Using currency futures for hedging currency risk

Overview: During periods of intense market risk, issues related to hedging different risk factors become critical. This paper has focused on currency risks. It started with a complete definition of currency effect on foreign portfolio returns, and argued in favor of protecting against this risk. The main benefit of a full hedge would be in the form of a reduction in portfolio volatility. Fund managers can choose from a range of instruments to hedge their currency risks. The paper argues that exchange-traded futures contracts have certain advantages that make them suitable for managing single currency as well as multiple currency exposures, providing examples of hedging U.S. dollars versus Mexican pesos and hedging equity portfolio hedging currency risk using the new CME$INDEX.

Currency Derivatives And Rupee Risk

Trading volumes in the Indian rupee have risen close to four times between 2004 and 2007, and its share of world currency transactions has more than doubled from about 1.5% to 3.5% during the period. Much of this is driven by foreign investors? discovery of India. In the last five years, foreign investment inflows have grown at a compounded annual growth rate (CAGR) exceeding 26%. Simultaneously, Indian corporates have gone for external commercial borrowings in a big way. During 2006-07, foreign borrowings of the largest Indian Companies amounted to about 30% of their domestic borrowings. Crossborder M&A activity and private equity flows to India have also zoomed.

All these crossborder investment flows, together with enhanced trade flows, create a corresponding need for hedging currency risk, particularly given that the exchange rate is more than twice as volatile in 2007 as it has been in the last few years. That?s where currency derivatives come in. Forwards, options, futures and swaps all help players better manage forex risk analysis.

Demand for currency hedging instruments for the Indian rupee is perhaps best reflected in the relative turnover volumes of forward contracts involving the currency. Forwards are the simplest of forex derivatives that involve an agreement on the price of a future purchase or sale. According to the Bank for International Settlements? triennial survey, the average forward market turnover in the rupee gently rose from 27% of that of the spot market turnover in 2001, to 31% in 2004. In 2007, the figure more than doubled to 65%.

Currency derivatives available in India today include forwards, options and swaps involving the rupee. All of these are over the counter (OTC) instruments that need to be purchased from banks, as opposed to being exchange-traded. Moreover, several stipulations apply to them. In an effort to ensure that forwards are used only for hedging purposes, resident individuals/firms and FIIs are required to provide proof of their underlying positions before they take positions in the forward market, though moves are now afoot to make things simpler for resident individuals and SMEs. This restricts the market entry of several entities with bonafide hedging needs, not to speak of speculative currency traders.

An important consequence of these restrictions has been the development of a vibrant offshore market in non-deliverable forwards (NDF) on the Indian rupee. Based primarily in Singapore and in operation since the mid-1990s, this is a market where...

Currency Risk Assessments

In addition to our regular monthly surveys for our panellists central projections for over 90 currencies we also ask our panellists for their estimates of the likelihood of alternative, perhaps less likely, outcomes in certain major currencies over the next twelve months in Foreign Exchange Consensus Forecasts (in July and December) for the currencies listed below.

have witnessed in recent months a sharp increase in volatility in international exchange rates, particularly with respect to emerging market currencies. The tightening of global monetary conditions, through higher interest rates and withdrawal of liquidity, has dampened the appetite for riskier investments in favour of quality assets. And the pull back of capital from countries with large budget or current account deficits that rely heavily on external financing has caused their currencies and stocks to tumble. In particular, the South African rand and the Hungarian forint have each suffered substantial

in the FX market and the tightening of monetary conditions. Over the next twelve months, the consensus is predicting that the rand will rise 2.6%, but probabilities of 35.0% and 12.5% are attached to losses of greater than 5.0% and more than 20%, respectively. The forint is expected to strengthen by a similar amount to the rand, but it too has a sizeable probability attached to a decline of greater than 5.0%. Currency risks for countries in Latin America, meanwhile, appear negatively skewed, reflecting concerns about competitiveness and political stability. By contrast, current account surpluses and the benefit of a substantial

Of the major currencies, the probability risk distribution for the Japanese yen seems more skewed toward appreciation, with a 51.5% probability attached to gains of greater than 5.0% against the US dollar over the next twelve months.

Currency Risk

Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.

The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates.

For example if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would realize no gain.

When a firm conducts transactions in different currencies, it exposes itself to risk. The risk arises because currencies may move in relation to each other. If a firm is buying and selling in different currencies, then revenue and costs can move upwards or downwards as exchange rates between currencies change. If a firm has borrowed funds in a different currency, the repayments on the debt could change or, if the firm has invested overseas, the returns on investment may alter with exchange rate movements — this is usually known as foreign currency exposure.