In this video, we discuss four financial strategies that can be employed to mitigate forex risk. Recall that there are two categories of foreign currency hedging: non-financial hedging and financial hedging. Specifically, we'll discuss forwards, futures, swaps, and options. A forward contract is a bilateral agreement between two counterparties to buy or sell an amount of currency for some price at a future time. Foreign contracts are non-standard customized contracts with negotiated terms. Since they're flexible, the requirements of both counterparties can be addressed during negotiations. Terms of the contract will include the amount of the contract, the future date, and of the exchange transaction, and the exchange rate or a forward price of the transaction. Other negotiated terms can include the maintenance of credit ratings, collateral pledged, payment terms, credit ratings, and anything else of importance to the counterparties. Because these contracts are time-consuming and expensive to negotiate, they're best suited for large companies looking to lock in future exchange rates for large sums of money. Here's an example of a forward contract. Suppose a German construction company contracts for a project in Brazil. Payment of 200 million Brazilian real is due upon completion of the project in one year. The real-euro exchange rate is 0.106 at the time of contract signing. That means that one Brazilian real will buy €0.16. The German company wants to protect itself against forex risk, so assigns a forward contract with a German bank. The bank agrees to buy 200 million real for €332 million in a year's time. The bank undoubtedly receives a handsome fee for these services, it's assuming the exchange rate risk, but the construction company now has its payment locked in. Note that the construction company has eliminated it's downside risk, but it is also eliminated the potential for any upside benefit. If during the year of the euro weakness against the real, the construction company would have received more than €32 million. That's the trade off, certainty versus risk and reward, like so many things in life. Forward contracts are suitable for large complex forex situations, but what about smaller, less complex situations? In recent years, standardized currency contract futures have become available on large commodity exchanges. Exchanges offer standardized foreign currency contracts with fixed exchange amounts, delivery dates and contract terms. There is no negotiation, so contracts execution is immediate. Exchanges offer futures contracts up to five years into the future. Some advantages of exchange traded futures are that instead of negotiating with a single counterparty, the exchange acts as the counterparty for all traits which minimizes counterparty risk. Contract clearing is centralized by the exchange; pricing is transparent and based on many market transactions; anyone can participate, including individual investors, not just large firms; and exchange markets are highly liquid, meaning that there's always a buyer or seller for standardized correct contracts. The downside of exchange traded futures is that they are standardized and thereby not flexible by definition. Also, the size of exchange-traded contracts is relatively small, making them awkward for large transactions. As an example of how exchange traded futures might be used, consider a Japanese robotics company that will receive a payment of €500 in six months from a European customer. To protect itself from forex transaction risk, it buys four euro-yen futures contracts. The standard exchange contract size is a €125,000, so it needs four contracts. The specified delivery date for the contract is in six months. The market-based contract rate with an expiry date in six months is 124.3. The contract locks in this exchange rate. At the end of the contract, the robotics company delivers €500,000 in six months and receives 6.215 million yen in return. The benefit to the robotics company is that it eliminates downside forex risk if the euro weakens, but it also eliminates any possible gains if the euro strengthens. Like forward contracts, currency swaps are negotiated between two counterparties that have complementary currency exposure. Like forwards, they are flexible and complex, so are most suited for large deals. Swaps work like this: two counterparties swap loans with each other. First, each borrows in its home currency, then it borrows the foreign currency loan from the other. Each party pays interest on its loan during the swap, and at the end of the swap, each party pays off its loan in the other's currency. The purposes of the swap are to obtain better loan interest rates when borrowing in home countries and reduce forex risk. Details of the swap private contracts can be very flexible with many variations of terms, and swaps are not traded on forex exchanges. Each cut swap contract is unique. The best way to understand swaps is with an example. Suppose a UK company needs to invest 200 million rand in a South African project. It can borrow at a rate of six percent in Britain, or in South Africa at a rate of nine percent. Very often, loan terms are much better in a company's home country than in a foreign country. A South African company wants to finance a 10 million pound project in the UK. It can borrow at a rate of eight percent in South Africa or in the UK at 11 percent. UK company borrows 10 million pounds in the UK, then lends it to the South African company at six percent. The South African company borrows 200 million rand in South Africa, which it then lends to the UK company at eight percent. During the swap, both pay the interest on their loans to each other, and at the end of the swap term, each company pays off its loan to the other at the agreed-upon exchange rate. At the end of the swap, each company has benefited in two ways. Each has borrowed money at a lower rate than it might would've otherwise. Each has protected itself against forex transaction risk during the terms of their projects. But as you can imagine, these are complex agreements that introduce other risks. What if one of the companies goes bankrupt and cannot pay back its loan? What if the projects take longer to complete than expected, thus delaying payments? What if there's political upheaval? Questions like these make swaps complex to negotiate. A fourth type of financial forex hedging are currency option contracts. Options offer the buyer the right, but not the obligation to exchange currency at a specified rate or a specified date. Options are like an insurance policy. You buy fire insurance for your house, but you hope never to need it, but if you do have a fire, you're glad you have the insurance. A currency option works similarly. Like insurance, an upfront premium payment must be made to the option seller. Like swaps, options are best explained with an example. Suppose a US business has €100,000 payable to a European supplier in June six months away. The current euro-dollar exchange rate is 1.10, so the amount due in six months is $110,000 US at the current exchange rate. But the US business worries that the US dollar will weaken in six months, so buys an option with a strike price of 1.10 to limits its transaction exposure. It pays a premium to buy the option just like an insurance premium. In six months, if the euro-dollar exchange rate is less than 1.10, let's say 1.00, the buyer walks away, just like unused fire insurance. The option is said to be out of the money. The cost to the buyer is the cost of the premium, again, just like unused fire insurance. However, if the euro-dollar exchange rate is greater than 1.10, let's say 1.20, then the buyer collects the difference. The option is said to be in the money. The buyer or the amount the buyer collects is about $10,000. The total benefit to the buyer is $10,000 less the cost of the premium. As you can see, options can be quite complex, and this is only the simplest example. Many different types of options and combinations of options can be used in creative ways to hedge against forex exposures. Summarizing financial hedging strategies, forward contracts are custom bilateral agreements to exchange currencies at some future date. Futures contracts are standardized market-based currency contracts offered on commodity exchanges. Currency swaps are bilateral exchanges of debt obligations in different currencies, and currency options offer insurance against undesirable future forex rates. In the next video, we'll examine the different marketplaces where foreign currency exchanges occur. We'll see you there.
