Currency Forward Contracts Research Articles

Yield curve risks in currency carry forwards

AbstractWe provide empirical evidence that cross‐country yield curve gaps (parallel gap, twist gap, and butterfly gap) are predictive to the expected currency carry premiums using currency forward contracts. We find that the expected currency gains are more notable as these yield curve risk factors at time t indicate short‐term bond prices of investment currencies to go up (positive parallel movement, negative twist, and positive butterfly). We also find carry gains are more sensitively affected by cross‐country monetary shocks than currency‐country inflation pressures and business cycles. Our findings support that cross‐country yield curve risk premiums still exist even after considering transaction costs.

Interest Rate Parity with Credit Risk: Implications for Carry Trades

The incredible profitability of the carry trade over the past six decades constitutes a puzzle for interest rate parity. Contrary to recent behavioral or friction-based approaches that explain deviations from traditional interest rate parity, I derive interest rate parity in a general arbitrage pricing model of foreign exchange with credit-risky sovereign lending and sharp currency devaluations associated with default; in particular, foreign sovereign credit risk makes forward contracts more valuable relative to standard covered interest rate parity. I calibrate the model for Mexico and the United States, and find that credit risk and currency devaluation fully account for the profitability of both the covered and uncovered carry trade. Modest default probabilities are sufficient to explain deviations from covered interest rate parity for G10 countries. I find support for the recent notion that the United States is a global provider of safe assets, via default intensities implied by currency forward contracts.

Corporate hedging: an answer to the \u201chow\u201d question

We develop a stochastic programming framework for hedging currency and interest rate risk, with market traded currency forward contracts and interest rate swaps, in an environment with uncertain cash flows. The framework captures the skewness and kurtosis in exchange rates, transaction costs, the systematic risks in interest rates, and most importantly, the term premia which determine the expected cost of different hedging instruments. Given three commonly used objective functions: variance, expected shortfall, and mean log profits, we study properties of the optimal hedge. We find that the choice of objective function can have a substantial effect on the resulting hedge in terms of the portfolio composition, the resulting risk and the hedging cost. Further, we find that unless the objective is indifferent to hedging costs, term premia in the different markets, along with transaction costs, are fundamental determinants of the optimal hedge. Our results also show that to reduce risk properly and to keep hedging costs low, a rich-enough universe of hedging instruments is critical. Through out-of-sample testing we validate the findings of the in-sample analysis, and importantly, we show that the model is robust enough to be used on real market data. The proposed framework offers great flexibility regarding the distributional assumptions of the underlying risk factors and the types of hedging instruments which can be included in the optimization model.

Cross Hedging with Currency Forward Contracts

This study examines the behavior of a competitive exporting firm that exports to a foreign country and faces multiple sources of exchange rate uncertainty. Although there are no hedging instruments between the home and foreign currencies, there is a third country that has well‐developed currency forward markets to which the firm has access. The firm's optimal cross‐hedging decision is shown to depend both on the degree of incompleteness of the currency forward markets in the third country, and on the correlation structure of the random spot exchange rates. Furthermore, the firm is shown to be more eager to produce and expand its exports to the foreign country when the missing currency forward contracts between the home and foreign currencies can be synthesized by the existing currency forward contracts. In this case of perfect cross hedging, the separation theorem holds but the full‐hedging theorem may or may not hold. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark

Reducing reporting risk: Designating foreign currency forward contracts as cash flow hedges

Abstract We present an example that compares the effects on earnings of designating a foreign currency forward contract as either a cash-flow or fair-value hedge of a foreign currency denominated receivable. Entities engaging in exchange transactions not denominated in their functional currency frequently enter into foreign currency forward contracts in order to mitigate their foreign exchange rate risk exposure. The aggregate effect on earnings of the transaction gain or loss on the foreign currency receivable and the gain or loss on the forward contract is known on the date the forward contract is initiated. The effect on each period’s earnings during the term of a forward contract designated as a cash-flow hedge is also known on the date the contract is initiated; whereas the effect on each periods’ earnings from a fair-value hedge cannot be determined until the respective balance sheet dates. Therefore, designating forward contracts as cash-flow hedges may suppress volatility in reported earnings compared to designating forward contracts as fair-value hedges. In addition, the reporting risk (the amount of uncertainty surrounding the pending measure of an item to be reported in the financial statements) is lower when a forward contract is designated as a cash-flow hedge relative to designating it as a fair-value hedge. This suggests foreign currency forward contracts designated as cash-flow hedges are more consistent with the purpose of hedge accounting: to mitigate the effects on earnings of applying different measurement criteria for the hedge and the hedged item.

The Term Structure of Currency Hedge Ratios

Many firms face product price risk in foreign currency, uncertain costs in home currency and exchange rate risk. If prices and exchange rates in different countries interact, natural hedges of foreign exchange risk might result. If the effectiveness of such hedges depends on the hedge horizon, they might affect a firm's usage of foreign exchange derivatives and lead to a term structure of optimal hedge ratios. We analyze this issue by deriving the variance minimizing hedge position in currency forward contracts of an exporting firm that is exposed to different risks. In an empirical study, we quantify the term structure of hedge ratios for a ' typical ' German firm that is exporting either to the United States, the United Kingdom or Japan. Based on cointegrated vector autoregressive models of prices, interest rates and exchange rates, we show that the hedge ratio decreases substantially with the hedge horizon, reaching values of one half or less for a ten-years horizon. Our findings can (partly) explain the severe underhedging of long-term exchange rate exposures that is frequently observed and have important implications for the design of risk management strategies.

International Portfolios with Commodity Futures and Currency Forward Contracts

Diversifying internationally produces foreign exchange risks, which investors can manage through hedging procedures. Since commodities drive the economies of many countries, the authors test whether commodities hedging may provide additional benefits to international diversification. They also examine the effect of including foreign currency forward contracts to hedge against foreign exchange risk. The results show that investors with international portfolios of stocks, bonds, and commodities can improve the efficiency of their portfolios by hedging foreign exchange exposure. All hedging strategies improve the efficiency of the portfolios.

An Analysis of Russia's 1998 Meltdown: Fundamentals and Market Signals

An Analysis of Russia's 1998 Meltdown:Fundamentals and Market Signals Homi Kharas, Brian Pinto, and Sergei Ulatov On August 17, 1998, a little more than a month after an international package of emergency financing and economic reforms was announced, Russia was forced to devalue the ruble.1 Russia also declared its intention to restructure all official domestic currency debt obligations falling due to the end of 1999 and imposed a ninety-day moratorium on the repayment of private external debt, to aid its commercial banks. The moratorium also applied to these banks' obligations from short positions on currency forward contracts, as well as margin calls on repurchase operations (repos) with foreign banks. Less than three weeks later, on September 2, the Central Bank of Russia (CBR) floated the ruble. By September 9 the exchange rate had reached 21 rubles to the dollar, more than three times the 6.29 rubles to the dollar that had prevailed on August 14. [End Page 1] The free fall of the ruble and the disruption in the government's access to market borrowing were costly, with an output decline, bank failures, and a spike in inflation. Russia ended 1998 with an output contraction of 4.9 percent for the year, compared with initial expectations of slight growth. Inflation for the year as a whole was 84 percent, compared with an original target of 8 percent. On the political front, the reformist government of Sergei Kirienko was dismissed in the wake of the devaluation, leading to fears of policy reversals and a return to hyperinflation. In an effort to avoid these economic and political costs and achieve a soft landing for the economy, a $22.6 billion international financing package to support fiscal and structural reforms had been announced on July 13. The package was designed to maintain the preannounced exchange rate band while buying time to implement what were recognized as difficult and time-consuming reforms, through an injection of liquidity into reserves and a swap out of short-term ruble treasury bills (called GKOs) into long-term Eurobonds.2 The objective of the swap was to address the rollover risk from the maturing of large volumes of GKOs each week, totaling $32.7 billion over the last seven months of 1998. It was envisaged that the announcement of the package would stabilize the market, reduce real interest rates to levels the government could afford, and take the pressure off the exchange rate. Indeed, GKO yields halved the next day but remained in excess of 50 percent, far above the 8 percent inflation target. By July 24, upon completion of the GKO-Eurobond swap, GKO yields had jumped to 66 percent, and they kept rising until the August 17 devaluation. Two factors apparently underlay the decision not to abandon the exchange rate band. First, for the Russians, the attainment of single-digit inflation in early 1998 (twelve-month inflation dipped below 10 percent from February until July) represented a major policy achievement, one that they would abandon only with great reluctance. Second, the recent East Asian experience with devaluation had been bad, especially in Indonesia. During the crises in some of those countries in 1997-98, attempts to float had precipitated free falls of the currency, damaging exposed banks and corporations as well as reducing output and raising inflation, and imposing [End Page 2] large welfare costs. As a result, there was strong motivation in the Russian case to try and maintain market sentiment and access until fiscal and structural reforms could deliver results. This soft landing scenario implicitly underpinned the international package, which also recognized that Russia's fiscal and structural problems admitted no quick fixes. The package did not achieve its objectives. Total foreign exchange resources, including reserves and new external borrowings, used to defend the ruble between the first speculative attack in late October 1997 and the September 2, 1998, decision to float the currency amounted to $30 billion, about one-sixth of postcrisis GDP.3 Russian-era foreign currency debt of the federal government increased by $20.5 billion over the same period.4 Of this, no less than $16 billion, or 8 percent of postcrisis GDP, was accumulated...

Currency Hedging and the Risk of Loss

The most commonly cited argument against currency hedging is the assertion that foreign exchange risk washes out over the long run. But even if we set aside these facts and accept the view that foreign exchange risk washes out over long horizons, it does not necessarily follow that we should ignore the volatility introduced by currency exposure. It depends critically on how we perceive risk. This study reviews currency arithmetic and shows explicitly how exchange rate fluctuations affect a foreign asset9s risk. It also contains a derivation of the minimum risk and optimal exposures to currency forward contracts. The article presents two alternative approaches for measuring risk of loss, and it shows the effect of currency exposure on these two measures of risk of loss.

Spreading currency forwards: why and how?

In this paper we have adopted a continuous time framework in which a hedger has a currency risk-sensitive non-traded cash position. The hedger has the opportunity to hedge against risk by using two currency forward contracts that differ only in their maturities. The hedger is able to reach a perfect hedge of his non-traded position by using only two currency forward contracts with different maturities even though four sources of uncertainty drive the international economy. This perfect hedge is reached by spreading forward contracts, where the hedger is short in the nearby contract and long in the deferred contract. This strategy is easy to implement since no parameter has to be estimated empirically when the hedger is a price taker. Finally, the analysis has been extended to currency futures contracts. We show in explicit terms how the marking-to-market of futures positions affects the spreading strategy.

International Acquisitions and Foreign Currency Exchange Risk Management

ABSTRACT Significant risk exists for corporations who are involved in foreign property acquisitions that result from foreign currency exchange rate movements. Unless managed properly, foreign currency exchange rate fluctuations may result in considerable adverse changes upon balance sheets, reported profit and loss, cash flows, and the cost of new asset purchases. Several methods of foreign currency risk management are available to firms entering into contracts to purchase or sell hotels located in foreign countries. Some of these methods are: foreign currency forward contracts, foreign currency option contracts, shifting currency risks, money market hedges, modifying the price, and netting foreign currency exposure.

International Acquisitions and Foreign Currency Exchange Risk Management

Abstract Significant risk exists for corporations who are involved in foreign property acquisitions that result from foreign currency exchange rate movements. Unless managed properly, foreign currency exchange rate fluctuations may result in considerable adverse changes upon balance sheets, reported profit and loss, cash flows, and die cost of new asset purchases. Several methods of foreign currency risk management are available to firms entering into contracts to purchase or sell hotels located in foreign countries. Some of th ese methods are: foreign currency forward contracts, foreign currency option contracts, shifting currency risks, money market hedges, modifying the price, and netting foreign currency exposure.

Portfolio insurance for foreign exchange risk management

Since the advent of floating exchange rates in the early 1970s management of exchange exposure has received much attention. Adler and Dumas [1, 21 and Dufey and Srinivasulu [14] contend that, because of imperfect markets for real goods and services and financial assets, exchange rate risk is relevant. Because of informational inefficiencies, exchange rate risk should be managed at the corporate rather than the shareholder level. Logue and Oldfield [22] and others suggest that hedging should be focused on cash flow rather than financial statement exposure. Several studies have evaluated and compared hedging alternatives that employ currency forward or futures contracts. Hill and Schneeweis 1191 compared the hedging capabilities of forward and futures contracts, finding no significant differences for the Deutschmark or British pound, but superior forward hedging for the Japanese yen. Babbel[5] used a mean-variance approach to compare the hedging effectiveness of the forward hedge and the money market hedge, Calderon-Rossel [12] provided a framework for choosing between either of these alternatives or not hedging. Swanson and Caples (291, Grammatikos [17], and others attempt to determine the optimal hedge ratio in currency futures and forward markets. Chang and Shanker [13] show that a synthetic futures contract generally exhibits less hedging effectiveness than currency futures contracts. And Eun and Resnick 1151, examining the hedging of interna~on~y diversified stock portfolios, report that substantial reductions in exchange rate risk obtain via forward contract hedging. While forward, futures, and ~ternational money market hedges effectively remove downside exchange risk, they also preclude the possibility of upside potential when exchange rates move in a favorable direction. An alternative

The profitability of currency speculation

This paper presents the results of a post-sample simulation of a speculative strategy using a portfolio of foreign currency forward contracts. The main new features of the speculative strategy are (a) the use of Kalman filters to updata the forecasting equation, (b) the allowance for transactions costs and margin requirements and (c) the endogeneous determination of the leveraging of the portfolio. While the forecasting model tended to overestimate profit and underestimate risk, the strategy was still profitable over a three year period and it was possible to reject the hypothesis that the sum of profits was zero.