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FRBSF WEEKLY LETTER November 20, 1987 Is Exchange Risk Hedgable? It is now about 15 years since the world ab Clll donedthe Bretton vvoods system of fixed exchange rates. The debate over the advantages of fixed vs. flexible rates will doubtless continue for many years as exchange rates continue to be highly volatile (see chart). Among the issues in this debate are the extent to which different exchange rate regimes promote or hinder international trade and investment and the impact of different regimes on the stability of prices, employment, investment, and interest rates. Perhaps the major criticism of flexible exchange rates has been that they impose exchange risk on economic agents, especially importers, exporters, and international investors. Exchange risk refers to loss associated with unexpected movements in international exchange rates. Opponents of flexible rates claim that exchange rate fluctuations comprise a major deterrent to international trade and investment, and hence impose significant costs on the economy. Presumably, agents would refrain from undertaking socially beneficial trade and investment projects because of the fear that they would suffer losses when exchange rates move. Proponents of flexible rates have tended to minimize the importance of exchange risk as a barrier to international trade and investment. In his classic defense of flexible rates, Milton Friedman states: "Under flexible exchange rates, traders can almost always protect themselves against changes in the (exchange) rate by hedging in a futures market ... Any uncertainty about returns will then be borne by speculators. The most that can be said ... is that flexible exchange rates impose a cost of hedging on traders." Attempts to settle this debate empirically have produced disappointing results. This Letter considers the circumstances under which exchange risk is "hedgable", that is, when it can be completely eliminated or neutralized. The issue of "hedgability" of exchange risk has important policy and theoretical implications. If all exchange risks were hedgable, there would be no harm to the economy from volatility and uncertainty in foreign exchange markets. Exchange risk, therefore, would not give governments cause to attempt to stabilize exchange rates, and would give even less cause for pegging rates. Moreover, exchange rate volatility would not constitute a barrier to international trade and investment. At the theoretical level the problem is often just assumed away, i.e., risks are assumed to be covered in all cases by a hedge created along the lines to be described. However, as will also be discussed, forward coverage eliminates exchange risk completely only in very special circumstances. In most cases, it reduces exchange risk without eliminating it. Whenever that is the case, exchange rate volatility remains "harmful" even when hedging tools are available and widely used by traders and investors. How does a hedge work? How does hedging of exchange risk operate? Suppose a U.5. exporter expects a payment of 1 million British pounds in 180 days. At that time, the exporter may convert the pounds into dollars at the then-prevailing spot exchange rate. The exporter faces some uncertainty, however, in that the rate, and hence the dollar value of the payment, will not be known for 180 days. To eliminate uncertainty regarding the dollar value of the future sterling payment, the exporter may decide to "sell the British pounds forward" by contracting with most commercial banks to convert them into dollars at the forward exchange rate quoted today. Such a forward contract would obligate the exporter and the bank to swap dollars for pounds on a specific date (180 days hence in our example) at a specified rate of conversion, known as the forward exchange rate. In general,no funds are exchanged until the day the contract expires. FABSF A futures contract purchased through a futures exchange would be an alternative means of hedging exchange rate risk. Foreign currency futures contracts are somewhat similar to forward contracts, but they tend to be more uniform, with a limited number of expiration dates and contract size and with margin requirements. (Forward contracts are often contracts "custom-built" according to customer needs and specifications.) In either case, the forward (or future) exchange rate can, in general, be either higher or lower than the prevailing spot exchange rate, but it is known and certain in all cases. In reality, only a small proportion of international trade is covered by forward or futures hedging. This may be because traders can engage in an alternative form of hedging that is equivalent to forward coverage but could involve lower transaction costs in some cases. The exporter can create an equivalent hedge by borrowing funds in sterling for 180 days against the funds receivable, and investing the borrowed funds in a dollar certificate of deposit maturing in 180 days. In effect, the exporter locks in the dollar value of the sterling receivables. Similar hedging tools would be available to importers who must make payment in foreign currency, and for some international investors who could use forward contracts or their equivalents to hedge against exchange rate risks. Hedging uncertain amounts The previous example assumes that the agent who wishes to hedge exchange rate risk knows exactly the quantity of foreign exchange to be received (or paid) at a specified future date and may then hedge it. But what if the agent does not? The "total" amount of uncertainty to which the exporter is exposed is, in a sense, a complex sum of the two .individual uncertaintiesexchange rate volatility and quantity risk. An analogy may help illustrate this point. A hearty employee walking to work on a midwestern winter's day faces two meteorological risks that contribute to total "risk": temperature variations and wind variations. While the walker could "hedge" the temperature variability by sticking to sunny exposed streets, those streets may not necessarily make the best route, especially if they involve walking through some wind corridors. Even when he chooses the best route for walking, any reduction in the general variability of temperature would make him better off, other things remaining equal. In the same sense, when price and quantity risks co-exist, exchange risk is not fully hedgable. It can be shown that even when the quantity of foreign exchange to be hedged is independent of exchange risk and the "best" hedging strategy (the one that minimizes the risk to the agent) is being used, there will always remain a residual risk. This residual depends positively on the variances or degree of uncertainty of both the exchange rate and the quantity to be hedged. That is, the residual risk is higher, the greater is exchange rate volatility. The more volatile is the exchange rate, the riskier would be the agent's position, and the less theincentive to trade. Any stabilization of exchange rates would then reduce risk, benefit the agent, and expand trade. If the quantity to be hedged were correlated with exchange risk, this correlation would also enter into the calculation, but the basic conclusion would still hold. The residual risk would be, in a sense, a hybrid function of each source of uncertainty, and it would depend in particular on exchange risk. That being the case, exchange rate volatility would impose a cost on and therefore remain a problem for the trader. Its reduction therefore would benefit the trader. Hedging and inflation Now suppose instead that the quantity of foreign currency to be hedged were known and certain, but that there were uncertainty in the United States with respect to inflation rates in the near future. An. exporter who was due to receive 1 million pounds in 180 days would convert them through forward coverage into dollars as described above. He would then know with certainty what the future nominal dollar value of that payment would be. But he would not know its real value (in terms of U.S. purchasing power), which remains uncertain even with forward coverage. Of course, inflation uncertainty accompanies domestic trade as well. Nevertheless, the total uncertainty of the foreign currency position would depend on both sources of risk - inflation and exchange rate volatility - and their interrelationship. Volatile Exchange Rates Per u.s. dollar* 250 200 150 100 50 1981 *Index Jan 1980 1983 1985 1987 100 Not only would the payment remain "risky" in real terms even when a risk-minimizing hedge is used, but it can be shown that the riskiness would increase with both exchange rate volatilityand inflation uncertainty. Once again the stabilization of exchange rates would reduce risk even for traders and investors who use forward markets to hedge. Hedging would completely eliminate exchange risk only if inflation risk could be totally eliminated. (This could only be done through trade in financial assets indexed to the consumer price index.) That is, it would increase with increases in exchange rate volatility. This is true, as we have seen, whether the other source of risk is uncertainty over inflation Or the quantity of foreign currency involved. It would also hold if the timing of the receipt of a payment in foreign currency were uncertain (as it would be for some international investments), if a forward exchange rate were unavailable for the date of payment (e.g., because the date isfar off), and if there were default risk associated with the foreign exchange receivable. Conclusion In general, exchange risk is completely "hedgable" only when there exists no other source of risk or uncertainty for agents engaged in foreign exchange transactions. When some other source of risk exists, "optimal hedging" may reduce exchange risk but will not in general eliminate it. Residual risk of hedged positions held by traders and investors in this circumstance will be a positive function of exchange rate volatility. Since the residual risk for even optimally hedged positions depends on exchange rate volatility, the debate over appropriate exchange rate regimes cannot ignore the impact of exchange rate volatility on risk. This volatility imposes costs and therefore deters some trade and investment. Steven Plaut Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246. uo~6u!4S0m 040PI 4o~n uo61ilJO !!omoH O!UJOdIIO) ouozP8 OpOAIilU ol-jsol8 O)SI)UOJj UOS JO aAJaSa~ ~uo8 IOJapaj ~uaw~Jodaa lpJOaSa~ BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Loans, Leases and Investments 1 2 Loans and Leases 1 6 Commercial and Industrial Real estate Loans to Individuals Leases U.S. Treasury and Agency Securities 2 Other Secu rities 2 Total Deposits Demand Deposits Demand Deposits Adjusted 3 Other Transaction Balances 4 Total Non-Transaction Balances 6 Money Market Deposit Accounts-Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Two Week Averages of Daily Figures Amount Outstanding Change from 10/28/87 10/21/87 208,853 183,986 51,102 71,904 36,986 5,416 17,642 7,225 205,574 51,459 35,596 19,657 134,458 - 1,169 496 5 112 136 7 644 29 839 410 1,012 280 150 - 43,990 31,573 26,408 Period ended 10/19/87 - - - Change from, 10/29/86 Dollar Percent? - 5,522 1,417 1,076 5,172 4,468 178 4,741 637 1,337 568 11,255 2,125 1,355 438 - 250 2,707 - - - 1 2 3 4 S 6 7 61 22 39 1.1 - 24.0 12.1 0.9 2,369 - 5.1 2,291 969 - 6.7 3.5 Period ended 10/5/87 Reserve Position, All Reporting Banks Excess Reserves (+ )/Deficiency (-) Borrowings Net free reserves (+ )/Net borrowed( -) 2.7 0.7 2.1 "7.7 - 10.7 3.1 36.7 - 8.1 0.6 ° 158 157 Includes loss reserves, unearned income, excludes interbank loans Excludes trading account securities Excludes U.S. government and depository institution deposits and cash items ATS, NOW, Super NOWand savings accounts with telephone transfers Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources Includes items not shown separately Annualized percent change
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