Forum Archive Index - June 2002

["Gordon King" <gordon.k@xtra.co.nz>]

OK <activate brain>  A standard marked-to-market hedge goes like this.

Say current exchange rate is $nz2.22 buys $us1.00 (.45c exchange rate in
TVNZ terms)

NZCo needs to buy $US10,000 of widgets from USCo in 12 months time as parts
for super-widgets.  It wants to sign a contract to sell superwidgets for a
fixed price and wants input price certainty before it agrees a price with
its customer.

It could:

1) Budget $22,222 now and assume the x-rate will stay the same
2) Perhaps gain if the eschange rate rises, say to $1.81 (55cents) and it
needs only $18,100 for the $US10,000
3) Risk the exchange rate falling, say to $2.50 (40cents) and it needs to
find $25,000 for the $US10,000

As it is in the business of selling superwidgets and not speculating on
currency movements, its logic is that regardless of market sentiment, it
prefers the certainty of a known exchange rate rather than the uncertainty
(even if it is a gain rather than a loss) of  a wait and see attitude.

NZCo approaches its local bank for a hedge contract. The current 1 year
market outlook is 'strengthening' and the bank writes a 12 month contract to
purchase $US10,000 at the forward rate of $2.00 (50cents) or $NZ20,000 (plus
a small commission).  NZCo uses this figure for purposes of calculating the
sales price for its superwidgets.  The bank itself hedges its risk by
writing swap agreements etc with other financial institutions.

12 months on comes settlement day.

Scenario One: Ex-rate remained at $2.22.  NZCo writes a $22,222 cheque to
USCo and a $20,000 cheque to the bank.  It then sells the $US10,000 for
$22,222.  Net cost $20,000 for its widgets.  (in real life there will be
some leakage due to fees and margins etc).

Scenario Two: NZ dollar strengthened to $1.81 (55cents).  NZCo writes a
cheque to USCo for $18,181 and a cheque to the bank for $20,000 (thieving
bastards).  It then sells the $US10,000 currency for $18,181.  Net cost
$20,000 for widgets.

Scenario Three:  NZ dollar collapsed to $2.50 (40cents).  NZCo writes a
cheque to USCo for  $25,000 (ouch) and one to the bank for $20,000 (haha
suckers).  It then sells the $US10,000 for $25,000.  Net cost for widgets,
$20,000.

In reality the last two transactions are combined and the bank and NZCo make
up the difference.  Either the bank pays NZCo or vice versa depending on
what is happening in the spot market that day.

>
> You purchase a forward exchange contract for next year, so that you
> can use that $USD money to buy goods to put into your retail
> 'Warehouse'.   As soon as you do this, the bank will purchase that
> amount of currency today and offer it to you in a years time at an
> adjusted rate

No at a agreed rate

> to mitigate the interest rate loss or gain over the
> coming 12 months.
>
> So, far from still being in the physical market, my understanding is
> that as far as the physical purchase of US dollars goes, this means
> you have brought the transaction forward (well the bank has done it
> for you).  By taking out a hedge you have in effect *removed
> yourself* from the physical market in one years time.  If you don't
> agree please point out where I have gone wrong in this reasoning.
> >
> >Company hedging isn't about speculation, its about securing a known
> >currency rate for a future transaction.
> >
>
> Yes, but why should a New Zealand company 'know' what the best
> exchange rate for them to have is.

Thats the point, they don't.  Studies of accuracy in predictions of exchange
rates show that all commentators get it pretty much wrong the entire time.
What well run businesses want it certainty.  You can get that by matching
your medium term foreign currency needs with hedges that are timed to
coincide with cash needs in the physical world

>  When the time comes should they
> hedge at US45c, US46c or US47c?    Isn't their 'choice', whatever
> they end up getting in the hedge contract, and although once chosen
> fixed, a form of speculation in itself?
>
>
> SNOOPY
>
>
>
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