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What is currency hedging?

It is foreign exchange trading aimed to minimize risk from currency fluctuations.

Aug 05,2008
Do you know what a hedge is?

Outside the world of finance, a hedge is a row of bushes or small trees, usually set along the edge of a garden, field or road as a kind of fence.

But in finance, a hedge is an investment designed to act as a fence against the risk in another investment.

There is a specific type of hedge called currency hedging.

This type of investment is of interest to Korean firms that earn foreign currencies from their exports. This means that instead of making money in Korean won, a company earns dollars, or euros, or other foreign currency.

Most of these kinds of Korean firms make currency-hedging contracts. These contracts are needed because some firms have to deal with more than one currency: in their case, the price of producing goods in one country is fixed in one type of currency, while the finished goods will be sold in another currency. This creates the risk that any change in the value of each currency would cut into profits. Currency hedging is a way for companies to limit the impact of foreign exchange risks.

For example, say a Korean shipbuilder gets an order for a new ship from a European country. The European buyer will pay the Korean shipbuilder in euros, in tranches over the course of several years, until the ship is delivered.

But during those years, the value of the euro against the Korean won may change. So the shipbuilder’s revenue in the local currency will also change. In particular, if the euro’s value drops while the won stays the same, the shipbuilder’s earnings in terms of won will also fall sharply. Of course, if the euro climbs against the won, the Korean company will benefit.

Even so, this kind of risk is troubling to exporters. That’s why they practice currency hedging.

Companies are bound to make at least some money from changes in currency values, so export-heavy firms also make contracts with banks and other financial institutions to sell their currency earnings at a fixed exchange rate on a certain date. With such a contract, a Korean company can avoid losses from a fall in the value of a foreign currency like the euro against the Korean won. But it’s a trade-off, because the firm also gives up its claim to possible profit from a rise in the euro against the won. These contracts are called derivatives.

There are various kinds of derivatives for currency hedging. Typical derivatives are currency futures and forward exchanges. Both derivatives are contracts to trade foreign currencies at a certain fixed rate at a designated time. But those who deal with the two derivatives and the character of the derivatives are different from each other.

Currency futures are traded on the Korea Exchange just like stocks. The derivative is offered to the public on the exchange. Forward exchanges are traded between two parties outside the market. The exchange rates and the time periods differ, depending on the agreement of the two parties.

This year, many exporters have faced great losses due to something called “Knock In Knock Out,” or KIKO. Despite having currency-hedging contracts, companies have suffered losses because of KIKO. Essentially, the contract that was meant to be a safeguard ended up making them lose money.

How did this happen?

In the last two years, shipbuilders saw a boom in orders. So the number of companies who wanted to make advance contracts to sell dollars increased sharply. But there were only a few financial institutions which would buy dollars through the contracts. Accordingly, companies had to make contracts to sell dollars at lower and lower rates against the Korean won.

At this point, a new derivative called KIKO appeared. It was a contract under which exporters could sell their dollar earnings at a higher exchange rate against the Korean won than the market exchange rate. This could happen under one condition.

Under the contract, if the market value of the dollar strengthens against the won above a certain limit, exporters have to sell their dollar holdings at a lower rate than the market exchange rate. So this contract can seriously damage exporters if the dollar strengthens against the local currency, while it is good for the exporters if the dollar remains weak against the won.

Last year, the dollar was weakening against the won. Most economic think tanks forecast that such a trend would continue this year.

Accordingly, many exporters made KIKO contracts last year.

But this year, the dollar unexpectedly strengthened sharply against the won. The won has plunged 8 percent against the dollar this year. So the market value of the dollar exceeded the level set under KIKO contracts. Under the contract, many companies had to sell their dollars at a much-lower rate against the won than the market exchange rate, facing huge losses. Some companies that made a lot of KIKO contracts are now suffering from serious financial problems.

Korea’s Financial Supervisory Service said on Sunday that 519 businesses, including 480 small- and midsized enterprises, were involved in $10.1 billion worth of KIKO contracts sold by banks as of the end of June. Local exporters reported a combined $258 million loss in the trades, the financial regulator said.

In this situation, small exporters and banks are now in a dispute. The exporters argue that banks had not sufficiently warned them that the exporting companies could risk great losses from the KIKO contracts when they made the contracts. Some of the companies are considering suing banks for damages. Meanwhile, banks argue that they sufficiently explained the possible losses and that many exporters benefited greatly from the contracts last year, when the dollar was weak against the won.

Amid such disputes, the Fair Trade Commission last month investigated banks after complaints from small exporters. The antitrust agency cleared banks of misrepresenting KIKO contracts sold to companies.

Business associations expressed disappointment over the investigation result. The FSS said Sunday that it will strengthen checks on banks’ sales of currency options. Regulators will tighten monitoring of whether banks are complying with their obligations, such as informing customers of the risk, it said.


By Cho Min-geun JoongAng Ilbo/ Moon So-young Staff Writer [symoon@joongang.co.kr]



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