19 November 2007: Hedging Currency Risk

The investor can react to foreign exchange risk in one of two ways. One alternative is to do nothing. In this case, the investor is left with foreign exchange risk and retains either the gains or losses from the currency exposure. The alternative is to hedge or not and, if so, how much to hedge and when can be complex. The choices depend on how much volatility the investor is exposed to, how much volatility can be reduced, how much it costs to hedge, what expectations the investor has for foreign exchange movements, and what trade-off the investor is willing to make between the reduction in volatility and the cost of the hedge.

For the investor who has decided to hedge some part of the foreign exchange exposure, there are three typical hedge alternatives. The first is the symmetrical hedge using forward or futures contracts to minimize both currency gains and losses. A matched hedge uses the same currency to hedge as the investor is exposed to. A currency-basket uses a portfolio of currencies to hedge the investor's exposure; the portfolio is configured in such a way as to reduce the expected hedging cost while minimizing the tracking error of the hedge.

The asymmetrical hedge uses options. The asymmetry of options is designed to preserve some gains from currency exposure while protecting against losses. The two most common option strategies are the protective put and the range forward or collar. The protective put is generally the most expensive protection, but it preserves the majority of the gains from favourable currency exposure. The range forward (collar) is a somewhat less expensive alternative; it lowers the cost by capturing the gains from favorable currency exposure only up to a certain level.

The final hedging alternative consists of active management of the hedge. In this strategy, currency exposure is left unhedged when currency returns are expected to be unfavorable. The goal of active hedge management is to capture the benefits of hedging while paying as little as possible for the protection. One might think of it as trying to create the same results as a protective put while minimizing the cost of the put option. Effective active hedge management requires a systematic, on-going evaluation of potential changes in foreign exchange rates.

Both forward and option contracts derive their value from the level of the underlying exchange rate, the relative interest rates between the two countries, and the time to maturity of the contracts. The price of an option also depends on the strike price of the option and the estimated volatility of currency returns.

Forward and Futures Contracts. The pricing of foreign exchange forward and futures contracts is driven by the covered interest arbitrage relationship. Although the two types of contracts contain important differences, they can be treated as equivalent for purposes of pricing.

The fair value forward or futures price is:

Current forward Forex rate = Current Spot Forex Rate (1 + Annualized domestic interest rate x time till expiration)
1 + Annualized foreign interest rate x time till expiration

A foreign exchange futures or forward contract calls for future delivery of a specified amount of foreign exchange at a fixed time and price. The buyer of the contract has the obligation to receive the foregin exchange amount; the seller has the obligation to deliver the specified amount.

In the United States, the majority of foreign currency futures contracts are traded in Chicago on the International Monetary Market (IMM), which was organized in 1972 as a division of the Chicago Mercantile Exchange. Since 1985, contracts traded on the IMM have been interchangeable on the Singapore International Monetary Exchange.

Currency futures contracts have standardized features in order to concentrate trading liquidity into common size and maturity specifications. IMM currency futures contracts follow a quaterly expiration cycle with expirations on the third Wednesday in March, June, September, and December.

Futures contract prices are quoted American style (USD/FX), and the purchase or sale of one contract on a particular currency corresponds to the associated contract size. Gains and losses caused by changes in the futures prices are settled on a daily basis between individual investors and the exchanges through the brokers.

For example, suppose an investor purchases 100 futures contracts on the Japanese yen at a price of 0.0100 USD/yen (100.0 yen/USD). If the yen appreciates from 0.0100 to 0.0101 USD/yen (0.99 yen/USD), the investor will gain US$125,000 (that is 100 contracts x (0.0101 - 0.0100) x Y12,500,000 per contract).


Standard foreign currency option contracts have the following features:

• The option contract gives the option purchaser the right (but not the obligation) to buy or sell a given amount of foreign exchange in the underlying currency at a fixed price per unit (strike or exercise price) within a specified period of time (set by the maturity or expiration date).
• A call option gives the investor the right to buy the foreign currency; a put option gives the investor the right to sell a foreign currency.
• An American option gives the buyer the right to exercise at any time up to the exercise date; a European option can be exercised only on the expiration date.
• The cost of the option is usually referred to as the option premium.
• Options on futures contracts give the buyer the option to purchase currency futures contracts instead of the underlying currency itself.
• The intrinsic value of an option depends on the relationship between the strike price and the exchange rate of the underlying currency, A call option has an intrinsic value equal to the maximum of zero or the difference between the underlying exchange rate and the exercise price. A put option has an intrinsic value equal to the maximum of zero or the difference between the strike price and underlying exchange rate.
• An option with a positive intrinsic value is said to be 'in the money'. Options with no intrinsic value are said to be 'out of the money'. An 'at the money' option is one whose strike price is equal to the underlying exchange rate.

Currency Option Markets. Foreign currency options are available in three markets in the US:

• Options on the physical currency in the over-the-counter (interbank) market;
• Options on the physical currency on organised exchanges;
• Options on futures contracts at the IMM in Chicago.

The most common over-the-counter (OTC) options written by banks are for US dollars against the British Pound, the Euro, Japanese yen and Swiss franc. The size, maturity, and strike price of the options can be tailored to meet the specific needs of the investor, and the market is quite liquid for transactions in multiples of US$5-$10 million. OTC options do expose the investor, however, to counterparty risk - the risk of the bank not being able to fulfill its obligation in the option contract.

In the OTC market, option prices are typically quoted as a percentage of the home currency amount of the transaction evaluated at the strike price of the option in home currency units. For example, a put option to exchange US$41,875,000 for NZ$62,500,000 at an exchange rate of 0.67 NZD/USD quoted at 1.76 percent would cost US$737,000 (that is, 0.0176 [US$41,875,000]), which is equivalent to quoting the option as a percentage of the exercise price of the option in home currency units. When considered in this way, the cost of the option would also be US$737,000 (that is 0.0176 [0.67 x NZ$62,500,000], where 0.67 x NZ$62,500,000 or US$41,875,000 represents the home currency value of the strike price).

Options on the underlying physical are traded on several exchanges around the world. In the United States, the greatest volume is traded on the Philadelphia Stock Exchange. The exchange clearing house serves as the guarantor behind the options contracts, and members of the clearing house bear the financial responsibility. Expiration months are March, June, September, and December plus the two nearest additional months to the contract date. Each option expires on the Saturdayu preceding the third Wednesday of the expiration month.

The number of exchange-traded options needed to cover a particular amount of foreign exchange is calculated by dividing the amount of foreign exchange by the amount covered by each option.

Options on futures contracts are traded on the IMM. Options are available on the futures contracts that expire according to the quarterly expiration cycle (March, June, September, and December), but the futures options carry monthly expiration dates. As a result, an investor can purchase option contracts on the March futures contract, for example that will expire in January, February, and March. Options expire two Fridays before the third Wednesday of the expiration month. As the exchange-traded options on the physical currency, prices for futures options are quoted in cents per unit of the foreign currency.

Synthetic Option Positions. The return effects of an option can be mimicked by using futures or forward contracts to adjust the hedge ratio in a systematic way as exchange rates move. Selling more futures contracts as the

15 November 2007: Foreign Exchange Risk - A Historical Perspective

Although the future is not likely to repeat the past precisely, past events can provide valuble lessons that will improve our understanding of how Forex markets will function in the future.

Major Historical Events in the Forex Markets
Forex management is motivated by the need to conduct international trade and manage international capital investments. In the post-barter era, international trade and investing have been conducted under a variety of foreign exchange regimes. We will briefly describe these regimes, beginning with the gold standard in 1870.

The Gold Stadard. From 1870 through to the beginning of World War II, most of the world was on the gold standard. The US joined this arrangement in 1879. Under the gold standard, each country committed to exchange rates for extended periods of time. Commitment to the gold standard required countries to maintain gold reserves. It also meant that central banks had to deflate their currencies during periods of trade deficits and inflate their currencies during periods of trade deficits and inflate their currencies during periods of trade surpluses. These adjustments were required to discourage investors from exchanging their currency holdings for gold and thus depleting a country's gold reserve.

Between the Wars. World War I temporarily halted the use of the gold standard as international trade declined sharply and gold shipments were suspended. In the aftermath of the war, countries experienced vastly different rates of inflation; a return to the prewar fixed exchange rates was impossible because the nominal prices of goods between countries had been changed so much. Fluctuation in exchange rates contributed to a decline in international trade, which was exacerbated by the Great Depression.

In an attempt to promote international trade and economic growth, some of the major countries returned to the gold standard. They failed to achieve stable parity values, however, partly because of the variation in economic policies, which generated different inflation rates. The lack of economic coordination strained many countries' balance of payments and domestic economies and led most of them, once again, to abandon the gold standard.

Some countries, most notably France, remained on the gold standard and imposed import quotas to address balance of payments deficits. As a result, the French franc became significantly overvalued. France negotiated an arrangement with the US and England to devalue its currency without retaliatory devaluations, but this cooperation in exchange rate management ended with the outbreak of World War II.

The Bretton Woods Agreement. In July 1944, as World War II drew to a close, 44 countries met in Bretton Woods, New Hampshire, to discuss the future of the international monetary system. The two major participants were the UK, represented by John Maynard Keynes, and the US, represented by Harry Dexter White. The participants took the following actions:

• The International Monetary Fund (IMF) was established with the authority to lend foreign exchange to the member countries on the condition that they pursue sound economic policies. These funds were to be used to stabilize exchange rates.
  
• The US dollar and the pound sterling were established as reserve currencies.
  
• Exchange rates were fixed within a 1% band relative to the dollar, and the dollar was fixed relative to gold at a rate of $35 an ounce. The US committed to convert dollars into gold.
  
• After a transition period, currencies were to become convertible into gold.
  IMF member countries were required to make a payment of gold and currency to fund the IMF's lending activities, and their voting privileges were proportional to their financial contributions.
  

By the late 1950s, the West European countries were discussing banding together to promote trade and financial cooperation among the countries. On March 25, 1957, France, West Germany, Belgium, the Netherlands, Luxembourg, and Italy signed the Treaty of Rome, which created the European Economic Community (the Common Market). At the same time, the US was encouraging European countries to increase their exports to the US in order to build up their dollar reserves. The Europeans succeeded to the point that by 1960, their dollar claims on the US exceeded its gold supply.

The US balance of payments deficit motivated Presidents John F. Kennedy and Lyndon B. Johnson to impose credit and capital controls, which spurred the development of the Eurodollar market. Eurodollars are dollar-denominated deposits in banks outside the US that are not subject to US-imposed credit controls.

The UK also ran a deficit in the mid-1960s, which led to a 14% devaluation of the pound in 1967. This devaluation, in turn, heightened fears that the dollar would be devalued, especially in light of continuing US balance of payments deficits.

The fear of a dollar devaluation produced a run on gold that forced the creation in 1968 of a two-tiered system for trading gold. Under this system, central banks could trade gold at a fixed official price whereas private investors could trade gold only at fluctuating market prices. Also in December 1969, the IMF issued Special Drawing Rights to augment gold and the dollar as international reserves.

By the late 1960s, the Japanese yen and the German mark had become significantly undervalued relative to the dollar, partly because of rising US inflation induced by the Vietnam War and President Johnson’s Great Society social welfare programs. In 1971, in an attempt to support the dollar’s exchange rate, West Germany bought a massive amount of dollars, which caused Germany’s money supply to expand by more than 20%. This strategy for supporting the dollar was not sustainable.

To remedy the US balance of payments problem, the US wanted West Germany and Japan to revalue their currencies upward. For their part, Germany and Japan wanted the US to curb the growth in money supply, tighten its credit, and cut its spending. Finally, in May 1971, Germany halted its intervention in the foreign exchange markets, effectively ending the Bretton Woods Agreement.

The Smithsonian Agreements and the Aftermath. In 1971, the US suspended the dollar's convertibility into gold and allowed the dollar to float freely. This decision was motivated by a large trade deficit that almost depleted the United States' gold supply. The dollar was devalued, and in an arrangement known as the Smithsonian Agreement, exchange rates were allowed to fluctuate within a 4.5% band. The official gold price was raised to $38/ounce, but convertibility was not resumed. By 1973, most currencies were floating against the dollar, which casued a fall in the dollar's value.

The Jamaica Accord. In 1976, at a meeting in Jamaica, the IMF officially agreed to floating exchange rates. Also, the countries forming the European Monetary Union established parties with narrow margins for their mutual exchange rates and agreed to let their currencies continue to float in a wide band with respect to the dollar. This arrangement was known as "the snake in the tunnel."

In 1979, the European Monetary System was created and the Exchange Rate Mechanism (ERM) was put in place. Under the ERM, the member countries, with the exception of Italy and the UK, pledged to maintain their exchange rates within a band of -/+2.5% around parity, which was referenced to the European Currency Unit. Italy and the UNK observed a band of -/+6%. During the next 10 years, numerous realignments of the parity relationship took place.

The Plaza and Louvre Accords. In 1985, the dollar reached an all-time high relative to the major currencies and the US experienced a high deficit. In September of that year, in an agreement known as the Plaza Accord, the Group of 5 (France, West Germany, Japan, the UK, and the US) coordinated their economic policies to drive down the price of the dollar. The Place Accord inaugurated a plan for the "orderly appreciation" of other currencies against the US dollar. These efforts resulted in a 30% decline in the dollar's value during the next 2 years.

To cope with the possibility that the dollar might overshoot its "natural level", the major industrial nations met again in February 1987 and reached a new agreement known as the Louvre Accord. Declaring that the US dollar had fallen far enough, the singers pledged to cooperate in stabilizing it and agreed to try as far as possible to maintain the then-current exchange rate levels.

The Maastricht Accord. In 1991, the European countries met in Maastricht and set a timetable and rules to establish a single European currency. The conditioned membership in this currency union on the maintainance of narrow bands around parity exchange rates.

When the reunification of Germany motivated Bundesbank in 1992 to pursue a tight monetary policy to forestall the onset of inflation, the narrow exchange rate bands forced other European countries to raise their interest rates at a time when their economies were mired in recession. This circumstance led speculators to sell the weak European currencies in anticipation of devaluation. Sweden, in an ill-fated attempt to defend the parity relationship of the krona, raised interest rates to 500%. The Bank of England unsuccessfully spent billions of pounds defending its exchange rate. The UK and Italy withdrew from the Maastricht Accord in September 1992, and several other European currencies were devalued shortly thereafter. A general realignment occurred in August 1993; bands were -/+15% around the new parity exchange rates. The Maastricht Accord was ratified in September 1993, but with considerably less enthusiasm for a unified European currency in the foreseeable future.

Over the years, exchange rate policies amoung nations have varied according to two major dimensions - cooperation versus noncooperation and rules-based intervention versus discretionary intervention. The current environment for most major currencies is characterized by government cooperation but with intervention at the discretion of the major central banks.