184 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
you probably want toreversethe hedge, that is, close out by adding a reverse
forward.^5 But by that time the erstwhile hedge contract may have a negative
value, in which case reversing the deal leads to a loss.
When there is default on the hedgedfc, the lowest-risk option indeed is to
reversethe original hedge position. For instance, if anA/Rwas hedged by a
forward sale and if the exposure suddenly evaporates, you immediately buy
the same amount for the same date. But there is about 50 percent chance that
this would be at a loss, the new forward rate being above the old one. This
risk, arising when a hedged exposure disappears, is calledreverse risk.
Example 5.10
Suppose you had hedged a promised rub10m inflow at a forward rate of
0.033eur/rub. Now you hear the customer is defaulting. So now you want
to buy forwardrub10m to neutralize the initial sale, but you soon discover
that, by now, the forward rate for the same date has risen to 0.038. So if
you reverse the position under these conditions, you’re stuck with a loss of
10 m×(0. 038 − 0 .033) =eur50,000.If the default risk is substantial, one can eliminate it, at a cost,^6 by obtaining
bank guarantees or by buying insurance from private or government credit-insurance
companies. Foreign trade credit insurance instruments that allow one to hedge
against credit risk are discussed in Chapter 15.
Credit risk means that contractual forex flows are not necessarily risk-free. But
this is just the top of an iceberg: in reality, the dividing line between contractual
(or, rather, known) and risky is fuzzy and gradual in many other ways. We return
to this when we discuss operations exposure, in Chapter 13.
Issue #3: Hedging of Pooled Cashflows—Interest Risk
We have already seen how one should aggregate the exposure from transactions
that have the same maturity date and that are denominated in the same currency.
Typically, however, a firm will have exposures with a great many different maturities.
Computing and hedging the contractual exposure for each day separately is rather
inefficient; rather, the treasurer would probably prefer to group thefcamounts
into time buckets—say, months for horizons up to two years, quarters for horizons
(^5) You could also close out with a combination of money- and spot-market deals, or negotiate
an early settlement with your banker, but this necessarily produces essentially the same cashflows
as those from closing out forward. Lastly, you could leave the position open until the end, and
then buy spot currency to deliver as promised under the forward contract. The problem with this
avenue is that the worst possible losses become bigger; so early termination of some form is usually
preferred.
(^6) Accountingwise this is a cost; but if the premium paid is worth the expected loss, theNPVof
this deal would be low or zero.