Currency risk identification and hedging - Forward and money...

Learning Outcomes

After reading this article, you will be able to identify and explain key types of foreign currency risk. You will also be able to describe and evaluate two main hedging techniques—forward exchange contracts and money market hedges—outline their mechanisms, distinguish between them, and calculate or comment on their use in practical scenarios for managing foreign currency transaction exposures.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the methods available to identify and manage foreign currency risk exposures. In particular, you should focus your revision on the following points:

• The meaning and causes of transaction, economic and translation risk
• Identification of foreign exchange risk exposures for importers and exporters
• The principles, advantages, and disadvantages of forward exchange contracts as hedging tools
• The structure and mechanics of money market hedges for payables and receivables
• Comparison and evaluation of traditional currency risk management techniques, with an emphasis on the calculation and interpretation of outcomes

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What does 'transaction risk' refer to in the context of foreign currency exposures?
2. An entity expects to pay $500,000 in three months. Name two techniques it could use to protect itself against an adverse currency movement.
3. True or false? A forward exchange contract provides complete protection against both adverse and favourable exchange rate movements.
4. Briefly explain the main calculation steps involved in a money market hedge for a future foreign currency payment.
5. Which hedging technique—forward contract or money market hedge—is generally more flexible if the timing of the cash flow is uncertain, and why?

Introduction

Currency risk is a daily reality for businesses involved in international trade. When future receipts or payments are due in a foreign currency, they are exposed to fluctuations in exchange rates. Volatile rates can turn a profitable contract into a loss or increase costs unexpectedly. Financial managers need to identify such currency risks and use effective tools to manage them.

This article focuses on transactional currency risk and the two most common hedging methods used to fix the home currency value of foreign currency receipts and payments: forward exchange contracts and money market hedges.

Key Term: transaction risk
The risk of exchange rate fluctuation affecting the home currency value of a specific future foreign currency receipt or payment occurring between the time a deal is agreed and the time payment is made.

TYPES OF CURRENCY RISK

Foreign currency risk is divided into three main types, but only transaction risk leads to direct cash flow impacts and is usually the priority for hedging.

• Transaction risk arises from actual future trade payables or receivables denominated in a foreign currency. This article focuses on managing this risk.
• Economic risk affects the long-term value of a business due to unexpected exchange rate movements impacting competitiveness.
• Translation risk concerns the effect of exchange rate movements on the reported value of foreign operations in consolidated financial statements.

Key Term: forward exchange contract
A binding agreement with a bank or broker to buy or sell a fixed amount of foreign currency at a specified rate for delivery on a set future date.

Key Term: money market hedge
A hedging method where a company uses the money markets to create a matching asset or liability, fixing the home currency value of a future foreign currency receipt or payment.

IDENTIFYING TRANSACTION RISK

A company is exposed to transaction risk if it has:

• Confirmed future payments or receipts denominated in a foreign currency
• Invoices issued or received whose value in home currency may change by the time of settlement

Any material foreign currency cash flow creates risk and requires attention. The main risk is that an adverse movement in the exchange rate increases the amount payable or reduces the amount receivable in the home currency.

HEDGING FOREIGN CURRENCY TRANSACTION RISK

There are multiple ways to hedge, but forward exchange contracts and money market hedges are standard, widely examinable in ACCA FM.

1. Forward Exchange Contracts

A forward exchange contract (FEC) is used to fix the exchange rate for a future date. This guarantees the home currency value, eliminating exposure to adverse rate movements.

• The company agrees today with a bank to buy or sell a set amount of currency at a predetermined rate (the 'forward rate') on a future date matching the foreign currency payment or receipt.
• FECs are available in most major currencies and can cover a wide range of amounts.
• FECs are typically inflexible—the amount and maturity must match the actual cash flow. Payment before or after the due date may not be covered.

Advantages:

• Simple and easy to arrange
• Completely eliminates downside risk

Disadvantages:

• Inflexible—if the cash flow's size or timing changes, the contract cannot be adapted
• No gain from a potentially favourable movement in the spot rate

2. Money Market Hedge

A money market hedge involves using borrowing and lending in both currencies today to effectively 'lock in' the home currency value of a future payment or receipt.

• To hedge a future payment, the company borrows home currency, converts to the foreign currency at today's spot rate, and invests the sum to grow to the required payment amount on the due date.
• To hedge a future receipt, the company borrows foreign currency now, converts to home currency at today's spot rate, invests the home currency until receipt, and repays the foreign currency loan using the receipt when received.

This creates a mirror asset or liability in the money market that matures to match the exposure.

Advantages:

• Can be tailored for any amount and timing, within the available loan/deposit products
• May offer more flexibility than standard FECs

Disadvantages:

• Can be more complex to set up, involving loan/deposit arrangements in two currencies
• May involve early cash flows compared to the exposure

Worked Example 1.1

A UK company must pay $250,000 to a US supplier in three months. The spot rate is $1.6200 = £1. The three-month forward rate is $1.6000 = £1. Three-month UK deposit rate is 1% (annual), US$ borrowing rate is 2% (annual). Ignore transaction costs.

Which hedging method yields a lower known sterling outflow—the forward contract or a money market hedge?

Answer:

• Forward contract: Lock in the payment at $1.6000 = £1 → £ required = $250,000 / 1.6000 = £156,250.
• Money market hedge:
  1. Need $250,000 in three months. Discount at US borrowing rate: \250,000 / [1 + (0.02 × 3/12)] = $250,000 / 1.005 = $248,756.
  2. Convert $248,756 into £ at spot: £ = $248,756 / 1.6200 = £153,549.
  3. Fund this by a UK loan for three months at 1% p.a.: interest = £153,549 × (0.01 × 3/12) = £384, so repay £153,933 at maturity.
• Conclusion: The money market hedge involves a smaller known outgoing (£153,933) than the forward contract (£156,250) in this case.

Worked Example 1.2

A company expects to receive €500,000 in six months. The spot rate is €1.2000 = £1, and the six-month forward rate is €1.1850 = £1. The company wants certainty of the sterling value it will receive. Explain the two main hedging choices.

Answer:

• Forward contract: Agree today to sell €500,000 at €1.1850 = £1 in six months. The receipt will be £421,940 (€500,000 / 1.1850).
• Money market hedge: Borrow €500,000 discounted for six months at the euro borrowing rate, convert to pounds at spot rate, invest in pounds for six months, use the actual receipt to repay the euro loan.
• In both cases, the company locks in the sterling value of the future receipt, eliminating risk from exchange rate movements.

Comparison Table: Forward vs. Money Market Hedge

Exam Warning

Forward and money market hedges usually give similar overall results. If the rates are 'fair', differences arise mainly due to timing, fees, or compounding differences. ACCA questions may combine both methods in a single scenario—read question wording very carefully.

Revision Tip

Always adjust annual interest rates for the length of the hedge period (e.g., divide by 4 for a three-month rate). Remember that with a money market hedge, the spot rate is applied—not the forward rate.

Summary

Forward exchange contracts and money market hedges are standard ways to manage currency risk from future payables and receivables. The choice between them depends on simplicity, flexibility, company policy, and the specific cash flow needs. Both methods can eliminate transaction risk if set up correctly.

Key Point Checklist

This article has covered the following key knowledge points:

• Define transaction risk and identify relevant exposures
• Describe the operation of forward exchange contracts as a hedging tool
• Explain the structure and calculation steps for money market hedges for payables and receivables
• Compare the pros and cons of forward contracts vs money market hedges
• Recognise common pitfalls and calculation requirements for each approach

Key Terms and Concepts

• transaction risk
• forward exchange contract
• money market hedge