International Finance and Accounting Handbook

recorded in Exhibit 7.1 on an annualized basis is:

The volatility of foreign exchange rates can be computed on a similar basis.

7.3 HEDGING FOREIGN EXCHANGE AND INTEREST RATE RISK. The basic ideas
underlying the management of foreign exchange and interest risk are quite similar.
First, consider the position of a company that borrows at a rate of $LIBOR +
to
finance its operations. The premium,
, (above LIBOR) that it has to pay depends
upon its credit status. A large company with a sound balance sheet should be able
to borrow, for example, at say $LIBOR + 25 basis points. If $LIBOR is 3%, it will
pay 3.25% on its borrowings. Such a firm would have seen its borrowing cost vary
considerably over the period shown in Exhibit 7.1: even recently, from 6.80 + 0.25
= 7.05% in December 2000 to 2.60 + 0.25 = 2.85% in December 2001.
Now, consider the position of an investor who invests a proportion of his or her
portfolio in three-month $Treasury bills (T bills), purchasing these bills every three
months. Since the price of three-month T bills closely follows the three-month
$LIBOR, the return on this investment strategy, net of transaction costs of say 0.5%,
turns out to be $LIBOR – 0.50%. Again, an investor who followed this strategy over
recent the period in Exhibit 7.1 would have seen a return varying from 6.80 – 0.50 =
6.30% in December 2000 to 2.60 – 0.50 = 2.10% in December 2001.
A similar example can be given for the case of foreign exchange risk. Consider a
firm that exports its products at prices denominated in a foreign currency. If the firm
does not hedge its exposure, its export earnings would be very volatile, given the un-
certainty of foreign exchange rates. For example, a company importing goods worth
$1 million would have paid about 100 million yen for it in September 2000 and
nearly 125 million yen in March 2001.
These examples show that foreign exchange and interest rates have varied consid-
erably over time and are likely, therefore, to vary in the future. For example, if a firm
is committed to investment expenditures in the future, or has working capital re-
quirements that will need to be financed, it faces the prospect of uncertain future cash
flows, both for capital and operating items. Similarly, investors face the prospect of
uncertain future returns on their investments.
The financial management of foreign exchange and interest rate risk often takes
the form of hedging. Hedging these risks involves placing a bet that pays off when
the foreign exchange rate or interest rate goes against the agent. For example, an ap-
propriate hedge for the borrowing company in the above example would be to place
a bet on the interest rate rising in the future. The bet will pay off if interest rates rise
and the resulting profit would offset, to some extent, the rise in the firm’s borrowing
costs. Similarly, a firm exporting goods denominated in a foreign currency will be
able to hedge its foreign currency exposure by selling its inflows with forward or op-
tions contracts. It is the purpose of foreign currency and interest rate futures/forward
and options markets to provide a simple way of betting on changes in foreign ex-
change and interest rates.

sL 1 volatility of LIBOR 2 


B

var 3 ln 1 LIBOR 24

1 > 4

22.54%

7.3 HEDGING FOREIGN EXCHANGE AND INTEREST RATE RISK 7 • 5