Risk Management (Currency and Interest Rate)

Businesses operating across borders face three types of currency exposure:

1. Transaction exposure:

• Arises from individual contractual cash flows denominated in a foreign currency
• The amount in foreign currency is KNOWN; the domestic currency equivalent is UNCERTAIN until settlement
• Examples: UK exporter invoices US customer $1m payable in 90 days; UK importer commits to pay €500k in 60 days; UK subsidiary's dividend received from US parent company
• Usually the most frequently hedged exposure because it is specific and quantifiable

2. Translation exposure (also called accounting exposure):

• Arises on CONSOLIDATION of foreign subsidiaries at the reporting date
• Foreign subsidiaries' assets, liabilities, and (sometimes) P/L need translation into the parent's presentation currency
• Changes in exchange rates create gains/losses in OCI (IAS 21 — foreign currency translation reserve)
• Does NOT affect actual cash flows — purely accounting
• Hedging translation exposure is DEBATED — some argue it's not worth hedging (no cash effect); others hedge to stabilise reported earnings

3. Economic exposure (also called operating exposure):

• LONG-TERM impact of exchange rate changes on the firm's FUTURE competitive position and cash flows
• Even firms with no foreign subsidiaries or foreign currency invoicing may have economic exposure
• Example: UK manufacturer sells in UK only but competes with German imports. If euro weakens vs sterling, German imports become cheaper and the UK firm loses market share.
• Very difficult to QUANTIFY or hedge with standard financial instruments
• Managed through OPERATIONAL strategies: diversifying production locations, sourcing from multiple countries, flexible pricing, matching revenues and costs in each currency

Summary table:

A forward contract is a binding agreement between two parties to exchange a specified amount of currency at a specified future date at a specified exchange rate (the forward rate). Over-the-counter (OTC) — typically with a bank.

Key features:

• Binding — both parties must transact at the forward rate regardless of the spot rate on settlement date
• Tailor-made — amount, maturity date, and currencies flexible to the user's needs
• No upfront cost (but bid-offer spread embeds the bank's margin)
• Credit risk — counterparty may default (mitigated by dealing with reputable banks; larger deals may require collateral or credit lines)

Forward rates:

• Quoted by banks as a bid-offer spread (like spot)
• The forward rate is NOT a prediction of the future spot rate — it reflects the interest rate differential between the two currencies (interest rate parity)
• Interest rate parity: (1 + i_A) / (1 + i_B) = Forward A/B rate / Spot A/B rate
• Rule of thumb: the currency with HIGHER interest rate trades at a forward discount (weakens in forward market)

Worked example — UK exporter:

A UK company expects to receive $500,000 in 3 months. Current exchange rate: £1 = $1.25. 3-month forward rate: £1 = $1.26. The exporter is concerned the dollar may weaken (fewer £ per $) before receipt.

• Action: sell $500,000 forward at £1 = $1.26
• Sterling received: $500,000 / 1.26 = £396,825 (guaranteed)
• At settlement date, regardless of actual spot rate, the exporter receives £396,825

Compare to doing nothing:

• If spot at settlement = £1 = $1.30 (dollar weakened): unhedged = $500,000 / 1.30 = £384,615. Hedge saved £12,210.
• If spot at settlement = £1 = $1.20 (dollar strengthened): unhedged = $500,000 / 1.20 = £416,667. Hedge LOST £19,842 of upside (but the point of hedging is to remove uncertainty, not maximise return).

Advantages of forwards:

• Simple to arrange
• Precise match to the underlying exposure (exact amount, exact date)
• No upfront cost
• Eliminates uncertainty entirely

Disadvantages:

• Binding — cannot benefit from favourable movements
• Counterparty risk with OTC contracts
• May be difficult/costly to close out early if underlying exposure changes
• Not standardised — less liquid than exchange-traded alternatives

A money market hedge uses borrowing and deposits in two currencies to lock in an effective exchange rate. Uses the SPOT market plus interest rates — no forward market needed.

Principle: A forward contract is economically equivalent to borrowing in one currency, converting at spot, and depositing in the other. If done correctly, the money market hedge gives (approximately) the same effective rate as the forward rate (interest rate parity).

For a receivable in foreign currency (e.g., US exporter receiving $):

1. Today: Borrow the PV of the foreign currency receivable (PV at the FC borrowing rate over the period)
2. Convert to domestic currency at SPOT rate
3. Deposit in domestic currency to earn domestic interest
4. At settlement: Use the foreign currency received to repay the foreign currency loan; use the matured domestic deposit

For a payable in foreign currency (e.g., importer paying $):

1. Today: Borrow in domestic currency, convert at SPOT to foreign currency
2. Deposit the foreign currency (to earn foreign interest) so that the deposit matures to exactly the amount payable
3. At settlement: Use the matured FC deposit to pay the supplier; repay the domestic loan

Worked example — UK exporter receiving $500,000 in 3 months:

Spot rate: £1 = $1.25. US interest rate: 4% per annum (1% for 3 months). UK interest rate: 8% per annum (2% for 3 months).

1. Borrow USD PV: $500,000 / 1.01 = $495,050 (this will grow to $500,000 at 1% over 3 months)
2. Convert at spot to £: $495,050 / 1.25 = £396,040
3. Deposit £396,040 at 2% for 3 months: matures to £396,040 × 1.02 = £403,960
4. At settlement: receive $500,000 from customer → use to repay the $ loan (principal + interest = $500,000)
5. Withdraw £403,960 from deposit

Effective rate: £1 = $500,000/£403,960 = $1.2378 — similar to a forward rate. Any small discrepancy with the forward market would be arbitraged away.

When money market hedge useful:

• Forward markets not available or illiquid (e.g., for some emerging market currencies)
• When a company already needs to borrow or deposit — can combine the hedge with genuine financing
• When forward rates look unfavourable — check if money market gives a better effective rate

Advantages: Flexibility (uses any bank, any currency); certainty; can combine with normal financing activity.

Disadvantages:

• More complex administrative process than forwards
• Requires ability to borrow in foreign currency (some smaller firms cannot)
• Uses balance sheet capacity (loan and deposit positions)
• Typically similar outcome to forward — usually the simpler choice is the forward

Currency futures:

• Standardised forward contracts traded on exchanges (CME, ICE, Euronext)
• Standard contract sizes (e.g., €125,000), standard maturity dates (typically quarterly — March, June, September, December)
• Marked-to-market daily — margin calls required as the position moves against the holder
• Basis risk — the hedge is imperfect because the standard contract amount and date may not match the exposure exactly
• Low counterparty risk — the exchange (central counterparty) guarantees performance via margin and clearing
• Highly liquid; easy to close out a position by an offsetting trade

Futures hedging process:

1. Select contract closest in maturity to the exposure (after — so "in the money" at settlement)
2. Determine number of contracts needed (exposure / contract size — rounded)
3. Take opposite position in the futures market to the underlying exposure
4. At settlement: close out the futures position (profit/loss on futures offsets the loss/profit on the underlying)

Advantages of futures over forwards: Lower counterparty risk (exchange guarantees); highly liquid; transparent pricing.

Disadvantages: Standardised (basis risk from dates/amounts); margin requirements (cash tied up); expertise needed; not tailor-made.

Currency options:

A currency option gives the holder the RIGHT, but not the obligation, to buy (call) or sell (put) a specified amount of currency at a specified rate (strike price) on or before a specified date. In return, the holder pays a premium upfront.

Two types:

• Call option: Right to BUY currency at the strike price. Exercise if market price > strike. Used by companies with FC payables (protect against currency appreciation).
• Put option: Right to SELL currency at the strike price. Exercise if market price < strike. Used by companies with FC receivables (protect against currency depreciation).

Exercise if in-the-money; abandon (don't exercise) if out-of-the-money.

Worked example — UK exporter with $500,000 receivable:

Exporter wants protection against a weakening dollar (fewer £ per $). Buys a PUT option on dollars at a strike of $1.28 per £. Premium: £5,000.

• If spot at expiry = $1.30 (dollar weakened): Exercise. Receive $500,000/$1.28 = £390,625 minus £5,000 premium = £385,625. Worse than pure forward (£396,825) due to premium but better than unhedged (£384,615).
• If spot at expiry = $1.20 (dollar strengthened): Don't exercise. Sell at spot: $500,000/1.20 = £416,667 minus £5,000 premium = £411,667. Better than forward (£396,825) — retained the upside.

Options vs forwards: Options give DOWNSIDE PROTECTION WITH UPSIDE PARTICIPATION — but cost the premium. Forwards are cheaper (no premium) but lock in the rate — no upside. Choose options when: direction uncertain, upside potentially valuable, premium affordable; choose forwards when: want certainty, premium too costly, direction clear.

European vs American options:

• European: Can only exercise on expiry date
• American: Can exercise any time up to expiry — slightly more valuable (more flexibility)

Traded vs OTC options:

• Traded on exchanges (Euronext, CME): standardised, liquid, low counterparty risk
• OTC options (with banks): tailor-made (exact amount, exact date) but less liquid, counterparty risk

Option premium factors:

• Intrinsic value (in-the-money-ness)
• Time to expiry (longer = more expensive)
• Volatility of exchange rate (higher volatility = more expensive)
• Interest rates in the two currencies

Currency swaps:

• Agreement to exchange principal and interest payments in different currencies
• Used for LONG-TERM hedging (years rather than months)
• Example: UK company has £-debt but wants $-debt to match $-revenue. Swaps with US counterparty.
• Typically bank-intermediated
• Enables access to borrowing in one market while effectively having debt in another currency

Interest rate risk arises when changes in interest rates affect the business:

Sources of exposure:

• Borrowing: Rising rates increase interest costs on floating-rate borrowings. Falling rates benefit (but companies may have to refinance when fixed-rate debt matures).
• Depositing/investing: Rising rates increase deposit income. Falling rates hurt.
• Planned future transactions: Uncertainty about rates when future borrowing/deposits will occur
• Mismatched balance sheet: Different maturities/repricing of assets and liabilities create net exposure

Gap analysis:

Classifies assets and liabilities by time-to-repricing (not just maturity). Shows the NET exposure in each time band.

Interest rate gap = Rate-Sensitive Assets (RSA) − Rate-Sensitive Liabilities (RSL) in each time band.

Interpretation:

• Negative gap (liabilities reprice faster than assets): exposed to RISING rates — interest costs rise faster than interest income
• Positive gap: exposed to FALLING rates
• Zero gap: balanced — not exposed to parallel rate movements

In the example above, the company has a negative gap in the short term (0-12 months) — vulnerable to rising rates. A positive 1-2 year gap partially offsets this (vulnerable to falling rates beyond one year).

Limitations of gap analysis:

• Assumes parallel shifts in the yield curve — but rates at different maturities often move differently
• Focuses on NET INTEREST INCOME, not market value of instruments (which also moves with rates)
• Doesn't capture option-like features (e.g., prepayment option on some loans)
• Duration analysis is more sophisticated — measures sensitivity of PV to rate changes

Strategies for managing interest rate risk:

• Natural hedging: Match fixed-rate assets with fixed-rate liabilities; floating-rate with floating-rate
• Balance sheet restructuring: Shift from floating to fixed rate borrowing (or vice versa) directly in the market
• Derivatives: FRAs, futures, swaps, options

Forward Rate Agreements (FRAs):

• OVER-THE-COUNTER (OTC) agreement — typically with a bank
• Fixes a rate of interest for a FUTURE PERIOD (e.g., for 3 months starting 6 months from now — "6×9 FRA")
• Notional amount specified but NO EXCHANGE OF PRINCIPAL — only the interest differential is settled (in cash)
• At settlement, if actual rate > FRA rate: writer (seller) pays buyer the difference × notional × fraction of year. If actual rate < FRA rate: buyer pays writer.
• Effectively fixes the cost of future borrowing (buyer of FRA) or deposit return (seller of FRA)
• Tailor-made: exact amount, exact dates

Worked example: Company plans to borrow £10m for 3 months, starting in 6 months. Current 6-month rate 4%; 9-month rate 4.5%. The company wants to fix the cost now. Buys a 6×9 FRA at 5.0% (implied forward rate).

• In 6 months, 3-month rate rises to 6%: Company borrows at 6%; FRA writer pays: (6% − 5%) × 3/12 × £10m = £25,000 to the company. Net effective cost: 6% − 1% compensation = 5%.
• If 3-month rate falls to 4%: Company borrows at 4%; company pays writer (5% − 4%) × 3/12 × £10m = £25,000. Net effective cost: 4% + 1% = 5%.
• Either way, effective cost = 5% (the FRA rate) — locked in.

Interest rate futures:

• Exchange-traded, standardised equivalents of FRAs
• Contracts on short-term interest rates (e.g., 3-month SONIA, EURIBOR, Eurodollar)
• Prices quoted as 100 − implied rate. If rate is 5%, price is 95.
• To hedge BORROWING (concerned about rising rates): SELL futures (if rates rise, futures prices fall → profit on short position offsets higher borrowing cost)
• To hedge DEPOSIT (concerned about falling rates): BUY futures (if rates fall, futures prices rise → profit on long position offsets lower deposit income)
• Standard contract sizes, monthly/quarterly expiries → BASIS RISK if underlying exposure doesn't match
• Marked-to-market daily — margin required

Worked example — hedging a future £10m, 3-month borrowing in 6 months:

Contract size £500,000. Each basis point (0.01%) movement over 3 months = £500,000 × 0.0001 × 3/12 = £12.50 per contract. Need to hedge £10m: number of contracts = £10m / £500,000 = 20 contracts.

• Concerned about rising rates → SELL 20 futures contracts now at price 95.00 (implied rate 5.0%)
• In 6 months, rate has risen to 6.5%; futures price falls to 93.50 (implied rate 6.5%)
• Profit on futures: (95.00 − 93.50) × 150 basis points × £12.50 × 20 = £37,500
• Additional borrowing cost from rate rise: (6.5% − 5.0%) × 3/12 × £10m = £37,500
• Hedge fully offsets the additional cost (in this idealised example)

FRAs vs futures:

• FRAs: tailor-made, OTC, counterparty risk, no margin, simple
• Futures: standardised, exchange-traded, low counterparty risk, margin required, basis risk from standardisation
• Most large corporates use BOTH — futures for short-term liquidity, FRAs for specific tailored needs

An interest rate swap is an agreement between two parties to exchange interest payment streams on a notional principal amount. Principal is NOT exchanged (in contrast to currency swaps) — only the interest cash flows.

Plain vanilla interest rate swap: One party pays FIXED rate; other pays FLOATING rate (usually linked to a reference rate like SONIA or SOFR). Netted each period.

Example structure:

• Company A has a floating-rate loan at SONIA + 1%. Prefers fixed payments for cash flow certainty.
• Company A enters a swap: receives SONIA + 0.8% (from swap counterparty); pays fixed 4.5%.
• Net effect: Company A's loan interest = floating rate + 1%; swap receipt = SONIA + 0.8%; net payment = 4.5% + 0.2% = 4.7% fixed.
• Floating-rate loan + pay-fixed swap = synthetically fixed-rate loan.

Why swaps might be useful:

1. Comparative advantage: Two companies have different access to fixed vs floating markets. They can each borrow where they have the best rates, then swap to achieve the desired interest rate profile — both save money.
2. Balance sheet hedging: Convert an existing floating-rate loan to fixed (or vice versa) without refinancing
3. Long-term hedging: Swaps typically 2-10 years, much longer than FRAs and futures (usually less than 1 year)
4. Flexibility: Can unwind/close out by entering an offsetting swap

Comparative advantage worked example:

A has a comparative advantage in fixed (2% cheaper than B); B has less disadvantage in floating (0.8% more vs 2% more). Total savings available: 2.0% − 0.8% = 1.2%.

Swap arrangement (simplified, ignoring bank fees):

• A borrows fixed at 5.0%; B borrows floating at SONIA + 1.0%
• A and B enter a swap: A pays B floating SONIA; B pays A fixed 5.6%
• A's net position: Pays 5.0% (loan) − 5.6% (from B) + SONIA (to B) = SONIA − 0.6% (floating, 0.8% cheaper than direct)
• B's net position: Pays SONIA + 1.0% (loan) + 5.6% (to A) − SONIA (from A) = 6.6% (fixed, 0.4% cheaper than direct)
• Total savings 1.2% split between parties (0.8% + 0.4%)

Counterparty risk in swaps:

• If one party defaults, the other loses the value of the swap (if positive) and must find a replacement
• Post-2008 regulations: most swaps are now cleared through central counterparties (CCPs), with margin and default protections
• Credit Support Annexes (CSAs) require collateral posting as swap values change

Interest rate options give the holder the right (but not obligation) to borrow/deposit at a specified rate. The main types:

1. Cap:

• Series of interest rate options giving a BORROWER the right to pay a MAXIMUM rate (the cap rate)
• If market rate > cap rate: option exercised, effectively pays the cap rate
• If market rate < cap rate: option not exercised, pays the (lower) market rate
• Buyer pays a premium upfront
• Useful for a borrower wanting protection against rate rises while retaining benefit from rate falls

2. Floor:

• Series of options giving a DEPOSITOR the right to receive a MINIMUM rate
• If market rate < floor rate: option exercised, effectively receives the floor rate
• If market rate > floor rate: option not exercised, receives the (higher) market rate
• Buyer pays a premium upfront
• Useful for a depositor wanting protection against rate falls while retaining benefit from rate rises

3. Collar (or "cylinder"):

• Combines buying a cap and SELLING a floor (or vice versa for a depositor)
• Limits both the MAXIMUM and MINIMUM effective rate — a "band" within which the borrower's rate fluctuates
• The premium paid for the cap is (partially or fully) offset by the premium RECEIVED from selling the floor
• A ZERO-COST COLLAR has equal premiums on cap and floor — no upfront cost. Achieved by choosing strike prices accordingly.
• Trade-off: lower cost than a simple cap, but you give up the benefit of rates falling below the floor

Example — borrower with £10m floating-rate loan, planning for next year:

• Option 1 — Buy a 5% cap (premium 1% × £10m = £100,000): Maximum effective rate = 5% + 1% (premium) = 6%. If rates fall to 3%: effective rate = 3% + 1% = 4%. Protects upside while retaining downside benefit, at a cost.
• Option 2 — Zero-cost collar (buy 5% cap, sell 3% floor): Effective rate guaranteed between 3% and 5%. If rates drop below 3%, pay 3%. If rates rise above 5%, pay 5%. No upfront cost. But can't benefit if rates fall below 3%.
• Option 3 — Swap to fixed 4%: Pay 4% regardless of market rate. Certainty but no benefit if rates fall below 4%.

Choosing between hedging instruments for interest rate risk:

Practical considerations in choosing a hedge:

• Cost: Premiums on options vs zero-cost forwards/swaps. Accept certainty of cost?
• Flexibility: Options preserve upside; forwards/swaps lock in
• Size/tailoring: OTC for tailor-made; exchange-traded for standardisation and liquidity
• Duration: Futures/FRAs for short term; swaps for long term
• Counterparty risk: Exchange-traded vs OTC
• Accounting: Hedge accounting under IFRS 9 — complex but can smooth P/L impact
• Regulatory: Post-2008 rules favour central clearing; CSAs require collateral