Managing Currency Risk: Using Financial Derivatives

Posted by Allison on 13 April 2009, 10:52

There are many books available that contain a great deal of information about trading on the foreign currency exchange market, most of which approach it from the standpoint of an individual investor trying to break into this potentially profitable area of investing.  Managing Currency Risk:  Using Financial Derivatives takes a different approach, however, focusing on the foreign exchange currency trading market from the standpoint of businesses that may be affected, either directly or indirectly, by fluctuations in the market.     

Why should businesses care about foreign currency exchange markets?

The roots of this subject can be traced back a number of years, to a point before the currency exchange markets had matured to the current structures.   Managing Currency Risk:  Using Financial Derivatives uses the example of Laker Airlines, a very successful UK-based air carrier in the 1970's and early 1980's.  The airline was so successful, in fact, that they ordered a number of new aircraft from U.S. company McDonnell-Douglas.  At the time they ordered the new airplanes they could easily afford to purchase them, however in the months between placing the order and when the airplanes were delivered there was a significant fluctuation in the currency markets.

As a UK-based airline, Laker Airlines revenues were based on the British pound; as a U.S.-based airplane manufacturer, McDonnell-Douglas sold their planes based on the U.S. dollar.  Why is this important?  Because the currency fluctuations that occurred between the order placement and the order delivery severely lowered the value of the British pound compared to the U.S. dollar, the relative price of the airplanes skyrocketed, leaving Laker Airlines struggling to pay for them.

The experience of Laker Airlines drove large corporations all over the world to find new ways to manage the risk of their foreign currency exposure, which led directly to the foreign currency exchange market structure we have in place today.  However, the lessons learned by the largest corporations are just as valid for all businesses that have some reason to think about the currency market.  And with our increasingly global economy, nearly every business is affected by the currency market in some way.

Currency risk management using financial derivatives

The area of risk management in the business world is huge, ranging across all sorts of business operations.  From liability to employment practices to product safety, there is plenty of need for effective risk management strategies.  Managing Currency Risk:  Using Financial Derivatives is not intended to be a comprehensive discussion of risk management in general, but rather a focused discussion on risk management related to foreign currency exchange markets.

The book narrows down the focus even further, paying close attention to how non-financial businesses can use financial derivatives just as effectively as large corporations and financial entities.  To accomplish this goal, Managing Currency Risk:  Using Financial Derivatives attempts to answer these basic questions:

The structure of the book takes the reader through each of these areas in a way that is logical, functional, and easy to grasp.

Chapter topics and discussions

Let's examine the chapter topics and discussions a bit more closely:

Chapter 1 – This chapter contains a thorough overview of currency risk, including the use of currency derivatives and the management role in currency risk management.  It is a good discussion and introduction to the topics and purposes of the book.

Chapter 2 – This chapter contains good discussion about significant strategies and issues surrounding currency risk management, including adequate systems of structure and control, the importance of proper diversification, and how to hedge against risk using financial currency derivatives.

Chapter 3 – This chapter focuses on currency forwards and currency spots, including very detailed information about the spot market and what it's all about, the advantages and disadvantages of currency forwards, and other general information about these two areas.

Chapter 4 – This chapter takes the reader through currency futures, paying special attention to the types of contracts and why they are important.  Standardised contracts are covered in detail, as are exchange traded forward contracts.  Additionally, there is good discussion about basis, hedge ratios, and some of the common terms and definitions found in the currency futures market.

Chapter 5 – This chapter introduces currency swaps; what they are, important principles of currency and cross currency swaps, and practical applications for both of these types of swaps as well as cocktail swaps.

Chapter 6 – This chapter offers some excellent insights on currency options, covering their fundamental principles and pricing.  There is also a good discussion about understanding both the time value and intrinsic value of options.  Risk is examined, too, along with standardisation, classification, and selling of currency options.

Chapter 7 – This chapter is all about strategies related to the use of currency derivatives, such as zero cost, reduced cost, and profit retention.  The discussion is thorough, clear, and easy to understand.

Chapter 8 – This final chapter focuses on specific currency risks and how to manage them successfully.  The three main areas covered are securing a foreign loan equivalent through the use of derivatives; cash flow cost and return management for long term currency risks; and anticipating transactions likely to involve foreign currency in order to properly manage the currency risk associated with those transactions.

Quality information with a usable content structure

The bottom line for Managing Currency Risk:  Using Financial Derivatives is that this book contains a wealth of quality information and content, structured in a way that is easy to understand and use.  A particularly helpful feature of the book is the inclusion of review checklists at the end of each chapter.  This is an excellent way for the reader to check their understanding and retention of topics presented in the chapter, allowing an opportunity to go back and review portions that are not entirely clear after the first read through.

The reader is taken through each topic step by step, with real life examples given in many key places.  What's really interesting about the book is the range of topics presented; it goes far beyond what you might expect from a book of this size.  That doesn't mean certain topics are glossed over or only touched upon briefly, though; rather, the discussions are clear, concise, and thorough on every single topic.

To be sure, this is not a book intended to help novice traders learn about the foreign currency exchange markets and how they can profit as individual traders.  There are plenty of other books out there that serve this purpose.  Instead, Managing Currency Risk:  Using Financial Derivatives takes a unique approach by focusing on how and why businesses should be conscious of risks they face from the foreign exchange currency trading market.  These risks can be direct or indirect, but are important to address either way.

Final thoughts

There are many different resource books available for businesses of all types and sizes, but many businesses overlook the potential risks a business faces in the foreign currency exchange market.   Managing Currency Risk:  Using Financial Derivatives takes full aim at these issues, offering very complete and detailed discussions that are relevant to a wide range of businesses.  It is unique in this approach, providing a wealth of information that simply is not available in this complete format from any other resource.

Although it is not intended for novice traders, and it is not a “how to” manual for trading on the foreign currency exchange market, Managing Currency Risk:  Using Financial Derivatives is a valuable resource to include in your financial library.  It is well worth taking the time to buy a copy and read it thoroughly.

Direct link to this book at Amazon