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TECHNIQUES FOR MANAGING EXPOSURE

PRESENTED BY, PRASANTH(11AB29) KAVITHA P(11AB17) NAVEEN KUMAR(11AB26)

RISK MANAGEMENT
Aim: to stabilize cash flow and to reduce uncertainty from financial forecast.  Different Instruments to hedge risk:
 

Forward


 

Futures
Swap Option

TECHNIQUES             Derivatives Forward Based Derivatives Options Hedging Money Market Forward Market Netting Matching Leading and Lagging Price Variation Invoicing in Foreign Currency Arbitrage .

Spot)/ Spot]*(12/n)*100 Forward Rate: Determined by actual demand and supply of respective currency .Forward)/ Forward]*(12/n)*100 Direct Quote: Premium/Discount =[(Forward.FORWARD BASED DERIVATIVES FORWARD CONTRACT:It Obliges one party to buy and other to sell a specified quantity of a nominated underlying financial instrument at a specific price on a specified date in future. Types:    Physical Commodity Interest Rate(Forward Rate Agreement) Currency(Foreign Exchange Forwards) Indirect Quote: Premium/Discount =[(Spot.

SWAPS:              Method of exchanging the underlying economic basis of a debt or asset without affecting the underlying principal obligation on the debt or asset. Types:Interest Rate Swaps Currency Swaps Plain vanilla Swaps Basis Rate Swaps Asset Swaps Mortgage Swaps Amortizing Swaps Forward Swaps Swapation Callable Swaps Canape Swaps .

FUTURES & OPTIONS Commitment to make or take delivery of a specified financial instrument at predetermined date I the future.  Types: Interest Rate Futures  Currency Futures  Stock Index Futures  Distinction of forward and Futures  Distinction of Options and Futures  Types:  Call Option  Put Option  .

agree to buy the foreign currency now by entering into long position in a forward contract.FORWARD MARKET HEDGE If you are going to owe foreign currency in the future.  If you are going to receive foreign currency in the future.  . agree to sell the foreign currency now by entering into short position in a forward contract.

FORWARD MARKET HEDGE: AN EXAMPLE You are a U. To fix the cash outflow in dollars:  One way is to put yourself in a position that delivers €100M in one year—a long forward contract on the euro. Payment of €100M is due in one year.S. . importer of Italian shoes and have just ordered next year’s inventory.

20/€ he saves $30 million relative to $1. Unhedged payable 9 .FORWARD MARKET HEDGE Suppose the forward exchange rate is $30m $1. The importer will be better off if the euro depreciates: he still buys €100m but at an exchange rate of only $1.50/€.20/€ $1.50/€ Value of €1 in $ in one year $1.80/€ But he will be worse off if the pound appreciates.50/€ $1. in one year his gain –$30m (loss) on the unhedged position is shown in green. If he does not hedge the €100m $0 payable.

If you agree to buy €100 million at a price of $1. .50/€ his gain (loss) on $0 the forward are shown in –$30m blue.50 per pound.FORWARD MARKET HEDGE If he agrees to buy €100m in $30m one year at $1.80. you will make $30 million if the price of the euro reaches $1.50/€ $1.50/€. you will lose $30 million if the price of the euro 10 falls to $1.20/€ $1.80/€ If you agree to buy €100 million at a price of $1.20/€. Long forward Value of €1 in $ in one year $1.

Long forward Hedged payable Value of €1 in $ in one year $1.FORWARD MARKET HEDGE The red line shows the payoff of the $30 hedged m payable.20/€ $1. Note that gains on $0 one position are offset by losses on the –$30 m other position.80/€ Unhedged payable .50/€ $1.

09) £9.MONEY MARKET HEDGING  Firm may borrow (lend) in foreign currency to hedge its foreign currency receivables(payables). The amount to borrow can be computed as the discounted present value of the pound receivable.    . £10 million/(1. thereby matching its assets and liabilities in the same currency.174. that is.312. Example: Boeing Determine the amount of pounds to borrow.

174.061). which is the guaranteed dollar proceeds from the British sale.468(1. . that is.K.312 in the U.  Step 4: Collect £10 million from British Airways and use it to repay the pound loan.312 into $13.761.468 at the current spot exchange rate of $1.468 in the United States.MONEY MARKET HEDGE  Step 1: Borrow £9.50/£  Step 3: Invest $13.  Step 5: Receive the maturity value of the dollar investment. $14.  Step 2: Convert £9.761.761.600.174.918 = $13.

128.000.320.34 Step 4: Invest in the euro zone for 12 months at 3% APR (the future value of the investment equals €750.) Step 5: Repay your borrowing with £586. receive €728.000. Using the numbers we have: Step 1: Borrow £564. invest in the euro zone for one year at i€ = 3%. buy euro at spot exchange rate with the dollars.39 at i£ = 4%.20 . receive $1.MONEY MARKET CROSS-CURRENCY HEDGE Sell pounds for dollars at spot exchange rate.155.640. all such that the future value of the investment equals €750.893. Step 2: Sell pounds for dollars.78 Step 3: Buy euro with the dollars.

77 × $2 £586.34 × $1.20 = £564.000 (1.128.320.39 = $1.77 = €728.55 €1 £1 £564.128.04) .640.893.155.320.640.03) $1.155.34 = €750.39 × (1.MONEY MARKET CROSS-CURRENCY HEDGE  Where do the numbers come from? €728.

EXPOSURE NETTING Many multinational firms use a reinvoice center.  In the following slides.00 = $1.00 = $0. a firm faces the following exchange rates:  £1.00 = $2.00 €1. then the firm implements hedging.90 . Which is a financial subsidiary that nets out the intrafirm transactions.  Once the residual exposure is determined.50 SFr 1.

Exposure Netting SFr150 $150 £150 €150 £150 SFr150 €150 $150 .

50 £150×£1 = $300 SFr150× €150× Exposure Netting SFr1 = $135 €1 = $225 SFr150 $135$135 $150 $150 $225$225 €150 £150 $300 $300 $225 $225 €150 $150 $300 £150 $300 $135 SFr150 $135 $150 .00 $0.$2.90 $1.

Exposure Netting $135 $15 $150 $225 $75 $300 $165 $150 $225 $75 $300 $135 .

Exposure Netting $75 $75 $15 $165 +$180 $180 = $165 $180 $15 .

 Parallel Matching: Receipts and payment in different currency  .  Applied both to intra group and third party Balancing.  It reduces the need of going through a foreign exchange  Prerequisite: Two-way cash flow in the same foreign currency within a group of companies.MATCHING:Mechanism whereby a company matches its foreign currency inflows with its foreign curreny outflows in respect of amount and approximate timing.

Delaying payment of an obligation beyond its due date.  . Price Variation:  Increasing selling price to counter the adverse effects of exchange rate change.LEADING AND LAGGING Foreign Management tactics  Adjustment of credit terms between companies  Leading:.Paying obligation in advance of the due date  Lagging:.

or diversify:  shift exchange rate risk by invoicing foreign sales in home currency  share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies  diversify exchange rate risk by using a market basket index .INVOICING THE FOREIGN CURRENCY  The firm can shift. share.

balance sheet and cash flow exposure Two Approaches: Aggressive Defensive    .ASSET AND LIABILITY MANAGEMENT  Used to manage income statement.

 Space Arbitrage  Time Arbitrage  .ARBITRAGE Method of making profit from foreign exchange transactions.  Sale/purchase of currencies takes place within an unstable market  Its helps in adjusting the market to equilibrium  Buying in one market and selling in another market.

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