HEDGING AND SPECULATION

FOREIGN EXCHANGE RISKS, HEDGING, AND SPECULATION

Whenever a future payment must be made or received in foreign currency, a foreign
exchange risk is involved because spot rates vary over time.
Future foreign currency payments may become more expensive if the domestic currency
falls in value.
Example: A contract requires a €100,000 payment in three months time. If the
exchange rate is currently $1/€1, the expected dollar cost is $100,000. If the
exchange rate changes to $1.10/ €1 in the intervening months, the dollar cost rises to
$110,000.
Future foreign currency receipts may fall in value if the domestic currency increases in
value.
Example: A producer expects to receive a payment of €100,000 in three months time.
If the exchange rate is currently $1/€1, the expected dollar receipt is $100,000.If
the exchange rate changes to $0.90/ €1 in the intervening months, the dollar receipt
falls to $90,000.
 HEDGING IN SPOT MARKET
In general, businesspeople are risk averse and will want to avoid or insure themselves against their
foreign exchange risk.

Hedging refers to the avoidance of a foreign exchange risk, or the covering of an open position.
 For example, the importer of the previous example could borrow €100,000 at the present spot rate of
SR = $1/ €1 and leave this sum on deposit in a bank (to earn interest) for three months, when payment
is due. By so doing, the importer avoids the risk that the spot rate in three months will be higher than
today’s spot rate and that he or she would have to pay more than $100,000 for the imports.
 The cost of insuring against the foreign exchange risk in this way is the positive difference between the
interest rate the importer has to pay on the loan of € 100,000 and the lower interest rate he or she
earns on the deposit of € 100,000.
 The cost of avoiding the foreign exchange risk in this manner is, once again, equal to the positive
difference between the borrowing and deposit rates of interest.
 HEDGING IN FORWARD MARKET
Covering the foreign exchange risk in the spot market as indicated above has a very serious disadvantage.
The businessperson or investor must borrow or tie up his or her own funds for three months.

To avoid this, hedging usually takes place in the forward market, where no borrowing or tying up of funds
is required.
 Thus, the importer could buy euros forward for delivery (and payment) in three months at today’s three-
month forward rate. If the euro is at a three-month forward premium of 4 percent per year, the importer
will have to pay $101,000 in three months for the € 100,000 needed to pay for the imports. Therefore,
the hedging cost will be $1,000 (1 percent of $100,000 for the three months).
 Similarly, the exporter could sell pounds forward for delivery (and payment) in three months at today’s
three-month forward rate, in anticipation of receiving the payment of € 100,000 for the exports.
 Since no transfer of funds takes place until three months have passed, the exporter need not borrow or
tie up his or her own funds now.
 If the euro is at a three-month forward discount of 4 percent per year, the exporter will get only
$99,000 for the € 100,000 he or she delivers in three months. On the other hand, if the euro is at a 4
percent forward premium, the exporter will receive $101,000 in three months with certainty by hedging.
HEDGING
A foreign exchange risk can also be hedged and an open position
avoided in the futures or options markets.
In a world of foreign exchange uncertainty, the ability of traders
and investors to hedge greatly facilitates the international flow of
trade and investments.
Without hedging there would be smaller international capital flows,
less trade and specialization in production, and smaller benefits
from trade.
SPECULATION
Speculation is the opposite of hedging. Whereas a hedger seeks to cover a
foreign exchange risk, a speculator accepts and even seeks out a foreign
exchange risk, or an open position, in the hope of making a profit.
If the speculator correctly anticipates future changes in spot rates, he or she
makes a profit; otherwise, he or she incurs a loss.
As in the case of hedging, speculation can take place in the spot, forward,
futures, or options markets—usually in the forward market.
SPECULATION
Speculation is the deliberate assumption of exchange risk in the expectation of a
profit. Speculators have definite expectations about future rates of exchange and
are interested in making a profit by buying foreign exchange when it is cheap and
selling it when it is expensive. Speculators who are right in their expectations make a
profit; but if they are wrong, they suffer a loss.
SPECULATION & ARBITRAGE
Arbitrage also involves the principle of buying a currency where it is cheap and
selling it where it is expensive. Nevertheless, arbitrage is riskless because for all
practical purposes the purchase and sale take place at the same moment and all
prices are known to the arbitrageur.
The activities of the speculator, however, are necessarily subject to exchange risk.
Indeed, the element of exchange risk is the characteristic feature of speculation.
SPECULATION IN SPOT MARKET
Example 1:
• If a speculator believes that the spot rate of a particular foreign currency will rise, he or she can
purchase the currency now and hold it on deposit in a bank for resale later.
• If the speculator is correct and the spot rate does indeed rise, he or she earns a profit on each unit of
the foreign currency equal to the spread between the previous lower spot rate at which he or she
purchased the foreign currency and the higher subsequent spot rate at which he or she resells it.
• If the speculator is wrong and the spot rate falls instead, he or she incurs a loss because the foreign
currency must be resold at a price lower than the purchase price.
SPECULATION IN SPOT MARKET
Example 1:
• If, on the other hand, the speculator believes that the spot rate will fall, he or she borrows the foreign
currency for three months, immediately exchanges it for the domestic currency at the prevailing spot
rate, and deposits the domestic currency in a bank to earn interest.
• After three months, if the spot rate on the foreign currency is lower, as anticipated, the speculator
earns a profit by purchasing the currency (to repay the foreign exchange loan) at the lower spot rate.
• (Of course, for the speculator to earn a profit, the new spot rate must be sufficiently lower than the
previous spot rate to also overcome the possibly higher interest rate paid on a foreign currency
deposit over the domestic currency deposit.)
• If the spot rate in three months is higher rather than lower, the speculator incurs a loss.
SPECULATION IN FORWARD MARKET
In both of the preceding examples, the speculator operated in the spot market and either had to tie up
his or her own funds or had to borrow to speculate. It is to avoid this serious shortcoming that speculation,
like hedging, usually takes place in the forward marke.t
Example 2:
If the speculator believes that the spot rate of a certain foreign currency will be higher in three months
than its present three-month forward rate, the speculator purchases a specified amount of the foreign
currency forward for delivery (and payment) in three months. After three months, if the speculator is
correct, he or she receives delivery of the foreign currency at the lower agreed forward rate and
immediately resells it at the higher spot rate, thus realizing a profit.
Of course, if the speculator is wrong and the spot rate in three months is lower than the agreed forward
rate, he or she incurs a loss.
In any event, no currency changes hands until the three months are over (except for the normal 10
percent security margin that the speculator is required to pay at the time he or she signs the forward
contract).
SPECULATION IN FORWARD MARKET
As another example,
suppose that the three-month forward rate on the euro is FR = $1.01/ €1 and the speculator
believes that the spot rate of the euro in three months will be SR = $0.99/ €1. The speculator
then sells euros forward for delivery in three months.
After three months, if the speculator is correct and the spot rate is indeed as anticipated, he or
she purchases euros in the spot market at SR = $0.99/ €1 and immediately resells them to
fulfill the forward contract at the agreed forward rate of $1.01/ €1, thereby earning a profit
of 2 cents per euro.
If the spot rate in three months is instead SR =$1.00/ €1, the speculator earns only 1 cent per
euro. If the spot rate in three months is $1.01/ €1, the speculator earns nothing.
Finally, if the spot rate in three months is higher than the forward rate at which the speculator
sold the forward euros, the speculator incurs a loss on each euro equal to the difference
between the two rates.
When a speculator BUYS a foreign currency on the spot, forward, or futures
market, or buys an option to purchase a foreign currency in the expectation of
reselling it at a higher future spot rate, he or she is said to take a long position
in the currency.
On the other hand, when the speculator BORROWS OR SELLS forward a foreign
currency in the expectation of buying it at a future lower price to repay the foreign
exchange loan or honor the forward sale contract or option, the speculator is said
to take a short position (i.e., the speculator is now selling what he or she does
not have).
BEAR & BULL
A speculator with pessimistic expectations about the future price of a currency is
called a bear; one with optimistic expectations, a bull.
For example, bulls on euro (that is, those who expect the euro to become more
expensive in the future) buy sterling now when it is cheap and plan to sell it later on
when it becomes expensive. In technical jargon, the bulls on euro take a long position.
Similarly, bears on euro (that is, those who expect the price of euro to fall in the
future) take a short position.
For instance, an American speculator who expects the euro to depreciate in the near
future can borrow euro in EMU and sell them for dollars in the foreign exchange
market. The speculator whose expectations are right will buy euro in the future at a
lower price and pay off the debt, in the meantime pocketing a handsome profit in
dollars.
TRADER SPECULATION
Exporters and importers who either expect to receive or make payment in a foreign currency
in the future are running an exchange risk. These traders can speculate merely by not covering
their exchange risk.
The decision by a trader not to cover his exchange risk is certainly similar to the decision of a
pure speculator to deliberately open a long or a short position in a foreign currency in order
to make a profit.
Nevertheless, not covering the exchange risk is not the only form of trader speculation Another
important form of trader speculation is what is usually referred to as LEADS and LAGS.
This term refers to the adjustment that importers and exporters make in the timing of
payments, the placement of orders, and the making of deliveries for the purpose of avoiding
losses or making profits from an anticipated change in the rate of foreign exchange.
EXAMPLE OF LEAD & LAG
Suppose, for instance, that a substantial depreciation of the euro is expected. EMU
exporters of goods invoiced in dollars will be anxious to delay (lag) receiving
payment in the hope of selling their dollar revenue at an exchange rate that is more
favorable than the present one. They can do so merely by extending credit to foreign
importers, perhaps at very attractive terms, or by delaying their deliveries.
If the EMU exports are invoiced in euro instead of dollars, the outcome is the same
except that American importers assume the initiative now. Thus, when a depreciation
of the euro is expected, American importers will delay (lag) payment and the
placement of orders in the hope of buying euro cheaper in the future.
EXAMPLE OF LEAD
EMU importers of goods invoiced in dollars will be anxious to accelerate (lead) their
payments and placement of orders merely to avoid being caught with dollar
obligations in the event of a depreciation of the euro.
Again, if the goods are invoiced in euro, it is the American exporters who will take
the initiative to accelerate their receipts. In addition, the American exporter may
offer better terms to the EMU importers and induce them to accelerate their order as
well
STABILIZING SPECULATION
Stabilizing speculation refers to the purchase of a foreign currency when the
domestic price of the foreign currency (i.e., the exchange rate) falls or is low,
in the expectation that it will soon rise, thus leading to a profit. Or
it refers to the sale of the foreign currency when the exchange rate rises or is
high, in the expectation that it will soon fall.
Stabilizing speculation moderates fluctuations in exchange rates over time and
performs a useful function.
DESTABILIZING SPECULATION
On the other hand, destabilizing speculation refers to the sale of a foreign
currency when the exchange rate falls or is low, in the expectation that it will fall
even lower in the future, or
the purchase of a foreign currency when the exchange rate is rising or is high, in
the expectation that it will rise even higher in the future.
Destabilizing speculation thus magnifies exchange rate fluctuations over time and
can prove very disruptive to the international flow of trade and investments.
REFFERENCES
Basic Reading:
1. International Economics, 11th Edition, Dominick Salvatore, Wiley
2. International Economics, 15th Edition, Robert J. Carbaugh, CENGAGE Leaning