A broader view than the yuan

BACKGROUND: Over the past year and a half, the world’s currency and business circles have been flooded, from time to time, with rumours about the Chinese yuan being revalued. Such rumours have not yet come to pass, leaving the door open for speculation. The common view is that China will widen the range of trading, effectively revaluing the yuan, this year. This means protecting the yuan payables should be an important aspect of treasury consideration this year.

At the World Economic Forum in Davos Switzerland in January, Zhou Xiaochuan, governor of the People’s Bank of China, issued a statement repeating the bank’s policy of keeping the yuan "basically stable". This gives the world an indication that when the yuan moves, it will be measured and steady.

However, most businesses discount the effect this impending move will have on other floating Asian currencies, such as the yen, the baht and the Singapore dollar. These currencies are already being pushed up and the weak US dollar will affect these currencies before China revalues.

PROBLEM: Most global businesses that deal or have operations in China also have dealings with Japan, Thailand, South Korea, Taiwan and Singapore. It is imperative that they hedge the exposures in these currencies using appropriate strategies to protect their bottom lines from erosion due to the effective revaluations of such related Asian currencies instead of obsessing about when China will move and revalue the yuan.

While the yuan has remained pegged to the US dollar for the past decade or so, we restrict our analysis to the latest dollar downwards trend, which started in February 2000. The table contains some important statistics.

In the past, we have seen a six- to seven-year trend for the dollar. This is the start of the fourth year of the current downwards trend for the currency. There is little information in the public domain that indicates there will be a reversal of the trend. Even with historically high trade and current account deficits, there is no sign of a dollar decline.

With China firmly locked to the greenback, the free-floating Asian currencies will have to absorb the continual decline of the dollar. This can dramatically affect businesses with exposures in the yen, the baht and the Singapore dollar.

Therefore, it will be prudent for businesses to hedge and protect against such a potential rise in 2005.

SOLUTION: How a US company hedged its dollar/yen exposure and managed currency risk.

• Forward plus. A company was buying products from Japan and had to pay yen to settle balances. It wanted to fix the cost of purchases, and therefore determine selling prices and profits. Having seen strength in yen already, it was not happy with the dollar/yen exchange rate but had to protect against further deterioration and try to claw back some gains if markets moved in that direction.

We advised the client to use a forward plus option contract. It would buy the right to purchase yen at predetermined rates. If the markets moved in its favour, it could use that rate. The window of gain was limited to a certain level and any gains beyond the trigger would lock it back into the synthetic forward rate.

The client bought for six months out:

• Buy yen call at strike rate of 109.

• Sell yen put at strike rate of 109 with kick-in trigger at 102.

This means the client has the right to buy yen at 109 on the expiry date. However, if the exchange rate trades below 102, the client would be locked into the 109 rate. Since the exchange rate did not hit the trigger level, the client was able to buy yen at 109 when the spot exchange rate was 104.

The client had to buy ¥100 million a month. Had it not hedged, it would have had to buy at 104, that is, $961,550. Due to the hedge, it was able to buy at 109, that is, $917,450. It saved $44,100 a month.