Lecture #11

1. Lecture #11 Hedging foreign currency risk: Issues in and out of China Aaron Smallwood, PhD. UT-Arlington

2. 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

3. 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.

4. 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:

5. 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

6. 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?

7. 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

8. 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

9. 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

10. £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:

11. 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

12. 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.

13. 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

14. 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)

15. 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

16. 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