Lecture 11
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Lecture #11. Hedging foreign currency risk: Issues in and out of China Aaron Smallwood, PhD. UT-Arlington. Yuan non-deliverables. Example: In June a Chinese firm wrote a contract so that they will receive $1,000,000 for exported goods in 12 months. But, the yuan may continue appreciating.

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Lecture #11

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Lecture 11

Lecture #11

Hedging foreign currency risk: Issues in and out of China

Aaron Smallwood, PhD.

UT-Arlington


Yuan non deliverables

Yuan non-deliverables

  • Example: In June a Chinese firm wrote a contract so that they will receive $1,000,000 for exported goods in 12 months.

  • But, the yuan may continue appreciating.

  • What to do?

    • While potentially costly, a yuan NDF is available. How do they work?

    • Additional detail can be found at the China Construction Bank’s website:

      http://www.asia.ccb.com/hongkong/personal/investment/cny_non_deliverable_forward.html3


Details

Details

  • Settlement amount given as follows:

    where F is the agreed upon forward rate and “settle” is the official parity rate on the date the contract expires.

    If the trader is “selling” dollars (they will receive $ in the future), money is added to the traders account when the RMB appreciates. Otherwise, money is subtracted. The reverse is true if the trader is “buying” dollars.


Example continued

Example continued

  • According to an article published in the Taipei times, on June 9, 2014,

    “Twelve-month non-deliverable forward contracts (NDFs) strengthened 0.47 percent to 6.2154 per US dollar.”

  • Suppose in 12 months, the RMB price of the dollar is RMB 6.05. The hedge would be quite useful.

  • The trader will move money added to her account:


Lecture 11

And….

  • The trader sells $27,338.84 at RMB 6.05. Proceeds: RMB 165,400.

  • As a completely separate transaction, the trader sells dollars in the spot market:

    • $1,000,000*(RMB/$) 6.05 = RMB 6,050,000

  • Total: 165,400 + 6,050,000 = RMB 6,215,400.

  • EXACTLY = 1,000,000 * 6.21540


Currency risk management

Currency Risk Management

Forward Market Hedge (Not yet available)

Options Market Hedge (Not yet available)

Money Market Hedge

Hedging Through Invoice Currency

Hedging via Lead and Lag

Should the Firm Hedge?


Forward market hedge imports

Forward Market Hedge: Imports

If you expect to owe foreign currency in the future, you can hedge by agreeing today to buy the foreign currency in the future at a set price by entering into a long position in a forward contract.

Foreign currency

Foreign currency

Domestic Currency

Goods or Services

Foreign Supplier

Importer

Forward Contract Counterparty


Forward market hedge exports

Forward Market Hedge: Exports

If you are going to receive foreign currency in the future, agree to sell the foreign currency in the future at a set price by entering into short position in a forward contract.

Foreign Currency

Domestic Currency

Goods or Services

Foreign Currency

Foreign Customer

Exporter

Forward Contract Counterparty


Lecture 11

Importer’s Forward Market Hedge

A U.S.-based importer of Italian shoes has just ordered next year’s inventory. Payment of €1M is due in one year. If the importer buys €1M at the forward exchange rate of $1.3695/€, the cash flows at maturity look like this:

€1,000,000

€1,000,000

$1,369,500

Shoes

U.S. Importer

Italian Supplier

Forward Contract Counterparty


Lecture 11

£0.846997

£635,247.45 = €750,000 ×

€1

Exporter’s Forward Market Cross-Currency Hedge

Suppose a British exporter of bicycles will receive €750,000 in six months, which they want to convert into pounds.

  • Suppose, the forward six-month rate (pound per euro) is £0.846997. Thus, the long position in euros would generate:

  • At the six-month forward exchange rate €750,000 will buy £635,247.45. We can secure this trade with a LONG position in six-month pound forward contracts:


Exporter s forward market cross currency hedge cash flows at maturity

Exporter’s Forward Market Cross-Currency Hedge: Cash Flows at Maturity

Exporter

Long position in six-month pound forward contracts at £0.8470/€1

Customer

€750,000

€750,000

Bicycles

£635,247.45


Importer s money market hedge

Importer’s Money Market Hedge

This is the same idea as covered interest arbitrage.

To hedge a foreign currency payable, buy the present value of that foreign currency payable today and put it in the bank at interest.

Buy the present value of the foreign currency payable today at the spot exchange rate.

Invest that amount at the foreign rate.

At maturity your investment will have grown enough to cover your foreign currency payable.


Importer s money market hedge1

Importer’s Money Market Hedge

A Chinese–based importer of Italian bicycles owes €100,000 to an Italian supplier in one year.

The spot exchange rate is ¥8.2344 = €1.00.

The one-year interest rate in Italy is i€ = 4%.

The importer can hedge this payable by buying

and investing €96,153.85 at 4% in Italy for one year. At maturity, she will have €100,000 = €96,153.85 × (1.04).

€100,000

€96,153.85 =

1.04

¥8.2344

RMB cost today = ¥791,769.23 = €96,153.85 ×

€1.00


Importer s money market hedge2

Importer’s Money Market Hedge

With this money market hedge, we have redenominated a one-year €100,000 payable into a ¥791,769.23 payable due today.

If the Chinese interest rate is i¥ = 5%, we could borrow the ¥791,769.23 today and owe ¥831,357.69 in one year.

€100,000

¥831,357.69=

S(¥/€)×

×

(1+ i¥)T

(1+ i€)T

¥831,357.69 = ¥791,769.723 × (1.05)


Importer s money market hedge cash flows now and at maturity

Importer’s Money Market Hedge: Cash Flows Now and at Maturity

deposit i€ = 4%

CNY Bank

Importer

Spot Foreign Exchange Market

Italia Bank

Supplier

T= 1 cash flows

¥831,357.69

bicycles

€100,000

¥791,769.23

¥791,769.23

€96,153.85

€96,153.85

€100,000


Exporter s money market hedge

Exporter’s Money Market Hedge

Borrow i€ = 5%

Crédit

Agricole

U.S Bank

Exporter

Spot Foreign Exchange Market

Customer

An American exporter has just sold €100,000 worth of shoes to a French customer.

Payment is due in one year.

Interest rates in dollars are 7.10 percent in the U.S. and 5 percent in the euro zone.

The spot exchange rate is $1.25/€1.00. Use a money market hedge to eliminate the exporter’s exchange rate risk.

T= 1 cash flows

shoes

$119,047.62

$127,500.00

€100,000

deposit i$ = 7.10%

$119,047.62

€95,238.10

€95,238.10

€100,000


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