Lecture 11 - Financial Derivatives and Forex Hedging

INTERNATIONAL FINANCE,
MARKETS AND MANAGEMENT

WEEK 11
Managing Exposure to
Exchange Rate Fluctuations :
Financial Derivatives & Foreign
Exchange Hedging
Last Updated: © LMS SEGi education group 1

Saturday, November 5, 2022
LEARNING OBJECTIVES
• Given a hedging requirement, what is the most

appropriate strategy, given the nature of the underlying
position and the risk exposure;
• The use of bilateral and multilateral netting and
matching.

LEARNING OUTCOMES
At the end of the chapter, students are able to
• Evaluate, for a given hedging requirement, what
is the most appropriate strategy, given the
nature of the underlying position and the risk
exposure;
• Advise on the use of bilateral and multilateral
netting and matching as tools for minimizing
FOREX transactions costs.

Techniques to Eliminate Transaction
Exposure
• Hedging techniques include:
• Futures hedge,
• Forward hedge,
• Money market hedge, and
• Currency option hedge.
• MNCs will normally compare the cash flows
that would be expected from each hedging
technique before determining which
technique to apply.
Hedge vs. No-Hedge
• The real cost of hedging = extra expenses

(additional cost)
• Real cost of hedging payables (RCHp) =
nominal cost of payables with hedging – nominal
cost of payables without hedging
• Real cost of hedging receivables (RCHr)

=nominal revenues received without hedging –
nominal revenues received with hedging

Hedge vs. No-Hedge
• If the real cost of hedging is negative 

hedging is more favorable
• To compute the expected value of the real
cost of hedging:
1. develop a probability distribution for the
future spot rate.
2. use it to develop a probability
distribution for the real cost of hedging.

The Real Cost of Hedging for Each £ in
Payables

The Real Cost of Hedging for Each £ in
Payables

Money Market Hedge
• A money market hedge involves taking a

money market position to cover a future
payables or receivables position.
• For payables:
 Borrow in the home currency (optional)
 Invest in the foreign currency
• For receivables:
 Borrow in the foreign currency
 Invest in the home currency (optional)

Money Market Hedge (Account Payable)

Money Market Hedge
(Account Receivable)

Money Market Hedge
• If interest rate parity (IRP) holds, and

transaction costs do not exist, a money
market hedge will yield the same results
as a forward hedge.
• This is so because the forward premium
on a forward rate reflects the interest rate
differential between the two currencies

Futures and Forward Hedges
• A futures hedge uses currency futures,
while a forward hedge uses forward
contracts, to lock in the future exchange
rate.
• To hedge future payables (receivables), a
firm may purchase (sell) currency futures,
or negotiate a forward contract to
purchase (sell) the currency forward.
Last Updated: © LMS SEGi education group

Futures and Forward Hedges
(Account Payable)
• Colemon Co. need to pay 100,000 euros
in 1 year.
• Buy a forward (or future) contract with 1-
year forward (future) rate = $1.20
Cost in $ = 100,000 euros x $1.20

= $120,000

Synthetic Agreements For Foreign
Exchange (SAFE)
• These are like forward contracts, except no currency is
delivered. Instead the profit or loss (i.e. the difference
between actual and NDF rates) on a notional amount of
currency (the face value of the NDF) is settled between
the two counter parties.
• Combined with an actual currency exchange at the
prevailing spot rate, this effectively fixes the future rate in
a similar manner to futures.
• One other feature is that the settlement is in US dollars.


Synthetic Agreements For Foreign
Exchange (SAFE)(Cont’d)
• Illustration
• Let the spot rate between the US$ and the
Brazilian Real be 1.6983 Reals to $1 and
suppose we agree a 3 month NDF to buy $1
million worth of Reals at 1.7000.
• If the spot rate moves to 1.6800 in 3 months,
then the counter-party will have to pay us
1million × 0.02 = 20,000 Reals.
• This will be settled in US$, so the actual receipt
will be 20,000/1.6800 = $11,905
Currency Option Hedge
• Uses currency call or put options to hedge

transaction exposure.
• Since options need not be exercised, they
can insulate a firm from adverse exchange
rate movements, and yet allow the firm to
benefit from favorable movements.
• Currency options are also useful for
hedging contingent exposure.

Hedging with Currency Options

Review of Hedging Techniques
To Hedge Payables To Hedge Receivables

Future Hedge Purchase currency future Sell currency future contract
contract
Forward Hedge Negotiate forward contract to Negotiate forward contract

buy foreign currency to sell foreign currency
Money Market Borrow local currency. Borrow foreign currency.

Hedge Convert to foreign currency. Convert to local currency.
Invest till needed. Invest till needed.
Currency Option Purchase currency call option Purchase currency put

Hedge option

Comparison of Hedging Techniques
• Hedging techniques are compared to

identify the one that minimizes payables or
maximizes receivables.
• Note that the cash flows associated with
currency option hedging are not known
with certainty but have to be forecasted.
• Several alternative currency options with
different exercise prices are also usually
available.
Hedging Policies of MNCs
• In general, an MNC’s hedging policy

varies with the management’s degree of
risk aversion.
• An MNC may choose to hedge most of its
exposure or none of its exposure.
• The MNC may also choose to hedge
selectively, such as hedging only when it
expects the currency to move in a certain
direction.
Limitations of Hedging
• Some international transactions involve an

uncertain amount of foreign currency, such
that overhedging may result.
• One solution is to hedge only the minimum
known amount. Additionally, the uncertain
amount may be hedged using options.

Managing Economic Exposure

Managing Madison Inc.’s Economic
Exposure
• Its earnings before taxes is inversely
related to the Canadian dollar’s strength
(due to higher expenses).
• Madison may reduce its exposure by
increasing Canadian sales, reducing
orders of Canadian materials, and
borrowing less in Canadian dollars.

How Restructuring Can Reduce
Economic Exposure
• Technique involves:
- shifting the sources of costs or revenue
to other locations in order to match cash
inflows and outflows in foreign currencies.
• The proposed structure is then evaluated
by assessing the sensitivity of its cash
inflows and outflows to various possible
exchange rate scenarios.

Impact of Possible Exchange Rate Movements on
Earnings under Two Alternative Operational Structures
(in Millions)

Economic Exposure Based on the
Original and Proposed Operating
Structures

Restructuring Decision
• Restructuring may involve:

 increasing/reducing sales in new or existing
foreign markets,
 increasing/reducing dependency on foreign
suppliers,
 establishing/eliminating production facilities in
foreign markets, and/or
 increasing/reducing the level of debt
denominated in foreign currencies.

Managing Translation Exposure
• To hedge translation exposure, forward or

futures contracts can be used.
• Specifically, an MNC may sell the currency
that its foreign subsidiary receive as
earnings forward, thus creating an
offsetting cash outflow in that currency.

Use of Forward Contracts to Hedge
Translation Exposure
Example:
• A U.S.-based MNC has a British subsidiary.
• The forecasted British earnings of £20 million (to be
entirely reinvested) will be translated at the

weighted average £ value over the year.
• To hedge this expected earnings, the MNC sells
£20 million one year forward with

F = S0 = $1.60/ £.
• If the £ depreciates to $1.50/ £, the gain generated
from the forward contract position will help to offset

the translation loss.
Using Currency Swaps to Hedge Translation Risk
(Execute The Matching Strategy)
1. An MNC faces exchange rate risk when it is

not able to obtain in the same currency as its
invoice currency to match long-term projects
with long-term financing (matching strategy).
2. A currency swap specifies the exchange of

currencies at periodic intervals and may allow
the MNC to have cash outflows in the same
currency in which it receives most or all of its
revenue.
3
Exhibit 18.1 Illustration of a Currency Swap
3
Reference
• Madura, J. (2012). International corporate

finance (11th ed.): South-Western Cengage
Learning
• Kaplan. (2014). Forward Contracts. Retrieved
24th August, 2014, 2014, from
http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki
%20Pages/Synthetic%20Forwards.aspx


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INTERNATIONAL FINANCE,

MARKETS AND MANAGEMENT

Last Updated: © LMS SEGi education group 1

• Given a hedging requirement, what is the most

Last Updated: © LMS SEGi education group 2

Last Updated: © LMS SEGi education group 3

• The real cost of hedging = extra expenses

• Real cost of hedging receivables (RCHr)

Last Updated: © LMS SEGi education group 5

• If the real cost of hedging is negative 

Last Updated: © LMS SEGi education group 6

Last Updated: © LMS SEGi education group 7

Last Updated: © LMS SEGi education group 8

• A money market hedge involves taking a

Last Updated: © LMS SEGi education group 9

Last Updated: © LMS SEGi education group 10

Last Updated: © LMS SEGi education group 11

• If interest rate parity (IRP) holds, and

Last Updated: © LMS SEGi education group 12

Last Updated: © LMS SEGi education group

Cost in $ = 100,000 euros x $1.20

Last Updated: © LMS SEGi education group 14

Last Updated: © LMS SEGi education group 15

• Uses currency call or put options to hedge

Last Updated: © LMS SEGi education group 17

Last Updated: © LMS SEGi education group 18

To Hedge Payables To Hedge Receivables

Forward Hedge Negotiate forward contract to Negotiate forward contract

Money Market Borrow local currency. Borrow foreign currency.

Currency Option Purchase currency call option Purchase currency put

Last Updated: © LMS SEGi education group 19

• Hedging techniques are compared to

• In general, an MNC’s hedging policy

• Some international transactions involve an

Last Updated: © LMS SEGi education group 22

Last Updated: © LMS SEGi education group 23

Last Updated: © LMS SEGi education group 24

Last Updated: © LMS SEGi education group 25

Last Updated: © LMS SEGi education group 26

Last Updated: © LMS SEGi education group 27

• Restructuring may involve:

Last Updated: © LMS SEGi education group 28

• To hedge translation exposure, forward or

Last Updated: © LMS SEGi education group 29

• The forecasted British earnings of £20 million (to be

entirely reinvested) will be translated at the

£20 million one year forward with

from the forward contract position will help to offset

1. An MNC faces exchange rate risk when it is

2. A currency swap specifies the exchange of

• Madura, J. (2012). International corporate

Last Updated: © LMS SEGi education group 33

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