The document discusses various types of currency exposure that companies face: transaction, economic, and translation. It describes techniques for hedging transaction exposure, including financial contracts like forwards, futures, money market hedges and currency options. Operational hedging techniques include lead/lag strategies and exposure netting. Forward contracts and futures locks in future exchange rates. Money market hedges involve borrowing and investing across currencies. Currency options provide downside protection for a premium. Exposure netting reduces risk by offsetting exposures across currencies.
2. Three Types of Exposure
• Transaction exposure : can be defined as the sensitivity of “realized”
domestic currency values of the firm’s contractual cash flows
denominated in foreign currencies to unexpected exchange rate
changes.
• Economic exposure : can be defined as the extent to which the value
of the firm would be affected by unanticipated changes in exchange
rates.
• Translation exposure : refers to the potential that the firm’s
consolidated financial statements can be affected by changes in
exchange rates. Consolidation involves translation of subsidiaries’
financial statements from local currencies to the home currency.
3. • The firm has foreign-currency-denominated receivables or payables, it is subject to transaction exposure, and their settlements are likely to affect the
firm’s cash flow position. Alternative ways of hedging transaction exposure using various financial contracts and operational techniques:
Financial Contracts
• Forward market hedge
• Money market hedge
• Option market hedge
• Swap market hedge
Operational Techniques
• Choice of the invoice currency
• Lead/lag Strategy : "Leads and lags" is a strategy for ducking that problem. If you believe the euro is going up in value, pay your bills before it happens.
Lagging takes the opposite approach: when you expect a currency to drop in value, delay the transfer so you're paying fewer dollars.
• Exposure Netting
4. Techniques to Eliminate Transaction Exposure
Hedging techniques include:
• Futures hedge,
• Forward hedge,
• Money market hedge
• Currency option hedge
MNCs will normally compare the cash flows that would be expected
from each hedging technique before determining which technique to
apply
5. Futures and Forward Hedges
• A futures hedge uses currency futures, while a forward hedge uses forward contracts, to lock in the future
exchange rate
• Recall that forward contracts are commonly negotiated for large transactions, while the standardized futures
contracts tend to be used for smaller amounts.
• To hedge future payables (receivables), a firm may purchase (sell) currency futures, or negotiate a forward
contract to purchase (sell) the currency forward.
• The hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible
results of remaining unhedged, and taking into consideration the firm’s degree of risk aversion.
• The real cost of hedging measures the additional expenses beyond those incurred without hedging.
• Real cost of hedging payables (RCH p) = nominal cost of payables with hedging – nominal cost of payables
without hedging
• Real cost of hedging receivables (RCH r) = nominal revenues received without hedging – nominal revenues
received with hedging
• If the real cost of hedging is negative, then hedging is more favorable than not hedging.
• To compute the expected value of the real cost of hedging, first develop a probability distribution for the
future spot rate. Then use it to develop a probability distribution for the real cost of hedging.
6. Exposures ; defined
• Exposure ------------------- Exposed to Risk
Transactional Risk Economic Risk Translation Risk
Difference in Payments due Exchange rate fluctuation
Profit Loss Same
7. Reducing Risk – Hedging
• Hedging Exposure --------- Reducing risk
Techniques of Hedging Exposure
1. Forward / Future Hedge
2. Money Market Hedge
3. Currency Option Hedge
Hedging is discussed in following transaction
1. Payables (Importers)
2. Receivables (Exporters)
8. Forward / Future Market hedge
• Forward / Future Contracts allow the company to lock specific
exchange rate for a currency.
• The forward contract would be entered in with most probably with a
bank and would include:
• Currency the company will pay
• Currency the company will get
• Maturity or future date
• Rate
• Amount and volume
9. Example of a forward market hedge
• ABC Company a US based MNC will need 100,000/- euro in one year
time. It obtains a forward contract to purchase to purchase euros one
year from now . The rate is 1.2 . The future contracts also has the
same rate on euros .
• Solution :
• Cost in USD= Payable X Forward Rate
= 100,000 X 1.2
= 120,000
10. Money Market Hedge
Goods imported for 100,000 (Borrow in Europe and invests in USA)
2020
XYZ in ABC in USA
Europe
Good Exported
2019
XYZ Deposits or invests in US
To be returned in 2020 as $100,000
Factors in decision making
• Borrowing rate Europe
• Deposit rate in USA
• Spot rate
11. • Step 1
• Deposit in US @ 5% to achieve 100,000 at the payment time
• Deposit amount $ = 100,000/(1+.05) = 92,238
• Step 2
• Convert amount in Euro @ spot rate 1.18
• Deposit amount in Euro = 95,238 X 1.18 = 112,381
• Step 3
• Borrow at home country @ 8%
• =112381 X (1+.08) = 121,371
12. Call Option Hedge
• A call option is a contract between 2 parties to exchange a stock at a strike price by a
predetermined date. The buyer of the call has the right but no obligation to buy the
commodity at the strike price by the future date while the seller of the call at the strike
price but an option. The seller of the call has the obligation to sell to the buyer of the
commodity at the strike price if the buyer exercises the option. The buyer gets this
option by paying a premium / margin to seal the deal.
• Currency call option ---- Right of buy Fcy if the contract is
(Buy Option) ------ denominated in FCY (importers perspective )
• Difference between call option and Forward / Future
• Right + no obligation Right + obligation
• Advantage
• Keeping the best of both world open Advantage
• Disadvantage:
• Cost of Premium / Margin as a cost of Hedging : 1.2 (Spot) + .05 (Premium / Margin) = 1.25
13. Scenarios
Scenario Spot rate at
payment time
Premium paid
for call option
Per unit amount Total amount
paid including
premium
Amount paid
without option
Real Cost of Hedging (payable) = Cost of Hedging (payable) – Cost of payable if not hedged
RCHp = CHp – Cp
14. Other Strategies- 1
• Lead/lag Strategy : "Leads and lags" is a strategy for ducking that
problem. If you believe the euro is going up in value, pay your bills
before it happens. Lagging takes the opposite approach: when you
expect a currency to drop in value, delay the transfer so you're paying
fewer dollars.
• If your business has substantial investments overseas, a change in
currency rates can cost you. Suppose you're about to pay a bill to a
French supplier. If the value of the euro compared to the dollar goes
up right before you settle a debt to a French company, you're going to
have to pay more dollars.
15. Technique Payable Recivables
Future Hedge Purchase of currency future
contract representing the amount
related to payable
Sell a currency future contracts
representing the amount related to
recievables
16. Other Strategies – 2
• Exposure Netting :
Exposure Netting has the objective of reducing a company’s exposure to exchange rate (currency)
risk. It is especially applicable in the case of a large multinational company, whose various currency
exposures can be managed as a single portfolio; it is often challenging and costly to hedge each and
every currency risk of a client individually when dealing with many international clients.
• Exposure Netting Example
Assume Widget Co., located in Canada, has imported machinery from the United States and
regularly exports to Europe. The company must pay $10 million to its U.S. machinery supplier in three
months, at which time it is also expecting a receipt of EUR 5 million and CHF 1 million for its exports.
The spot rate is EUR 1 = USD 1.35, and CHF 1 = USD 1.10. How can Widget Co. use exposure netting
to hedge itself?
The company’s net currency exposure is USD $2.15 million (i.e., USD $10 million - [(5 x 1.35) + (1 x
1.10)]). If Widget Co. is confident that the Canadian dollar will appreciate over the next three
months, it would do nothing, since a stronger Canadian dollar would result in U.S. dollars becoming
cheaper in three months. On the other hand, if the company is concerned the Canadian dollar may
depreciate against the U.S. dollar, it may elect to lock in its exchange rate in three months through a
forward contract or a currency option. Exposure netting is thus a more efficient way of managing
currency exposure by viewing it as a portfolio, rather than hedging each currency exposure
separately.
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