. The following material will teach you how to hedge Forex risk.
What Does Hedging Mean?
Dealing with different currencies, the participants in the Foreign Exchange Market are constantly exposed to exchange rate risk.
If you expect a cash flow in a certain currency after a certain period of time, you never know what the future exchange rate of this currency will be and how much you will actually get in terms of another currency. In other words, if your currency decreases until you receive the cash flow, you will experience losses as a result of the currency risk exposure.
For this reason, some financial specialists are eager to hedge (to protect) their future cash flows in order minimize, their currency risk exposure. Actually, this is why the hedgefund managers are needed. Companies, which implement international business are constantly exposed to exchange rate risk, because they receive many transactions in currencies, different than their domestic one, or the opposite – they have to make many future payments. Therefore, they hire hedgefund managers, whose job is to hedge (to protect) the future cash flows of the company, which are based in currencies different than their domestic currency.
But how do they do that?
How does Hedgefund Work?
Hedgefund techniques are like a chess play – if you do not make the right move, you will lose.
Today, we are going to discuss hedgefund techniques for currency risk protection. Below you will find three important financial instruments to hedge Forex risk:
- Forward Contract
- Money Market
- Option Contract
These could significantly decrease the exchange rate risk of your future cash flows!
Hedgefund Techniques with a Forward Contract:
One of the alternatives of the Hedgefund Managers to protect their future cash flows is by purchasing a Forward Contract from a bank or another financial institution. The Forward Contract locks you in an arranged deal to get a certain exchange rate after a certain period of time on a certain amount of money.
For example, your company is based in Europe and it operates in Euro. You sell inventory to a company based in the United States, where the contract you take will bring you a cash flow of $1,000,000 after 6 months. The current spot rate of the EUR/USD is 1.1195 Dollars for 1 Euro, and you do not know where this Forex pair will go in the next 6 months. You call your local bank and you ask them for a Forward Contract offer. They offer you after 6 months to exchange your $1,000,000 in Euro at the exchange rate of 1.1355. This guarantees you 1,000,000 / 1.1355 = €880,669.31 after 6 months.
On the other hand, if you decide to remain exposed (unprotected) and not to hedge your transaction, if the exchange rate remains the same, you will get 1,000,000 / 1.1195 = €893,255.92, which is more than the offer we got from our local bank. If the Dollar appreciates against the Euro in the next 6 months to 1.0850 for example, in 6 months your $1,000,000 will cost 1,000,000 / 1.0850 = €921,658.99. BUT, if you remain unprotected and the Dollar depreciates against the Euro and reaches 1.2100 Dollars for 1 Euro, in 6 months your $1,000,000 will cost 1,000,000 / 1.2100 = €826,446.28, which is with €54,223 less than the Forward Contract of your local bank.
In any case you should remember that, if you remain unprotected, you will never know exactly how much your cash flow will cost in 6 months. But if you purchase a Forward Contract, you remain lock in this rate and your €880,669.31 are GUARANTEED after 6 months.
This operation could be reversed:
You operate in Euro and you have to pay $1,000,000 in 6 months.
Therefore, corporations hire financial analysts, who forecast eventual outcomes regarding the respective currency pairs in order to support the decision making process – to take or not to take the deal.
Hedgefund Techniques with the Money Market
Other of the hedgefund techniques is to protect your future cash flow with entering the Money Market. This means, if you are about to get a future cash flow in 6 months, you can get a bank loan now, where you get a bit less than you are about to receive in 6 months from your future cash flow. For 6 months the interest rate of your loan increases the money you own to the amount you are about to get from your cash flow, and you cover your loan with your cash flow.
The operation could be reversed:
In 6 months you are about to pay a certain amount of money. You deposit a bit less than you own NOW and for 6 months, the interest rate of your deposit increases the amount you deposited to the amount you own. In 6 months, when your deposit expires, you get your deposit + the interest and you cover your expense.
In the first case, you get the money NOW, but you get an amount, which is less, so you will be able to cover the loan + the interest added with the future cash flow. In the second case you pay the money NOW, but you pay a bit less than you own, so the interest added will cover your full expense.
You are based in the United States and you operate in Dollars. In 6 months you are about to get a cash flow of €1,000,000. If you decide to hedge this transaction with the money market, you call few banks and you decide to get a loan in Euro now. But how much should you get? You decide to go with the offer of a bank, which gives you these interest rates:
Deposit rates = 6.00%
Loan rates = 6.50%
Note that these rates are p.a. (per annum, per year). Since you are interested to get a loan for 6 months, you will be getting half of these rates.
In this case, you are interested in getting a loan NOW, so you calculate with the loan rate 6.50% p.a. (per annum) = 3.25% for 6 month loan.
Since the €1,000,000 are a FV (Future Value), you need to find their PV (Present Value) and you have the semi-annual interest rate of 3.25%. Note that in order to calculate it properly, you need to transform the 3.25% into a decimal.
3.25% / 100 = 0.0325
You calculate by deducting 0.0325 (3.25%) from 1 (100%) and you get:
1 + 0.0325 = 1.0325
1,000,000 / 1.0325 = €968,523 loan NOW.
You can always double check your answer by multiplying 968,523 x (1+0.0325) = 968,523 x 1.0325 = 1,000,000
So, with getting a loan of €968,523 NOW, in 6 months you will be able to cover it fully with the cash flow of €1,000,000 you are about to get.
Imagine the opposite situation:
In 6 months you are about to pay €1,000,000 and you would like to hedge your payment with the Money Market. You call the banks again and you get the same rates again:
Deposit rates = 6.00%
Loan rates = 6.50%
This time, you need the deposit rate of 6.00%. Since the time frame is 6 months, the rate you will get for a 6 month deposit is half the per annum (per year) rate. This means your semi-annual rate is 3.00%.
You deposit now:
1,000,000 / 1.03 = €970,873. 79
(970,873.79 x 1.03 = 1,000,000)
In 6 months, the 3.00% interest rate of your €970,873.79 deposit, will increase your deposit to €1,000,000 and you will be able to cover your payment.
In this case, you are able to clear your deals NOW, where if you are about to get, you get less and if you are about to pay, you pay less. Leave the other to the interest rate, which for 6 months will compensate the difference to €1,000,000. Therefore, with a money market hedge, you are not subject to the exchange rate risk, before you settle NOW at the current spot rate.
Note that in order to calculate the value of your contracts you should establish the Cost of Capital of your company, or how much does a certain amount will grow, if held in the company and not reinvested. For example, if your company grows by 4% per year, then your cost of capital of your company will be 4% per annum, or 2% semi-annual.
In the case, where you need to pay €1,000,000 after 6 months, we realized that we can deposit €979,873.79 NOW, and after 6 months the 3.00% interest rate will generate the rest of the amount until €1,000,000. In this case the cost of this type of hedge will be:
€979,873.79 x 1.02 = €999,471.27
The 0.02 are the 2% which is the cost of your capital, or the rate at which you grow any amount of your company. Since you will reinvest and will not keep in the company, this is considered as a lost potential and an expense. Therefore, we add it to the cost of the contract. Do not forget that paying €979,873.79 NOW, we have cleaned our debt after 6 months and the other is only documentation. Despite we pay €979,873.79 NOW, the actual cost of the hedge is €999,471.27 because of not being able to grow this amount through your company. One of the basic rules of the Time Value of Money States: “A Dollar Now, costs more than a Dollar tomorrow”.
Hedgefund Techniques with an Option Contract
The last of the hedgefund techniques we will discuss involves speculation with an option contract. Also, it costs money – you have to pay a premium (the price of the option contract) equal to a certain percentage of your contract size at the spot rate. Remember, there are two types of options – a call option and a put option. The call option stands for a long position, where you hedge against a decrease and you speculate on an eventual increase. The put option stands for a short position, where you hedge against an increase and you speculate on an eventual decrease. When you enter an option contract, you get a premium rate (the commission you pay for the contract) and a strike price, which is the price on which your options contract will be closed (similar to the Stop Loss).
Imagine you are based in Japan and in 6 months you are about to get $1,000,000. Since you are based in Japan, you operate in Yens. Therefore, you will be exposed to an exchange rate risk concerning the USD/JPY currency pair. For this reason, you decide to hedge your currency risk exposure at the USD/JPY by purchasing an option contract. Since you are based in Japan, you are afraid that the Dollar might increase against the Yen and you would like to protect yourself and to minimize your losses if this happens. For this reason, you purchase a Put Option on the USD/JPY currency pair. This means, if the USD/JPY increases and the Dollar increases against the JPY, we will be hedged by the strike price of our options contract. If the USD/JPY starts decreasing and the Yen starts appreciating against the Dollar, our profit potential will literally be unlimited.
So, how do we calculate the value of our Option Contract?
We multiply the size of our contract by the premium and substract the result from the size of the contract. If a financial institution gives us a put option contract with a premium of 2.00%, then:
$1,000,000 x 0.02 = $20,000
Remember, that we would not be able to invest these $20,000 elsewhere. Therefore, in order to calculate the value of the contract, we should consider our cost of capital, or at what rate we grow any capital at our company. Let’s use again 4.00% per annum and 2.00% semi-annual rate, like in the money market hedge example:
If we have kept the $20,000 premium in the company, for 6 months it should have grew by 2.00%:
20,000 x 1.02 = $24,000
Therefore, the value of our options contract will be:
1,000,000 – 24,000 = $976,000
Then, you use the current spot rate in order to display the result in Yens, because you are based in Japan and you operate in Yens. If the current spot rate of the USD/JPY is 120.05, your options contract will cost you:
24,000 x 120.05 = ¥2,881,200
Therefore, value of your options contract will be:
$1,000,000 x 120.05 – ¥2,881,200 = ¥117,168,800
$976,000 x 120,05 = ¥117,168,800
Just remember: Whenever you invest, you should add the cost of capital to the amount you invest in order to calculate its actual value! If you are not accumulating a certain amount in your company, this amount costs you a certain percentage per year, equal to the cost of your capital. So, if you get $500,000 out of your company and buy a Bentley, when your cost of capital equals 4% per annum, after one year, you will realize, that this Bentley has costed your company 500,000 x 1.04 = $520,000. This is so, because a Dollar NOW costs more in future!
There are many pros of trading on the Forex Market. However, you should always understand the risk you take when dealing with foreign currency. For this reason, you should first consider the alternatives you have to hedge Forex risk. Whenever you are about to receive a cash flow, or to do a payment in foreign currency, you will face each of these three Hedgefund Techniques. Depending on the rates you will get from the different financial institutions, you will be about to make a decision on which of the hedgefund techniques to use. Do not forget, that you always have the option NOT TO HEDGE and sometimes hedgefund managers choose the option not hedge. This is so, because Hedgefund Techniques Costs Money and are Risky, especially if not implemented properly.
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