 Hello and welcome to the session in which we would look at various methods on how to mitigate foreign currency exchange risk using tools such as forward contract, futures, as well as options, calls and puts. But before we start, we would like to go through a quick review to determine what is the risk in a foreign currency transaction. We are gonna be looking at the US as the home currency and we are selling and buying from a European supplier. Starting with what happened if your domestic currency appreciated? And when we say domestic, it's the US of aid, the domestic currency. Well, if your domestic currency appreciate, it's gonna benefit your liability. So if you have a payment to a foreign currency and your currency went up in value, it's gonna benefit you. It's gonna become more expensive for the European to buy the US goods. So as an importer, you would like it. As an exporter, you don't like it. Also, with the same token, if the domestic currency appreciate, it's gonna harm your account receivable because if you're receiving money in euros and your domestic currency appreciate, you're gonna convert into less US dollar. With the same token, it will be cheaper for US consumers and companies to buy foreign goods and services. What's gonna happen is you're gonna see more US tourist in Europe. Now, if the domestic currency depreciate, again, the domestic currency here, we are saying the USA. Well, if you're a US company, it's gonna benefit your account receivable. Why? Because you are expecting to receive euros and if your currency goes down, you're gonna buy more US dollar with those foreign currency. It's gonna become less expensive for European to buy US goods, which is good and more Europeans will visit New York City. Why? Because euros relatively stronger than the US dollar. Also, if the domestic currency depreciate, it's gonna harm your accounts payable, which is the opposite of if your domestic currency appreciate, and it's gonna become more expensive for US consumer to buy foreign goods and supplies. So this is a review and the reason I go through this to make sure you understand which side you are on and what's your exposure. And the best way to illustrate this concept is to work with an example that shows us in numbers how all these rules apply. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. So let's take a look at Adam, who's an international US-based company, buys raw material from Canada. The current exposure is one million Canadian dollar, due in 60 days from now. The current spot for one US dollar, you can get $1.35 Canadian. Now, as of today, Adam will need 740,740 dollars, which is taking the million Canadian dollar, dividing it by 1.35 to satisfy this obligation. Now, Adam don't have this money right now, and this money is not due until 60 days from now. Well, in 60 days, a lot of things could happen. So if Adam fears that the Canadian dollars might strengthen and expected it to be one to 120, in 60 days, what can Adam do? Well, if that's the case, let's think about it. If the, indeed, the Canadian currency strengthened, and now how much do we need? If we take a million dollar divided by 1.2, now we're going to need, if we wait and that actually materialized, we're gonna need 833,000. If we don't do anything, and this actually happens, we are gonna be at a loss of an additional loss of 92,593, because we are going to need 833,333. If our position, our position means our liability, our account spable is not hedged. Now write down this data, because I'm gonna be using the example in this data to illustrate the various concept. Now, how to mitigate this risk? How do we hedge? Well, the first thing you need to know, what is my exposure? Is it a net asset or a net liability? And the example that I just showed you, we had a net liability. Why? Because I told you we have an account spable. So always you have to see, how is my foreign currency AR compared to AP? If I have more AR than AP, I have an asset, an asset exposure. If I have more AP than AR, I have a liability exposure. So you need to hedge your position, but first you need to know what's my exposure? Is it a liability exposure? Is it an asset exposure? You can use forward contract and future contract. And for the purpose of this illustration, forward contract and future contract, they basically work the same way. The difference is in a forward contract, it's a private party, the contract could be customized. And a future contract, the future contract are traded on an organized exchange, they're more standardized. But for the purpose of this illustration, I'm gonna treat them both as the same. You could use options, calls and puts, or you could use swaps. I will keep the swaps for a different session. So let's assume you do have a liability exposure. What can you do? Like the million dollar of Canadian dollar. Well, you can buy a future contract or a forward contract that give the holder either the buy or the right to buy or to sell. Now you want to buy an hour example to buy the currency at a future rate. So you can buy a contract, you can enter into a contract with someone, tell them, this is what I want to do. I want to buy the foreign currency at a certain price. So if your net account spable, if your exposure is account spable, well, you are an importer, you have a liability exposure. What's your risk? What's the risk? Again, the risk is the foreign currency appreciating in this situation. Maybe the one US dollar may only be able to get you 1.2 Canadian. And what happened as a result, the Canadian went up, the US currency depreciated. Okay? Now remember, I'm showing you US dollar to 120. If that's the case, well, you're gonna have to pay more money as I just showed you. So how to hedge? What can you do to hedge? Well, the first thing you can do to hedge is basically if you have cash, go ahead and buy the currency now. Remember we have a million dollar exposure, a million Canadian dollar and the currency is dollar 35. If we buy it today, we will pay 740, 740, just buy the Canadian dollar and have peace of mind today if you have the money. Now, then what you do is you buy the Canadian, you buy the Canadian and you invest the Canadian money in a Canadian account to earn some profit. That's fine. And assume you can earn 1% for that 60 days, you would only need 733,405 because you are going to earn 1% of this on the 740,740 because you would earn 1%. So you may be able to get it at a discount assuming you have the money. So that's one option. If you don't have the money, you might be, you may want to borrow the money to buy the foreign currency today. That's another option. At this point, you have to evaluate whether the interest cost is worth the protection. Also, you can buy a future or a forward contract to buy the currency at a certain rate. For example, you would pay a fee, you would pay a fee to a broker to lock your price at $1.41. So someone will agree for $20,000 for a fee of that much. I will agree with you that I will sell you the Canadian dollar at $1.31. Therefore, what's gonna happen is this, if you take a million dollar, you can buy it at $1.31, you would only pay 763,358. So you can enter into a contract, either a forward contract or a future contract and lock your fee. Lock your fee and therefore, you know you will pay 733,763,358. This number here. That's one way to hedge. Otherwise, assuming the Canadian goes down to, again, $20, not dollar, yeah, $20, remember you're gonna have to pay 833,333. So that's why you will hedge your position. Now you could also buy what we called a call option to purchase the currency. What is the difference between the call option and the forward and the forward and the future contract? They basically serve the same purpose, except the call option, it's more traded and it's an option. An option means you can exercise it or you don't have to exercise it. So you buy a call option, call means what? You buy the right, not the obligation, to buy the foreign currency, which is the Canadian dollar at a certain price. So let's take a look at an example if we do buy a call option. It's basically the same as the future, the purpose is to lock in your price, but also the call option could go up in value, go down in value. So if you have an accounts payable and your currency indeed went up in value, you would lose on the accounts payable, but you will make money on the call option because this gives you the right to buy it at a limited price. So the purpose of the call option is to limit your payout, which is the purpose of the forward as well as the future contract because your risk, if you have a liability, your risk is I want to limit my payout. I want to limit how much do I have to pay if I have a liability in a foreign currency? So you want to put a cap, the maximum amount I pay for that one million Canadian dollar. So the call option, if you buy a call option, which is call means the right to buy, it means you lock your price, you lock your price. And if the currency goes up, the call option itself that you paid will increase in value. So although your liability, you have to pay more, but the call option appreciation should offset that. So let's take a look at with some numbers. Let's assume the spot rate is dollar 35. In other words, if you want to buy it today, you'll pay dollar 35. Now we cannot buy it today. What is our risk? What's our expectation? The risk is the Canadian dollar made strengthen and now down the road, when we are ready to pay, we might have to pay dollar 20. And this is what we want to avoid. So what do we do? We'll buy a call option, paying a premium of 0.05, which is what a premium, which is a million dollar times 0.05, that's gonna be 50,000 Canadian. We have to pay a fee. Then with the call option comes a strike price. Strike means what? It's the price that we can do the exchange. So we can exchange the currency. If we pay five pennies today, we can exchange our currency when we receive it at dollar 30. Now, simply put, let's think about it. We can exchange it at dollar 25 and we paid 50 pennies. So really actually what we can do is we're gonna end up exchanging our foreign currency at dollar 30, which is good. This is basically what we call this is the break even. It's the strike price plus the fee because we have to pay a fee. So at dollar 30, we'll break even. Now, let's see what's gonna happen now. Let's assume we exercise this option and we exchange it at dollar 30. The maximum we have to pay is 769,230. So let's assume we do do the exchange. It's a million dollar divided assuming we exercise the option. We don't have to exercise the option, but that's the max I have to pay for this liability. Now we have a peace of mind, okay? Little bit more than now, which is 740, more than the current rate. Nevertheless, I'm okay putting a limit on this payout. Now, assume the spot rate is dollar 50. So 60 days later, actually the Canadian dollar weakened further. Now one US dollar will buy you dollar 50. So what do you do now? Well, you don't do anything. You let the option expires. Yes, you did loss 50,000 here, but you will go ahead and exchange your million dollar at dollar 50 and pay, I'm sorry, not exchange, buy the million Canadian at dollar 50 and only pay 666,666. Why? Because actually the Canadian dollar weakened. The Canadian dollar weakened. Your risk, your risk was the Canadian dollar strengthened. So if the Canadian dollar weakened, you let the option expires. You don't have to worry about the option. Okay, you paid the fee, you lost the money on the option. It bought you peace of mind. Now you let it go and you take your Canadian, you take your US dollar and buy Canadian money, which is now it's only gonna cost you 666,666. So you let the option expires. Now if indeed the Canadian dollar strengthened it, went down to dollar 10, what you do is you will exercise your option and you would only have to pay 769,230. So let's assume you did not hedge your position and the Canadian dollar went to dollar 10. So let's take a million divided by dollars and to show you why buying the call option would help, divided by 1.1, you would have to come up with 900,990 dollars. So what you did is you hedge your option. Now let's assume we have an asset exposure. So let's switch the example from an account receivable, from an accounts payable to an account receivable. Let's assume you have an account receivable. Now you sold to the Canadian company and you are expecting to receive a million dollars. Now and you expect the Canadian dollar to weakened. Now this is your risk now. Why? Because you have an asset. Your risk is different. Now what you do is you will buy some sort of a forward contract or a call option or a forward contract to hedge this position. It gives you the right to buy and sell in this situation sell the currency for a set price at a future date. You have a net as account receivable. Here what we're saying is you are exporting more. You have an asset. What is your risk? Your risk is the foreign currency depreciating, the foreign currency weakening. That's your risk. In other words, the US dollar strengthening and you don't like this because you have a Canadian receivable. You want the opposite. How to hedge? Well, the first thing is you can do is try to sell the receivable to a foreign Canadian bank. Simply put, go to a Canadian bank and say, look, I'm waiting for a million dollar of Canadian money. Would you like to buy this receivable from me? Which is called factoring. If they would factor it, that's fine. What does that mean? They will give you the money now. You will convert your money. You will convert your Canadian money to US dollar. And once the Canadian company pays you, you will pay the bank directly or the bank will collect from the Canadian dollar. If that's available, that's you just get done with this problem. This is how you would hedge a receivable. That's one option. The other option is to, so if you did it today, if you convert your money today, you would receive today 740,740, you will exchange your money at the spot rate. Now, again, there's a fee. Maybe there's 10, 15, $20,000 fee. You will deduct the fee from the proceeds. Of course, there's a fee for the bank. Now, also you can buy a future or a forward contract to sell the currency at a particular price. So you can also pay a fee, pay a fee to sell the currency at $1.30. Let's assume someone agreed with you on that price. I'm just making up this price. This price could be anything. If that's the case, you'd say, okay, I'll pay a fee. I'll pay $25,000 to someone. And this someone, the other party would say, don't worry, once you receive the million Canadian dollar, you will be able to convert at $1.30 and you will guarantee to yourself $769.230. You can do that as well. Buy a future or a forward contract or you can buy a put, which is an option also to sell the currency. Again, the option, the put is the option to sell the currency because you are expecting to receive the currency. So let's see how the put option work. The put, the purpose of the put option is to guarantee a certain amount of money from my receivable. Same thing as the forward contract and the future contract. Basically you create a floor. This is, I'm guaranteeing this price. The put option, remember, also would increase in value if the Canadian depreciate. Why? The put option gives you the right to sell the Canadian money at a certain price. So if the Canadian dollar kept on going down, your put option goes up because you are limited. You can sell it at a certain price. In other words, as the account receivable goes down because of the foreign currency depreciation, your put option will go up and you will create the option in a way for them to offset each other. Now we're not gonna go exactly how dollar per dollar, but the point here is to explain how options and put will work in hedging your foreign currency exchange. So right now the spot rate is dollar 35. The risk is the currency weakening. Now your risk is totally different because we changed the example because you have an asset. The risk is the currency weakening to dollar 50. You don't want that. So you buy a put option and you buy the put option at a strike price at dollar 25. You can sell your option at dollar 25. Now bear in mind because it's a put option, you can sell it at dollar 25 and you paid five dollars because it's a put option, your break-even is dollar 20. Your break-even is dollar 20. Now let's see what's gonna happen. But now you know at any, the maximum that you can do, what you can do is you'll get the million and you can convert at dollar 20, you'll get 833,000. Obviously you have to pay a fee. You have to pay a fee, 450,000 or whatever that fee is. Let's assume the spot rate 60 days later when you receive the money is two dollar. So one US dollar will buy you two Canadian dollar. Actually the Canadian dollar weakened. The Canadian dollar weakened. The risk is the currency weakened and indeed it weakened. Now, if you want to, if you waited and you were not protected, then you would take the million dollar divided by two and you will get only 500 USD. Wow, that would have been bad. So what you do under those circumstances, you will exercise the option and you'd say, look, whoever sell you that option make the wrong choice. Well, they got the fee, but they are on the wrong side of the trade. And some people do that. That's what they do. They have different options. They lost on this trade. They may make money on the other trade. That's not your business. Your business is to make sure you don't overpay or under, you don't overpay, you want to underpay. You don't overpay. And when you have a receivable to receive at least a certain amount of US dollar from your receivable. And this is what this put option did to you because you have an asset exposure. You have an asset, you're going to be receiving the money. I will put a floor on the amount of receivable I am going to receive. Another strategy is to use swaps. I will cover swaps in a different session. What should you do now? Go to Farhad Lectures and look at additional lectures, MCQs, through faults, additional resources that's going to help you manage to learn this topic. The best way to do this is to really understand it. You need to understand how foreign currency exchange work. I believe it should make sense. Try to understand it. Otherwise, ask questions. We are here to help. Good luck and stay safe.