Hedging
Essay Preview: Hedging
Report this essay
HEDGING
Hedging is an act of protecting risk from currency fluctuations. The investor must decide whether to:
fully hedge (risk adverse)
Partly hedge
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:
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)
Futures contracts – expire at certain times of the year and are in denominations of $100,000
Currency options – provides you with an option but not an obligation, therefore is more expensive
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 countrys 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 countrys financiers may lend you bigger loan ratios 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:
Funds will move to the country with the higher rate;
Market pressures develop:
currency is more demanded for spot and sold forward
inflow of funds depress interest rates, and
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