5.3. USING FORWARD CONTRACTS (2): HEDGING CONTRACTUAL EXPOSURE 185
between two and five years, and years thereafter. Then only one contract would be
used to hedge the entire bucket.
Example 5.11
There are two obvious potential savings from grouping various exposures over time:
- If there are changes in sign of the flows in the bucket,netting over timesaves
money. Suppose that on day 135 you have an inflow ofsek1.8m and the next
day an outflow ofsek1.0m. Rather than taking out two forward hedges for
a total gross face value ofsek2.8m, it would be more sensible to sell forward
justsek0.8m for day 135, and keep the remainingsek1m inflow to settle the
debt the next day. You’d save the extra half-spread onsek2m. - Scale economies in transaction costs. Even if there are no changes in sign—for
example, if the firm is a pure exporter—the total commission cost of doing
one weekly deal ofsek500,000 will be lower than the cost of doing five daily
deals of aboutsek100,000.
One should be aware that, if pooling over time is carried too far, a degree of
interest risk is introduced. Suppose, to keep things simple, that Whyran Cabels
faces an inflow ofsek100m at the beginning of yeart+ 5, and one ofsek50 at the
end of that year. They could hedge this by selling forwardsek150 dated July 1.
Interest risk creeps in here because thesek100m that arrives on January 2 will earn
interest for six months, while Whyran will have to borrow aboutsek50m because
they sold forward thesek50m for a day predating the actual inflow. If the horizon
is substantial and the potential amount of interest at play becomes nontrivial, the
company can hedge the interest risk by forward deposits and loans. The example
that follows assumes you know these instruments; if not, skip the example or return
to Appendix 4.7 first.
Example 5.12
Suppose the forward interest rates 5×5.5 years are 3.50-3.55 %p.a., and the forward
interest rates 5.5×6 years are 3.75-3.80 %p.a..^7 Then Whyran Cabels can do the
following:
- Arrange a depositadsek100m, 5 against 5.5 years, at the bid rate of 3.5 %
p.a., that is, 1.75 percent effective over six months. This will guarantee asek
inflow of 101.75m on July 1st. - Arrange a loan with final valuesek50m, 5.5 against 6 years at the ask rate
of 3.8 %p.a., that is, 1.9 percent effective over six months. The proceeds of
the loan, on July 1st, will be 50m/1.019 = 49,067,713.44. - Sell forward the combined proceeds of the deposit (sek101.75m) and the loan
(sek49.07m) for July 1.
(^7) See the Appendix to Chapter 4 about forward interest rates.