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Hedging can be used to minimise financial loss that has the potential to occur in commodities, such as oil, grains or livestock, and the theory of hedging was developed as a tool to minimise the potential loss in this line of business. Holbrook Working, a 20th century professor of economics and statistics at Stanford University’s Food Research Institute made significant contributions on hedging and the theory of futures prices. Workings contributions to the theoretical practice of hedging precluded Eugene Fama’s efficient market hypothesis, which he developed when he wrote his PhD thesis, entitled “The Behavior of Stock Market Prices”, which was published as the entire January 1965 issue of the Journal of business. The efficient market hypothesis was an early theory of market maker behaviour (Wikipedia, 2007).

A market maker is a business that quotes both a buy and sell price in a financial instrument or commodity, hoping to make a profit on the bid/offer, or aid/ask spread. This spread is the difference between the price available for immediate sales (bid) and an immediate purchase (ask). This behaviour that a market maker exhibits when he chooses to buy or sell a financial instrument or commodity will ultimately affect market prices, returns, or allocation of resources. The efficient market theory, however, states that financial markets are ‘informationally efficient’ and any variances in the bid/offer spread will eventually be minimalised by arbitrage, which is the practice of taking advantage of price differentials between two or more markets (Wikipedia, 2007).

Whilst hedging was originally used in the trading of commodities, such as oil, grain and livestock, the use has evolved over time and has further developed as a tool that can be used in international finance, such as in the exchange of foreign currencies. Whenever a business endeavours to trade outside its own country or currency, the risk it will encounter will be the possibility that the exchange rate will fluctuate and the business could incur a financial loss as a result of this fluctuation of exchange rates. Hedging, therefore, is a valuable tool that can be used to minimize the potential loss that can be incurred when a company decides to do business outside of its own country or currency.

An example of how a business can suffer a financial loss when doing business outside of its own country or currency can be seen by examining the exchange rate of several countries:- ,

On 12th January 2007 the £/$ rate was 1.944, which means that there were 1.944 US dollars to the British pound. If we use £1,000 as our base, £1,000 would buy $1,944. Using $1,000 as our base, $1,000 would buy £514.40 (Daily Express, 2007).

Six months later on 12 July 2007, the £/$ rate was 2.033, which means there were 2.033 US dollars to the UK pound. Using £1,000 as our base, £1,000 would buy $2,033. Using $1,000 as our base, $1,000 would buy £491.88 (Daily Express, 2007).

As a result of the fluctuation in exchange rates, the British pound became stronger against the US dollar, so £1,000 could buy 89 more US dollars in July than it could in January. Because the US dollar had weakened against the British pound, however, $1,000 could buy 22.52 less British pounds in July than it could in January. Therefore, because the US dollar was weak against the British pound, Americans could more easily export their goods and services to the UK, but would not necessarily feel they were getting value for money by purchasing British goods and services. The weakened US dollar, therefore, could in essence cause and import/export imbalance between the two countries if it continues indefinitely.

The example above illustrates how exchange rates can fluctuate over a period of time, and multi-national companies must bear the brunt of these fluctuations whilst conducting business internationally. It is this risk that a business could incur a loss whilst trading internationally that they tend to use hedging techniques in an attempt to minimalise any potential losses.

Whilst there are several hedging techniques that do not involve foreign currency exchange, such as netting, swapping, or even the increasingly popular management decision to move business operations to a country that has a weak currency, this paper will endeavour to focus on only those hedging instruments that involve the exchanging of foreign currencies. The most popular foreign currency hedging instruments are forwards, futures, and options.

Forwards, which are the most widely used hedging techniques, are contracts that are made now for a payment and delivery of a foreign currency at some specified date in the future, which can be in increments of 30 days all the way up to 10 years’ time. Although the foreign currency will not be exchanged until the future date set out in the contract, the rate at which it will be exchanged will be set out when the contract is initially made. Forward markets are used by importers, exporters, borrowers, investors, and speculators. The primary use of the forward contract is to offset the exchange rate risk when the exact amount of currency involved is known in advance. Whilst many large companies use forward contracts when trading or investing, mot of the activity in the forward markets is the result of interbank transactions that are designed to minimize the exposure of individual banks (University of Leicester, 2001).

Forward contracts are drawn up between banks and their customers or between two banks. Most forward contracts are now swap agreements, which involve two forward transactions: one agreement will be to exchange specific amounts of currencies on one date and the second agreement will be to reverse the exchange on a later date, usually at an exchange rate that differs from the first date. These swaps are useful for investors and borrowers in foreign currency because they are useful in managing the exchange risk (University of Leicester, 2001).

An example of a company using a forward market hedge, using the exchange rates cited above, would be a UK company exporting goods to America and invoicing them for £1 million. On 12 January 2007 the exchange rate was 1.944, so £1 million would be valued at $1.944 million. Of course, the American company would have no way of knowing what the exchange rate would be in six months’ time, but it is expecting the US dollar to continue to weaken. The American company can therefore hedge the risk of losing money on the transaction by entering into a forward contract with a bank to purchase £1 million in six months’ time at an agreed exchange rate of 2.000. Therefore, in six months’ time the American company would be obliged to buy £1 million for $2 million. It just so happens that on 12 July 2007 the spot rate was 2.033 so £1 million was valued at $2.033 million. Therefore, although the American company would have had to pay £33,000 less then they would have had to pay if they had not entered into a forward agreement at all (Lumby and Jones, 2003).

The second hedging instrument is the future, which was first introduced in the early 1970’s. Futures contracts are popular because they provide hedging mechanism for those organizations that would otherwise not be given access to forward contracts (University of Leicester, 2001). Whilst futures are similar to forwards because they both involve a future exchange of currencies at agreed exchange rates, there are fundamental differences between these two hedging differences. Whilst forward contracts are flexible in terms of maturity and contract amount, they lack standardisation. Forwards cannot be cancelled, so the only way that a forward contract can be negated is to enter into an agreement in the opposite direction of the initial forward contract, which is known as a swap agreement. Futures contracts, on the other hand, are of a standard size and maturity date. The exchange will also reverse a futures contact as long as there are other traders willing to take on the other side of the proposed reversing transactions and it is for this reason that few futures contracts reach maturity (University of Leicester, 2001).

Whilst a forward is an over the counter agreement between a bank and its customer or between two banks, a futures contract is a legally binding agreement made at a futures exchange, such as Chicago Mercantile Exchange, to buy or sell a standard quantity of one currency in exchange for another at an agreed rate of exchange and an agreed time in the future.

While a forward contract can be drawn up for any amount of money at any desired currency, a futures contract has standardized quantities with only certain currencies, such as the US dollar, UK pound, Euro, or Yen. Each futures contract is in respect of a fixed amount of currency: for example, $/£ contracts are for £25,000 each. Futures contracts are issued on a quarterly cycle of March, June, September, and December, and typically expire on the third Wednesday of the month (Lumby and Jones, 2003).

While banks generally do not ask the purchaser of the forward contract to make a deposit, the purchaser of a futures contract is required to post a daily margin, which is based on the closing settlement price of each day’s trading. The margin is a cash deposit by the buyer or seller of futures contracts and is a guarantee to fulfill the contract. Each day the exchange decides upon a settlement price for each futures contract, which is normally fixed with reference to trading that takes place 30 seconds before the close of business. If the value of the account has risen it is credited as a gain and the surplus can be withdrawn as cash; if it has fallen then it has incurred a loss. If the customer’s account records a loss and the balance of the account falls below the minimum margin requirement then the customer will be asked to increase the balance to make up the loss. Therefore, if a customer is unable to meet the losses and defaults on the agreement, the most that the exchange would suffer would be only one day’s price movement, which means the default risk of futures contracts is much lower then forwards contracts. This lower default risk means that exchanges can enter into more contracts with individuals and businesses that do not have impeccable credit ratings (University of Leicester, 2001).

For example, if an individual wishes to purchase a £25,000 contract on 12 July 2007, the exchange rate would be 2.033, so it would be valued at $50,825. The following day, on 13 July 2007, the exchange rate was 2.030 (Daily Express, 2007), so the same £25,000 futures contract would be valued at $50,750, resulting in a loss of $75. Three days later, on 17 July 2007, the exchange rate increased to 2.038 (Daily Express, 2007), so the £25,000 futures contract would be valued at $50,950, resulting in a profit of $125. Because the futures account recorded a profit, the owner of the futures account would be able to withdraw the surplus in cash.

The third hedging instrument, which is the instrument that is most suitable for multinational companies, is the options contract. Options contracts are hedging tools that companies use to reduce their risk of loss through fluctuations in exchange rates (Brealey et al, 2006).

The main difference between an option and a future or forward is the fact that the purchaser of the option contract purchases the option to buy or sell a currency or commodity and is under no obligation to buy or sell it. As a result of the fact that the purchaser of the contract is under no obligation to buy or sell the currency or commodity in question makes this hedging instrument more expensive than the forward or future. The purchaser of the option has to pay a premium for the right to buy or sell (University of Leicester, 2001).

Another differentiation of the option is the fact that whilst futures and forwards hedge the company against adverse and favourable movements in the exchange rate, options can be used to hedge the company against an adverse movement of an exchange rate, whilst at the same time allowing the company to take advantage of favourable movements in the exchange rate. It is this flexibility of the options contract that makes these instruments more expensive than the forward or future. Therefore, companies will tend to use forwards and futures if they are confident of an adverse movement in the exchange rate because those hedging instruments are cheaper than options. If the exchange rate is volatile, however, companies would be wise to use options because, even though they are more expensive, they would be able to take advantage of any positive movements in the exchange rate, should they occur (Lumby and Jones, 2003).

An example of how an option works can be illustrated by supposing a British company is due to pay $1 million in six months’ time to an American company. At the time the invoice was sent to the British company, on 12 January 2007, the exchange rate was 1.944. If in six months’ time the exchange rate the exchange rate was 1.644 the company would choose to exercise the option and buy $1 million / 1.944 = £514,403, whereas to buy $1 million at the spot rate, or current exchange rate, would mean a cost of $1 million / 1.644 = £608,273. It just so happens that on 12 July 2007 the spot rate was 2.033, so the company could have purchased $1 million at the exchange rate of $1 million / 2.033 = £491,884. Therefore, in the worst case scenario, ie the spot rate went down to 1.644 and the company did not purchase an option, it would be obliged to pay £603,273 for $1 million worth of goods. If the company had purchased an option at the agreed exchange rate of 1.944 then it could pay £514,403 for those same goods if it wanted to, so the potential for loss would have been offset by £88,870. In the best case scenario, the UK pound strengthened against the US dollar, so at a spot rate of 2.033 $1 million of goods was valued at £491,884, and this is £22,519 less than the company would have paid if it had exercised the option, so allowing the option to lapse would have been the most profitable business decision for the company to make (Lumby and Jones, 2003).

There are two kinds of foreign exchange options contracts: over the counter options (OTC) and traded currency options. The OTC options are similar to forward contracts and they are operated by the banks. Like forwards, OTC options are available for any amount of money, in any currency, for any time period forward. The traded currency option is similar to a futures contract. They are available from LIFFE, which is the largest European futures market, in a limited rang of currencies with a standard amount of money, of say £25,000, for each contract. Like futures, traded currency options are available on quarterly cycles – typically March, June, September, and December (Lumby and Jones, 2003).

There are two basic kinds of options, and they are calls and puts. A currency call option is an option to buy a particular currency, and a put option is an option to sell a particular currency. For example, if a company bought a $/£ put option, they would be buying a contract to sell £25,000 in exchange for US dollars. If they bought a $/£ call option, they would be buying a contract to buy £25,000 in exchange for US dollars (Lumby and Jones, 2003).

In conclusion, hedging is merely an individual or company’s way of limiting their exposure to risk in any venture they may choose to undertake. In its simplest form, hedging can be seen as an insurance policy that is bought in anticipation of a potential financial loss at some time in the future. In the financial exchange market, there are three main hedging instruments that a company can use to limits its exposure to risk, which are forwards, futures, and options. A forward contract is perhaps the oldest foreign current hedging device, and it is primarily used for interbank transactions designed to minimise the exposure of individual banks. Futures were introduced to the financial sector in the early 1970’s and provide a hedging mechanism for some organizations that would not otherwise be given across to the forward market. They are more flexible than forwards because they are traded in an exchange, are bought and sold by brokers on behalf of the customer, are standardized for ease of use, and if a company or individual would like to liquidate them before the maturity date, they are allowed to do so. Options are perhaps the most flexible of the three hedging devices discussed in this paper. When an individual or company purchases an option, they are purchasing the right to buy or sell a particular commodity or currency, and are under no obligation to exercise the contract if it would not be profitable for them to do so. It is because an option can be used to hedge the company against an adverse movement in exchange rates as well as allow it to take advantage of favourable exchange rates that this hedging device is most suitable for multi-national companies.

References

Brealey, R. et al. (2006). Corporate Finance: International Edition, McGraw-Hill: New York, New York

Daily Express (12 January 2007). City & Business Section, The Daily Express Newspaper: London, England.

Daily Express (12 July 2007). City & Business Section, The Daily Express Newspaper: London, England.

Daily Express (13 July 2007). City & Business Section, The Daily Express Newspaper: London, England.

Daily Express (17 July 2007). City & Business Section, The Daily Express Newspaper: London, England.

Lumby, S. and Jones, C. (2003). Corporate Finance Theory and Practice, Seventh Edition, Thomson: London, England

University of Leicester (2001). MSc in Finance: 2506 International Finance, Learning Resources: Cheltenham. England.

Wikipedia (2007)
URL://http//www.wikipedia.org
[7 September 2007]