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Lecture 9 Managing Foreign Exchange Exposure Further tools
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Learning Objectives
Learn how different types of exposure are measured
Gain knowledge of approaches to hedging transaction exposure
Understand and be able to apply further risk management instruments and techniques
Forward hedge
Futures hedge
Money market hedge
Option hedge
Analyse and compare the advantages and disadvantages of different approaches under different circumstances
Reading: Madura and Fox, Ch 11
Wang, Peijie, Ch 15-16
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Management of transaction exposure
Is to control and reduce the risk
Of exchange rate fluctuations
Involved in these contractual transactions
Managing transaction exposure
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Tools employed to manage exposure
To hedge the risks firms might use the tools we have largely discussed already
Forward hedge
Futures hedge
Money market hedge
Option hedge
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Forward or futures contract
Recall that these contracts
Agree to exchange a specific amount of foreign currency
At a specific exchange rate
At a specified future point in time.
Note also that both parties
Are obliged to exchange
So both face downside risks
Though these may be offset by gains elsewhere
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Features of a Forward/Futures Hedge
Advantages/disadvantages
Forward market gains offset spot market losses exactly;
Spot market gains may also be offset by forward market losses
| Cash inflows/ receivables | Cash outflows/ payables | Features |
| Short position on the foreign currency | Long position on the foreign currency | Right and obligations |
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Example of Forward Hedge
Suppose a British importer of home electric appliances
Has made orders for the coming year.
Payment of €10 million in Euros is due in twelve months.
If the current prevailing exchange rate of £0.6757/€.
The cash outflow in pounds would be £6.757 million
But if the exchange rate is increased to £0.7246/€,
The payment in pounds would be £7.2464 million,
An increase of £0.4894 million (=7.2464 – 6.757)
Or 7.24% more than the payment if the exchange rate were kept unchanged
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Example Forward Hedge
Therefore, the importer
Decides to enter into a forward contract
With a forward exchange rate being £0.6934/€
The importer has effectively fixed
The amount of payables or cash outflows in sterling
At £6.934m = €10m * £0.6934/€
No matter what the exchange rate will be in twelve months
The forward hedge gain is (S1-F0,1)€10m,
Where S1 is the spot exchange rate at the end of the contract period, F0,1 is the forward exchange rate contracted at the beginning of the period for delivery at the end of the period
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Forward Hedge Example
£/€
0.6934
Gain/loss in £m
0.6250
0.7692
0.758
-0.684
Forward hedge for payables – gains and losses
(S1-F0,1) €10m =(0.6250-0.6934)*10m =-0.684
(S1-F0,1) €10m =(0.7692-0.6934)*10m =0.758
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Forward Hedge Example
If the spot rate in 12 months is £0.7692/€,
the forward gain is (£0.7692/€ – £0.6934/€) €10m
= £0.758m
If the spot exchange rate in twelve months is £0.6250/€,
then the forward loss is (£0.6250/€ – £0.6934/€) €10m
= – £0.684m
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Forward Hedge Example
If the importer does not enter into a forward contract
the spot gain is derived as (F0,1–S1)€10m
exactly the opposite to that of the forward gain
To, briefly repeat the example from before
If the spot exchange rate in twelve months is £0.7692/€
the spot loss is (£0.6934/€ – £0.7692/€) €10
= – £0.758m
If the spot exchange rate in twelve months is £0.6250/€
the spot gain is (£0.6934/€ – £0.6250/€) €10
= £0.684m
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Forward Hedge Example
£/€
0.6934
Gain/loss in £m
0.6250
0.7692
-0.758
0.684
Un-hedged position of payables – gains and losses
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Forward Hedge Example
The gain in the forward (spot) market
is exactly offset by the loss in the spot (forward) market
We have discussed this already
Explained as covered interest rate parity
And since the gains / losses off-set
There is no arbitrage possible
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Futures Hedge
A futures hedge works in the same way as a forward hedge,
To lock in the future exchange rate
At which the firm will buy or sell a currency
When the futures contract/product is held
Until maturity/expiry
A futures hedge works exactly the same as a forward hedge over the same period
So again this relates to covered interest rate parity
Without arbitrage
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Money Market Hedge
This does not involve the use of a derivative
But (un)covered interest rate parity is related to the approach
Involves borrowing in domestic / foreign country
And then saving in the other country
By an amount equivalent to the amount receivable / payable
For example (simplified)
Expect to receive US$10000 in three months
So borrow this amount now
Convert to £ and invest for three months
Use $US receipt in three months to pay back loan
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Features of a Money Market Hedge
Advantages/disadvantages
Simple and works exactly the same if IRP holds;
IRP may not hold and there can be shortfall or excess in payables or receivables but that is not the case with a money market hedge
| Cash inflows/ receivables | Cash outflows/ payables | Features |
| Borrow the foreign currency | Borrow the domestic currency | Borrow, save and repay |
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Money Market Hedge
This does not make use of the derivatives we have already discussed
However a money market hedge is related to covered interest rate parity
When CIRP holds in absence of transaction costs,
A money market hedge
Will yield the same result as forward hedge
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Money Market Hedge
To hedge future foreign currency inflows/ receivables, a firm may
Step 1: Borrow the foreign currency
Step 2: Sell the foreign currency for the domestic currency now
Step 3: Let it grow at the domestic interest rate
Step 4: Repay the borrowed foreign money plus interest
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Money Market Hedge
To hedge future foreign currency outflows/ payables, a firm may:
Step 1: Borrow the domestic currency in the domestic money market.
Step 2: Convert the borrowed domestic currency into the foreign currency now
Step 3: Let the money grow at the foreign interest rate
Step 4: Repay the borrowed domestic currency plus interest
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Money Market Hedge Example
Using the same example as in the forward hedge case, plus additional information:
Forward rate F0,1 = £0.6934/€
Spot rate S0 = £0.6757/€
r€ = 1.50%, r£ = 4.15% (effective in one year)
Spot rate S1 = £0.7692/€
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Money Market Hedge Example
Step 1: The PV of €10 million payable in one year
is €10m/(1+0.015) = €9.8522m.
Given the current exchange rate of £0.6757/€
the importer needs to borrow €9.8522m * £0.6757/€
= £6.6571m in the domestic currency
Step 2: Convert the borrowed domestic currency into the foreign currency now:
£6.6571m €9.8522m
Step 3: Let the money grow at the foreign interest rate: €9.8522m(1+0.015)
= €10m = payables
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Money Market Hedge Example
Step 4: The domestic currency borrowing incurs interest
so the amount of repayment in twelve months
is the principal plus the interest,
being £6.6571m (1+0.0415) =£6.9334m.
This is the same amount the importer would pay with the forward hedge
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Forward/Futures Hedge v. Money Market Hedge
The results of money market hedge
can be compared with the results of forward or futures hedge
to determine which type of hedging is preferred
When CIRP holds in the absence of transaction costs,
A money market hedge will yield the same result as a forward hedge
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Forward/Futures Hedge v. Money Market Hedge
When CIRP does not hold
Forward/Futures hedge is preferred in hedging receivables if:
Forward/Futures hedge is superior in hedging payables if:
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Forward/Futures Hedge v. Money Market Hedge
| When CIRP does not hold | Cash inflows/receivables | Cash outflows/payables |
| Forward/Futures Hedge Money Market Hedge | Money Market Hedge Forward/Futures Hedge | |
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Options contracts
As for forwards and futures these contracts
Agree to exchange a specific amount of foreign currency
At a specific exchange rate
At (or until) a specified future point in time.
However in contrast
Only one party is obliged to exchange
So the buyer of an option
Does not face downside risks beyond the cost of buying the option
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Option Hedge
Advantages/disadvantages
No contractual obligation to exercise,
Only (small) part of the spot market gain may be offset by the option loss
| Cash inflows/ receivables | Cash outflows/ payables | Features |
| Long in put on the foreign currency | Long in call on the foreign currency | Right but no obligations |
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Currency Option Hedge
A currency option hedge
Involves the use of currency call or put options
To hedge transaction exposure
Since options do not involve obligations to exercise
Firms will be insulated from adverse exchange rate movements,
While still benefitting from favorable movements
However, firms must assess
Whether the option premium paid is worthwhile
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Example of a Currency Option Hedge
Using the same information as in the forward hedge and money market hedge examples, plus additional information:
The exercise price X is £0.6934/€
The option premium/price c0 is £0.02 per euro
The cost of option at maturity, r£ = 4.15%
Is £0.02(1+0.0415) = £0.02083 per euro
Or £0.2083m for €10m
Taking the diagram that we used for payoffs for an option
We can see what the gains or losses might be
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Currency Option Hedge Example
If the spot rate in 12 months is £0.7692/€,
The option will be exercised
The net option payoff is
(£0.7692/€ – £0.6934/€)€10m – £0.2083m = £0.5507m
If the future spot exchange rate in twelve months
Is £0.6934/€ or lower,
The currency option will not exercised,
The option payoff is –£0.2083m (the cost of buying it)
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Currency Option Hedge Example
£/€
0.6934
Gain/loss in £m
0.6250
0.7692
0.5507
Option hedge for payables – gains and losses
0.2083
Option payoff
Spot market payoff
Net gain / loss
0.4757
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Should Firms Hedge?
In general, hedging policies vary with the MNC management’s
Degree of risk aversion
And exchange rate forecasts
The hedging policy of an MNC
May be to hedge most of its exposure
None of its exposure,
Or to selectively hedge its exposure
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Should Firms Hedge?
Some currency inflows and outflows offset each other
And so need not be hedged individually and totally
Only the net flows need be hedged
Currency diversification.
When an MNC’s currency “portfolio” is more diversified
There is less need to hedge exposure with derivatives.
Some of them can hedge each other
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Conclusion
This session has brought together
The concept of transactions exposure that we discussed earlier
Together with the different financial instruments that we examined earlier
We have noted that
The use of forward or futures contracts
Might be matched by the use of a money market hedge
Options contracts may be used to hedge
But the absence of downside risk means a cost
Next time we will discuss the management of
Economic Exposure
Business School
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