Hedging

HEDGING

Hedging is an act of protecting risk from currency fluctuations. The investor must decide whether to:

1. fully hedge (risk adverse)

2. Partly hedge

3. Not to hedge (risk taker)

Since most borrowing is for commercial transactions (i.e. buying/selling deals), investors tend to take some risk.

An American investor buys in Australia

Assume:

$AUD: $US (1990) = 0.85 (1.1765)

$AUD: $US (1995) = 0.75 (1.3333)

Bought in 1990 $AUD $100,000 ($US 85,000)

Sold in 1995: $AUD 150,000 ($US 112,500)

Profit is AUD $50,000 (50%)

BUT Real result is....

Real profit = $US 112,500 - $85,000 = $US 27,000

Hence real return = 27,500 / 85,000 = 32.35%

The Return is less as the exchange rate has weakened.

Foreign Exchange Market

Foreign investors will often involve the use of the currency futures and option markets to hedge their positions. They can use:

1. Forward contracts - used by the main players and can be made to measure e.g. banks for say 4, 6 or 12 months (we wont cover)

2. Futures contracts - expire at certain times of the year and are in denominations of $100,000

3. Currency options - provides you with an option but not an obligation, therefore is more expensive

4. Currency swaps - combination of forward contracts (we wont cover)

Interest Rate Parity

"At equilibrium (all other things equal), the currency of the higher interest rate country will trade at a forward rate discount in terms of the lower interest rate country's currency".

Id = if + forward rate

Forward rate = -ve (discount)

+ve (premium)

The equation tells us that when hedging:

id(domestic) = if(foreign)

i.e. that when we fully hedge the domestic rate of interest should equal to foreign interest rate.

Why borrow from overseas then? As some country's financiers may lend you bigger loan ratio's than local banks, better lending terms etc.

Forward Margin

The "forward rate" is determined by:

F = s x (rd - rf) x n/365

1 + (rd x n/365)

F = forward rate

S = spot rate

Rd = domestic interest rate

Rf = foreign interest rate

N = number of days (spot to forward)

Forward Rate

The forward rate is given by:

Spot - Fwd Points

Forward rate = S - s x (rd - rf) x n/365

1 + (rd x n/365)

If the domestic interest rate increases more than the foreign interest rate then the forward rate will be lower.

Look at class notes for comments on spreadsheet

Interest Arbitrage

Covered interest arbitrage ensures that forward exchange rates are set properly:

If interest rate differential does not equal the forward premium or discount, then:

1. Funds will move to the country with the higher rate;

2. Market pressures develop:

a. currency is more demanded for spot and sold forward

b. inflow of funds depress interest rates, and

c. parity (uniformity) is eventually reached.

Forward Rate Example

Forward Rate = 0.7678 - 0.7678 x (0.0675 - 0.0465) x 1

1 + (0.675 x 1)

Future X/Rate = 0.7527

*figures from handout

Interest Rate Arbitrage - Example

IFF fwd rate ≠ interest rate differentials

Assume:

- AUD $10 million capital

- AUD / pound = 0.425

- 180 day Prime Rates

- UK 6.5%

- Aust 4%

Alternatives:

- UK: $4.25m x (1 +(0.065 x 180/365) = Ј4,386,233 = $10,320,547

- Aust: $10m x (1 (0.04 x 180/365) = $10,197,260

What will happen?

If future rate is then same there is an effective 2.5% profit without risk!

Interest Rate Arbitrage

In an efficient futures market, the forward rate will be determined by:

0.425 - [0.425 x (0.04 - 0.065) x 180/365] = 0.0051

1 = (0.04 x 180/365)

*Gives