RDP 2006-09: Limiting Foreign Exchange Exposure through Hedging: The Australian Experience 2. Hedging Instruments.
In the context of this paper, hedging refers to those activities employed by residents to reduce or eliminate their exposure to exchange rate changes arising from transactions or existing assets and liabilities denominated in foreign currencies. Since residents are ultimately concerned with values in local currency terms, they often wish to remove the risk associated with uncertain future movements in the Australian dollar. Hedging activities can vary substantially depending on the core business of firms and the nature of their foreign exchange risk. [5] However, they normally involve some combination of restructuring business activities so as to create a ‘natural’ hedge and using some type of financial derivative to offset underlying foreign currency exposures. [6]
Firms generally develop their hedging strategy to account for ‘net’ foreign currency exposure either carried on their balance sheet, as a result of trade, or a combination of both. It rarely makes sense for a single firm to purchase insurance for one part of their balance sheet by hedging against appreciation in the Australian dollar, while also purchasing insurance against depreciation on an offsetting position.
Figure 1 provides a stylised illustration. Natural hedging can be characterised as structuring the first layers of core business activities so that net exposure is eliminated or reduced before entering into derivative contracts. While this is important – particularly for large firms with diversified business activities – it is often difficult to quantify or even observe. In the event that natural hedging is not viable, too costly, or insufficient to reduce foreign exchange risk to the desired level, firms may choose to enter explicit derivative contracts in securities to further reduce risks. The remaining net position gives the best indication of the concept of foreign currency exposure dealt with in this paper.
Figure 1: Decision to Hedge Foreign Currency Exposures.
2.1 Natural Hedging.
Firms involved in international trade often attempt to ‘match’ the currency denomination of their receipts and payments in order to limit foreign exchange exposure. Similarly, this principle is employed by firms by taking on foreign currency assets or liabilities to net out existing exposures. [7]
Similar to the technique of matching, multinational firms often use a strategy called ‘leading and lagging’. This strategy essentially involves a parent company bringing forward or delaying payments or receipts of foreign currency with its subsidiaries to offset the currency risks associated with other foreign currency transactions. This strategy is one of managing cash flows across the consolidated group by the parent company.
Some firms are also able to achieve a partial natural hedge through the correlation between the price of the goods they produce and the exchange rate. An example would be an Australian gold mining company that sells bullion into world markets in US dollars. An appreciation of the Australian dollar would lower its receipts in local currency terms. However, as an appreciation of the Australian dollar is often correlated with gold prices, it is likely that rising prices would provide at least a partial offset to the dampening impact on revenue from the exchange rate.
In managing foreign exchange risks, firms may also be able to avoid engaging in explicit hedges if they have sufficient currency diversification across their costs and revenues, or assets and liabilities. Diversification should act to reduce aggregate currency exposure, at least to a level below the sum of all individual currency exposures. This technique is often referred to as ‘pooling’ and is adopted by some of the larger Australian resource companies. The Conference Board survey (Fosler and Winger 2004) found that nearly one-third of multinational firms stated that pooling was a very important part of their hedging strategy. Faff and Marshall (2002) also found that pooling was a common method of natural hedging by multinational firms from the US, UK, and Asia-Pacific region.
2.2 Foreign Exchange Derivatives.
Firms that consider any residual exposure to exchange rate fluctuations undesirable (after taking into account natural hedges) often choose to explicitly purchase insurance using financial derivative contracts. The main types of derivatives used in hedging are foreign exchange forward contracts, cross-currency interest rate swaps, and foreign exchange options.
2.2.1 Outright foreign exchange forward contracts.
A simple way to limit risk surrounding exchange rate fluctuations is a commitment to an outright purchase or sale of currency at a specified future date, for a predetermined price. [8] For firms expecting to receive or make foreign currency payments at a specific future date, forwards are a flexible and readily available hedging instrument. Australian exporters who typically receive revenues in foreign currencies tend to enter forward agreements to purchase the Australian dollar, while importers mainly purchase foreign currencies forward. A simple example would be that of an exporter of wheat who has a long lag between incurring initial costs and receiving export revenue in US dollars as contracted. A contract to sell forward the expected foreign revenues for Australian dollars would eliminate some cash flow uncertainty. Since the forward rate would be agreed upon entering the contract, subsequent exchange rate movements become irrelevant. [9] For Australia and most other countries, forwards are the most commonly used hedging instrument (Figure 2).
Figure 2: Foreign Exchange Derivatives Turnover.
Daily average in April.
Early surveys of Australian non-financial firms also demonstrate the preference for forwards. Teoh and Er (1988) found that forwards were the most used derivative, with swaps also used by larger firms (see also Batten, Mellor and Wan 1992, and Naughton and Teoh 1995). The BIE (1991) survey found that around 90 per cent of manufacturers tended to use forwards, 17 per cent used options, and 7 per cent used other instruments. More recently, the 2001 and 2005 ABS surveys found for non-financial firms that the notional values of currency forwards accounted for nearly 90 per cent of outstanding derivative contracts, cross-currency interest rate swaps accounted for 5½ per cent and 9 per cent in each of the respective surveys, while options accounted for around 6 per cent and 2 per cent in each of the respective surveys. Futures and all other derivatives accounted for a negligible proportion of outstanding derivatives. [10]
The prevalence of forwards over other derivatives in currency hedging may reflect certain features. First, unlike options, there is no initial outlay required. Second, while futures are standardised in amount and maturity, forwards can be tailored to suit an individual firm's needs. Furthermore, the markets for futures in some minor currencies either do not exist, or are relatively illiquid.
2.2.2 Cross-currency interest rate swaps.
A cross-currency interest rate swap involves the exchange of a stream of interest payments in one currency for a stream of interest receipts in another over a given period of time. At maturity, there is typically also an exchange of principal. Since these transactions involve exchange rate risk they can be structured to offset an existing exposure. This type of derivative is therefore primarily used to hedge balance sheet exposure on debt securities and the associated transaction risk on interest payments.
The use of these instruments can be illustrated using the following example based on practices common in the Australian banking sector. Figure 3 describes the issuance of foreign currency-denominated debt into an offshore market by a bank. The bank uses the proceeds from the bond issuance to fund its core business of domestic lending and insulates itself from exchange rate fluctuations by entering into a cross-currency interest rate swap.
Figure 3: Hedging with a Cross-currency Interest Rate Swap.
Note: Bank bill swap rate (BBSW), London interbank offer rate (LIBOR)
Initially, the bank issues floating-rate US dollar-denominated debt to non-resident investors in the offshore market and swaps the principal received at origination into Australian dollars in the foreign exchange market. The local currency principal is then lent to a resident borrower. At this stage, the bank has created a foreign exchange balance-sheet exposure in that it has raised a foreign currency liability (which will have to be repaid at maturity) to fund a local currency asset. Furthermore, there is a risk that the Australian dollar interest received on the asset will not be sufficient to cover the servicing burden denominated in foreign currency. The hedging strategy therefore has to address the on-balance-sheet translation exposure arising from the US dollar liability, as well as the series of transaction exposures to the US dollar that arise as a result of interest payments.
The bank could enter into a cross-currency interest rate swap to fully cover these exposures. The swap transaction would have the following main characteristics:
the bank enters an agreement with the swap counterparty under which the bank will receive a US dollar principal amount at maturity equal to that of the original debt issuance. In return, the bank undertakes to deliver an Australian dollar principal (predetermined by the prevailing spot rate at the time of arrangement), which is correspondingly matched by its loan book asset. This ensures that the balance sheet exposure is fully hedged; and for the duration of the swap the bank also receives a stream of US dollar interest payments from the swap counterparty, which it uses to meet the debt-servicing obligations on its US dollar liability. In return, the bank makes a series of Australian dollar-denominated interest payments to the swap counterparty that are met by the interest receipts from the Australian dollar loan asset. This ensures that the transaction exposure is also fully hedged. [11]
As an additional consideration, if the eventual holder of the foreign exchange risk embodied in the swap transaction is a non-resident, then the Australian bank has succeeded in taking on a foreign currency-denominated liability with the ultimate exchange rate risk held by non-residents. Natural non-resident counterparties are foreign institutions, such as the World Bank, which issue Australian dollar-denominated debt and hedge this exposure back into foreign currencies. [12]
2.2.3 Foreign exchange options.
Currency options give the holder the right, but not the obligation, to purchase (‘call’) or sell (‘put’) an amount of one currency for another at a given future date, for a pre-arranged exchange rate (‘strike’). Importantly, the holder of the instrument has discretion over whether or not to exercise his right to transact, allowing for a greater degree of flexibility than forwards, and leaving open the possibility of gaining from favourable exchange rate movements. This flexibility comes at a premium built into the price of the option. [13]
For example, to hedge the anticipated receipt of foreign currency, an exporter may buy a call option to purchase the Australian dollar for a predetermined strike rate at a future date (Figure 4). This eliminates the downside risk to revenue that is implied by exchange rate appreciation beyond the option strike, while at the same time preserving any revenue gains that would accrue if the exchange rate depreciates (under which circumstance the holder would choose not to exercise the option, but rather convert receipts into Australian dollars in the spot market at a more favourable price).
Figure 4: Export Revenue under Option Hedging.
Note: Hedged revenue is equivalent to unhedged revenue plus the call option pay-off.
On the other hand, the counterparty to the transaction (usually a bank), while earning the option premium, has unlimited potential for loss and is therefore exposed to adverse exchange rate movements. The option writer can hedge this exposure by purchasing an option providing an equal and opposite position, or by using a dynamic hedging method (Taleb 1997 and Nandi and Waggoner 2000 provide a detailed discussion of these techniques).
Footnotes.
The empirical literature on foreign exchange hedging is relatively sparse. References cited in this paper provide a selection of related articles which cover issues relevant to the topic but not directly dealt with in the interest of brevity. Discussion of why companies hedge can be found in Berkman, Bradbury and Magan (1997), Geczy, Minton and Schrand (1997), Cassie (2001), Battellino (2002), Berkman et al (2002) and Lel (2004), while general market risk is covered by Group of Thirty (1993, 1994) and BIS (2005). The Reserve Bank's articles related to foreign exchange exposures can be found in RBA (1986, 1994, 1997, 2000, 2002) and Becker, Debelle and Fabbro (2005). [5]
The Bureau of Industry Economics (BIE 1991) found that around 83 per cent of manufacturing firms used some combination of natural hedging in conjunction with derivatives, while only 17 per cent relied exclusively on the use of derivatives. Similar results were found in surveys for other countries (e.g., Statistics New Zealand 1999), and not surprisingly multinational firms are prevalent natural hedgers (Fosler and Winger 2004). [6]
This is often referred to as a ‘money market hedge’. For example, to offset the risk on an existing foreign currency liability, a firm could borrow in domestic currency, exchange this amount in the spot market for foreign currency, and invest in a secure offshore asset. These physical transactions are the underlying basis upon which pricing of forward foreign exchange contracts is based. [7]
Currency futures essentially have the same function as forwards. An important difference between the two instruments is that forwards are traded over-the-counter (OTC), meaning directly between counterparties, while futures are standardised exchange-traded instruments settled with a central counterparty, and therefore less flexible. [8]
The terms of a forward agreement usually imply that if the exchange rate were to move favourably, those benefits would be foregone by the firm. Survey responses collected by Teoh and Er (1988) suggest that Australian non-financial firms generally did not take short-term positions in exchange rate markets for speculative purposes. Surveys covering firms in the US, Switzerland, Hong Kong, Singapore, the Netherlands and NZ provide evidence that supports the contention that firms are ‘passive’ rather than ‘active’ in this respect, seeking mainly to smooth cash flows. See Bodnar, Hayt and Marston (1998), Loderer and Pichler (2000), Sheedy (2001), Bodnar, de Jong and Macrae (2002) and Briggs (2004). [9]
Surveys of firms across a number of countries – including the US, Germany, Switzerland, the Netherlands, Sweden, and Korea – also show a clear preference for forwards over other derivatives. See, for example, Bodnar, Hayt and Marston (1996), Bodnar and Gebhardt (1998), Loderer and Pichler (2000), Bodnar et al (2002), Bartram, Brown and Fehle (2004) and Pramborg (2005). [10]
The bank makes and receives foreign currency interest payments at the London interbank offer rate (LIBOR) , and makes local currency interest payments to the swap counterparty at the bank bill swap rate (BBSW). However, the rate at which it is able to lend out the local currency principal is higher than BBSW and represents the margin it is able to generate on its core business functions. Importantly, this means that once all hedging is taken into account, this margin is the only residual. Therefore, for a fully hedged offshore debt issuance there is no interest rate differential motivating the bank's decision to fund itself offshore. However, there are a range of other reasons why banks may prefer to fund their domestic lending through offshore debt issuance (see Battellino 2002 for a discussion). [11]
The World Bank alone issued over $8 billion of Australian dollar-denominated debt during 2004 and 2005. [12]
The two standard ‘vanilla’ options are the European-style option, which gives a buyer the right to exercise the option only at the expiry date, and the American-style option, which gives a buyer the right to exercise the option at any time up to the expiry date. Options are traded both over-the-counter (OTC) and on exchanges. When traded on exchanges, they generally take the form of an option on a futures contract. OTC trading in European-style options accounts for the majority of total turnover in options (see Bodnar et al 1998). [13]
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