FORWARD CONTRACT AS A HEDGING TOOL
Abstract
This paper investigates how a New Zealand based Investment Fund manage its foreign exchange risk by forward contract. We find some factors such as S&P 500 returns, interest rate, and term of contract impact on the hedging decision. A long term contract may benefit a company in capital planning but also exposure the firm to unexpected events. A short term contract may be the better choice.
1. Introduction
The control of currency risk or foreign-exchange risk is an important part in improving economic efficiency of a company. The concern has been growing since the company expanded its activities into international market because the business has become more vulnerable to foreign exchange fluctuations. Cash flows in and out- denominated in foreign currencies, expose different companies to a foreign exchange risk. Any change in exchange rate may have an impact on the net cash flow and the profitability.
In order to minimize the influence of currency fluctuations on the budget planning, a company may plan to join a forward market where currencies are traded. Parties involved in a forward contract agree to buy or sell a currency at a specific date in the future and at a fixed price. By locking into a forward contract, a company makes its future net cash flow predictable and less sensitive to changes in exchange rates.
This paper begins with the definition of foreign exchange risk. We start to look at the risk identification and risk management to see how it impacts the profitability of a company. Next, we present the relationship between the interest rates and exchange rates. Then some characteristics of forward contract will be discussed. The paper also includes a specific case of a New Zealand-based investment Fund. Finally, we will conclude about the use of forward contract as a hedging tool.
2. Foreign exchange risk (currency risk)
“Foreign exchange risk is commonly defined as additional variability experiences by a multinational corporation in its worldwide consolidated earnings that results from unexpected currency fluctuations. It is generally understood that this considerable earnings variability can be eliminated – partially or fully – at a cost, the cost of Foreign Exchange Risk Management.” (Jacques).
For example, if a New Zealand-based investment fund invests in a US Exchange Traded Fund (ETF) that tracks the S&P 500 index, the return that the firm will receive is affected by both changes in the performance of S&P 500 and variations in the value of the New Zealand dollar (NZD) against the U.S. dollar (USD). If the investment brings a 10% return in USD but simultaneously the New Zealand dollar appreciates 10% against USD, the statement of income in NZD will realize no gain at all.
2.1 Risk identification
Generally, foreign exchange risk is the combination of transaction exposure and economic exposure.
Transaction exposure is faced by a company when there is a commitment denominated in a foreign currency and the transaction occurs in a different time from the date of receipt or payment.
In the case of the investment fund mentioned above, if the firm mobilizes European resources and receives the U.S. dollar from its investment, it carries the risk when it has to buy Euro to pay its creditors.
Economic exposure (operating exposure) is the probability of changes in the future cash flows of a company due to unexpected change in the exchange rate. (Eiteman, Stonehill and Moffet, 2011). It can be seen from the example said above. The profits of the investment fund decreases because of the appreciation of New Zealand dollar.
2.2 Risk measurement
In order to measure transaction exposure, the volatility of a currency against a foreign currency based on historical data can be used.
The investment fund invests in the U.S. so the firm needs to analyse the historical data of USD/NZD cross rate. As a research by Mabin in 2011, The NZD/USD bilateral exchange rate is a