CHAPTER 4

Using Forward Contracts to Manage Risk

Firms face price risk in their input markets and their output markets. Price risk exists because the
future price of the inputs and outputs are unknown today. Price changes in the input market or out-
put market can adversely affect a firm’s bottom line.
Forward contracts are routinely written to help shift price risk on commodities such as crude
oil, heating oil, copper, grains, and livestock. However, forward contracts are not limited to com-
modities. Forward contracts can also help firms protect themselves against adverse changes in
interest rates or adverse changes in foreign exchange rates.
Forward contracts provide firms with an efficient means to manage price risk. The main advan-
tage of forward contracts is their flexibility. Forward contracts can be structured for nearly any firm-
specific situation that requires protection against adverse price changes. This is a terrific advantage. A
disadvantage of a forward contract, however, is that the firm is bound by the terms of the forward con-
tract even when prices move advantageously. Another disadvantage is the risk that the counterparty to
a forward contract will default. That is, the counterparty may not live up to the terms of the contract.
In this chapter, we illustrate how forward contracts are used to shift risk. We start by showing how
commodity price risk can be managed. Then we demonstrate how forward contracts can be used to
manage interest rate risk and foreign exchange risk. Much of the material in this chapter also describes
how futures contracts can be used manage risk. Only the discussion of forward rate agreements
(FRAs; see Section 4.2) and their use in managing interest rate risk is specific to forward contracts.

4.1 USING FORWARDS TO MANAGE COMMODITY PRICE RISK

4.1.1 Buying Forwards to Hedge Against Price Increases

The user of a raw material faces the risk that the price of that commodity will rise. For example,
many industrial firms require crude oil as an input to their production processes. If the price of
crude oil rises, then these firms’ costs will rise. All else equal, this will lower profits and lower firm
value. An elementary income statement is:

Revenues = output price x units sold

Costs = input prices x input units purchased
Profits

Unless the firm can pass the higher costs on to consumers in the form of higher output prices, its
profits will be eroded by higher input (crude oil) prices, and this will cause a drop in firm value.
Figure 4.1 illustrates the input price risk faced by a user of a raw material.

68
 4.1 USING FORWARDS TO MANAGE COMMODITY PRICE RISK 69

Change in
firm value

Change (A) in price of

raw material

Figure 4.1 An increase in the price of a raw material used by the firm leads to a decline in the value of that
firm, all else equal.

A firm facing the risk that the price of one of its inputs will rise can use forward contracts to
manage that risk. Buying forward contracts on the raw material will lock in its purchase price. One
way to think about using forwards (and futures and swaps) to hedge price risk is that a firm should
act to eliminate the price risk in the forward market in the same way that it otherwise would have
acted in the spot market. In this case, buying the raw material in the spot market would have
eliminated its exposure to the risk that its price would rise. Instead, buying the raw material in the
forward market (going long forward contracts) accomplishes the same result; instead of actually
buying the raw material today, the firm is committing itself to buy it at a later date. The advantages
of buying the forward contract are as follows.
1. There is no cost to taking on a long position in a forward contract; buying the commodity
in the spot market requires an initial cash outlay. Because there is an opportunity cost to
any cash outlay, it is cheaper to use the forward contract.'
2. Buying the good in the spot market will result in storage costs and insurance costs. The
firm does not have to incur the expense of storing and insuring the commodity if it buys the
forward contract.
3. Should the firm later change its mind about hedging its price risk, or later discover that it
has no need for the commodity, it may be easier to offset a long forward position than to
find a buyer for a commodity already bought.
4. The amount exposed to default risk in a forward contract is only a fraction of what is at risk
in a cash transaction. The principal amount of a forward contract is not at risk; essentially,
only the difference between the contracted forward price and the current spot price, times
the principal amount, is at risk.
5. The transactions costs (commissions and bid—ask spreads) may be lower in the forward
market than in the spot market.

There are also some disadvantages to using forward contracts to manage risk compared with
just using the spot market:
1. Two sets of transactions costs may be incurred.
2. The forward market is more or less reserved only for larger organizations.
70 4 USING FORWARD CONTRACTS TO MANAGE RIS

3. Each party to a forward contract must be concerned about default risk.

4. Unless the asset underlying the forward contract is identical to the item being hedged, the
hedge will likely be imperfect.

Figure 4.2 presents the profit diagram for a long forward contract. If the price on the delivery
day is greater than the forward price that was agreed upon on the origination day, then the party that
is long the forward contract realizes a profit. Suppose a firm is exposed to the risk of an increase in
the price of a raw material. This firm then buys a forward contract that constitutes an obligation to
buy that raw material in the future. Figure 4.3 show how the exposure to price risk is removed.

4.1.2 Selling Forwards to Hedge Against Price Declines

A producer of a commodity may be exposed to the risk that the price of its output will decline.
That is, the firm might be engaged in copper mining, crude oil production, or growing cash crops.

Profit

Change in price

Figure 4.2 Profit diagram for a long forward position. A rise in the price of the good makes a long position
in a forward contract profitable.

Change in
(a) Change in (b)
firm value
firm value
Long forward The firm has
position hedged its
risk exposure
rs
Change in price of > Change in price
raw material of raw
material
Inherent risk
exposure

Figure 4.3 A firm that is exposed to the risk that the price of a commodity will rise can manage
its risk
exposure by buying a forward contract on that commodity (a). If the hedge is effective,
then all of its risk
exposure is removed, as shown in (b).
 4.1 USING FORWARDS TO MANAGE COMMODITY PRICE RISK 71

As explained shortly, if the price of the output product declines, and if the product is price inelas-
tic, then the firm’s revenues will decline. Figure 4.4 illustrates that when the price of its output
declines, the value of a firm declines, all else equal.
An important assumption in the analysis of the effect of a decline in the price of this firm’s
output is that the demand for its product is price inelastic. The “law of demand” states that quan-
tity demanded increases when prices fall. Thus, all else equal, the firm should experience an
increase in units sold when the price of its output declines. If the product is price inelastic, then the
percentage increase in units sold is less than the percentage fall in its price, so that revenues will
decrease. Put another way, when a good exhibits inelastic demand, an x% decline in its price
results in a percentage increase in the quantity demanded that is smaller than x%:

Ti iP togalSpvsvreteg poate ELE

%A price

For example, if the price of oil rises by 10% and demand for the output of an oil producer declines
only 1%, we conclude that the demand for the product is inelastic. If demand for the firm’s output
good is price inelastic, then all else equal, the decline in price leads to a decline in revenues and a
decline in profits:

Revenues = output price x quantity sold

— Costs
Profits

In contrast, if demand for a product is price elastic, then changes in price will lead to larger
changes in the quantity demanded:

tity d d
Elastic demand: Pee Quai geuiane S ||
%A price

Change in
firm value

Change in price of
output

Figure 4.4 When the price of a firm’s output declines, its revenues decline (all else equal), and firm value
declines.
72 4 USING FORWARD CONTRACTS TO MANAGE RISK

If demand for firm’s product is elastic, it will not be concerned with declining prices because the
quantity demanded will increase by such a large amount that its revenues will increase. Figure 4.5
illustrates the difference between elastic demand and inelastic demand.
In general, we should conclude that for an individual firm, demand for its product is price
inelastic. Therefore price declines will diminish revenues.?
A firm exposed to the risk that the price of a commodity will decline can hedge the risk by
selling that good in the spot market today. At times, however, selling the good in the spot market is
impossible or not feasible. For example, a wheat farmer who has just planted a crop is exposed to
the risk that the price of wheat will decline. Obviously, he cannot sell the wheat in the spot market,
since the crop has not been harvested. Instead, the farmer can transact in the forward market in the
same way that he would otherwise act in the spot market. That is, he can sell his wheat in the for-
ward market to protect himself. Going short a forward contract, which obligates him to sell the
wheat at the contractual forward price, eliminates his exposure to price risk.
Figure 4.6 presents the profit diagram for a firm that is short a forward contract. It shows that
a price decline (i.e., the spot price on the delivery day is below the origination day forward price)

ap
ape
Elastic demand

price
Output
— Inelastic demand

Quantity demanded of output

Figure 4.5 ©When demand is inelastic, a rise in price has only a small impact on the quantity demanded.
Elastic demand means that a rise in price leads to a large decline in demand.

Profit

Change in price

Figure 4.6 Profit diagram for a firm that is short a forward contract. A decline in the price
of the good
creates a profit for the firm that is short a forward contract.
 4.2 USING FORWARDS TO MANAGE INTEREST RATE RISK 73

(a) (b) Change in

Change in
firm value firm value

Inherent risk
exposure The firm has
hedged its
risk exposure
SS
Change Change
in price of in price of
output output
Short forward
contract

Figure 4.7 A firm that is exposed to the risk that the price of a commodity will fall manages its risk
exposure by selling a forward contract on that commodity (a). If the hedge is effective, then all of its risk
exposure is removed, as shown in (bd).

leads to profits for a firm that has sold a forward contract. Figure 4.7 combines Figures 4.5 and 4.6
to illustrate that a firm that is exposed to the risk of a price decline can sell a forward contract to
hedge its risk exposure.

4.2 USING FORWARDS TO MANAGE INTEREST RATE RISK

Recall that a forward rate agreement (FRA) is a forward contract on an interest rate. That is, if
interest rates rise above the forward rate, the buyer of the FRA profits. If the interest rate at matu-
rity is below the forward rate that was originally agreed to in the FRA, then the seller of the FRA
realizes a profit. The settlement amount is essentially the present value of the lost/gained interest
on the notional principal amount [see Equation (3.1)]. Thus, FRAs can be used to hedge against
higher or lower than expected interest expense or revenue. It is important to note that a FRA is
used to hedge just one period of interest.

4.2.1 Hedging Against an Increase in Interest Rates

A firm that buys a FRA does so to hedge against the risk that interest rates will rise. If interest rates
subsequently rise, the hedger will lose money in the spot market and make an offsetting profit with
the FRA it bought. For example, a firm that is a borrower at a floating interest rate faces the risk
that interest rates will rise; a higher interest rate will lead to an increase in the firm’s interest
expense, and lower profits, all else equal. When a firm issues a floating-rate debt instrument, it
is borrowing at a floating rate, and it loses when interest rates rise.4 Another firm that plans
to issue short-term debt some time in the near future may wish to lock in its interest expense
today. Investors who own fixed-rate debt will experience a decline in the value of their assets if
interest rates rise. For all these cases, buying a FRA serves to hedge the unwanted effect of higher
interest rates.
Figure 4.8 shows the risk exposure of a firm that fears rising interest rates. Figure 4.9
illustrates the profit diagram for a long FRA position. Combining the two creates a hedge.
74 4 USING FORWARD CONTRACTS TO MANAGE RISK

Change in
firm value

Interest rate

Figure 4.8 Risk exposure of a firm that fears rising interest rates.

Profit

Interest rate

Figure 4.9 Profit diagram for a long FRA position.

Pays a fixed rate

Receives a floating rate

Floating interest rate

paid to investors

Figure 4.10 A FRA is equivalent to a one-period interest rate swap. It converts a floating-rate expense
into a fixed-rate expense for a firm that is exposed to the risk that interest rates rise, such as a firm that has
a floating-rate bond outstanding.

Another vehicle for visualizing what entering into a long FRA contract accomplishes in the
way of interest rate risk management is shown in Figure 4.10. The firm is paying out a floating
interest rate to investors. A long position in a FRA is equivalent to a one-period interest rate swap in
which the firm is the fixed-rate payer, and it receives the floating rate. If the formula that establishes
both floating rates is the same, then the firm is left with a locked-in fixed rate as a future expense.
Suppose that a firm has borrowed $60 million at a floating rate. The floating rate is reset every
6 months, and 6-month LIBOR at time ft establishes the interest payment on the loan at time t+ 1.
Thus, the firm knows what its next interest expense will be, 6 months from today. A FRA
 15

can be used to hedge one floating-rate interest rate payment, to be made at one future date. To
hedge the interest expense it faces a year hence, the firm will buy a 6X12 FRA with a notional
principal of $60 million. Suppose the price of the FRA is 8%. Table 4.1 illustrates how the firm has
hedged itself.
Note in Table 4.1 that the profit/loss on the FRA is realized six months hence, while the actual
interest expense on the loan is paid out 12 months hence. The interest payment to be made six
months hence is already known, because LIBOR at time zero determines the interest payment on
the floating rate note six months hence.
To be made comparable, and to illustrate the results of the hedge more clearly, we can
compound the FRA’s profits or losses so that they can be subtracted from or added to the actual
interest expense on the floating-rate note. Table 4.2 performs this step. A perfect hedge is not

TABLE 4.1 Hedging Interest Rate Risk with a Long FRA Position: An Example

Interest Expense on the Profit (+), or Loss (—)

Six Month LIBOR, $60 million loan, paid on the FRA, realized
Six Months Hence Twelve Months from Today Six Months from Today’

7.0% (0.070/2) $60 million=$2.10 million —$291,410.63

7.59% (0.075/2) $60 million=$2.25 million —$145,352.34
8.0% (0.080/2)
$60 million=$2.40 million $0
8.5% (0.085/2)
$60 million=$2.55 million +$144,651.49
9.0% (0.090/2)
$60 million=$2.70 million +$288,607.19

IThe figures in this column are computed by means of Equation (3.1); it is assumed that there are 181 days until settlement and the
day count method is actual/360. Equation (3.1) is repeated here:

|
P{r(tl, t2)— fr(O, t1, t2)|(D/B)
1+ [r(¢1, t2)(D/B)]

For example, the $291,410.63 loss on the FRA realized when six-month LIBOR is 7% is found by calculating:

$60,000, 000[0.07—0.08](181/360)
= $291, 410.63
1+[0.07(181/360)]

TABLE 4.2 Computing Profits or Losses for a FRA

Interest Expense,
Six-Month LIBOR, Paid Twelve Months Compounded Profit (+), Total Effective
Six Months Hence from Today or Loss (—) on the FRA’ Interest Expense

7.0% $2.10 million —$301,666.67 $2,401 ,666.67

7.5% $2.25 million —$150,833.33 $2,400,833.33
8.0% $2.40 million $0 $2,400,000.00

8.5% $2.55 million +$150,833.33 $2,399, 166.67

9.0% $2.70 million +$301,666.67 $2,398,333.33

nn
'For example, the compounded loss if LIBOR is 7% is computed as follows:

$291, 410.63[1 + 0.07(181/360)] = $301, 666.67

76 4 USING FORWARD CONTRACTS TO MANAGE RISK

achieved (note the figures in the last column) because the FRA uses an actual/360 day count
method, while we assumed that the loan uses a 30/360 day count method.

4.2.2 Hedging Against a Decline in Interest Rates

Sellers of FRAs wish to hedge against the risk that interest rates will fall. A decline in
interest rates will reduce interest income for a floating-rate lender. But if that lender has sold
a FRA, the lender will have hedged, since the drop in interest rates will also result in a profit on
the FRA. An investor who owns a portfolio of short-term debt instruments or floating-rate
bonds is also exposed to a decline in interest rates. Banks and other financial institutions that
have made floating-rate loans, and financed them with fixed-rate sources of capital, also fear
declining interest rates; their interest expense is fixed, but their interest income from the loans
is variable.
Figure 4.11 illustrates the risk exposure for a firm that fears a decline in interest rates. The
decline will lead to lower interest income, hence lower profits and a drop in firm value. Figure 4.12
is the profit diagram for a short FRA position. Selling a FRA will be profitable if interest rates fall
below the contracted forward rate; the profits will help offset the decline in the value of a firm that
depends on interest income from short-term securities or floating-rate notes. Instead of paying
interest expense, this firm will receive interest income. Because the profit or loss on the FRA is
reversed when the firm is short the FRA, the firm has greatly reduced the dispersion of interest
income.

Change in
firm value

Change in
interest rate

Figure 4.11 Risk exposure of a firm that fears falling interest rates.

Profit

Change in
interest rate

Figure 4.12 Profit diagram for a short FRA position; profits are made if interest rates fall.
 4.3 USING FORWARD FOREIGN EXCHANGE CONTRACTS TO MANAGE RISK 77

4.3 USING FORWARD FOREIGN EXCHANGE CONTRACTS TO MANAGE RISK

Firms that buy and/or sell products in foreign countries are exposed to risks that the prices of for-
eign currencies will change. Even if a company does not import or export goods, it may be
impacted by changing exchange rates if its competitors are either foreign-based exporters or
domestic firms that import raw materials. In this section, we discuss the nature of this exposure
to exchange rate risk, both from an income statement perspective and from a balance sheet
perspective.
Understanding the jargon is important. If the home country is Great Britain, then the price of
a foreign currency, say yen (¥), is expressed as £/¥. This is the British pound price of a Japanese
yen. If this exchange rate rises, then we say that the yen has risen in value, or that the yen has
strengthened (relative to the pound). If the yen becomes more expensive, then it is equivalent to
saying that the pound has dropped in value, relative to the yen.

4.3.1 Managing the Risk That the Price of a Foreign

Currency Will Rise
Consider a U.S. firm that imports its raw materials and must pay for them in a foreign currency.
Assume that this U.S. firm is importing goods from Japan and thus must pay yen for its raw mate-
rials, which represents a cost. The U.S. firm wishes to maximize its dollar-denominated profits. A
simple income statement is:

Revenues = $Revs
—Costs (in yen) x $/¥ =$Costs
Profits (in dollars)

The $/¥ exchange rate is what converts the firm’s yen-denominated expenses into dollar
expenses. This firm is exposed to the risk that the $/¥ exchange rate will rise. If it costs more dol-
lars to buy a yen, then all else equal, this importer’s dollar-denominated expenses will rise. Profits
will fall and firm value will decline. We are assuming that the firm is unable to pass its increased
costs on to the buyers of its products.
Another scenario is based on the balance sheet. A simple balance sheet has the following
headings:

Assets Owners’ Equity Liabilities

Think of this balance sheet in terms of economic values, not accounting figures. If the market
value of a firm’s liabilities is subtracted from the market value of its assets, we are left with
the market value of the stockholders’ equity. The goal of a firm is to maximize the value of the
owners’ common stock, denominated in its home currency.
Suppose that some of the firm’s liabilities are denominated in a foreign currency, and their
value (in terms of the firm’s local currency) is dependent on the exchange rate. It follows that if the
exchange rate rises, the value of the liabilities rise. If all the firm’s assets are denominated in the
es equity) only if the value of owners’
+ owners’
local currency, then assets can equal (liabiliti
equity declines.
78 4 USING FORWARD CONTRACTS TO MANAGE RISK

stock
For example, suppose that a firm in France wishes to maximize the value of its common
denominat ed in
in terms of euros. This French firm has some of its liabilities with values that are
interest and
terms of yen. The liabilities may be bonds that were issued in Japan, with coupon
principal denominated in yen, or perhaps some yen-denominated payables. This French firm has
no yen-denominated assets. Using some specific figures, we might have the following
balance sheet, in millions of euros, and assuming an initial exchange rate of €0.01 for each yen
(€0.01/¥).

Assets Liabilities and Owners' Equity

Euro denominated = €145 Euro denominated liabilities = €50
Yen denominated liabilities = ¥3000 = €30
Owners' equity 665
Total assets = €145 Total liabilities and owners' equity = €145

Now suppose that the exchange rate rises from €0.01/¥ to €0.012A%. The assets and
liabilities that are denominated in euros remain unchanged in value, all else equal. But the euro
value of the yen-denominated liabilities rises to €36 million. Because the stockholders’ claims are
a residual, the value of the firm’s common stock must decline to €59 million. The increase in the
value of the firm’s liabilities is accompanied by a commensurate decline in the euro value of
Owner’s equity.
Thus, we conclude that a firm with substantial liabilities whose values are denominated in
terms of a foreign currency is exposed to the risk that the exchange rate (home currency/foreign
currency) will rise.
For this reason, many firms try to match their liabilities and assets in terms of currencies.
In other words, this firm could hedge itself by selling €30 million of its assets and buying ¥3000
million of yen-denominated assets with the proceeds. By doing this, a rise in the €/¥ exchange rate
will increase the value (expressed in euros) of both its assets and its liabilities by the same amount;
the value of the firm’s common stock will remain unchanged.

Change in
firm value

A€ /¥

Figure 4.13 A rise in the euro price of a yen will cause a drop in the value of this firm.
 4.3 USING FORWARD FOREIGN EXCHANGE CONTRACTS TO MANAGE RISK 72

Profit

Change in €/¥

Figure 4.14 Profit diagram for long forward position in yen.

The French firm can also use forward contracts on foreign exchange to manage its risk expo-
sure. Figure 4.13 illustrates the risk exposure of the French firm. Since a rise in the price of the yen
causes a decline in the value of its stock, the French firm should buy a forward contract on yen to
hedge. Figure 4.14 shows the profit diagram for a long forward position. If the firm depicted in
Figure 4.13 buys yen forward, it can be hedged against a rise in the Japanese currency.

4.3.2 Managing the Risk That the Price of a Foreign

Currency Will Decline
The exporter of a finished product that is paid in units of a foreign currency is exposed to the risk
of a falling exchange rate, where the exchange rate is expressed as home currency/foreign cur-
rency. Again, think in terms of a simple income statement. This time consider the example of a
Canadian firm that exports its production output to the United States and is paid in U.S. dollars.
The firm wishes to maximize its profits in terms of Canadian dollars (Can$):

Revenues (U.S.$) x Can$/U.S.$ = Can$

—Costs = Can$
Profits = Can$

The Canadian firm fears that the Can$/U.S.$ exchange rate will decline. If this happens, its
revenue stream, denominated in Canadian currency, will decline, and so will its profits. To hedge
itself, the Canadian firm should sell U.S. dollars forward. If Can$/U.S.$ falls, the firm’s revenues
denominated in local currency will decline, but the firm will also realize a profit because it sold
U.S. dollars forward.
As before, we can also analyze an exposure to risk in terms of a firm’s balance sheet. Suppose
that the value of some of a firm’s assets is dependent on the exchange rate. It follows that if the
exchange rate declines, and if all its liabilities are denominated in the local currency, the lower
asset value must be accompanied by a decline in the value of the firm’s common stock (denomi-
nated in the home currency).
For example, suppose that a firm in France (wishing to maximize the euro-denoininated
value of its common stock) has some of its assets with a value that is denominated in terms
80 4 USING FORWARD CONTRACTS TO MANAGE RISK

unde-
of British pounds. The assets may be British securities (stocks or bonds), or perhaps some
This French firm has no
veloped British real estate, and they are currently worth £30 million.
pound-denominated liabilities. Assume an initial exchange rate of €1.5/£, and consider the
following simple balance sheet:

Assets (in millions) Liabilities and Owners' Equity (in millions)

Euro denominated = €100 Euro-denominated liabilities = €80
Pound denominated = £30 = €45 Owners' equity = 405.
Total assets = €145 Total liabilities and owners' equity = €145

Now suppose that the exchange rate declines from €1.5/£ to €1.4/£. The assets and liabilities
that are denominated in euros remain unchanged, all else equal. But the euro value of the British
assets declines to €42 million. Because the stockholders’ claims are a residual, the value of the
firm’s common stock must decline to €62 million.
Thus, we conclude that a firm with substantial assets whose values are denominated in terms
of a foreign currency is exposed to the risk that the exchange rate (home currency/foreign cur-
rency) will decline.
This French firm could hedge itself by retiring €45 million of its euro-denominated liabilities
and then issuing £30 million of pound-denominated debt. Upon doing this, a decline in the €/£
exchange rate will reduce the value (expressed in euros) of some of its assets and its liabilities; the
value of the firm’s common stock will remain unchanged. Alternatively, the firm could hedge by
selling £30 million in the forward market.
As another case, consider a U.S.-based mutual fund that believes not only that some Japanese
stocks are undervalued (in terms of their yen prices) but that the $/¥ exchange rate is likely to
decline. A fall in the yen would offset the anticipated rise in the price of the Japanese stocks. The
mutual fund can hedge its initial investment (but not its profit or loss) in the stocks by selling yen
forward.
For example, assume that the spot exchange rate is $0.008696/¥. The mutual fund invests
$10 million in the Japanese stocks. Therefore, at the current spot rate, it will invest ¥1.15 billion
in Japanese stocks. To hedge its exposure to a decline in the yen, the fund sells ¥1.15 billion
forward at the current forward price of $0.009076/¥. This forward contract is for delivery one
year hence.
One year hence, the mutual fund is pleased to note that it was correct on both accounts. The
value (in yen) of its Japanese stocks rose to ¥1.426 billion (up 24% in yen). But at the same time,
the spot exchange rate declined to $0.008475/¥. Thus, the fund also made a profit on the forward
contract. Its total dollar-denominated profit is computed as follows:
Sell stocks for ¥1.426 billion.
Exchange yen for dollars at the spot exchange rate: ¥1.426 billionx$0.008475/¥=
$12,085,350
Profit on forward contract: ¥1.15 billion ($0.009076/¥ — $0.008475/¥) = $691,150
Total dollar profit: $12,085,350 + $691,150—$10,000,000 = $2,776,500
Dollar rate of return = ($12,776,500 —$10,000,000)/$ 10,000,000 = 27.765%
 81

Had the fund not hedged itself, its dollar profit and dollar rate of return would not have been
So impressive because of the decline in the price of yen. Even though the Japanese stocks rose in
value by 24%, the fund’s profits would have been only 20.85% [($12,085,350—$10,000,000)/
$10,000,000] because the yen dropped in value.
In this example, the fund sold its yen-denominated initial investment forward. It could not sell
forward the total amount of yen it subsequently had, one year later, because it did not know how
many yen it would have at that time. The value of the J apanese stocks rose, so in this example, the
company ended up having more yen to sell. Had the prices of the Japanese stocks declined, it
would have had less than ¥1.15 billion to exchange for dollars one year later.

4.4 WHAT QUANTITY SHOULD BE BOUGHT OR SOLD FORWARD?

So far, we have analyzed the direction of a firm’s risk exposure and determined whether forward
contracts should be bought or sold to reduce the variance of a firm’s profits, and/or to reduce the
volatility of firm value due to changes in prices. But we have not had much to say about how much
should be bought or sold in the forward market to achieve the optimal results.
When an individual transaction is being hedged, it readily follows that the amount to buy or
sell forward should equal the amount that underlies that transaction. If a firm will buy 5000 barrels
of oil at the end of each of the next four quarters, then it should buy 5000 barrels of oil for forward
delivery 3, 6, 9, and 12 months hence. A firm that knows that it will have $30 million in variable-
rate debt outstanding for the next 2 years, but wishes to fix its future interest expense will want to
buy a strip of FRAs, with delivery dates that correspond to each of the eight future dates on which
the interest rate on its debt will be set, and each of which has a principal amount of $30 million.°
A British firm that has an account receivable in the amount of €30 million will sell that many
euros forward, with delivery on or around the date on which it expects to be paid; when it delivers
the €30 million to satisfy the terms of the forward contract it will want its counterparty to pay
British pounds.
Hedging economic profits (cash flows) or equity value against price risk is more difficult to
accomplish. But in Chapter 2 you learned the basic tools that are required to manage risk when a
firm has such goals. Suppose that a U.S. exporting firm has decided to hedge the next eight quar-
terly (2 years) cash flows against foreign exchange price risk; assume that the dollar price of
Japanese yen is of concern. The firm must first estimate how its cash flows are related to changes
in the $/¥ exchange rate. To do this, it can estimate different regression models with historical data,
or use Monte Carlo simulation techniques to evaluate the relationship. Suppose that it estimates
that a $0.001 decline in the price of the yen will lead to a decline of $200,000 in quarterly profits
(and similarly, quarterly profits will rise at the rate of $200,000 per $0.001 increase in the price of
yen). The firm will then want to sell forward a sufficient number of yen to be able to realize a profit
of $200,000 on the forward contract for every $0.001 fall in the yen’s price. This means that
$200,000/($0.001/¥) = ¥200,000,000 should be sold for forward delivery at each quarterly deliv-
ery date (i.e., eight forward contracts calling for the forward delivery of ¥200 million SO pee ld
and 24 months hence).° This will lock in the forward prices that exist as of “today.” Suppose that
today’s spot price and forward price for delivering yen 9 months hence is $0.0086/¥. Then, 9
months from today, the actual spot price is $0.0080/¥. The firm’s operating profits should decline by
about $120,000. But the firm will realize a profit equal to ¥200,000,000($0.0086/¥ — $0.0080/¥) =
$120,000 on the forward contract.’ Thus, the change in the price of the yen has a reduced impact
on total cash flow for the firm that has hedged itself by selling yen forward.
82 4 USING FORWARD CONTRACTS TO MANAGE RISK

price
Similar techniques are needed if the firm is managing equity volatility induced by
volatility. The firm must first estimate how equity value is affected by a change in a price of some
in
good. Then, a sufficient quantity of the good must be bought or sold forward to result in a profit
the forward contract equal to the decline in equity value. The firm must also decide what horizon
length is of concern.
Chapter 7 presents other aspects concerning the decision of the amount to be bought or sold
forward.

4.5 SUMMARY
Forward contracts are used to manage price risk. Each contract, with its own delivery date, is
used to manage a single cash flow. Hedgers buy forward contracts to protect themselves against
price increases. They sell forward contracts to hedge against price declines. When the spot price
at delivery is greater than the forward price, the party that has a long position in the forward
contract profits, and the short loses. The party that sells forward contracts realizes a profit when
the delivery day price is below the forward price that was agreed upon when the contract was
originated.
Products that create revenues for a firm expose it to the risk that output prices will decline,
assuming that demand for the firm’s product is price inelastic. Inputs are costs, or expenses, and
firms fear that the prices of these goods will rise. In both these cases, profits decline.
When a price decline causes a firm’s assets to decline in value, then forward contracts
should be sold. If a price rise causes a firm’s assets to lose value, then forwards should be
bought. Price changes will also affect liability values. If a price decline causes liabilities to
increase in value, all else equal, the firm’s stockholders will see the value of their position
be eroded by the price drop and the firm should then sell forward contracts to hedge this risk. If
a price rise leads to an increase in a firm’s liability values, all else equal, then a long forward
position is needed.
FRAs are used to protect firms against interest rate fluctuations. A party will buy a FRA to
hedge against interest rate increases. FRAs will be sold when interest rate declines are feared.
Forward foreign exchange contracts are used to manage the risk that is created by changes in
exchange rates. For example, suppose the dollar is the home currency, and fx is the foreign
currency. Then a U.S.-based exporter that is paid fx for its product faces the risk that the $/fx rate
will decline, because that will lead to decline in its dollar-denominated revenues. Alternatively,
a U.S.-based importer that must pay fx for its imports faces the risk that the $/fc exchange rate will
rise. It will take more dollars to buy one unit of fx, creating greater dollar-denominated expenses
for the importer.
Another model of analyzing exchange rate risk focuses on the balance sheet. A firm with
fx-denominated assets fears a decline in the value of fx. Another firm may have fx-denominated
liabilities; it faces the risk that the price of fx will rise. In either case, the value of the stock-
holders’ position declines.
Finally, in the last section of the chapter, we explained that to determine how much of an asset
should be bought or sold forward, the firm should estimate how its cash flow or equity value is
affected by price changes. Then, the best hedge dictates the buying or selling forward of a suffi-
cient quantity of the asset to result in profits on the forward contract that equal the decline in prof-
its or the decline in the firm’s common stock.
 PROBLEMS 83

References

Luenberger, David G. 1998. Investment Science. New York: Oxford University Press.
Wilson, Richard S. 1997. “Domestic Floating-Rate and Adjustable-Rate Debt Securities,” in The Handbook
of Fixed Income Securities, 5th ed, Frank J. Fabozzi, ed. Burr Ridge, IL: Irwin Professional Publishing.

Notes

" But the forward price will often reflect some of this advantage, as well as the benefit described in item #2.
* For all price risk to be removed, it is necessary that (a) the amount of the raw material underlying the forward con-
tract equal the amount it will have to buy in the future to fulfill its production requirements, and (b) the quality of
the raw material underlying the forward contract and its delivery location be the same as the quality and delivery
location required by the firm in its production process. For example, there are many grades of crude oil, and relative
prices can fluctuate. Similarly, the price of crude oil at the physical location of a chemical production plant will
likely be different from the price of crude oil at the location at which it is removed from the ground.
> We have deliberately ignored another complication. Frequently, a firm’s production is negatively correlated with
price. Consider a farmer. When his harvest is large, it is likely that the harvests of many farmers are large, and there-
fore product prices will be lower. In other words, quantity risk naturally serves as a hedge in many cases. See Luen-
berger (1998, pp. 287-290). We thank Jerald Pinto for directing our attention to this situation.
“A floating-rate debt instrument is a security with a coupon or interest rate that periodically changes. The change in
the level of interest is typically tied to an index. The index may be a short-term index such as LIBOR, or it may be
a long-term index. See Wilson (1997) for a discussion of U.S. floating-rate securities. Floating rate notes are often
called FRNs.
> Tf the firm wanted to lock in a fixed interest rate, it would probably prefer to enter into an interest rate swap as the
fixed rate payer. Swaps will be introduced in Chapter 11.
on currency swap would accomplish the same goal.
7 Note two items. First, the firm only estimated that its profits would decline by $200,000 if the yen declines by
$0.001. The actual change in profits is a random variable. Second, the firm must realize that it is actually hedging
against a change in the forward price. In other words, profits on the forward exchange contract are realized if the
spot price at delivery is less than the original forward price. But changes in operating profits have been estimated as
being a function of changes in the spot price of the yen.

-
PROBLEMS
4.1. What price risk does a gold mining firm mining firm B’s output is price inelastic. How
typically face? Suppose that demand for gold will this situation affect how firmA will use for-
mining firm A’s output is totally independent —_ward contracts on gold to protect itself, relative
of the price of gold, while demand for gold _ to how firm B will use gold forward contracts?
 4 USING FORWARD CONTRACTS TO MANAGE RISK

4.2 A cereal manufacturer buys grains Future Interest Profit/

Relevant Expense Loss on
from farmers. What price risk does the cereal
Interest on Issued FRA
manufacturer face? What price risk does the
Rate Commercial
farmer face? How can each party use forward Paper
contracts on wheat and corn to manage its
price risk? 5%
4.3 Banks and other financial institutions S346
have issued most of the floating-rate debt out- 6%
standing in the United States. Why do you
6.5%
think this is so?
1%
4.4 A bank borrows $10 million for 12
months, and lends $10 million for 9 months, 4.8 A financial institution has a portfolio of
both at fixed interest rates. Discuss the interest floating-rate loans. Its capital structure con-
rate risk that the bank is exposed to. How can it sists mainly of 5-year CDs and long-term
use a FRA to hedge this risk? fixed-coupon rate bonds that it sold several
years ago. Discuss the interest rate risk that it
4.5 A bank borrows $10 million for 9 faces. How can FRAs be used to manage its
months, and lends $10 million for a year, both risk exposure?
at fixed interest rates. Discuss the interest rate
risk that the bank is exposed to. How can it 4.9
use a FRA to hedge this risk? a. A Japanese firm knows that in 4
4.6 A firm believes that it will have to bor- months it will have 45 million French
row money 4 months from today. To what Francs to deposit in a French bank. It
interest rate risk is this firm exposed? If it will leave these funds deposited in this
believes that it will need the funds for 2 interest-earning account (earning FFR-
months, how can it use a FRA to hedge this denominated interest) for a period of 8
risk? months, at which time it will need
Japanese Yen to pay one of its Japanese
4.7 suppliers. Discuss the interest rate risk
the Japanese firm faces. Discuss the
a. A firm plans on issuing $25 million
in 9-month commercial paper. It nature of the foreign exchange risk that
it faces.
expects to sell this security 6 months
from today. How can it use a FRA to b. Will the Japanese bank want to buy
hedge this risk? What is the start and end or sell a FRA? Suppose that 4x12
date of the FRA it should use? That is, FRAs in France are quoted at 9%. Four
should it buy or sell an “N”’ x‘““M”’ FRA? months hence, spot 8-month French
What are the values of ““N”’ and “M”’? interest rates are 7.8%. What profit or
b. Suppose that the price of the loss was realized on the FRA?
“N” X“M” FRA is 6%. Prepare a table 4.10 A Japanese firm has all its assets in
showing the interest expense on its Japan and sells all its products in Japan; all its
commercial paper. Assume that the day raw materials are produced domestically, as
count method for both the commercial well. Last year, this firm borrowed money
paper and the FRA is 30/360. from a U.S. bank. It must pay both interest and
 PROBLEMS 85

principal in U.S. dollars. Discuss the exchange concerning the rates at which the coupons will
rate risk faced by this firm. How can it use a be able to be reinvested).
forward foreign exchange contract to manage
this risk? 4.14 An international portfolio manager
located in Germany expects to receive $60
4.11 A U.S. mutual fund has invested in a million to invest in German stocks next month.
portfolio of British stocks. However it does not Discuss the price risks the manager faces.
wish to be exposed to exchange rate risk. How can a forward foreign exchange con-
tract be used to manage the currency risk
a. Is the fund exposed to the risk that the
exposure?
$/£ rate will rise or fall?
4.15 A firm uses historical data to estimate
b. To hedge, should it buy or sell British
pounds forward? the following equation:

c. Suppose that the fund invests $16 Y =10—4500X

million in British stocks. The spot
exchange rate is $1.68/£. The forward where Y=the change in annual cash flows and
rate for delivery 6 months hence is X=the change in 1-year LIBOR, in basis
$1.673/£. Six months later, the stocks points. Fully discuss how the firm can use a
are sold for £9 million, and the spot FRA to manage its risk exposure regarding
exchange rate is $1.70/£. What final next year’s cash flow, including a discussion of
profit or loss would the fund have real- the principal amount of the FRA that should be
ized, in terms of dollars, had it origi- used.
nally hedged its initial investment in
4.16 The prospectus to an_ international
British stocks? What was its dollar-
mutual fund states that the fund may enter into
based annualized rate of return?
contracts to purchase or sell foreign currencies
What would have been its dollar-
at a future date.
denominated profit and rate of return,
had it not hedged? a. Under what scenario or situation
would it want to buy forward exchange
4.12 <A Japanese firm imports U.S. apples
contracts? Under what scenario or situ-
and pays for them with dollars. What price
ation would it want to sell forward
risks does it face? How can it use forward
exchange contracts?
contracts to hedge its price risks?
b. The fund prospectus states that “such
4.13 An insurance company owns a coupon hedging...does not prevent losses if
bond that pays interest every November 15 and prices of such securities decline.
May 15. The face value of the bond is $45 Furthermore, it precludes the opportu-
million, and the coupon rate is 9%. The bond nity for gain if the value of the hedged
matures on May 15, 2002, and the firm plans currency should rise.” Discuss what
on holding the bond until maturity. The insur- these statements mean.
ance company is concerned about the total
funds that it will have available on May 15, 4.17 A Swiss fixed-income mutual fund has
2002. Today is October 15, 1997. Discuss how invested €50 million in long-term British
FRAs can be used to manage the insurance bonds having a coupon rate of 6%. The current
company’s reinvestment risk (the risk it faces exchange rate is €0.84/£.
86 4 USING FORWARD CONTRACTS TO MANAGE RISK

a. What interest rate risk does the fund exchange contracts to manage the
face? Why? How can it use a FRA to exchange rate risk it will face after the
manage this risk exposure? loan is actually made. Again, be as pre-
cise and thorough as you can, given the
b. What exchange rate risk does it face?
information provided. Explain how the
Why? How can it use a forward
forward exchange contract will reduce
exchange contract to manage this risk
the exchange rate risk faced by the bank.
exposure?
4.18 A Japanese bank expects to lend €10 4.19 Which of the following is true?
million to a Spanish firm. If negotiations are a. A firm will sell forward contracts to
successful, the loan will be made 1-month hedge against the risk that the price
from today. The terms of the loan have already (cost) of its raw materials will rise.
been established: the Spanish firm is to pay
b. A firm will sell forward contracts to
a fixed rate of 5%; the term of the loan will
hedge against the price (cost) of its raw
be one year; interest and principal, in euros,
materials falling.
will be repaid to the bank 1-year after the loan
is made. The Japanese bank is interested in
c. A firm will sell forward contracts to
hedge against the selling price of its
maximizing the yen-denominated wealth of its
Japanese stockholders. output rising.
d. A firm will sell forward contracts to
a. Clearly discuss the nature of the inter- hedge against the selling price of its
est rate risk the Japanese bank faces. output falling.
b. Clearly state how the Japanese bank
4.20 A French food manufacturer uses
can use forward rate agreements to
Virginian (U.S.) peanuts as a raw material. It
manage the interest rate risk it faces.
pays dollars for peanuts. This French firm
Explain how the FRA will reduce the
interest rate risk faced by the bank. Be a. fears an increase in the price of a
as precise and thorough as you can, dollar (an increase in the €/$ exchange
given the information provided. rate) and an increase in the price of
c. Should the bank desire that the contract peanuts
rate on the FRA be above or below b. fears an increase in the price of a dollar
5%? Why? and a decrease in the price of peanuts
d. Clearly discuss the nature of the for- c. fears a decrease in the price of a
eign exchange rate risks the bank will dollar and an increase in the price of
face after the loan is actually made. peanuts
e. Given your response in part d, clearly d. fears a decrease in the price of a dollar
state how the bank can use forward and a decrease in the price of peanuts