Introduction
In our last lesson, we focused on the mechanics of swaps, learning how to calculate the cash flows exchanged in both interest rate and currency swaps. Now, we move from the "how" to the "why." This lesson will show you how these instruments, along with forward contracts, are strategically used to manage one of the most significant risks in international business: currency risk.
This directly addresses your learning outcome to demonstrate how to hedge currency risk using forwards and currency swaps. We will explore, through practical numerical examples, how a company can lock in future exchange rates to eliminate the uncertainty associated with foreign currency payables, receivables, and loans. For a statistician, you can think of this as a financial strategy to reduce the variance of a future outcome to zero, thereby achieving certainty.
1. Hedging with Forward Contracts
When a company has a single, specific foreign currency payment or receipt due on a future date, a currency forward contract is an ideal hedging tool. As a reminder, this is a private agreement with a financial institution to exchange a specific amount of one currency for another on a future date, at a rate agreed upon today (the forward rate). This effectively locks in the domestic currency value of the future transaction.
To start, let's review the definition and purpose of currency forwards.
Currency Forward: Understanding FX Hedging Contracts in the OTC ...
This article from Investopedia provides a clear overview of currency forwards and their use in hedging.
Please read the following sections: The initial definition to refresh your understanding. The section on hedging risks, which gives a concise example of an exporter's situation. Finally, the short FAQ answer to "Why Are Currency Forwards Used?" to solidify the core purpose.
Hedging a Foreign Currency Payable
Imagine your company has purchased goods from a supplier in Hong Kong and must pay 210,000 Hong Kong Dollars (HKD) in four months. The current exchange rate (spot rate) is irrelevant to your future payment risk; what matters is the uncertainty of what the spot rate will be in four months. A forward contract eliminates this uncertainty.
The following video provides an excellent, detailed walkthrough of exactly this scenario. It covers the accounting entries and, more importantly for our purposes, shows the financial outcome and how the forward contract neutralises the exchange rate risk.
Accounting for Currency Hedging using Forward Contract | Advanced Accounting | CPA Exam FAR
This video from Farhat's Accounting Lectures, titled "Accounting for Currency Hedging using Forward Contract," gives a comprehensive numerical example.
Focus on these two key segments: Watch the detailed worked example from the beginning of the scenario. Follow the setup of the initial purchase and the simultaneous forward contract. Pay close attention to how the value of the payable and the value of the forward contract change over time, and how these changes offset each other. Next, watch the crucial summary from the comparison. The lecturer clearly shows what the company's loss would have been without the hedge, and how the forward contract locked in a known, manageable cost from the very beginning.
The key takeaway from the video is that while the unhedged payable resulted in a large loss due to adverse currency movements, the hedged position resulted in a small, predictable cost (the difference between the spot and forward rates at inception). The company paid a small premium to eliminate a large, unpredictable risk.
Hedging a Foreign Currency Receivable
The logic is identical when you are due to receive foreign currency. Let's use the scenario from the Investopedia article you read.
Scenario:
- A Canadian exporter is due to receive US$1,000,000 in one year.
- The company is concerned the Canadian dollar (C$) will strengthen against the US dollar, meaning the US$1M will convert into fewer C$. This is the risk to be hedged.
- The one-year forward rate is C$1.0655 per US$1.
The Hedge:
The company enters into a forward contract to sell US$1,000,000 in one year at the agreed-upon rate of 1.0655. This guarantees they will receive C$1,065,500, no matter what the actual spot rate is in one year.
Demonstrating the Outcome:
-
Case 1: The risk materialises. The C$ strengthens, and the spot rate in one year is C$1.0300.
- Without the hedge: The company would receive US$1,000,000 x 1.0300 = C$1,030,000.
- With the hedge: The company executes its forward contract and receives C$1,065,500.
- Result: The hedge protected the company from the adverse rate movement, securing an extra C$35,500 in revenue.
-
Case 2: The rate moves favourably. The C$ weakens, and the spot rate in one year is C$1.0800.
- Without the hedge: The company would receive US$1,000,000 x 1.0800 = C$1,080,000.
- With the hedge: The company must still execute its forward contract at the lower rate, receiving C$1,065,500.
- Result: The company experiences an opportunity loss of C$14,500. This is not a true accounting loss, but the price of certainty. The hedge prevented the company from benefiting from the favourable rate movement.
This trade-off is the essence of hedging: you forgo potential upside to eliminate potential downside.
2. Hedging with Currency Swaps
While forwards are excellent for single transactions, currency swaps are better suited for hedging longer-term, ongoing exposures, such as those arising from foreign-currency-denominated loans.
As we saw in the previous lesson, a currency swap involves exchanging principal amounts at the start and end of the agreement, with periodic interest payments exchanged in between. The primary motivation is often to exploit a comparative advantage in borrowing, allowing two companies to effectively borrow in a foreign market at a cheaper rate than they could obtain directly.
The following video provides a clear, numerical demonstration of how this works.
This video, "Currency Swaps" by Dr. Ronald Moy, explains the entire process from the business need to the final calculation of savings.
Please watch the following parts: First, the introduction from the beginning, which sets up the common business problem: a US company needing to finance a project in France. Next, the brief explanation of the underlying principle of comparative advantage. Finally, and most importantly, the full numerical example from the walkthrough. This shows how a US firm wanting to borrow euros and a French firm wanting to borrow dollars can both benefit.
How the Swap Acts as a Hedge
Let's break down the hedging aspect of the example from the video:
- The US multinational needs to finance an expansion in France, meaning it needs euros (€).
- If it borrows dollars (its cheap domestic currency) and converts them to euros, it is exposed to currency risk. Its revenues from the French plant will be in euros, but its loan repayments will be in dollars. If the euro weakens against the dollar, it will take more of its euro earnings to make the same dollar payment.
- By entering the currency swap, the US company borrows dollars at its advantageous 8% rate but immediately swaps them for euros. Crucially, its ongoing payments into the swap are in euros (at 6%).
- The Hedge: The company's euro-denominated interest payments (via the swap) are now perfectly matched with its euro-denominated revenues from the French plant. It has created a synthetic euro loan. Furthermore, it has done so at an effective rate of 6%, which is 1% cheaper than the 7% rate it would have paid to borrow euros directly. It has eliminated its currency risk and saved money.
For a different perspective on the same principle, the following article shows the calculations laid out in clear tables.
Currency swaps | ACCA Qualification | Students
This technical article from ACCA provides another clear, fixed-for-fixed swap example.
Focus on the first example involving the American and South African companies. Notice how it concludes that each party can borrow at the other's more advantageous rate through the swap, demonstrating the core benefit that drives this hedging activity.
Conclusion
In this lesson, we have moved beyond simple calculation to see the powerful strategic application of derivatives. You have learned how to demonstrate the effectiveness of these tools in neutralising currency risk, a crucial skill for the CB1 exam.
Key Takeaways:
- Hedging is the process of using financial instruments to reduce or eliminate the risk of adverse price movements. In this context, it provides certainty about the domestic value of future foreign cash flows.
- Forward Contracts are best for hedging specific, known, single-point-in-time transactions, such as a future payment for imported goods or a future receipt from an export sale.
- Currency Swaps are used to hedge longer-term, ongoing exposures, like servicing a foreign currency loan. They allow companies to synthetically create a foreign currency liability while taking advantage of better borrowing rates in their domestic market.
In our next and final lesson on derivatives, we will complete this topic by demonstrating how to hedge interest rate risk and equity price risk using a range of derivative instruments.