Welcome to part 2 of our foreign currency loan risk management guide
In part 1, we discussed how borrowing in a foreign currency can complicate things. The good news? There are tools to help manage this complexity. In this lesson, we’ll break them down.
When taking out a foreign currency loan, there are three main tools you can use to hedge the FX risk:
Cross-currency swaps
Forward contracts (including rolling forward contracts)
Currency options
Let’s start with cross-currency swaps
What is a cross-currency swap?
A cross-currency swap is a financial agreement with a counterparty to exchange loan obligations in one currency for equivalent obligations in another currency, typically aligning with the reporting currency. The notional amounts are exchanged at the start of the contract and again at maturity, with periodic interest payments based on the respective currencies' rates.
Why would you use it?
Assume you are borrowing in a foreign currency, because you can not get a loan in your functional currency:
At the beginning, the lender gives you money in that foreign currency (e.g. USD). You would then take the USD and convert into your functional Currency (e.g. GBP) to use the funds.
During the life of the loan, you need USD for interest payments back to your lender.
At the end, you need to pay back the USD to your lender.
At each of these three steps, currency swings can impact your payments.
What are the benefits?
Access to liquidity: Companies can borrow in foreign currencies to access greater liquidity in international markets.
Lower borrowing costs: Borrowing in foreign currencies can sometimes offer lower interest rates compared to domestic markets. When combined with a swap, these rates can be effectively converted to the domestic equivalent, creating cost advantages.
What are the risks?
Complexity: Cross-currency swaps are complex financial instruments, typically offered by specialist financial counterparties. They often require the borrower to provide credit support or collateral.
Cost: These swaps can be expensive, involving fees and significant collateral requirements, which may increase the overall cost of borrowing..
Counterparty risk: If your counterparty defaults, you could lose the hedge and be exposed to market risks.
Lack of flexibility:The terms of a cross-currency swap are set at the outset and can’t easily be changed.
Here is a video to explain it
Forward contracts: the alternative
What is a forward contract?
A forward contract provides you with a fixed exchange rate for a set date in the future.
You can use a forward to maturity or a rolling contract.
Forward contracts to maturity
A forward contract locks you into a fixed exchange rate for a set date in the future. No more worrying about what the market’s doing because you’ve already locked it in.
How it works: You and the counterparty agree to exchange a specific amount of currency at a set rate on a specific future date (usually when your loan is due).
Rolling forward contracts
Instead of locking in a single rate until maturity, you enter into a series of forward contracts that renew periodically – typically every three months.
How it works: You agree to exchange currencies at fixed rates for 3-month periods, effectively ‘rolling’ the contract forward each time.
With rolling forwards, you manage risk in shorter increments. Each renewal locks in a new exchange rate for the next period, giving you ongoing protection while maintaining flexibility to repay your loan early.
Let’s compare
Currency options
A currency option gives you the right, but not the obligation, to exchange currency at a specific rate in the future. Think of it as a ‘just in case’ strategy that gives you flexibility.
How it works: You buy an option that gives you the right to lock in a certain exchange rate for a future date, but if the market is in your favour, you can choose not to use it.
Pros:
Upside potential: If the market moves in your favour, you don’t have to exercise the option. You can just sit back and enjoy the ride.
Flexibility: You’re not forced to stick with the option if the market changes in a way that benefits you.
Cons:
Premium cost: You’ll have to pay a premium for the option, even if you don’t use it. In general, the longer dated the contract, the more expensive it will be.
Complex: Understanding how options work, and how they are priced,can be tricky, especially when it comes to timing and strategy.
Main components of option pricing include:
Current price
Strike price
Term
Volatility of underlying asset
Explanation videos
Cross currency swaps:
Forward contracts:
In our next lesson, we will focus on key considerations around each approach and examine different ways to execute them. Sign up to receive lesson 3 directly in your inbox, or join our LinkedIn newsletter.
If you want to take action now to tame your FX risk, talk to one of our experts – book a call here
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