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INTERNATIONNAL FINANCIAL MANAGEMENT

LESSON 29: HEDGING WITH CURRENCY OPTIONS
Lesson Objectives
2. Forward hedge If the fulfill buys DEM 5:00,000 forward at the offer rate of DEM2.8130/£ or £0.3557/ DEM, the value of the payable is £(5,00,000 x 0.3557) = £1,77,850. This is shown as a horizontal line in Figure 13.1. 3. A Call option. Instead the firm buys call options on DEM 5,00,000 for a total premium expense of £1000. At maturity, its cash outflow will be £[(5,00,060)ST + 1Q:f_] for ST::; 0.3546 and £[(5,00,OOO)(0.3546) + 1025] = £178325 for ST 0.3546 We have assumed here that the premium expense is financed by a 90-day borrowing at 10%. Figure 13.1 illustrates. Open position and forward hedge are equivalent if the maturity GBP/DEM spot rate equals the forward rate at the beginning, viz. 0.3557. If it is higher, the firm is better off with a forward Call option and open position are equivalent when (5,00,000) St = (0.3546) (500000) + 1025 i.e. when St = 0.3537. At higher values, call option is better. Call option and forward are equivalent when (5,00,000) St + 1025 = (0.3537)(500000) i.e. when ST = 0.3567. At lower values than this the option alternative is better because of its one-way privilege – the firm can buy DEM in the spot market letting the option lapse. Figure 13.2 shows gains/losses of forward and call relative to the open position. For forward, the relative gain is £ [(ST- 0.3537 )(5,00,000)], while for the call relative gain is -£1025 for ST< 0.3546 and £ [(5,00,000)(ST-0.35465) – 1025 ] for ST >=0.3546 The call option becomes attractive relative to an open position for values of ST beyond 0.3567. Relative to the forward hedge, the call option is better I if the DEM depreciates below 0.3537. The maximum gain from the forward hedge, relative to the call is (5,00,000)(0.3546) + 1025 – (0.3557)(5,00,000 = £475 whereas, if the DEM depreciates sharply, call option can result in substantial savings. For instance at ST = 0.3520, saving from the call over the forward is £825.

• Different kinds of currency options and their uses • Hedging with currency options • Internal hedging strategies like neeting, offsetting, leading •
and lagging. Speculation in foreign exchange and money markets

Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while -an inflow an be hedged by buying a put option.(Or writing a call option. This is a “covered call” strategy). Options are particularly useful for hedging uncertain cash flows, i.e. cash flows that are contingent on other events. Typical situations are: 1. International tenders: Foreign exchange inflows will materialise only if the bid is.’ successful. If execution of the” contract also involves purchase of materials, equipment, etc. from third coun-tries, there are contingent foreign currency outflows too. 2. Foreign currency receivables with substantial default risk or political risk-e.g. the host govern-ment of a foreign subsidiary” might suddenly impose restrictions on dividend repatriation; 3. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/ bonds currently worth say DEM 50 million, which he is planning to liquidate in six months time. If he sells DEM 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates, he will find himself to be over insured and short in DEM. We will discuss a few more examples of the use of options. We will particularly focus on the com-parison of options with forward hedge both with reference to an open position.

• On June 1, a UK firm has a DEM 5,00,000 payable due on
September 1. The market rates are as follows: DEM/GBP Spot: 2.8175/85 90-day Swap points: 60/55

• September calls with a strike of 2.82 (DEM/GBP) are
available for a premium of O.20p per DEM. We will evaluate the forward hedge versus purchase of call options both with reference to an open position. 1. Open position Suppose the firm decides to leave the payable unheeded. If at maturity the £IDEM spot rate is ST’ the sterling value of the payable is (5,00,OdO)ST’ In figure 13.1 this appears as a straight line through the origin. -

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11.338

Call The firm would like to cover the potential exposure. Thus suppose its forecast of S T can be summarised as follows: ST 0. the forward hedge now has a’.20 and 0. If the contract is awarded.000. the original hedge is carried to maturity. the expected cost is lower by £475 with a standard deviation of’602.3567 0. call’ option should be the preferred choice because of its smaller expected cost and smaller variance.60.0.3590 Probability 0. The choice now depends upon the firm’s riskreturn preferences: In the appendix to this chapter we briefly present a more rigorous analysis of this choice. subjective probabilities to future values of the spot rate.60 0. If the contract is not awarded.3557 0. 1.46 per USD.028 per DEM. the contract will be offset by a 2-month forward purchase at the then ruling rate. Figure 13. But it thinks that there is a 30% chance of a very slurp depreciation of the DEM (possibly because it thinks that the Bundesbimk is shortly going-to cut interest rates to stimulate the economy) and a 10% chance of a very sharp appreciation. close out by selling put options. (Assume that the options are bought on an options exchange). A put option on DEM with a strike price of DEM 1. The firm unwinds the hedge by either purchasing DEM 5 million 60-days forward if the initial choice was a forward contract or by selling put options. If however. The expected cost with forward hedge. 2.3537 Loss(-) Fig 13. the firm gets the contract and does not get the contract we will evaluate the two alternatives.INTERNATIONNAL FINANCIAL MANAGEMENT Value of the payable Open position Call option Forward 0.338 © Copy Right: Rai University 117 . viz. the choice is not clear.46 (We are ignoring two-sided quotes.30 0.3546 relative to an open posi-tion is then higher by £540 and its standard deviation is 1279.6.3510 0. The outcome of the competitive tender bidding will be known one month from now and the equipment is t6 be supplied over two months following the award of contract with payment being made on completion of delivery.75. the probabilities-s are changed to 0.45 per $ and maturity of 90 days is available for a premium of 2. Sell DEM 5 million 90-day forward at DEM 1. The contract is valued at DEM 5 million.2 Gain & Losses from Alternative Hedging Strategies Thus whether the firm should choose the call option strategy. It might do a probabilistic mean variance analysis to compare the forwardhedge with the call if it can assign.5. For an option. 11. Thus in the mean-variance framework.3537 S(T) 0.1. the management has decided that any cover obtained must be offset if the firm is not awarded the contract. Also. smaller expected cost-compared to the call option (-140 and 255_respectively) but a much larger variance. The firm must pay an up-front premium of $1.20. Under each contingency.10 The firm wishes to evaluate the following two alternatives: 1.8 or $0.3557 0. It does not make any substantive difference). The bid is unsuccessful. scenarios. In each case we will consider three exchange rate. 0 0. The current market rates are: DEM/$ spot: 1. We consider the gain/loss from each choice under the following three exchange rate scenarios at the end of one month: The firm considers the most probable value of maturity spot to be equal to the current forward rate. • A US firm has bid for a contract to supply computers and Forward Gain(+) related equipment to a German buyer. Purchase a put option 4 .3567 0.3557 0.50 90-day forward: 1. If at the end of the month the bid is not successful. the forward hedge or leave the expo-sure unhedged depends upon the view it takes of future spot rate.

Scenario C : Forward hedge-Unwound at a loss of $279046 two months hence.000 right away. The market rates are as follows: JPYIFRF Spat: 25.DEMJUSD Spot: 1. if it overestimates the weakness of DEM (underestimates its strength) it runs the risk of submitting an uncompetitive bid.48 1.000. for the.loss if the DEM sharply appreciates in the interim and it has covered the uncertain inflow with a forward contract. 2. Put options-Sell puts.0380 0.DEM/USD Spot: 1.279 two months henge. The strike price for the Formicas FRF/JPY 0.0380 and premium is FRF 0. Assume these are offer rates for the yen). Premium income $1. the level of protection against depredation is reduced.the range forward. 2-month put 2.02 estimate the future spot rate and quote a foreign currency price based on this forecast. It can decide on a hedging device such as a put option and load t-he expected cost of the hedge into its price. The final example illustrates the use of range forward contracts : Consider the case of a French firm which has imported microelectronic components from a Japanese supplier. latter. In the reverese case. It can attempt to Note: These calculations do not incorporate the interest foregone on the net premium payment in the case of the range forward. The invoice is for ¥250. amount and the exercise price of the put option should be chosen to correspond to the forward contract which the firm might have bought had the receivable not been uncertain.35 1.0. Cost of the put option can be reduced by buying an out-of-the money option with lower strike and hence lower premium. Spot rate unchanged C.60 60-day forward:.0375 0. a forward hedge and.DEM/USD Spot: 1.45.000 for the entire payable.07 per DEM for a total premium income of $3.0385 0. at worst. the put option hedge offers an advantage if over the next three months the DEM experiences a sharp appreciation.0004 per yen or FRF 1. Realizes a gain of $3382385 two months hence.0400 0. DEM has appreciated Scenario A : . The timing.000.48.Range Forward 9550000 9550000 9550000 9675000 9800000 9925000 9925000 9925000 Thus in the event of the bid being unsuccessful.] 5. The bid is successful.0405 9250000 9375000 9500000 9625000 9750000 9875000 10000000 11250000 Forward Hedge 9750000 9750000 9750000 9750000 9750000 9750000 9750000 9750000 .45.37 60-day forward: 1. 2-month put 7 .DEM remains unchanged or depreciates.0395 0. This may not always be possible with exchange traded options. With an option. The net premium payment is thus FRF 50. 2-month put 0. the for-ward contract is more advantageous since it is costless to enter into.0006 per yen or FRF 1.62 1.6410 (FRF/JPY: 0.000 Payable INTERNATIONNAL FINANCIAL MANAGEMENT Forward hedge-Firm unwinds by purchasing forward at 1. it will have built-up some experience pertaining to the probability of success at various bid levels. The firm in tendering a bid will wish to know how to incorporate the element of currency risk.50.000 accruing right away. the strike is FRF/JPY 0.0370 0.000.000 for ¥250.0390 0. its profit margins will shrink.0007.A.-’ Put options-Firm sells puts on DEM 5 million at $0.0390) (For expositional convenience we have ignored two way rates. 1. the firm need not hedge the entire amount. Cor-respondingly.50 60-day forward: 1.3 -. the firm risks a large . its maximum loss is limited to the upfront premium.62. This involves buying a call and selling a put. Cash flows under this contingency are summarised below: Scenario A Time 0 1 2 3 0 1 2 3 0 1 2 3 Forward 0 Puts -140000 350000 338238 0 B -140000 115000 46280 0 -140000 C -279046 1000 Mfi1y Spot Open (FRFI¥) Position 0.338 . We have assumed that the forward hedge is unwound by means of another forward which matures at the same time as the original contract. Put option-Premium income of $1000 right away. DEM has depreciated B. It can reduce the cost of hedge by buying a put to cover only a fraction of the expected receivable reflecting the probability of success.0385) I80-days forward: 25. Scenario B : Forward hedge-Unwound at 1.9740 (FRF/JPY: 0. If the bid is successful.OOO due in 180 days. French Franc Outflow for ¥250. Gain of $46. for various values of the maturity spot8. if it is a frequent bidder for certain types of contracts. If the .45. The following table shows the FRF outflows on settlement of the payable with an open position. Alternatively.0395 with a premium of FRF 0.50.0.000. 118 © Copy Right: Rai University 11. The firm. buys a range forward.

908.85.00 .7170 The firm decides to hedge’ by/’selling 47 sterlifig9"”contracts with a total.500. The brokerage fee paid is worth ¥8.Thus if the firm does not expect a sharp depreciation of the yen.6680 = £2.9 Gain on futures_=$(1. a range forward provides’ a relatively cheap way of protecting itself against yen appreciation without giving up the opportu-nity to gain from yep depreciation at least up to a point. The hedge turns out to be better than a forward hedge.r1if 0/£.1. The advantage of futures over forwards is firstly easier access and secondly greater liquidity.5 at $ l.338 © Copy Right: Rai University 119 .6650)(2937500) . INTERNATIONNAL FINANCIAL MANAGEMENT A Long Hedge A Japanese firm has sold a large quantity of memory chips to a US computer marcher. Trade in primary products and capital assets is generally invoiced in a major vehicle currency 11. A firm may be able to shift the entire exchange risk to the other party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency. in a study of the financial structure of foreign trade Grassman (1973) discovered the following regularities: . We take a look at some of the commonly used or recommended methods.= $152750= £91576. a forward hedge. Also futures unlike forwards’: give-rise intermediatecashtflows due to the mark-ing-to-market feature. For the sake of completeness.8549 The firm sells $10. The total yen inflow is therefore ¥1236 million.“ Empirically. The gain on this is $2. The effective rate with the latter would have been 1. The sale is invoiced in US dollars at $10. • A Short Hedge On June-1 a British firm “orders farm equipment worth $ 5 million from a US supplier. A receivable is hedged by selling futures while a payable is hedged by buying futures.7191.350 for 98 contracts. yielding an effective ¥/$ rate of 123.50 December futures: 0.74 at $1.6680/£. Invoicing We have already discussed above the problem of currency of invoicing.50 IMM December Yen futures are trading at $0. 2. This is despite the adverse basis movement. Futures contracts require a deposit to be posted. a futures hedge is much easier to unwind since there is an organised exchange with alarge turn over.000.601.6680 September futures: 1. The firm decides to hedge by buying 98 December contracts valued at¥1. value of £2. payment due in 180 days.e.7165.64.000 =7.91576.50. = (5000000/2908375. \At times.000. Of course if the basis had narrowed much more. ‘Due to a much larger turnover. Trade between developed countries in manufactured products is generally invoiced in the export-er’s currency.675.000..14) = £2.000. futures rate would have been worse than the forward rate. Total sterling outlay = (299760190+ 2350. ignored the effect of markil1g-to-market).900 at $0.6650 The firm buys $ 5 million at the ruling spot and closes out its futures position. Since”.$10.884. in the presence of well-functioning forward markets this will not yield any added benefit compared to. $104162.8333 per 100 yen.8333) *125000x98] which translates into ¥31.225.8549 . (As usual we have.8333 per 100 yen. On November 25.937.000. The market rates are: $/£ Spot: 1. since each contract represents ¥12.207. It pays a brokerage fee of £50 per contract or £2350 form the total amount.000.000. Today is May 25. -(Yen depreciation below the strike price of the written put yields no extra benefit). we will of present to examples of hedging’ with futures.300 at the spot rate of 120.30 180-day forward: 121. Banks will enter into forward contracts only with corporations (and in rare cases individuals) with the highest credit rating. The market rates are: ¥/$ Spot: 125.7165 LIFFE September $/£ Futures: 1.997.50’per contract. The brokerage fee is $75 per contract or $7.000)/1. Hedging With Currency Futures Hedging contractual foreign currency flows with currency futures is in many respects.600 [= (0. Sterling outflow on spot purchase of $ 5 million =(5. A futures hedge differs from a forward hedge because of the intrinsic features of futures contracts. it may diminish the firm’s competitive advantage if it refuses to invoice its cross: border sales in the buyer’s currency.60 which is better than I the forward rate.375. These examples serve to bring out the point that options represent a flexible hedging tool enabling the firm to incorporate its views on exchange rate movements and its risk-return preferences in the hedging decision.000. Qn September 1 the following optic’s rule :$/£Spot: 1. the problem of timing mismatch is not serious and the liquid-ity of the market along with the absence of counterpart risk makes it an attractive hedging tool. With their continuous trading in the latter.000 in the spot market to receive ¥1. As we have seen above.20) = 1. Second. amounts and delivery dates for futures are standardized” a perfect futures hedge is generally not possible.0. Currency futures are used by commercial banks to hedge positions taken in the forward markets. the rates are: ¥/$ Spot: 120. the bid-ask spreads are tighter in the forward markets. a firm may be able to reduce or eliminate currency exposure by means of internal strategies. Payment is due on September 1. 1.500= $5043687. similar Jo hedging with forward contracts. (Even forward contracts may require a com-pensating bank balance or a line of credit) there are also brokerage fees to be paid with futures contracts.20 Effective $/£ rate obtained by the firm is -’ Internal Hedging Strategies In addition to the various market-based hedging devices discussed so far. i.205. It closes its futures posi-tion by selling 98 contracts.7225 90:daytforward : 1.7170.

the parent has a three-month payable of FRF 8. A netting system might work as follows. As a result. If a country has a higher and more volatile inflation rate than its trading partners. postpone receivables in “strong” currencies and. Suppose that the 120 Leading and Lagging Another internal way of managing transactions exposure is to shift the tim-ing of-exposures by leading or legging payables and receivables. Netting also assumes importance in the context of cash management in a multinational corporation with a number of subsidies and extensive intra-company transactions. such as the DEM and the Belgian Franc. 21. the company must have continuously updated information on inter-subsidiary payments position as ‘well as payables and receivables to outsiders.250. the movements in the two currencies are very closely correlated so that a loss (gain) on the payable due to an appreciation (depreciation) of the CHF vis-à-vis the firm’s home currency would be closely matched by the gain (loss) on the receivable due to the appreciation (depreciation) of the DEM. This latter aspect can become significant for a multinational with extensive network of subsidiaries and substantial intra-company trade. The parent must pay the French subsidiary FRF 68.50pOO to the French subsidiary’s German supplier. If the parties agree on a price of say DEM 1000 per ton and the spot rate is DEM3. Even though CHF is not part of the EC exchange rate mechanism.6 0.50. Any discrepancies between’ the forecast exchange rates and the actual spot rates three months hence can be settled by making the necessary intracompany transfers. Some countries impose rest rejections on netting as part of their ex ‘Change -control regulations. Reserve Bank of India.1 presents. i.4 4.50.75/$ implying FRF 3. Such offsetting of one exposure against another in a closely related currency provides a natural hedge.52/$ and FRF 4. the price may be stated as (DEM 550+£150) per ton].92. Also.1 1. One way of ensur-ing efficient information gathering is to centralize cash management.0 0.500.1 7 The German subsidiary is asked to pay OEM 2.50. When the two currencies involved are part of the ERM.000 to a German supplier {who is not a -part of the multina-tional). The forecasts of spot rates three months hence are: OEM/$: 1. etc. this technique has not become very popular. a British importer of fertilizer from Germany can negotiate with the supplier that the invoice be partly in DEM and partly in sterling. Even if the timings of the two flows do not match.some data on the pattern of currency of invoicing of India’ a exports and imports.9 3.9 Imports (1988-89) 67. there is no way by which the exposure can be hedged since there are no forward markets (or options.80 implying FRF/OEM : 3.500.000 equals FRF 7.) in these composite currencies.000.500. Note: Imports and Exports on Bilateral account are not included in the above data. OEM 2. Let us consider a simple example of an American parent company with subsidiaries in Germany and France. say Germany need not cover each transaction separately.6 6. The risk is reduced but not eliminated. it can use a receivable to settle all or part of a payable and take a hedge only for the’ net DEM payable or receivable. © Copy Right: Rai University 11. It may still be possible to minimise the number of currency conversions by centralizing cash management. Thus for in. The parent may obtain a hedge for the residual amount of F8. there is a tendency not to use that country’s currency in trade invoicing. conversely. To be able to use netting effectively.2 1.81. Thus the French firm has to hedge only the residual payable of OEM 5£).8 4.such as the US dollar. it might be possible to lead or lag (see the next subsection) one of them to achieve a match.stance. Table 13. Thus a firm wit!} exempts to and imports from. 3. This way both parties share the exposure Another possi-bility is to use one of the standard currency baskets such as the SDR or the ECD for invoicing trade -transactions. Table 13. At this rate’ OEM 2. INTERNATIONNAL FINANCIAL MANAGEMENT Source: RBI Monthly Bulletin.00. of diversification and can reduce the variance of home Clarence value of the payable or receivable as long as there is no perfect correlation between the constitu-ent currencies.338 .7 2.000 in three months time. These may limit the scope for netting or prohibit it altogether.000 to the French subsidiary and the French subsidiary has a three-month payable of OEM 3.5 0. The general rule is leave advance payables and fag.e.5 Neg.l25/0EM.50.00/£.0 8. Occasionally. Bombay.0 6. Netting and Offsetting A firm with receivables and payables in diverse currencies can net out its exposure in each currency by matching receivables with payables.8 7. This technique not only reduces the amount of exposures to be covered company-wide but also minimizes the number and amount of currency conversions required to settle intra-company payments. the offset provides almost a perfect hedge since the latter maintains are % margin of variation vis-à-vis the former. This suppose the actual spot rates turn out to be OEM 1.5 German subsidiary has to make a dividend payment to the parent of OEM 2. Trade between a developed and a less developed country tends to be invoiced in the developed country’s currency. Basket invoicing offers the advantage.F57.1 Currency Composition of India’s Trade (%) Currency US Dollar Pound Sterling Deutsche Mark Yen French Franc Swiss Franc Belgian Franc Indian Rs (External) Others Exports (1987-88) 61.000 converted into FRF at the forecast exchange rate amounts to FRF 7.50 FRF/$4. November 1991 (Exports) IS? August 1992 (irnports). lead receivables and lag payables in weak currencies. Another hedging tool in this context is the use of “currency cocktails” for invoicing. a firm might find that it has a receivable in one currency say OEM and a payable not in the same currency but a closely correlated currency such as the CHF.5 1.750 of which it has covered FRF 57. 4.

463.a. The Swiss supplier will give a discount of 2. US$(954653. A French firm has a 180-day payable of CHF 3.5% p. Similarly. The use of leads and lags therefore must reevaluated in the overall framework of financing and exposure management and this consideration must be kept in mind when evaluating the performance of the local management.04 2. if a multinational parent company requires its subsidiaries to employ this method it may All occasion interfere with opti-mal cash management at the level of a subsidiary.3347 = 749232. Buy AUD 1. If some imperfections drive a significant wedge between eurointerest rates and domestic interest rates.a.000 to an Australian supplier.54. This is equivalent to the Lead strategy. Borrow US$ for 180 days.as exposure management devkes. i. The American firm wants to evaluate the following four alternative hedging strategies: a. differing tax rates in different countries. Leads and lags in combination with netting form an important cash management strategy for multina-tionals with extensive intra-company payments. The French firm can borrow at 10% p.As we will see below. settle the payable with the deposit proceeds. shifting the exposure in time is not enough. settle the payable. requiring repayment of US$[708463. adding and lagging are a response to the existence of market imperfections. c.43. Since it destabilizes currency markets. AUD9. Thus this strategy is as good as the forward cover.05)] = US$ 7.3347 EuroUS$ 180-day interest rate: 10% p. As a consequence. leading and lagging involve trading off interest rate differentials against expected currency appreciation or depreciation. get a discount. it can offer a discount to the Mexican buyer for immediate payment. lead the payable.653.43. Finally there may also be some legal constraints in free use of leading and lagging .08. Suppose for instance that an American-parent ask-s its Mexican subsidiary to lead a OEM payable.03 must be borro_ed at 10%.867. The pertinent question is. Thus suppose an American firm has a three-month OEM payable and the firm (and everyone else) is almost sure [hat the DEM is going to sharply appreciate against the dollar. governments may impose restrictions on the extent to which leading and lagging can be done. will this method of covering be equivalent to a forward hedge? Consider this example. Lead: The American firm can possibly extract a discount at 9.653. 3.3312.a.14. In employing this strategy for intra-corporate payments between units of a multinational account must be taken of possibly differing tax treatments of different expense items. Money Market Cover: The firm must invest AUD(1000000/1. it has to be ‘combined with a borrowing/lending transaction or a forward transaction to complete the hedge 4Essentially. convert spot to AUD. then leading or lagging an exposure may turn out to be cheaper than a forward hedge. It. This represents a saving of US$ 5. To obtain this.(The small difference is on account of rounding errors).e.347_5 180-day forward: 1. Lead with a Forward: The firm must borrow AUD 9.000.04). the lead with forward strategy would have been better than a simple lead. The spot rate is: ERF 3.46/ 1.000. firm can offer to settle the payment immediately. suppose it has a receivable in a weak currency such as the Mexican peso.13. Also.94. if the covered interest parity mechanism is working satisfactorily.886.572. the domestic 180-day interest rate in Australia is 9. It may also adversely affect the interests of local minority shareholders. It must repay US${713572.a.a.338 © Copy Right: Rai University 121 . buy AUD 180-day forward to payoff the loan.OOO on matu-rity. (Lead with a forward). exchange gains and losses as also of.92.a.10 which must be bought forward requiring an outflow of US$ 7.61.345. (Money market cover). requiring repayment of ADD 9.538.5% for cash payment. The market rates are: AUD/USD Spot: 1. Forward Cover: US$ outflow = 1000000/1.54.2500/CHF The 180-day forward is 3. forego the usual 90-day credit and demand a discount for cash payment On the other hand. To obtain this it must borrow and sell spot US$(961538. The. 4. Borrow US$.(Forward) b.46 to get AUD1. INTERNATIONNAL FINANCIAL MANAGEMENT 11.19.e. Borrow AUD in the euromarket.3475) = US$ 7. The net cost of leading the payment would thus be 2.75 180 days later. invest in a euroAUD deposit.03(1.94 at 8% p.5% p. Let us determine US$ outflow 180 days hence under each strategy.5% which is equal to the 180-day premium on the CRE The interest differential is exactly captured in the forward premium and hence leading and forward hedge are equivalent. from the Australian firm since this is the latter’s opportunity cost of short-term funds. Thus leading would require cash payment of AUD(lOOOOOO/1. which in turn determine forward margins.50.840. (Lead) d.OOO. This should not be surprising since the borrowing and lending are done at Eurorates. The Australian authorities have imposed a restriction on Australian firms which prevents them from borrowing in the euroAUD market.61. non-residents cannot make moneymarket investments in Australia.05)] = US$749250. EuroAUD 180-day interest rate: 8% p. convert spot to AUD.000.94/1. In effect. you can convince yourself that if the American firm’s borrowing cost were higher than the Euro state.14(1.0475) = AUD 9.85 over the forward hedge.3475) = US$ 7. Consider the following example: An American firm has a 180-day payable of AUD 1. 1. i. This might put the subsidiary in an awkward position if it is already strapped for cash and has exhausted its credit lines with local banks.000 ISO-day forward.

into dollars. He can speculate by borrowing dollars. Suppose a speculator believes that the DEM is going to appreciate against the dollar by 5 % over the next three months. The main differences are. with futures since there are intermediate cash flows. etc. Summary This chapter elaborates the various devices available for hedging transactions exposure. Further he finds that he can borrow three-month dollars at 10% and invest three-month OEM at 8%. Alternatively. options. avoiding financial distress and the possible adverse effect of increased risk-on managerial incentives.Speculation in Foreign Exchage and Money Markets Speculation in contrast to hedging involves deliberately creating positions in order to profit from ex-change rate and/or interestrate movements. risk preferences. the various types of currency exposures faced by a firm. In perfect markets. the risk pre-mium-the amount by which the forward rate has to be below or above the speculator’s expected future spot rate-is 1ikely to be quite small. the investor must speculate on interest rate move-ments too and second. exchange rate risk is diversifiable and_ hence unsystematic. and sell DEM three months later in the spot market for a net annualised profit of 2%. However. he will be a 2% (annualised) profit on. outright speculation is a high risk activity. Chapter 9 contains some examples of speculating with currency futures. Discuss. Empirical investigations indicate that it is also the-varying. Do you agree with the following statement: “ The only exposure that really matters is operating exposure that can not be hedged . Explain why this is an incorrect view. The speculator believes that market’s forecasts as reflected in forward rates and the term structure of interest rates are “wrong”.recon version of DEM. Obviously. Thus he will take an open long (short) forward position if he expects the currency to appreciate (depreciate) more than what is implied in the forward rate. Speculating with futures is quite similar to speculating with forwards. these rates imply a 2%(annualised) premium on OEM. There is a continuing debate on this issue. The risk of an -open position depends upon the covariance of exchange Tate with other assets in the speculator’s portfolio. with an example each. the only valid reasons for corporate level hedging are exploiting internal information. since most futures contrads are liquidated prior to maturity. Not hedging a receivable or payable is thus equivalent to speculation. As a result. with shareholders having access to instruments such as futures. hedging activities are a waste of time and resources. country of residence. A speculator who is not risk neutral will demand a premium for undertaking the risk.338 . Many finance managers view forward premia/discounts as cost of hedging. If his fore-cast materializes. Student’s Activity 1. the speculator can fake an open long position in forward DEM. converting spot to OEM and keeping DEM on deposit. 122 © Copy Right: Rai University 11. the relevant comparison is not between expected maturity sport ate and futures price. He -hopes to profit by taking open positions at these prices. We have also addressed the question of whether the firm should engage in hedging itself or leave it to the shareholders to hedge their own exposures in the light of the portfolio compositions. If a firm has a payable in a foreign currency and is confident that the currency is going to depreciate more than what is implied in the forward rate (or appreciate less) it speculates by not covering the payable.” INTERNATIONNAL FINANCIAL MANAGEMENT . first. etc. Consider outright speculation in foreign exchange makes.