Hedging Foreign Exchange Exposures

BY MRINMOY 1121610

Hedging Strategies
• Recall that most firms (except for those involved in currency-trading) would prefer to hedge their foreign exchange exposures. • But, how can firms hedge?
– (1) Financial Contracts • Forward contracts (also futures contracts) – See Appendix 1 for a discussion of forward contracts. • Options contracts (puts and calls) • Borrowing or investing in local markets. – (2) Operational Techniques • Geographic diversification (spreading the risk)

– These contracts are used to offset the foreign exchange exposure resulting from an initial commercial or financial transaction.Forward Contracts • These are foreign exchange contracts offered by market maker banks. and – They will buy foreign currency forward – Market maker banks will quote exchange rates today at which they will carry out these forward agreements. – They will sell foreign currency forward. . • These forward contracts allow the global firm to lock in a home currency equivalent of some “fixed” contractual foreign currency cash flow.

. firm is in assuming the risk that the euro might weaken over this period.Example # 1: The Need to Hedge • U.S. and in 30 days it will be worth less (in terms of U.S. not to cover)? • Problem for the U. .S.S.S. the U. firm agrees to accept payment of €100.000 in 30 days. – What type of exposure does the U. firm has sold a manufactured product to a German company. an agreement to receive a fixed amount of foreign currency in the future. – And as a result of this sale. firm if it decides not hedge (i.S. dollars) than it is now.e. – What is the potential problem for the U. • This would result in a foreign exchange loss for the firm. firm have? • Answer: Transaction exposure.

2300 • Market maker will sell euros in 30 days for $1. as follows: – EUR/USD 1. firm a bid and ask price for 30 day euros.2400 .S.S.Hedging Example #1 with a Forward • So the U. – What do these quotes mean: • Market maker will buy euros in 30 days for $1. firm decides it wants to hedge (cover) this foreign exchange transaction exposure.2400.2300/1. – It goes to a market maker bank and requests a 30 day forward quote on the euro. – The market marker bank quotes the U.

S. and in 30 days it take more U.000 in 30 days. • This would result in a foreign exchange loss for the firm.S. firm has purchased a product from a British company. dollars than now to purchase the required pounds. – What type of exposure is this for the U. an agreement to pay a fixed amount of foreign currency in the future.S. company £100.S. the U. firm is in assuming the risk that the pound might strengthen over this period.Example #2: The Need to Hedge • U. . firm? • Answer: Transaction exposure. • What is the potential problem if the firm does not hedge? • Problem for the U.S.K. firm agrees to pay the U. – And as a result of this purchase.

– It goes to a market maker bank and requests a 30 day forward quote on pounds. – The market maker quotes the U.Hedging Example #2 with a Forward • So the U. firm decides it wants to hedge (cover) this foreign exchange transaction exposure.7600 .7600.7500/1.S.S.7500 • Market maker will sell pounds in 30 days for $1. firm a bid and ask price for 30 day pounds as follows: – GBP/USD 1. – What do these quotes mean: • Market maker will buy pounds in 30 days for $1.

7500/$1.So What will the Firm Accomplished with the Forward Contract? • Example #1: The firm with the long position in euros: – Can lock in the U.S. dollar equivalent of its liability to the British firm: – It knows it will cost $176.S.2400 • Example #2: The firm with the short position in pounds: – Can lock in the U.000 • At the forward bid: $1. dollar equivalent of the sale to the German company.2300/$1.000 • At the forward ask price: $1.7600 . – It knows it can receive $123.

• However.Advantages and Disadvantages of the Forward Contract • Contracts written by market maker banks to the “specifications” of the global firm. – For some exact amount of a foreign currency. – For some specific date in the future. . • Global firm knows exactly what the home currency equivalent of a fixed amount of foreign currency will be in the future. • Bid and Ask spreads produce round transaction profits. global firm cannot take advantage of a favorable change in the foreign exchange spot rate. – No upfront fees or commissions.

but not the obligation.Foreign Exchange Options Contracts • One type of financial contract used to hedge foreign exchange exposure is an options contract.. and to do so: – at a specified price (i.e. to buy (a “call” option) or sell (a “put” option) a given quantity of some foreign exchange. . exchange rate). and – at some date in the future. • Definition: An options contract offers a global firm the right.

and additionally – (2) the ability to take advantage of a favorable change in the exchange rate. • But the global firm must pay for this right..g. • Options contracts provide the global firm with: Foreign Exchange Options Contracts – (1) “Insurance” (floor or ceiling exchange rate) against unfavorable changes in the exchange rate. – This is the option premium (which is a non-refundable fee). • This latter feature is potentially important as it is something a forward contract will not allow the firm to do. the Chicago Mercantile Exchange).• Options contracts are either written by global banks (market maker banks) or purchased on organized exchanges (e. .

g. • Provides the firm with an lower limit (“floor’) price for the foreign currency it expects to receive in the future.. – Firm will not exercised if the spot rate is “worth more.• Put Option: A Put Option: To Sell Foreign Exchange – Allows a global firm to sell a (1) specified amount of foreign currency at (2) a specified future date and at (3) a specified price (i. • If spot rate proves to be advantageous. but instead sell the foreign currency in the spot market..e. an account receivable).” . exchange rate) all of which are set today. the holder will not exercise the put option. • Put option is used to offset a foreign currency long position (e.

• If spot rate proves to be advantageous.e. the holder will not exercise the call option.A Call Option: To Buy Foreign Exchange • Call Option: – Allows a global firm to buy a (1) specified amount of foreign currency at (2) a specified future date and at a (3) specified a price (i.g. – Firm will not exercise if the spot rate is “cheaper. • Call option is used to offset a foreign currency short position (e. • Provides the holder with an upper limit (“ceiling’) price for the foreign currency the firm needs in the future.” .. at an exchange rate) all of which are set today. but instead buy the needed foreign currency in the spot market. an account payable)..

• Important advantage: Overview of Options Contracts – Options provide the global firm which the potential to take advantage of a favorable change in the spot exchange rate. • This fee must be considered in calculating the home currency equivalent of the foreign currency. • This cost can be especially relevant for smaller firms and/or those firms with liquidity issues. – See Appendix 2 for a further discussion of options contracts. • Important disadvantage: – Options can be costly: • Firm must pay an upfront non-refundable option premium which it loses if it does not exercise the option. – Recall there are no upfront fees with a forward contract. • Recall that this is not possible with a forward contract. .

. – Borrowing in a foreign currency is done to offset a long position. – Investing in a foreign currency is done to offset a short position.Hedging Through Borrowing or Investing in Foreign Markets • Another strategy used to hedge foreign exchange exposure is through the use of borrowing or investing in foreign currencies. – Global firms can borrow or invest in foreign currencies as a means of offsetting foreign exchange exposure.

immediate conversion of its foreign currency long position into its home currency..• Global firm expecting to receive foreign currency in the future (long position): – Will take out a loan (i. . – And eventually use the long position to pay off the foreign currency denominated loan. – Will convert the foreign currency loan amount into its home currency at the spot exchange rate. Specific Strategy for a Long Position • What has the firm accomplished? – Has effectively offset its foreign currency long position (with the foreign currency loan. borrow) in the foreign currency equal to the amount of the long position.e. which is a short position). – Plus.

– Will convert the home currency loan into the foreign currency at the spot rate.Specific Strategy for foreign currency in the • Global firm needing to pay out a Short Position future (short position). – Will borrow in its home currency (an amount equal to its short position at the current spot rate). – Will invest in a foreign currency denominated asset – And eventually use the proceeds from the maturing financial asset to pay off the short position. • Global firm has: – Offset its foreign currency short exposure (with the foreign currency denominate asset which is a long position) – Plus immediate conversion of its foreign currency liability into a home currency liability. . • See Appendix 3 for more discussion of this borrowing and lending strategy.

Hedging Unknown Cash Flows • Up to this point. the hedging techniques we have covered (forwards. • Why? – Because transaction exposures have known foreign currency cash flows and thus they are easy to hedge with financial contracts • However. borrowing and investing) have been most appropriate for covering transaction exposure. options. economic foreign exchange exposures do not provide the firm with this “known” cash flow information. .

the firm can “stabilize” its overall cash flow. – What can the firm do to manage this economic exposure? • Firm can employ an “operational hedge. Dealing with Economic Exposure . • As long as exchange rates with respect to these different markets do not move in the same direction.• Recall that economic exposure is long term and involves unknown future cash flows.” • This strategy involves global diversification of production and/or sales markets to produce natural hedges for the firm’s unknown foreign exchange exposures. – So this type of exposure is difficult to hedge with the financial contracts we have discussed thus far.

A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure • Step 1: Determining Specific Foreign Exchange Exposures. – By currency and amounts (where possible) • Step 2: Exchange Rate Forecasting – Determining the likelihood of “adverse” currency movements. • Perhaps a “range” of forecasts is appropriate here (i.. • Important to select the appropriate forecasting model.e. forecasts under various assumptions) .

• Or. perhaps the firm is convinced it can benefit from its exposure.A Comprehensive Approach for Assessing and Managing Foreign Exchange Exposure • Step 3: Assessing the Impact of the Forecasted Exchange Rates on Company’s Home Currency Equivalents – Impact on earnings. • Perhaps the estimated impact is so small as not to be of a concern. . cash flow. liabilities… • Step 4: Deciding Whether to Hedge or Not – Determine whether the anticipated impact of the forecasted exchange rate change merits the need to hedge.

A Comprehensive Approach or Assessing and Managing Foreign Exchange Exposure • Step 5: Selecting the Appropriate Hedging Instruments. . • The type of exposure the firm is dealing with. • Cost involved with financial contracts. – What is important here are: • Firm’s desire for flexibility.

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