Hedging European Union subsidies against exchange rate risk The case of Jönköping County rural entrepreneurs

Master’s Thesis in Business Administration Authors:

Barbara Pięta Gergana Tanova

Tutors:

Agostino Manduchi Mark Bagley

Jönköping

May 2014

Acknowledgements First and foremost we want to acknowledge our tutors, Agostino Manduchi and Mark Bagley for their impact on our thesis through supervision, criticism and advice. We enjoyed the constructive seminar group meetings with the teachers and our colleagues. Shi Chen, Imran Khanbhai, Asma Mohamad Jaber Al Jafari, Sebastian Reijo Westerlund and Xueying Zhang, thank you kindly for your feedback. We would like to show gratitude towards the contact persons in the organizations we consulted, without whom we would not be able to obtain all the necessary data: Nicklas Bengtsson from LRF, Tomas Eriksson from the Swedish Board of Agriculture, Philip Grist from Danske Bank and Christian Hjalmarsson from Nordea. English is not our native language, therefore we decided to ask for support with linguistic correctness of the thesis for which we thank Joanna Peksa. Last, but not least, we want to show gratefulness to our families and friends, who motivated us during the entire Master degree studies and gave us strength throughout the process. We dedicate the thesis to our parents, Sylwia Pięta, Zbigniew Pięta, Milka Tanova and Hristofor Tanov. It would not be possible without you.

Barbara Pięta and Gergana Tanova

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Master’s Thesis in Business Administration Title:

Hedging European Union subsidies against exchange rate risk. The case of Jönköping County rural entrepreneurs

Authors:

Barbara Pięta and Gergana Tanova

Tutors:

Agostino Manduchi and Mark Bagley

Date:

2014-05-11

Subject terms:

hedging, subsidies, European Union, primary sector, derivatives securities, forward contracts, futures contracts, options, exchange rate, Euro, Swedish Krona

Abstract This thesis focuses on the exchange rate risk faced by the Jönköping County rural entrepreneurs. They receive subsidies from the European Union funds. Although the farmers are paid in Swedish Krona, the value of the support is bound to Euro. We address the problem of lack of knowledge about hedging possibilities among the small entrepreneurs. We describe the currency derivatives instruments, the offers for hedging provided by banks and online investment and give our suggestions on how to make the choice between them. The latter we build on the exchange rate volatility calculations, amounts of subsidies from previous years and information from hedging instruments providers. The findings are targeted to farmers in Jönköping County, but can apply to wider groups of recipients, like small and medium enterprises receiving support bounded to other currency or companies engaged in export and import activities.

ii

Table of Contents 1 Introduction ............................................................................... 1 1.1 1.2 1.3 1.4

Background ............................................................................................1 Problem statement .................................................................................2 Purpose ..................................................................................................2 Research questions ................................................................................2

2 Theoretical Framework ............................................................. 3 2.1 2.2 2.2.1 2.2.2 2.2.3 2.2.4

Hedging ..................................................................................................3 Derivatives instruments ..........................................................................4 Forward contracts ...................................................................................5 Futures contracts ....................................................................................6 Options ...................................................................................................9 Margin accounts ................................................................................... 11

3 Methodology ............................................................................ 12 3.1 3.2 3.3

Research method ................................................................................. 12 Data collection ...................................................................................... 12 Data analysis ........................................................................................ 12

4 Results ..................................................................................... 12 4.1 4.2 4.3 4.4 4.5 4.5.1 4.5.2 4.5.3 4.5.4 4.5.5 4.6 4.7 4.8

Subsidies .............................................................................................. 13 Impact of exchange rate volatility ......................................................... 14 Hypothetical subsidies .......................................................................... 17 Hedging cases ...................................................................................... 18 Banks’ services .................................................................................... 19 Danske Bank ........................................................................................ 20 Nordea.................................................................................................. 20 SEB ...................................................................................................... 21 Svenska Handelsbanken ...................................................................... 21 Swedbank............................................................................................. 22 Online trading ....................................................................................... 22 Taxes in Sweden .................................................................................. 24 An alternative ....................................................................................... 26

5 Discussion ............................................................................... 27 5.1 5.2 5.3 5.4

Deciding on the hedging strategy ......................................................... 27 Alternative solutions ............................................................................. 28 Limitations and generalization .............................................................. 29 Suggestions for future research ........................................................... 30

6 Conclusions ............................................................................ 30 List of references ......................................................................... 32

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Figures Figure 2.1. Forward contract payoffs ...................................................................6 Figure 2.2. Buyer's and seller's margins .............................................................9 Figure 2.3. Holder’s payoff from the call option ................................................. 10 Figure 2.4. Holder’s payoff from the put option ................................................. 11 Figure 4.1. Daily exchange rate April 2004 - March 2014 ................................. 14 Figure 4.2. Wheat spot price April 2013 - March 2014 ...................................... 26

Tables Table 2.1. Margin dynamics for the buyer ...........................................................8 Table 2.2. Margin dynamics for the seller ...........................................................8 Table 4.1. Subsidies 2011-2013 in Swedish Kronas and Euros ........................ 14 Table 4.2. Volatility calculations ........................................................................ 15 Table 4.3. Gains and losses for 2011-2014 ...................................................... 15 Table 4.4. Primary sector incomes 2007-2012 .................................................. 16 Table 4.5. Value of subsidy per hectare ............................................................ 17 Table 4.6. Hypothetical incomes ....................................................................... 17 Table 4.7. Outcome of hedging for the farmer................................................... 19 Table 4.8. Bank's opportunities ......................................................................... 19 Table 4.9. Examples of changes in income ....................................................... 27

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1

Introduction

In our thesis we investigate a possible solution to the problem of rural enterprises in Jönköping County as we conduct the study for the case of Lantbrukarnas Riksförbund (LRF), the Federation of Swedish Farmers. Some of their members receive subsidies from the European Union funds. The money is transferred to them by Jordbruksverket, which is the Swedish Board of Agriculture. The currency they receive is Swedish Krona, but as the institution is given the money in Euros, the value of the support is determined by the exchange rate and the farmers face the risk of its volatility. When the rural entrepreneurs apply for the funding, they do not know the spot exchange rate for the time of the money transfer. This is why it is probable that the subsidy received in Swedish Krona will be in fact smaller than expected when expressed in Euro. For this reason there is a potential need for small entrepreneurs to hedge the value of a future subsidy.

1.1

Background

The Federation of Swedish Farmers is the biggest organization in Sweden gathering small enterprises. It has not only 170 000 individual members from 90 000 companies, but also agriculture and forestry cooperatives as associates (Lantbrukarnas Riksförbund, 2012). One of the most important features of the institution is its focus on the green industry. Their mission is to create an impact on the growth of Sweden as a country. They also help farming and forestry companies improve their profitability, growth and quality (Lantbrukarnas Riksförbund, 2014a). In political terms the organization claims to be completely independent. It is financed by the membership fee and its own businesses and financial activities (Lantbrukarnas Riksförbund, 2014b). The main organization is non-profit, but it has several portfolio companies the aim of which is to collect gains. They are: LRF Media, LRF Konsult, Sånga Säby, Svensk Sigill, Macklean Consulting, LRF Samköp and LRF Försäkring. Swedish farmers apply for and receive the financial support from the European Union in accordance to the Common Agricultural Policy (CAP). This policy was launched in 1962 as a partnership between the European society and agriculture (European Comission, 2012). The main aim of CAP is to develop agricultural productivity in order to ensure stable supply of food for consumers at an affordable price. In addition, it is oriented towards securing European farmers’ profits. The CAP is one of the oldest policies of the European Union and it has been amended many times over the years to reflect the changing environment and the needs of the citizens of the member countries. Overall, the CAP aims at the development of the countryside areas, where the agricultural sector is the main employment source for population. The policy is financed by two funds which are part of the European Union budget – the European Agricultural Guarantee Fund and the European Agricultural Fund for Rural Development. Based on the two types of funding sources there are also two types of payments.

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The European Agricultural Guarantee Fund is giving direct payments to farmers in response to market demand. The payments are supposed to support farmers’ income and are not linked to production but to meeting standards regarding food safety, environmental protection together with animal and land welfare. According to LRF Konsult’s accountant this single payment scheme1, accounts for 50% of the total subsidies received in Jönköping County. The European Agricultural Fund for Rural Development is financing the development programs of the Member States. In Sweden, this is the support for less favored areas in correspondence to the Rural Development Program (Jordbruksverket, 2014a). The funding aims at improving the competitiveness of farming and forestry, protection of the environment and the countryside, and the improvement of rural life quality and economy. In order to receive a payment from the European Union, one should own at least 4 hectares of farmland (Jordbruksverket, 2014b).

1.2

Problem statement

Considering the fact that the financing which the rural entrepreneurs obtain is highly dependent on the exchange rate between Euro and Swedish Krona, the volatility of this rate can be a crucial determinant of the subsidy value received in home currency. This is why the farmers need to take into account the currency price fluctuations. Then, they can determine how many Swedish Kronas they will have transferred and what the possible loss on the subsidy can be. The measured reduction may be a starting point in respect to whether farmers will be reluctant to encounter this decrease in the financial support. Thus, they have the opportunity to undertake some kind of insurance trading. Consequently, hedging the subsidy against the exchange rate risk can be one solution to reducing the loss on the subsidy and securing the farmers’ income. Furthermore, the individual preferences and demands will be a leading factor in deciding which opportunities to consider in order for constructing a hedge. This can refer to the choice among banks’ or brokers’ services as well as among different ways of hedging.

1.3

Purpose

The purpose of the thesis is to create a decision base for the primary sector entrepreneurs from Jönköping County on if and how to hedge the value of their subsidies provided by the European Union’s funding to limit the effect of fluctuations of the exchange rates on which it depends.

1.4

Research questions

How much can the farmers lose without hedging and what impact does it have on their income? Since the subsidy is paid to the farmers in Swedish Krona but it is still bound to Euro, its value depends on the exchange rate set by the European Central Bank. Thus, it can go up or down in response to the fluctuations. This movement defines if the farmers will 1

Also called farmers support, Gårdsstöd in Swedish.

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encounter a loss and if so, of what amount. This might be the case if they do not engage in hedging activities and face the ordinary scenario. Overall, the impact of the loss depends on what share of the farmers’ profits is composed of the subsidy. What are the possible options for hedging for rural entrepreneurs provided by the banking sector in Jönköping County? After estimating the possible loss or respectively gain to be encountered due to the exchange rate fluctuations, there is a need to consider what choices exist for individual and corporate entrepreneurs for trading currencies. The main strategy of the trading would be to reduce the effect of fluctuations in the exchange rate on the amount of subsidy the farmers receive. What are the possible options for hedging for rural entrepreneurs provided online? If we need to consider different alternatives a rural entrepreneur can have in order to hedge and trade derivatives, we cannot rule out the opportunities provided by the online brokers. This is because the services on the Internet tend to be more convenient for their users.

2 2.1

Theoretical Framework Hedging

A currency hedging transaction consists of making an investment to offset the risk of exchange rate movements. This is done by taking an opposite short position to the current value of an asset expressed in one of the currencies. A perfect hedge is supposed to reduce the risk to zero, so that the investor pays only the cost of it. In practice this kind of hedge may not exist. There is also no guarantee that the outcome will be better than without the additional investment. This may happen if the exchange rate changes unfavorably for the investor on some future date. However the most important for a person that is engaging in hedging activities is that the uncertainty and risk are decreasing. Companies doing business in the international environment experience the volatility of exchange rates which influence their cash flows, profits and market value (Chang, Hsin, & Shiah-Hou, 2013). The fluctuations may be predicted but even then the unfortunate movements may pose a risk for entrepreneurs. Besides there is always a possibility of unpredicted changes which cannot be anticipated. For these reasons many choose to hedge the potential for a loss in the future and in order to reduce the risk of the volatility of different factors affecting their business, which cannot be forecasted with certainty. When receiving payments in a foreign currency, the business will be influenced by the change in the exchange rate between the received and domestic currency. The owners can lose or gain, accordingly to the size of the change and amount of the gains. A potential problem when the market for a currency is small is that the demand for hedging can affect the spot price by increasing its volatility. This is possible as the exchange rate is affected by the producer’s increased demand for securing the price in the present time (Acharya, Lochstoer, & Ramadorai, 2013).

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One of the most popular ways of decreasing financial uncertainty and risk is by using derivatives securities (Rambo, Main, & Beaubien, 2011), especially in manufacturing and the primary sector (Brunzell et al., 2011). This is also the easiest way for entrepreneurs to hedge currencies. On the other hand, small companies face the cost of risk management as an obstacle for hedging activities (Dolde, 1993). The usage is also frequently withheld due to the lack of knowledge about the market operations. In addition to these concerns are the liquidity risk and the transaction costs (Alkebäck & Hagelin, 1999). Enterprises engage in different hedging practices and policies depending on the place where they are operating. There are studies making relative comparisons between countries (Alkebäck & Hagelin, 1999; Bodnar & Gebhardt, 1999; Pramborg, 2005). Thus, companies in various locations are compared based on the reasons for derivatives usage which stem from the differences in their economic state and past trade of these instruments (Alkebäck & Hagelin, 1999). Also based on the volume of traded instruments, there is higher or lower demand for certain derivatives. When the derivatives market is just developing, the limited knowledge and its maturity can lead to higher fixed costs when engaging in hedging activities. Thus, the incentive to invest may decrease. If a market is well-developed, there are more users who increase the liquidity and accessibility of these instruments, hence more traders will choose to invest in them. Different practices to manage the exchange risk are employed, depending on the possibilities in a country and a company’s governance structure. In Sweden the derivatives market is well developed which makes it easier for firms to hedge (Pramborg, 2005). Hedging is the main reason for their usage for Swedish firms. Larger companies use derivatives more than smaller firms because of the possibility for economies of scale on the market, these come from the decrease in transaction costs due to the bigger trading volumes. Not only the higher transaction costs due to the low trade but also the lack of knowledge, as mentioned before, is a major concern for financial managers in the smaller firms in Sweden (Alkebäck & Hagelin, 1999).

2.2

Derivatives instruments

Currency derivatives can have a positive impact in reducing firms’ exposure to the exchange risk. They are used for two purposes: speculating which reflects the profit seeking, and hedging (Brunzell, Hansson, & Liljeblom, 2011). In our case though the farmers would engage in the speculation in order to hedge. This is caused by the fact that they do not receive the subsidy in Euro, but the value they obtain depends on the Euro - Swedish Krona exchange rate. The profit or loss they make on the investment is used to equal out the difference of price of Euro expressed in Swedish Kronas. Derivatives hedging is mostly used to manage the foreign exchange risk. Smaller firms choose exchange-traded products, medium firms use more futures contracts and larger ones rather select over-the-counter products (Alkebäck & Hagelin, 1999). Most widely used derivatives are futures, forwards contracts and options (Bodnar, Hayt, & Martson, 1998; Bodnar & Gebhardt, 1999).

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There are possible gains and losses depending on the type of hedging instrument chosen by an agent. We decided to focus on three above mentioned derivatives instruments as we consider them to be most appropriate for rural entrepreneurs to hedge the value of their subsidies. We present the characteristics of each of them together with the costs and benefits pertaining to them. 2.2.1

Forward contracts

A forward contract is an agreement to buy or sell an asset at a given time in the future and for a certain price. In the case of forward contracts the parties are free to structure and agree on the conditions and stipulations of the contract in a way that best fits both of them. The forward contracts are generally signed over-the-counter by using a financial institution as an intermediary between the two parties having opposite needs and willing to enter such a contract. A bank can play a role of repository of information about customers’ demand and be able to tailor the forward contract in accordance to their needs (Grossman, 1992), but it can also be a party in an agreement. When the forward contract is used for trading currencies one side agrees to sell a specified amount of currency in exchange for another on a chosen day in the future. On the contrary, the other party is obliged to make the opposite transaction – give the second currency, receiving the first one on the same, set out beforehand date. The most important feature of the forward contracts is that the two parties are legally obliged to fulfil them. Besides this, the obligations should be met on a fixed date. In addition, there is no premium to be paid by the parties (Cont, 2010). This is due to the fact, that the contracts are over-the-counter instrument. The greatest advantage of the forward contracts is that they are tailor-made. There are no restrictions ruling the agreements. The parties can determine whatever time to maturity, volume and price of the contract is suitable for them. On the other hand, there is a drawback of this feature. Once a person signs it, she or he must deliver a promised currency, even if the change in conditions is not in favor. To give an example of a forward contract we can assume that there is a Swedish company exporting dairy products to Norway and another importing salmon from there. The first one is receiving Norwegian Krone for the goods sold and the second one needs it in order to pay for the fish. The payments from and to suppliers respectively to obligations are due in three months from today and their amounts are around 200 thousand Swedish Kronas. Hypothetical current spot price is equal to 1.1 Swedish Krona per Norwegian Krone and there is a decreasing tendency in the given exchange rate. The two firms can reduce the volatility of their income by currency hedging and signing a forward contract with each other. Taking into consideration the current trend in the exchange rate between the currencies, the parties agree to convert 1.05 Swedish Krona for 1 Norwegian Krone. In three months the dairy products company transfers 190.5 thousand Norwegian Krone to the salmon-importing firm and receives 200 thousand Swedish Kronas. The more problematic part with forward contracts comes from the spot exchange rate on the date of delivery. If the Swedish Krona appreciates less than agreed or depreciates in respect to Norwegian Krone the importing company loses money and the exporting one

5

“wins” the contract. If the opposite is true, the first one gains from the forward contract and the latter one “loses”. The possible payoffs are shown in Figure 2.1. We shall keep in mind that the parties did not engage in speculating activities in order to make gain on the hedge, but to equal out the fluctuations of exchange rate affecting the value of one currency expressed in the other. The main point of hedging is the reduction of uncertainty and this is what is secured no matter what end outcome may be.

Figure 2.1. Forward contract payoffs Source: own calculations.

2.2.2

Futures contracts

Futures are very similar to forward contracts. These are also agreements between two parties but with very important differences in particular. Futures can only be signed at organized markets. The institutions offering them are called clearing houses. These entities stand between buyers and sellers, signing separate contracts with them so that they do not interact with each other. Second difference is that futures are traded on open exchange markets and thus their price is determined by the demand and supply of the market (Hull, 2012). This includes uncertainty concerning the future price of the currency one would like to purchase or sell. The gains and losses from the contracts are settled on a daily basis as the new prices are reflected in the existing contracts as well. This leads to the fact that while forward contracts charge a gain or a loss only at the maturity, the futures contracts’ value is calculated continuously in a process which is called marking-to-market. Thus, there is not a single delayed to maturity payment but there are some additional cash-flows involved due to a current change in price. It is argued though that besides unequal pricing methods the volatility of forward contracts and futures is identical (Lioui, 1998).

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Another element of futures are the margin accounts. A trader is obliged to keep certain amounts of cash on these accounts when being a party in such contract. Both marking-tomarket and margins are clearing house’s insurances of the liability of the buyers and sellers using its mediation. If one party defaults, the organization must execute the contract signed with the other one. This is why the organization sets initial and maintenance margins. The first ones are the sums which must be put on a special account of a clearing house when entering a futures contract, the latter are the lowest possible amounts which should be kept there. In practice, a trading person needs to have in the account the sum of money between the initial and the maintenance margin. Once their boundaries are crossed, positive or negative cash flows are transferred. If the sum in the account is lower than the maintenance margin, the margin is called. This means that the trader must put more money on the account. If there is more money than required in the initial margin, a person can withdraw the difference from the account. The margins are set individually for buyers and sellers, accordingly to the risk of execution of the contract. They are calculated based on the probability of default and trust of clearing house towards a trader. A significant advantage of futures contracts is their liquidity. Due to the restricted possible maturities and the market price of the agreements the traders’ activity is higher, causing greater trading volumes. This also allows easy exit of the contract. A person who wants to leave a futures agreement simply buys an opposite one with the closest maturity and value. All of the above may not be true for currency markets which are not very liquid and are constrained by the limited number of futures contracts available. For this reason, a more effective way would be to enter a forward contract or buy an option. The mismatch in maturity and the date when a currency is needed cause several problems as well. Traders involved in hedging usually choose the next or second next possible maturity if the former is too close, in order to avoid turbulences. For better understanding we provide an example of margin account dynamics in a futures contract. Let us assume that there is a Swedish person working in the United States and her or his American equivalent. Both of them decide to return to their countries and are planning to convert their future salary to the respective home currencies. They want to hedge a potential loss when converting the money. Each futures contract consists of ten thousand units and the spot price of the contract is 65.5 thousand Swedish Krona. The American wants to buy 30 thousand United States Dollars with Swedish Kronas, so she or he enters three futures contracts with most appropriate maturity as a buyer. The Swede would like to sell 20 thousand United States Dollars for Swedish Kronas, which is why she or he enters two futures contracts as a seller. Here the advantage of futures over forward should be noticed: as there are many traders on the market a perfect fit between the parties is not required. For simplicity of the calculations we assume that the clearing house measures the risk of traders to be similar and sets the same margin accounts for both of them: the initial at ten thousand and the maintenance at eight thousand, expressed in Swedish Kronas. The dynamics for the American, as a buyer of the United States Dollars, are shown in Table 2.1. For this person the change in exchange rates was beneficial, as the total gain from the hedge

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equals three thousand Swedish Kronas which is the sum which could have been withdrawn for the period of ten days. Table 2.1. Margin dynamics for the buyer

0

Price per unit 6.55

1

6.51

-0.04

-1200

0

8800

2

6.52

0.01

300

0

9100

3

6.57

0.05

1500

-600

10000

4

6.58

0.01

300

-300

10000

5

6.63

0.05

1500

-1500

10000

6

6.65

0.02

600

-600

10000

7

6.6

-0.05

-1500

0

8500

8

6.61

0.01

300

0

8800

9

6.59

-0.02

-600

0

8200

10

6.65

0.06

1800

0

10000

Total

3000

-3000

Day

Daily change per unit

Daily gain or loss

Call or withdrawal

Margin 10000

Source: own calculations.

The margin dynamics for the Swede, as a seller of the American currency can be seen in Table 2.2. It is easily noticed, that the change in United States Dollars was unfortunate for this person. The loss from the hedging activity for the first ten days is equal to two thousand Swedish Kronas. The Swede has had to bring in 800 Swedish Kronas for the margin account. Table 2.2. Margin dynamics for the seller

0

Price per unit 6.55

1

6.51

0.04

800

-800

10000

2

6.52

-0.01

-200

0

9800

3

6.57

-0.05

-1000

0

8800

4

6.58

-0.01

-200

0

8600

5

6.63

-0.05

-1000

2400

10000

6

6.65

-0.02

-400

0

9600

7

6.6

0.05

1000

-600

10000

8

6.61

-0.01

-200

0

9800

9

6.59

0.02

400

-200

10000

10

6.65

-0.06

-1200

0

8800

Total

-2000

800

Day

Daily change per unit

Daily gain or loss

Call or withdrawal

Margin 10000

Source: own calculations.

In Figure 2.2 we can see clearly when the ten or eight thousand barriers were crossed and the gains could have been withdrawn or margins must have been called. For the American there was a possibility of withdrawal on four dates and for the Swede there was one occasion when the margin was called and three times withdrawal option.

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14000 12000

seller's margin

10000 8000

buyer's margin

6000 4000 2000 0 0

1

2

3

4

5

6

7

8

9

10

Figure 2.2. Buyer's and seller's margins Source: own calculations.

2.2.3

Options

Options are securities which are a kind of an insurance, giving their holder the right to buy or sell a given currency from or to their writer. They can be traded both on exchanges and over-the-counter. Price at which a transaction takes place is called exercise or strike price, and is always stated in the agreement. The currency on which the option is written is called the underlying and determines its price – the option premium (Hull, 2012) – which is a cost for the buyer. This is the greatest difference between this instrument with the forward and the futures contracts. It is caused by the fact that the provisions of these contracts are fixed while the holder of an option can decide whether to use her or his right or not (Dow & Kunz, 2009). In case of unfortunate change of the spot market the only cost for the trader is the option premium, while when using forward or futures contracts there can be a significant loss to be beared. The option exercise timing determines two basic option types. European options can be exercised only on the maturity day while the American ones – anytime during trading hours before expiration (Hull, 2012). Almost all options traded in Sweden are American, and only several are European (Nasdaq OMX, 2014). If the current exchange rate is more beneficial for the holder of a currency option, he or she does not exercise it and simply waits until it expires. Then, the person can acquire the needed currency at the spot market at favorable conditions. There are two kinds of these currency derivatives. Calls give the holder the right to buy the underlying currency. Puts give the holders the possibility to sell it. The payoff from a call option is the difference between the price at maturity and the strike price. For a put option it is the difference between the strike price and the price at maturity. An example of options when trading the currencies can be two Swedish companies doing business in China. One of them is selling franchise and the other one is buying support

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accounting services. The former company wants to convert 150 thousand Chinese Yuans which is supposed to receive in future to Swedish Kronas, the latter one needs to buy 50 thousand Chinese Yuans for Swedish Kronas to pay the supplier. Both of them can solve the problem of uncertainty and possible change in exchange rate to less favorable than the one on the spot market buying currency options. The franchising company chooses to purchase a European call with a maturity close to the payment date with a strike price equal to 1.04 and pays a premium for it. The possible payoffs from the option are plotted on Figure 2.3. If the price at maturity is higher than the exercise price, the company will choose to use the option. The greater the difference between the prices, the higher the gain from the hedge will be.

Figure 2.3. Holder’s payoff from the call option Source: own calculations.

The outsourcing company, due to its necessity of Chinese Yuans, purchases a put option giving it the right to sell Swedish Kronas for the former currency. The instrument’s strike price is also equal to 1.04. The possible payoffs can be found in Figure 2.4. This time the outcomes are the opposite. If the price at maturity is higher than the exercise price, the firm does not use the put and waits until it expires. If the strike price is greater though, the holder executes the option and seizes the positive outcome from the hedge. Again its seize depends on how big is the difference between the prices.

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Figure 2.4. Holder’s payoff from the put option Source: own calculations.

2.2.4

Margin accounts

The margin accounts were introduced in the section 2.2.2, as their importance is the greatest for futures contracts. Nevertheless banks and trading brokers require their clients to introduce certain sums in order to start using their services, also in the case of forward contracts and options trading. In general, the financial intermediaries are used by traders because they can absorb part of the credit risk (Cotter & Dowd, 2006). In turn, the brokers impose the requirements for margin accounts as an insurance for themselves in cases when the investors are not able to pay their obligations or when the prices change more than initially expected (Gemmill, 1994). The margins are set in correspondence with the current market conditions and the market volatility (Cotter & Dowd, 2006). Thus, when major economic shocks are expected, the margins may be higher. In order to set the initial margins, clearing houses use financial risk measures using systems of standard stress tests (Cotter & Dowd, 2006). These accounts are set to cover a potential loss from the daily price movements and in addition to this, intermediaries determine variation margin to cover the actual price change (Gemmill, 1994). The advantage of forward trading with margin calls is that the credit risk is essentially eliminated for the financial intermediaries while for the traders the margin accounts comprise the cost of using their services. Therefore, this can be seen as the price paid by investors to protect themselves from the market risk as they share it with the bank or broker. Margin accounts can reduce the trading volume and frequency as one of the reasons why trade for some derivatives on markets is smaller, is the difficulty to deal with the margin calls on a daily basis (Anderson, Hu, & Winchester, 2007). Therefore, the requirements for margins may lower the liquidity of the market for some instruments. As the exchange rate volatility is comparatively small, which we demonstrate later in Table 4.2, the margins issue shall not be that crucial when trading.

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3 3.1

Methodology Research method

In the thesis, the theory is described in the theoretical framework chapter, forming a base for empirical findings. This means that we use a deductive approach (Saunders, Lewis, & Thornhill, 2009) understood in a pragmatic way. The data in the study is gathered throughout the process of writing within a short time-horizon. We set out a cross sectional research, presenting the possibilities of LRF members to hedge the value of the received subsidies, portraying their situation, which is in line with the definition of descriptive research (Robson, 2002). The aim of the study is to provide the information needed to decide whether to take an action and if so, how to do it to the rural entrepreneurs from Jönköping County. The research’s incentive is the need for diagnosis of the LRF’s members and we are providing it in order for them to implement a change in their companies. This process is called action research (Saunders et al., 2009), where the focus of the study is given by a sponsor who is actively involved in it (Schein, 1999).

3.2

Data collection

In our study we have collected both primary and secondary data. We do that through meetings, phone calls, e-mails, interviews and internet research. First of all we receive information through consultations with Nicklas Bengtsson, our contact person in LRF. Our second source are the banks offering the hedging opportunities, which could be used by the LRF members. We gather the information via telephone conversations and e-mails. We also turn to the Swedish Board of Agriculture. We provide our own calculations and theoretical examples. The secondary data is taken from scientific articles and Thomson Reuters Datastream available to us through the university library and information found on the internet, for example historical exchange rates or Swedish market statistics.

3.3

Data analysis

Once all the data was collected it was analyzed from the perspective of LRF members. We display the reasons for these entrepreneurs to hedge currency, we show the pros and cons of each method available for them, namely forward contracts, futures and options. Also detailed information about entering such contracts with banks located in Jönköping is provided. In addition, we present our exchange rate volatility calculations based on historical prices and the possible outcomes without hedging Euro price in Swedish Kronas. We show the same estimations for daily wheat price.

4

Results

The deadline for application for subsidy was 3rd of April 2014. It is the same date for the single payments and for the less favored areas payments. The official decision that a farmer will receive the subsidy will be given at the end of November. Nevertheless according to the

12

contact person in the Swedish Board of Agriculture, Tomas Eriksson, the majority of the applicants, up to 95%, receive the support. In fact almost all of the farmers, even 99%, who obtained subsidies during the previous years, receive them again. The only situations that they do not is when they decide not to reapply. The reason for it could be long process and extensive required documentation. The exchange rate at which the value of the subsidy is converted into Swedish Krona is determined by the European Central Bank on the last working day of September. This means that there is half a year gap between the application for the subsidy, which we assume the rural entrepreneur is receiving, and the date on which the conversion exchange rate is decided. This means that the time period for which they may decide to hedge can last several months. The transfer of the money to the farmers is done on the first working day of December for the single payments. For LFA there are two payments – in the middle of November, when 70% of the sum is given to farmers, and at the end of December, when the final transfer is made. The Swedish Board of Agriculture is paying out the value of all subsidies and then the money is reimbursed to them by the European Commission upon statement of the distributed funds (Jordbruksverket, 2014c).

4.1

Subsidies

The subsidies given by the European Union funds are available on national governmental rural institutions websites. The Swedish Board of Agriculture provides data for two years back. We have been fortunate enough to charge the data for 2011 before it was replaced by 2013, so we have obtained it for the last 3 years. Unfortunately the sole proprietorship companies are not included in there. It is probably due to the fact that this legal enterprise form is not required by the state to disclose any financial information to the public. We have managed to obtain the additional information, including the subsidies given to the sole proprietorship firms. Based on this data, in the year 2013, 3.4 thousand entities in Jönköping County receive the support with the single payment scheme, which is the third biggest number in the country. The total amount of subsidies is equal to 250.7 million Swedish Kronas, which gives the county 12 place in comparison to the rest of Sweden. The average value per company is 74 thousand Swedish Krona. As the data from the Swedish Board of Agriculture’s website is more detailed we choose it for further calculations, besides the fact that does not contain full information. According to Tomas Eriksson less favored area support is not bound anyhow to the value of Euro that is why we disregard it in the further study. Whole financial support given to public entities in Jönköping County, received as single payments scheme, can be found in Table 4.1 (Jordbruksverket, 2014a).

13

Table 4.1. Subsidies 2011-2013 in Swedish Kronas and Euros

29 142 216

30.09.2011 EUR 3 144 120

29 470 685

28.09.2012 EUR 3 492 449

112 954

12 187

105 252

1 974 323

213 007

246 776

26 624

2011 SEK Total Average Maximum Standard deviation

27 398 987

30.09.2013 EUR 3 158 130

12 473

105 381

12 147

1 945 546

230 559

1 769 763

203 991

243 432

28 848

228 595

26 349

2012 SEK

2013 SEK

Source: own calculations based on the values of single payments provided by the Swedish Board of Agriculture (Jordbruksverket, 2014a).

The numbers in the table are expressed both in Swedish Krona and converted to Euro, based on the following exchange rates. On 30.09.2011 it was 9.2688, on 28.09.2012 it was equal to 8.4384 and on 30.09.2013 – 8.6757 Swedish Krona per Euro (Sveriges Riksbank, 2014). Total yearly numbers of subsidies received in the years 2011-2013 were almost 30 million Swedish Kronas, which corresponds to more than 3 million Euros. The average number of subsidy received is equal to more than 100 thousand Swedish Kronas so slightly more than 12 thousand Euros. Maximum value for the three years is almost 2 million Swedish Kronas, originally more than 200 thousand Euros, based on these values we can expect high standard deviation of the subsidies’ amounts. In fact, the volatility is higher than 225 thousand Swedish Kronas or more than 26 thousand Euros.

4.2

Impact of exchange rate volatility

At this point we want to show how much the exchange rate between Euro and Swedish Krona can affect the value of subsidies. In order to estimate the volatility daily historical prices from Swedish Central Bank’s website have been downloaded (Sveriges Riksbank, 2014) for the period from April 2004 till March 2014 (see Figure 4.1).

Figure 4.1. Daily exchange rate April 2004 - March 2014 Source: Swedish Central Bank (Sveriges Riksbank, 2014).

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The mean of daily exchange rate for three periods have been calculated, namely: ten years, five years and one year. We also find minimum and maximum values. Next, the continuous returns2 and their daily standard deviations have been estimated. As the scope of the thesis is how the exchange rate can change within the period of half a year we convert them into 6-month standard deviations3. The values obtained can be found in Table 4.2. Table 4.2. Volatility calculations Years 1 5 10

Average 8.7386 9.2081 9.2995

Minimum 8.3149 8.2065 8.2065

Maximum 9.097 11.201 11.6465

6-Month standard deviation 4.58% 5.47% 5.13%

Source: own calculations based on daily exchange rate from Swedish Central Bank (Sveriges Riksbank, 2014).

For the one year period the volatility is 4.58% with average value of 8.7386, minimum 8.3149 and maximum 9.097. Standard deviation is the highest when calculated considering five years data, as it reaches 5.47%. Then the average, minimum and maximum are equal to 9.2081, 8.2065 and 11.201 respectively. When estimating values for the ten years period, 6-month standard deviation is 5.13%, average exchange rate equals 9.2995, minimum is the same as the five years one and maximum increases to 11.6465 Swedish Kronas per Euro. To show the impact of the volatility we calculate how much the farmers have gained or lost on the exchange rate fluctuations during last three years or how much they could gain or lose in the current year. We take the approximate values of total, average, maximum and standard deviation of the subsidies based on the numbers from previous years. The data obtained is displayed in Table 4.3. Table 4.3. Gains and losses for 2011-2014 Years

03.044

2011

8.951

9.2688

3.55%

953 400

3 814

63 560

8 263

2012

8.7929

8.4384

-4.03%

-1 063 500

-4 254

-70 900

-9 217

2013

8.3234

8.6757

4.23%

1 056 900

4 228

70 460

9 160

8.7929

9.1956

6

6

1 208 144

4 833

80 543

10 471

8.7929

8.39026

-4.58%6

-1 208 144

-4 833

-80 543

-10 471

2014

30.095

Change

4.58%

3 M EUR

12 k EUR

200 k EUR

26 k EUR

Source: own calculations, Swedish Central Bank (Sveriges Riksbank, 2014) and the Swedish Board of Agriculture (Jordbruksverket, 2014a).

In the first column we show the years for which we provide the calculations. The second shows the values of Euro in Swedish Kronas from 3rd of April (Sveriges Riksbank, 2014) for each of them, as this is when the farmers apply for the subsidies. These are probably the Continuous returns are calculated as natural logarithm from change between given daily price and the previous day value. 3 6-month standard deviation equals daily standard deviation multiplied by the square root of 120, as it is assumed that 20 is the average number of trading days per month. 4 Only in 2011 it was 1.04. 5 Only in 2012 it was 28.09. 6 Forecast. 2

15

exchange rates which they use to calculate how many Euros they need to apply for based on their costs in Swedish Kronas. Third column contains exchange rates as from last trading day in September for respective years, so the one which is used by the Swedish Board of Agriculture to calculate the value of the subsidies in Swedish Krona. In the fourth column the percentage change in the April and September values is shown. Fifth to eighth column show how much money in Swedish Kronas the rural entrepreneurs have gained given the value of subsidy in Euro. In the headers M stands for million and k for thousand. The percentage of change for 2014 is the estimated before volatility of exchange rate based on last-year continuous returns. Given the probability of increase or decrease in value of Euro we assume that the change can be positive or negative. We calculate the possible exchange rate for 30th of September 2014. The value will be most probably somewhere between 9.1956 and 8.3902. Looking at the values from Table 4.3 we can conclude that the changes are very close to each other in absolute values, from 3.55% to 4.58% as the standard deviation estimated by us. This means that the gains and losses reckoned will be similar in absolute values as well. We can see in the table that given the total gain of the single payments received by the entrepreneurs in Jönköping County compared to the April value of Euro is equal to around million Swedish Kronas for every year. When taken into account the average value of subsidy received, the gain is deviating from 3.8 to 4.8 thousand Swedish Krona. The maximum support is worth eventually more by 63.6 to 80.5 thousand Swedish Krona. In terms of standard deviation, its value is different from 8 to 10.5 thousand Swedish Krona. In order to judge the importance of subsidies and securing their value for the rural entrepreneurs we need to know what percentage of their income consists of the support. In general we can notice a decreasing trend of financial support for the primary sector in the whole European Union. For the years 1995-97 it was around 34% of the total income while for 2009-11 - 20%, according to OECD’s report. The organization explains it mainly by the fact that the prices of rural products increased while the values of subsidies were dropping. In Sweden during the years 2008-10 the support is equal to 18%, while European Union’s average is 14% based on Eurostat’s data (Jordbruksverket, 2012). In 2012 the proportions are even smaller – 15% for Sweden, again right above the European Union’s average, which is equal to 13% (Jordbruksverket, 2013a). We find the data about the primary sector incomes for the years 2007-2012 in Sweden (Jordbruksverket, 2013b). The numbers in million Swedish Krona can be seen in Table 4.4. Table 4.4. Primary sector incomes 2007-2012 2007 48 850 M

2008

2009

2010

2011

2012

50 180 M

46 128 M

51 629 M

54 200 M

55 959 M

Source: the Swedish Board of Agriculture (Jordbruksverket, 2013b).

As we can notice in every year besides 2009, the value is increasing. This is why we can assume that in 2013 the income has been also greater than in the 2012. We calculate that the total sum of direct payments in Sweden, which is 5.9 billion Swedish Krona is equal to 10.4%

16

of the primary sector production the year before. This would mean that the single payment scheme is around 10% of total income of the Swedish agriculture. It shows the importance of the subsidies in the country. Even if the change in support value is small for a single entrepreneur, the accumulated gain or loss due to the fluctuations of exchange rates can have an impact on the Swedish economy.

4.3

Hypothetical subsidies

The amount of subsidy is different in each area in Sweden. The land is divided into five zones (Jordbruksverket, 2014b). Region 1 is receiving the highest support and region 5 the lowest. Jönköping County is comprised of two regions, 4 and 5. The amounts which are to be received per hectare in 2014 are reported in Table 4.5. The values presented in Euros by the Swedish Board of Agriculture, are converted into Swedish Kronas by using the average exchange rate calculated by taking last year daily exchange rates, which was equal to 8.7386 (see Table 4.2.). Table 4.5. Value of subsidy per hectare Cropland Currency

Pasture

EUR

SEK

EUR

SEK

Support for region 4

161.00

1406.91

129.36

1130.42

Support for region 5

128.55

1123.35

128.55

1123.35

Source: the Swedish Board of Agriculture (Jordbruksverket, 2014b).

To show the impact of subsidy we have provided five hypothetical examples of farmers receiving the support. The data can be found in Table 4.6. Table 4.6. Hypothetical incomes Type of land, region Income Hectares Subsidy Euro Subsidy Swedish Krona Loss or gain Loss or gain as % of income Subsidy as % of income

pasture, 4

cropland, 4

pasture, 5

cropland, 5

cropland, 4

100 000

200 000

400 000

500 000

600 000

17

25

45

79

100

2 199

4 025

5 785

10 155

16 100

19 337

35 391

50 865

89 296

141 566

886

1 621

2 330

4 090

6 484

0.89%

0.81%

0.58%

0.82%

1.08%

19.34%

17.7%

12.72%

17.86%

23.59%

Source: own calculations based on the Swedish Board of Agriculture (Jordbruksverket, 2014b).

For each of the rural entrepreneurs we have taken exemplar type of land together with region, income expressed in Swedish Krona and number of hectares to be considered as base for the subsidy. Next we calculate the value of support in Euro for each of them, multiplying the size of land with a corresponding value for the type of region from Table 4.5. Then we convert it into Swedish Kronas taking the exchange rate from 3rd of April 2014, equal to 8.7929, which is the last day to apply for subsidy and estimate the probable loss or gain based on the previously obtained volatility, 4.58% (see Table 4.3). Dividing the latter value by the amount of income we receive a percentage value – this is the relation between the change in subsidy due to the fluctuations in exchange rate. The fact that the highest value exceeds

17

slightly 1% implies that the change in subsidies will not be crucial for the farmers’ incomes. We also show that the values of subsidy are more or less corresponding to 15% given before as the percentage of subsidies to incomes of farmers in Sweden.

4.4

Hedging cases

Hedging the value of the European subsidy is not a new phenomenon. There is a recent example from the United Kingdom of farmers using forward contracts to set acceptable exchange rates (Strauss, 2013). One of the British banks claims that 15% of its farming clients are engaged in currency hedging. The reason is that it brings certainty to part of the rural entrepreneur’s income. Thus, some of the farmers state that they follow the exchange rate movements as much as they do with the weather forecasts. Since the subsidy is 40% of gains for a number of them a difference of a few thousand Great Britain Pounds is critical for them. Hedging the European Union subsidies is not new in Sweden neither. In 2009 4 thousand of Swedish farmers were involved in hedging (Birgerson, 2010). On average, their gain was 0.7 Swedish Krona per Euro. When choosing to hedge the European Union subsidy the rural entrepreneurs can obtain compensation for the Swedish Krona appreciation. A farmer hedging attempt in 2009 was not successful as the exchange rate between the Swedish Krona and Euro decreased. In 2010 her or his expectation was to gain more than 80 thousands Swedish Krona which was better than accepting the current exchange rate. We have received the information about one of the LRF members hedging the value of his subsidies. We have not been able to conduct the interview due to the language barrier, as he does not speak English. This is why we have used kindness of a Swedish Bachelor student also writing her thesis about hedging who has provided us with the following information. The farmer’s main area of business is cattle-breeding and meat production. His activities also include forestry. He studied two years in a secondary economic school. The entrepreneur receives yearly subsidy comprised of mostly less favored area support, which amounts to 250 thousand Swedish Krona. This sum is only increasing his salary to the taxation breakpoint of 380 thousand7 Swedish Krona. This is the income threshold for the state income tax which is paid only when the bound is exceeded. The value of the threshold is adjusted for inflation every year (Skatteverket, 2014). The entrepreneur claims that he does not have any costs in other currencies. The incentive to start hedging according to him was rather a seasonal pattern. Euro was expected to decrease in value during autumn time circulating. This was a simple method to raise the profits. The entrepreneur did not use online trading, but decided to use the services of a bank. He dealt the hedging issues in Swedbank as his intermediary. The instrument the farmer chose was a forward contract. Within a period of five years when the farmer was hedging the outcome was twice positive and once negative. He decided that the values were

7

It was exactly 383 thousand, see section 4.7.

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small (see Table 4.7), and he stopped securing of Euro-Swedish Krona exchange rate for some time. Table 4.7. Outcome of hedging for the farmer Positive value of hedging

30 000

Negative value of hedging

6 000

Net outcome

24 000

Source: the interviewee.

Currently the entrepreneur is hedging when he expects the outcome of the trade to be positive but not when the risk of losses due to exchange rate fluctuations is too high. His recommendation for persons who would like to hedge is to follow the exchange rates and try to make the best decisions based on the current market conditions.

4.5

Banks’ services

As a starting point we searched through the websites of all banks which are present in Jönköping, namely Danske Bank, Nordea, SEB, Svenska Handelsbanken and Swedbank. The information about financial instruments offered by the banks is presented in Table 4.8. Table 4.8. Bank's opportunities Forward

Futures

Options

Online service

Danske Bank

yes

no

yes

yes

Nordea SEB Svenska Handelsbanken Swedbank

yes no yes yes

no yes no yes

yes yes yes yes

yes yes yes yes

Source: Danske Bank (2014), Nordea (2014), SEB (2014), Svenska Handelsbanken (2014a) and Swedbank (2014a).

We can see that each of the banks offers at least one contract, either forward or futures, apart from Swedbank which is providing both. The derivatives are mostly tailor-made for investors. Online service is available for the customers of all banks. In addition to the information provided on the banks’ websites we gathered data through telephone conversations and email correspondence with representatives from different banks. The starting point of each conversation was explaining the situation which Swedish rural entrepreneurs face. Then, we have been asking whether the banks provide investing opportunities for hedging by using derivatives instruments, focusing on the forward contracts, futures and options. Further questions addressed the convenience of trading with each of the instruments and the way in which one can start the trade taking into account if such person needs to be a client of the bank, if she or he should physically go to the office, and if there is a possibility to use the bank’s online or telephone services. Later, based on the details given for the respective instrument we were interested in the size of contracts, possible maturity dates, commissions and fees.

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One needs to remember that there are certain regulations to be followed when engaging in hedging activities. For individuals, the farmers with sole proprietorship as legal status of their business, this is the Markets in Financial Instruments Directive (MiFID). The regulation is supposed to create competition between investment services through governing their provision by institutions offering financial instruments. Its main aim is to protect traders but also to increase the efficiency, transparency and resilience of financial markets (European Commission, 2014a). For corporate customers, the entrepreneurs whose companies are legal entities, European Market Infrastructure Regulation (EMIR) should be applied. Its goal is to achieve transparency on over-the-counter market to mitigate the risk associated with derivatives instruments and bring stability to the trade. The regulation is ensuring the transactions to be cleared and accessible to authorities in order to give an overview of the market (European Commission, 2014b). 4.5.1

Danske Bank

In order for an entrepreneur to hedge in Danske Bank she or he needs to be a customer of the bank. Thus, this person can come to the local office and meet one of the customer relations managers, who will assist them with advice and services. They would contact a specialist of currency markets from Stockholm, Gothenburg or Malmö. After having the credit lines approved, the entrepreneur is allowed to start trading. She or he can do that through an electronic banking platform, without coming to the bank. Danske Bank customer service is assisting when dealing with both MiFID and EMIR. In Danske Bank a farmer can enter a forward contract or buy an option selling Euros for Swedish Kronas at the moment when she or he knows that subsidy would be paid, as we assume at the moment of filing the application at the beginning of April. The maturity date of the contract or the option should be shortly after 30th of September. It can be set then for 2nd of October. Thus, the exchange rate is fixed when the agreement with the bank is made. The entrepreneur has the opportunity to choose a satisfactory level of it and enter the hedge. As the farmers do not receive the Euros, they have to buy it on the spot market on the last working day of September to be able to net out the forward contract or option due two days later. The difference between the exchange rate stated in it and the one from the last trading day of September is the profit or loss. If the value of Swedish Krona to Euro is higher in the contract, the hedge brings a gain; if it is lower, the outcome of the hedge is negative. This hedging strategy for a rural entrepreneur was proposed by Philip Grist working in the area of foreign exchange trade in Danske Bank. 4.5.2

Nordea

In order to use the bank’s services, one does not need to be a customer of the bank. Thus, entrepreneurs can sign a contract for/or purchase a derivatives instrument. There are two possibilities to hedge currencies offered in this bank taking into account the three derivatives that are the focus of the research. The entrepreneurs can enter a forward contract in April, if they are certain they will receive the subsidy. The price of the contract is determined by the spot price and the rate of the differences between the Euro and Swedish Krona currencies. The other way to hedge in Nordea is by buying a foreign exchange call option. The

20

instrument can be bought in April with maturity in December, when the money transfer happens. It is a possibility for a person who does not have cash to net out the hedge before receiving the subsidy. If exercise price is lower than the current spot, a farmer can sell at this specified spot rate. On the other hand, if the strike price is higher than the current spot, they do not use the option. Using options is a good way of hedging if a person is not certain what the decision for obtaining support would be. There are no limitations regarding the minimum amount to be hedged in Nordea. However if the amount of the subsidy is, for example, less than ten thousand Swedish Kronas, the potential loss is not significant. This is why the hedging may not be needed, following Christian Hjalmarsson’s advice. The bank provides online trading system, which is easy to use, and therefore, does not require much time. Especially taking into account that many of the rural enterprise owners live outside of Jönköping city. However if a person prefers to come to the office Nordea does not charge any fees for its services. 4.5.3

SEB

The bank provides many innovative investment solutions (SEB, 2014a), but for currencies mostly options are traded from the derivatives securities in our interest. For this reason when using the service of SEB, these instruments are recommendable as the most liquid ones. In order to get started with the trade of derivatives, the farmers shall come to the local SEB office. Then they have the possibility to choose and decide on the time period and provide the bank with the nominal value they wish to secure and further data about the company. Then, the information is forwarded to the office in Stockholm for the risk calculation. The contract is made in the way that best suits the customers’ needs according to our interlocutor from the head office. After the approval, the clients can start trading via telephone or the e-platform where they can use a trading station or internet office, making trade possible whenever they need it. The SEB’s platform has a 24-hour access with high speed of execution and connectivity. Currently 70% of the activities of clients related to the exchange rate are done by using the online services (SEB, 2014b). Real-time information about the exchange rates is provided in addition to reports and forecasts. The bank acting as a broker provides the opportunity to trade at a low cost and in a more efficient way. In addition, they have wide-reaching services which allow for multi-bank liquidity and reduced legal negotiating. In that way, trade is possible with many counterparties. The bank develops very good relationships with its clients as there is a Client Relations Manager and a corporate advisor at each office to assist in making the contracts and trading. 4.5.4

Svenska Handelsbanken

The bank provides different instruments for currency risk management (Svenska Handelsbanken, 2014a). Hedging with forward contracts refers to amounts above 100 thousand Swedish Krona and a time period not exceeding one year (Svenska Handelsbanken, 2014b). It can be an effective trading strategy when the customer wants to set a particular exchange rate for some moment in the future.

21

According to the Svenska Handelsbanken the currency options are suitable in the cases when the payments are done in a currency other than the one needed by a person. On the website, companies can use the online system for risk management. But they can also do that at every office of the bank with the help of consultants. Before starting to trade online they need to open an account in one of the branches. On the Svenska Handelsbanken’s website it is recommended to contact the advisors at the bank before taking an investment decision. 4.5.5

Swedbank

Swedbank provides a special offer for currency hedging of the European Union support. The level of the funding can be secured with a forward transaction at a predetermined price. A farmer is taking a position as a seller of Euros. When there is a currency loss, meaning that the value of Euro in Swedish Kronas is lower, the bank pays up to the determined price per Euro and in the opposite case the individual pays the difference to the bank. When, the Swedish Krona trend is to become stronger, the bank’s advice is to hedge the value European Union subsidies. They propose to hedge using currency options (Swedbank, 2014b). In the interbank market the amounts are high, for not tailored offers in the bank the minimum underlying value is one million Swedish Krona. This is why Swedbank allows lower amounts for small entrepreneurs. When buying an option the so-called framework agreement for option transactions is signed with the bank. Swedbank’s specialists can give advice about the foreign exchange option, the possible risks and opportunities. In addition to these possibilities, at Swedbank one can secure the European Union payments with futures (2014a). The contracts are signed at the beginning of the year and the farmer takes the position of a seller of Euros. She or he should put 10% of the contract value on the margin account as a collateral for the bank. The bank is acting as a clearing house. If the rate from the European Central Bank is set lower than the agreed one, at the expiration date in October, the farmer can buy Euros at the spot price and receive the value in Swedish Krona at the agreed rate. Thus, the entrepreneur will obtain a compensation from the bank corresponding to the difference in the exchange rates. This compensation covers the reduction in the support that the exchange rate causes and the farmer’s wins from the hedge. Therefore, the total compensation is equal to the initial amount of the subsidy the farmer is applying for in April. In the case of an increase in the exchange rate the farmer pays the difference between the agreed and the actual rate to the bank. As she or he should be buying the Euros at the higher rate but selling them at the agreed one. Thus, the actual compensation is the same but the entrepreneur loses from the hedge.

4.6

Online trading

Trading online can be potentially less costly and easier for the small entrepreneurs than using bank services. Thus it is potentially a better possibility for the LRF members to hedge. Nasdaq OMX Nordic is the Swedish stock exchange electronic platform. Nasdaq OMX is using high-speed technology. Thus, the new information can be provided very quickly regardless of its amount. This maximizes the liquidity and encourages price competition. The

22

trading platform is very well developed and offers functional innovativeness to the users (Nasdaq OMX Nordic, 2014). The times when the world currency options are traded are from 9.30 a.m. to 4.00 p.m. Central European time. Nasdaq OMX securities can be purchased or sold only through a broker. This is why the website would serve only as an information platform for the LRF members, where they can observe current exchange rate affected by the intra-day trades and also calculate the value of subsidy in Swedish Kronas (Nasdaq OMX Nordic, 2014). As there is a necessity of using broker services Select a Broker website was examined, where a person can find international brokers who operate in a chosen region and investments products which she or he would like to trade (2014). Using their services includes paying commissions and fees. Some brokers have requirements for a minimum amount of cash to be invested. The benefit of using an online broker is that they have the expertise needed for trading. Brokers provide technical analysis, market research, live quoting, and different types of orders for optimizing the transactions. The placing of orders can be done via websites, on the phone or using applications on mobile devices. If a client wishes so, a broker can prepare for her or him a potential trading strategy. Unfortunately not all of them trade with Swedish Krona. This is why we checked all of the brokers, which appeared after choosing Sweden as a region and Forex-Currencies in the filters. Out of many, only 16 trade Euro-Swedish Krona currency pair. These are: Armada Markets (2014), BelforFX (2014), EXANTE (2014), Forex Metal (2014), FoxTrading (2014), FreshForex (2014), Hantec Markets (2014), IFC Markets (2014), InstaForex (2014), IronFX (2014), MW (2014), NetoTrade (2014), Plus500, which is the most important one, as the only broker we found on Select a Broker offering services online in Swedish (2014), Renesource Capital (2014), Think Forex (2014) and XGLOBAL Markets (2014). Most of them would just allow to purchase Euro for Swedish Krona on the spot market but it might be possible that some offer also currency derivatives. We were not able to find this information, as it is available only to their customers. Another broker operating on the Swedish market is UBS, offering Euro for Swedish Kronas (UBS, 2013). They have an office in Stockholm, so despite the fact that the website is in English, the service may be provided in Swedish. There are two clearing houses which offer Euro-Swedish Krona futures. These currency contracts can be purchased on the internet through the IntercontinentalExchange Group network – ICE (2014a). The liquidity of trade is very high since they have more than six million futures and over-the-counter contracts cleared daily (IntercontinentalExchange, 2014b). In order to start trading, one needs to contact the administrators of the website and receive the necessary permissions. What is convenient when using the ICE platform is the possibility to make orders and trade via a mobile phone. For the Euro-Swedish Krona futures contracts the clearing house provides two opportunities. The first one is a contract with the size of 125 thousand Euros (IntercontinentalExchange, 2014c) and the second one is of one million Euros (IntercontinentalExchange, 2014d). The contracts listings are four times per year, in March, June, September and December and the trading can be done from 1 am till 10 pm London time (IntercontinentalExchange Group, 2014a). Because of their size, the trade would rather suit big companies. Another potential problem may appear due to the language barrier, the ICE platform is only available in English. Some farmers may not be

23

fluent in this language or even if they are, they may not be familiar with financial terms so would not feel comfortable trading. CME Group is the second clearing house which provides an alternative electronic trading platform. It is claimed to be the leading and most diversified marketplace for derivatives in the world and also the largest regulated foreign exchange (CME Group, 2014a). The liquidity is very high as a wide range of global products are exchanged. Among them are the futures and options based on foreign exchange. Euro-Swedish Krona futures can be traded with a contract size of 125 thousand Euros. Month listings are the same as for ICE: March, June, September and December. Required initial and maintenance margins are equal to 15.4 and 14 thousand Swedish Krona (CME Group, 2014b). The contract size may be again not feasible for a rural entrepreneur from Jönköping County and the language used on the website is English, too. A very interesting suitable is provided by Avanza, Swedish Internet bank – online stock broker with more than 300 thousand customers. It is the largest, in terms of transactions volume, of banks on the Stockholm Stock Exchange (Avanza, 2014a). The broker offers Euro-Swedish Krona futures contracts (Avanza, 2014b). The contracts can be short or long term and their issuer is SEB. To trade with Avanza, registration is needed together with signing by electronic ID or bank ID which can be obtained by the individual’s bank. This makes the trading more convenient and flexible. On the other hand, for companies a signature is necessary for certainty that the authorized person approves the opening of the account. The volume of a contract is 20 thousand Swedish Kronas, so it would be appropriate for a small entrepreneur. The website is in Swedish, which is a huge advantage for the LRF members. Nordnet is another based in Sweden online bank; it is the biggest one in Nordic countries. It has 400 thousand active customers and operating profit of 95.3 million Swedish Kronas (Nordnet, 2014a). The broker provides hedging services, but there is no detailed information about the instruments on the website. First one must become Nordnet’s customer. However the broker provides Euro-Swedish Krona exchange on the spot market (Nordnet, 2014b). Also this website is in Swedish, only the basic information is provided in English. IG is an online broker operating in 16 countries and has 140 thousand customers (2014a). This means that the company’s products will be liquid and accessible. They provide a number of services, but most importantly, the spot market currencies. One can purchase Euro for Swedish Kronas through special application (IG, 2014b). The website is only available in Swedish, which presents more opportunities for the farmers, but at the same time makes us unable to present more information about the trading.

4.7

Taxes in Sweden

An important issue for farmers to consider when deciding to engage in the hedging activities is the amount of taxes to be paid on incomes and investments. This is relevant because the disposable income is dependent on the taxes paid to the authorities. When a person receives the subsidy, taxable income is higher, so the total amount of tax increases. On the other hand, when the entrepreneur is engaged in hedging activities, the corporate tax on

24

investments is paid on the amount which is hedged in addition to the income tax on the sole profit of the individual. Furthermore, depending on the legal status of the company, the tax on the earnings is different. Therefore, familiarity with the basic taxation regulations can be helpful for deciding whether to hedge the European subsidy. Most widely spread are private firms run by a single person, unlimited partnerships, limited companies and economic associations or cooperative societies. The sole proprietorship is not recognized as a legal entity and thus it is not easy to distinguish the income of small private firms from the employment income. An individual who runs a business as a sole trader pays municipal and national income tax and social security contribution on the net income from the operation (Skatteverket, 2014). There are particular criteria determining whether the income is from a business, such as the profit motive and the relation to customers. The other form of business, the unlimited partnership, is generally a legal entity but not for the income tax purpose. In this case, each one of the partners declares her or his own share of the profit in a similar way as private firms’ owner. In addition though, most of the limited companies are small and have one owner, this group includes large multinationals which have a leading place regarding turnover and employment. The cooperative societies include housing cooperatives, manufacturing enterprises, also non-profit organizations, foundations and other legal entities registered for VAT and/or employers’ tax (Skatteverket, 2014). The taxable business income is calculated in respect to the generally accepted accounting standards. According to the taxation regulations for private firms and partnership, individuals with business income, may have different tax depending on whether the owner is actively involved in the business or she or he receives the business income without participating in it actively. The former should pay social security contributions, as self-employed, at a higher rate, which in 2012 was equal to 28.97%, while the latter was supposed to pay a tax of 24.26% (Skatteverket, 2014). When calculating company income tax, there is another type of taxation involved called the tax on capital income and is equal to 30% (Skatteverket, 2014). The capital gains include interests and dividends, profits from the sale of shares, houses and tenant-ownership rights. Next kind is tax on investments in shares and mutual funds together with insurance savings. Individuals pay capital income tax on the interest, dividends and capital gains. In case of interest paid and capital losses, deductions of 30% of the loss up to 100 thousand Swedish Krona and 21% of it exceeding the amount are made (Skatteverket, 2014). They are credited against the state and the local tax for the following year. In terms of individual income tax, income earned from employment or business8 is classified as direct tax on labor. By definition, income from employment is the sum of all earnings, namely cash payments such as wages, sickness and pension. It includes also other benefits

8

In other words self-employment.

25

such as the company car and food vouchers. The tax on the income is formed by the municipal tax and the state tax. The majority of persons pay only the municipal tax though. The rate varies in different municipalities. Thus, the individuals pay between 29% and 34% depending on the place of residence, in 2013 the average combined rate of the local income tax was equal to 31.7 % (Skatteverket, 2014). As mentioned in the description of the interview with the hedging farmer (see Section 4.4) the state tax is only paid if a certain threshold is crossed. In 2011 it was equal to 383 thousand Swedish Kronas. For 2013 there were two thresholds, the lower one was 426.3 thousand Swedish Kronas above which people were supposed to pay 20% of income tax, and the upper one was equal to 604.7 thousand above which individuals should have paid additional 5% (Skatteverket, 2014).

4.8

An alternative

The value of subsidy is 15% of an average Swedish farmer income. We have decided to check the volatility of the price of main source of profits for a rural entrepreneur and compare it with the standard deviation of exchange rates from Table 4.2. It is assumed that the farmer’s area of business is wheat cultivation. We charge daily wheat spot prices for the time-period of one year from Thomson Reuters Datastream. The data of U.S. Department of Agriculture was taken into consideration, because of lack of the information about the Swedish market for it. We assume that the price movements are similar to the extent which will serve our purpose. The wheat value is expressed in United States Cents per bushel. It was not converted it into Swedish Kronas to avoid the exchange rate impact. Besides we are interested only in its volatility, which is a measure of price risk. The daily movements are plotted in Figure 4.2. 800 750 700 650 600 550 500 450 400

Figure 4.2. Wheat spot price April 2013 - March 2014 Source: Thomson Reuters Datastream.

26

As the first step we have estimated continuous returns from the wheat price. Then we have calculated the daily standard deviation. Next, I was found that the value for half a year. There are two reasons to choose it. Mainly because we want to compare it with the standard deviation obtained for the Euro - Swedish Krona exchange rate, which have been calculated for this period. Another reason is that we assume that the uncertainty about the price of the commodity will last also around half a year for the farmer, as in the spring time she or he will plant the grains and in the autumn crop and sell them. As a result, the obtained number is equal to 33%. Compared with the 4.58% volatility of the exchange rate, this number is much greater and potentially a threat of loss for a rural entrepreneur. Exemplary changes in income due to different changes in price and income value (see Table 4.9). Table 4.9. Examples of changes in income 38%

33%

28%

30 000

11 400

9 900

8 400

40 000

15 200

13 200

11 200

60 000

22 800

19 800

16 800

Source: own calculations based on Thomson Reuters Datastream.

The loss or gain, accordingly to the direction of change in price, can be around 10 thousand for a famer whose total income equals 30 thousand Swedish Krona. For an entrepreneur with income of 40 thousand, the change can be a sum oscillating around 13 thousand Swedish Krona. If a person’s total gain is 60 thousand, she or he can lose or win on the price movement even 20 thousand Swedish Krona.

5 5.1

Discussion Deciding on the hedging strategy

Several steps have been outlined which should be considered by the farmers when deciding on a hedging strategy. The suggestions are based on the research regarding the whole process from application for European Union subsidy until obtaining it, and the opportunities provided by the local Swedish banks and online brokers operating in Sweden. Step 1. A farmer should determine how certain she or he is that the subsidy will be received. As there is a high probability of obtaining the financial support, the hedge can be constructed in April, after the entrepreneur applies for the funds. The maturity date for the investment can be set for the first days of October, as the last trading day of September is the date when the exchange rate is set for the conversion. Step 2. The most important issue to be considered is whether to hedge. The decision should be based on the current trend and the volatility of the exchange rate. It can be crucial to estimate the possible loss from the movements in an unfavorable direction. Thus, based on the amount of the subsidy that a farmer is applying for, even a small decrease in the value of Euro expressed in Swedish Krona can bring high loss. Moreover, as the subsidy is a part of

27

the farmers’ income, taxes are paid on it. Nevertheless, the person should consider how the taxes paid on personal income add to the gain or loss from the hedging position. On the other hand, as the gains from the hedging activities are classified as the capital income which is also taxed according to the Swedish regulations, they will further increase the amount to be paid to the tax authorities. Other costs, which cannot be directly measured may be also encountered such as the time and effort needed for visiting banks, meeting consultants and making the purchase of the option or signing a contract. Besides, when the hedge is constructed, with expiry date on the first days of October, the Euros should be delivered as agreed in the forward or futures contract. Thus, the entrepreneurs need to make sure that they have the cash available to buy them on the spot market. Step 3. The intermediary which will assist in the hedging position should be chosen by the farmer. The costs and benefits of working with a bank or a broker should be taken together and then the alternative which suits best the needs of each individual can be outlined. Regarding the option of online services using their trading platforms, the technical part can impede the process, as for example, a specific computer software may be required. In addition, the level of the margin account required by a bank or a broker will be also a determinant in the choice among these two. Still other issues can stay on the way as in the case of online trading where most of the services are provided in English. Step 4. The choice of the instrument to use in the hedge is another key decision. An entrepreneur should think of the amount of risk she or he can bear. One possibility is to enter the contract where the cost can be greater if the future spot exchange rate is unfavorable. A safer possibility is to pay the premium on the option and in case of unfortunate exchange rates, one can simply not use the option and let it expire. It should be also taken into account that the necessary margins are mostly required for futures contracts but are not excluded for the rest of the derivatives securities neither. Step 5. After signing a contract or buying an option monitoring the current exchange rate until the last day of September is useful. Then Euro should be purchased on the spot market and the hedge can be netted out. In case a farmer is not eligible to obtain the subsidy, an exit strategy should be developed. An attempt to secure the prices of the financial support can be beneficial even if the hedge does not completely balance out the difference in the values of the subsidy in Euro and in Swedish Krona. Then the investment can be seen as a simple speculation. There of course can be still a loss while using contracts but in case one have used an option nothing changes – the only cost is the option premium. Step 6. At the end of the hedging activities one shall look back and consider all the actions taken in order to assess the experience and learn from it. The knowledge taken out can serve for the future. Important would be to contact other persons engaging in hedging and share impressions and useful tips about the opportunities.

5.2

Alternative solutions

The value of the subsidy received by one farmer is not very high if we consider Swedish agriculture gains in general. However looking at the sum the Swedish Board of Agriculture

28

is transferring each year to the rural entrepreneurs, it becomes more significant. Most owners of a sole proprietorship enterprises would probably not be very interested in hedging the value of the subsidies they receive. In case they have a loss due to decrease in value of Euro expressed in Swedish Kronas, it will not have a significant impact for their income. Nevertheless the accumulated costs can have an influence on the economy of a region. This is why we propose to transfer the exchange rate risk from the farmers to the Swedish Board of Agriculture, which is a governmental organization and possesses more possibilities to hedge the value of subsidies. The entrepreneurs would receive the sums in Swedish Kronas calculated taking the exchange rate from the last day of applications. The gain or loss would be beared by the Swedish Board of Agriculture’s regional offices, which could hedge the sums more effectively taking into account the high value of the aggregated subsidies. Because of that they would be able to seize the economies of scale and receive better deals with the commercial banks. Estimated volatility of wheat price is much higher than the standard deviation of the exchange rate between Euro and Swedish Krona. This, and the fact that the incomes from sale of main areas of farmers’ businesses are greater than the one they obtain as a subsidy from European Union is a base for suggestion that the rural entrepreneurs could benefit more engaging in hedging value of commodities.

5.3

Limitations and generalization

The findings have a local nature since we closely examine the existing situation of the entrepreneurs from Jönköping County. This is why the information regarding the tax regulations, the banking sector and online trading which have country-specific characteristics can be applicable mainly to the Swedish small entrepreneurs. Overall, the hedging strategies that concern which derivatives to choose for the position can refer to farmers in other countries from the European Union which are not part of Eurozone. This is due to the fact that the CAP is common for all Member States and the national authorities in each country would receive the payments in Euro. The difference would arrive from the local currency used by the country and the fluctuations of the exchange rate between this currency and Euro. There are still other recipients of the European Union financial support in addition to those from the agricultural sector. These are beneficiaries from other sectors such as fisheries. Also, small and medium enterprises together with start-ups which engage in projects with innovativeness and fair competition-related goals obtain grants. They can apply for and receive the European Union subsidy which is determined in Euro. For this reason, the decisions to hedge can be extended to them as well. In particular, the financial markets and banking sector in less developed countries, for example, the last-to-join members of the European Union, can have different level of development of the derivatives markets. Furthermore, the financial institutions may offer different conditions for their services and contracts for the financial instruments they offer. For these reasons the decision strategy may not be entirely applicable in each Member State.

29

The information provided in the thesis can also be used for bigger companies, both for these receiving subsidies from European Union, but also the ones which do business internationally. As shown in the theoretical examples hedging is a very useful tool for exporting and importing firms. Accordingly to the value of transactions in foreign currency, it can be much more beneficial for them compared to rural entrepreneurs. Most of the instruments are created for corporations, which is why the big contract volumes offered for example by the clearing houses, would be an advantage rather than a drawback. There would be also a possibility for them to seize the economies of scale – when the trading amounts are greater, the costs are lower.

5.4

Suggestions for future research

A topic for further research can focus on the way that the rural entrepreneurs obtain their financial support, if more specifically it would be feasible to transfer the amounts of the subsidy in Euros directly to farmers or let them choose the most preferable method. Another idea would be to research the needs and opportunities of Jönköping County farmers, to hedge the value of commodities they offer. As shown in our example with the volatility of wheat prices, there is a major risk linked to their fluctuations. The study could be further developed by examining the situation of rural entrepreneurs in other European Union Member States. Also providing a comparison between hedging opportunities in Sweden and other countries.

6

Conclusions

The study has been set out to explore the problem faced by the rural entrepreneurs in Jönköping County. Part of their income comes from the European Union subsidies, which value is bound to Euro-Swedish Krona exchange rate. This is why the farmers can potentially benefit from currency hedging. The issue of lack of knowledge, which is one of the main reasons why small companies decide not to hedge has been addressed in the thesis. We take into consideration the simplest derivatives securities as proposed for the entrepreneurs instruments. In order to fulfill the purpose three research questions have been sought to answer. The first is the issue of how much the farmers can lose without hedging and what impact it has on their income. The former part of the question is addressed through the calculations of possible gains and losses due to the exchange rate fluctuations for the years 2011-2014 and exemplified in the hedging cases section. The latter part is shown in the point where we display the information of what percentage of the total income consists of the subsidy for an average farmer and the distribution of hypothetical examples based on different total gains, type of farmland and its size. Their little significance is proven by the comparison with the impact of wheat price, as a case of main source of income for a farmer, on the total incomes. The second research question is what the possible options for hedging are for the rural entrepreneurs provided by the banking sector in Jönköping County. The answer is provided in the banks’ services section, the five of them offer online service after registration in a local office. We establish which of the three derivatives instruments in scope are available in which

30

bank together with instances of hedging strategies. The third of the interrogations is what the possible options for hedging are provided online for the rural entrepreneurs. In response to it, Stockholm Stock Exchange website together with brokers and clearing houses are described. There are many opportunities for entrepreneurs to choose from, although margin accounts and trade volumes must be taken into consideration. Building on the findings, the six-step decision base on if and how to hedge have been created. Besides this, two alternative solutions for the problem are provided. We hope that our suggestions will help LRF members to make beneficial for them decisions about the strategy of securing the value of subsidies they receive from the European Union. However the findings can apply to wider groups of small entrepreneurs both in Sweden and beyond its borders.

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