A Presentation on

Hedging as Exchange Risk Offsetting Tool

Presented by

AKM Abdullah
October 26, 2004

This Session Covers

What is Hedging Types of Hedging Examples Comparison of Different Hedging Techniques

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Defining Hedge
Hedge refers to an offsetting contract made in order to insulate the home currency value of receivables or payables denominated in foreign currency. Objective of hedging is to offset exchange
risk arising from transaction exposure.
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Types of Hedging
1. Forward Market Hedges: use forward
contracts to offset exchange rate exposure

2. Money Market Hedges: use borrowing and

lending in the money markets

3. Hedging with Swaps: use combination of

forward and money market instruments 4. Hedging with Foreign Currency Futures: 5. Hedging with Foreign Currency Options:

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Forward Market Hedges: Objective: To nullify future spot rate

2 Situations: 1. Expected Inflows of Foreign Currency:
Make forward contracts to sell the foreign currency at a specified rate to insulate against depreciation of value of that foreign currency (in terms of home currency).

2. Expected Outflows of Foreign Currency:

Make forward contracts to buy the foreign currency at a specified rate to insulate against appreciation of value of the currency (in terms of home currency).
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Examples
1. A US firm is expected to receive 200,000

UK pound in 60 days from a UK buyer. UK pound may depreciate against US $ in 60 days.

What to Do for offsetting the risk of receiving less amount of US $?

2. A US firm will have to pay 400,000 Euros

in 30 days to a German seller. Euro may appreciate against US $ in 30 days.

What to do for offsetting the risk of spending more US $?
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Money Market Hedges

Objective: borrow/lend to lock in home currency value of cash flow

1. Expected Inflow of Foreign Currency:

Borrow present value of the foreign currency at a

fixed interest and convert it into home currency Deposit the home currency at a fixed interest rate When the foreign currency is received, use it to pay off the foreign currency loan

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Money Market Hedges

(Continued)

2. Expected Outflow of Foreign Currency:

Determine PV of the foreign currency to be paid (using foreign currency interest rate as the discount rate). Borrow equivalent amount of home currency (considering spot exchange rate) Convert the home currency into PV equivalent of the foreign currency (in the spot market now) and make a foreign currency deposit On payment day, withdraw the foreign currency deposit (which by the time equals the payable amount) and make payment.
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Example
A US firm is expected to pay A$300,000 to an Australian supplier 3 months from now. A$ interest rate is 12% and US$ interest rate is 8%. Spot rate is 0.60A$/US$.
PV of A$: 300,000/(1+.12/4) = A$291,262.14 Borrow (291,262.14X0.60) US$174,757.28 and convert it to A$291,262.14 at spot rate (0.60/US$) Use the A$ to make an A$ deposit which will grow to A$300,000 in 3 months. Pay this A$300,000 on due date Pay {174,757.28X(1+0.8/4)} US$178,252.43 with interest for settling the US$ loan.
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Hedge using Swaps

Swap refers to exchange of an agreed amount of a currency for another currency at a specific future date. This is equivalent to currency forward contract in a sophisticated way.

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Questions?

Have a Great Day

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