Forum Archive Index - June 2002

["tennyson@caverock.net.nz" <tennyson@caverock.net.nz>]

Hi trader 100,
 

>
> 
> Your explanations are spot on 
> 
>


Great.  Although I expect there must be some margin in there for the 
bank to make a profit on the hedge.  Otherwise why would they do it?


>
>
>I don't entirely understand your question.  By entering into a
>forward contract a NZ company has technically removed all of FX risk
>(assuming you accept the standard finance defintion of risk as "the
>variability of outcomes".)  The NZ company knows for certain that
>they will receive the forward rate so all of their risk is removed. 
>The fact that the forward rate may be better or worse than the spot
>rate in one years time doesn't have any impact on the risk.  Putting
>it another way, the act of insuring your house removes the risk of
>financial loss from a natural disaster regardless of whether
>disaster strikes or not.  You may not make a single a claim over say
>a 10 year period causing you, with the benefit of hindsight, to
>conclude that the insurance wasn't worth it but without it in place
>you would be opening yourself up to risk.
> 
>


I think my question comes down to my different understanding of 
'risk'.   By taking out a hedge contract a New Zealand company has 
removed all *volatility* of the exchange rate at a contracted date.
But I question whether that is the same as eliminating the risk.   

I see there is maximum risk if you do nothing to allow for an 
unplanned for event.  Take your house insurance example.  

House insurance works fine for natural disasters.  But what 
happens if there is a war and your house gets bombed?   You have lost 
your premium (as you paid for natural disaster insurance) AND you 
have lost your house!  In this example you are better off having no 
insurance at all as you were not insuring for the actual event that 
claimed your house. 

In the same way a New Zealand importer taking a hedge is also 
taking an insurance.  In this case the 'disaster' is that his kiwi 
dollars will buy fewer US dollars next year because of the interest 
rate differential.   But what if the relative exchange rate level 
betwwen $NZ and $US is nothing to do with the interest rate 
differential?   What if it depends on capital flows instead?  That 
means the NZ company's insurance (hedging) is based on an event that 
isn't going to happen. 

Does this matter?   I'm not sure.  But if the New Zealand dollar was 
to actually go from buying 47c in US currency to 50c, and the company 
was locked into buying the US funds at the rate of 43c (because of 
the hedge) they are much worse off.    I say they are much worse off 
because if they had followed the alternative strategy of buying US 
funds immediately (at 47c) then waited for a year (which was 
supposedly equal to hedging) this would have turned out much better 
than hedging.    

In conclusion I am saying that the New Zealand company succeeded in 
eliminating the future exchange rate volatility.   But in my view 
this did nothing to reduce the risk because they took out the *wrong* 
insurance policy (hedging contract).

SNOOPY


  

 
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