Description
imports using call options, explains cross hedging, hedging recurrent exposure with swaps, hedging through invoice currency
Management of Transaction Exposure
Forward Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts
Chapter Outline (continued)
Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use?
1
Options Market Hedge
Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency.
If the currency appreciates, your call option lets you buy the currency at the exercise price of the call.
To hedge a foreign currency receivable buy puts on the currency.
If the currency depreciates, your put option lets you sell the currency for the exercise price.
Options Markets Hedge
Suppose our importer buys a call option on £100m with an exercise price of $1.50 per –$5m pound. He pays $.05 per pound for the call.
Profit Long call on £100m
$1.55/£ $1.50/£
Value of £1 in $ in one year
loss
2
Options Markets Hedge
Profit The payoff of the portfolio of a call and a payable is shown in red. $25m He can still profit from decreases in the exchange rate –$5m below $1.45/£ but has a hedge against unfavorable increases in the loss exchange rate. Long call on £100m
$1.20/£ $1.45 /£ $1.50/£
Value of £1 in $ in one year Unhedged payable
Options Markets Hedge
IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS.
If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.
EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS.
If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.
3
Hedging Exports with Put Options
Show the portfolio payoff of an exporter who is owed £1 million in one year. The current one-year forward rate is £1 = $2. Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2.
The cost of this option is $0.05 per pound.
Options Market Hedge:
Exporter buys a put option to protect the dollar value of his receivable.
$1,950,000
ed ge d H re ce iv ab le
–$50k
va b le ce i
S($/£)360 Long put $2 $2.05
–$2m
Lo ng
re
4
Hedging Imports with Call Options
Show the portfolio payoff of an importer who owes £1 million in one year. The current one-year forward rate is £1 = $1.80; but instead of entering into a short forward contract, He buys a call option written on £1 million with an expiry of one year and a strike of £1 = $1.80 The cost of this option is $0.08 per pound.
$1.8m $1,720,000
Options Market Hedge: Importer buys call option on £1m.
Call Call option limits the potential cost of servicing the payable. S($/£)360 $1.80 $1.72 $1.88
–$80k
U ge ed nh d
n io at lig ob
5
Cross-Hedging Minor Currency Exposure
The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Thai bhat. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.
Cross-Hedging Minor Currency Exposure
Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated.
An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way.
6
Hedging Contingent Exposure
If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if a U.S. firm is bidding on a hydroelectric dam project in Canada, it will need to hedge the Canadian-U.S. dollar exchange rate only if its bid wins the contract. The firm can hedge this contingent risk with options.
Hedging Recurrent Exposure with Swaps
Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards.
7
Hedging through Invoice Currency
The firm can shift, share, or diversify:
shift exchange rate risk
by invoicing foreign sales in home currency
share exchange rate risk
by pro-rating the currency of the invoice between foreign and home currencies
diversify exchange rate risk
by using a basket of currencies / SDR
Hedging via Lead and Lag
If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.
8
Exposure Netting
A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.
As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.
Exposure Netting
Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging.
9
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions:
$20 $30 $40 $10 $35 $25 $20 $30 $60 $10 $30 $40
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign exchange transactions by half:
$20 $10 $30 $25 $10 $35 $40 $20 $25 $20 $10 $30 $60 $15 $10 $30 $40 $10
10
Multilateral Netting: an Example
Consider simplifying the bilateral netting with multilateral netting:
$10 $40 $30 $20 $40
$15 $15 $10 $10
$15 $10 $15$25
$10
Should the Firm Hedge?
Not everyone agrees that a firm should hedge:
Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.
11
Should the Firm Hedge?
In the presence of market imperfections, the firm should hedge.
Information Asymmetry
The managers may have better information than the shareholders.
Differential Transactions Costs
The firm may be able to hedge at better prices than the shareholders.
Default Costs
Hedging may reduce the firms cost of capital if it reduces the probability of default.
What Risk Management Products do Firms Use?
Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts. The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.
12
Airbus’s Dollar Exposure
Airbus sold an A400 aircraft to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned about the Euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.05/€ and six month forward exchange rate is $1.10/€. Airbus can buy a six-month put option on U.S. dollars with a strike price of €0.95/$ for a premium of €0.02 per U.S. dollar. Currently, six-month interest rate is 2.5 percent in the euro zone and 3.0 percent in the U.S.
Compute the proceeds if Airbus decides to hedge using a forward contract. If Airbus decides to hedge using money market instruments, what action does it need to take? What would be the proceeds from the sales? If Airbus decides to hedge using put options on U.S. dollars, what would be the expected euro proceeds? Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.
Thank You!!!
13
doc_248497414.pdf
imports using call options, explains cross hedging, hedging recurrent exposure with swaps, hedging through invoice currency
Management of Transaction Exposure
Forward Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts
Chapter Outline (continued)
Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use?
1
Options Market Hedge
Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency.
If the currency appreciates, your call option lets you buy the currency at the exercise price of the call.
To hedge a foreign currency receivable buy puts on the currency.
If the currency depreciates, your put option lets you sell the currency for the exercise price.
Options Markets Hedge
Suppose our importer buys a call option on £100m with an exercise price of $1.50 per –$5m pound. He pays $.05 per pound for the call.
Profit Long call on £100m
$1.55/£ $1.50/£
Value of £1 in $ in one year
loss
2
Options Markets Hedge
Profit The payoff of the portfolio of a call and a payable is shown in red. $25m He can still profit from decreases in the exchange rate –$5m below $1.45/£ but has a hedge against unfavorable increases in the loss exchange rate. Long call on £100m
$1.20/£ $1.45 /£ $1.50/£
Value of £1 in $ in one year Unhedged payable
Options Markets Hedge
IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS.
If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.
EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS.
If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.
3
Hedging Exports with Put Options
Show the portfolio payoff of an exporter who is owed £1 million in one year. The current one-year forward rate is £1 = $2. Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2.
The cost of this option is $0.05 per pound.
Options Market Hedge:
Exporter buys a put option to protect the dollar value of his receivable.
$1,950,000
ed ge d H re ce iv ab le
–$50k
va b le ce i
S($/£)360 Long put $2 $2.05
–$2m
Lo ng
re
4
Hedging Imports with Call Options
Show the portfolio payoff of an importer who owes £1 million in one year. The current one-year forward rate is £1 = $1.80; but instead of entering into a short forward contract, He buys a call option written on £1 million with an expiry of one year and a strike of £1 = $1.80 The cost of this option is $0.08 per pound.
$1.8m $1,720,000
Options Market Hedge: Importer buys call option on £1m.
Call Call option limits the potential cost of servicing the payable. S($/£)360 $1.80 $1.72 $1.88
–$80k
U ge ed nh d
n io at lig ob
5
Cross-Hedging Minor Currency Exposure
The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Thai bhat. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.
Cross-Hedging Minor Currency Exposure
Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated.
An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way.
6
Hedging Contingent Exposure
If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if a U.S. firm is bidding on a hydroelectric dam project in Canada, it will need to hedge the Canadian-U.S. dollar exchange rate only if its bid wins the contract. The firm can hedge this contingent risk with options.
Hedging Recurrent Exposure with Swaps
Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards.
7
Hedging through Invoice Currency
The firm can shift, share, or diversify:
shift exchange rate risk
by invoicing foreign sales in home currency
share exchange rate risk
by pro-rating the currency of the invoice between foreign and home currencies
diversify exchange rate risk
by using a basket of currencies / SDR
Hedging via Lead and Lag
If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.
8
Exposure Netting
A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.
As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.
Exposure Netting
Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging.
9
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions:
$20 $30 $40 $10 $35 $25 $20 $30 $60 $10 $30 $40
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign exchange transactions by half:
$20 $10 $30 $25 $10 $35 $40 $20 $25 $20 $10 $30 $60 $15 $10 $30 $40 $10
10
Multilateral Netting: an Example
Consider simplifying the bilateral netting with multilateral netting:
$10 $40 $30 $20 $40
$15 $15 $10 $10
$15 $10 $15$25
$10
Should the Firm Hedge?
Not everyone agrees that a firm should hedge:
Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.
11
Should the Firm Hedge?
In the presence of market imperfections, the firm should hedge.
Information Asymmetry
The managers may have better information than the shareholders.
Differential Transactions Costs
The firm may be able to hedge at better prices than the shareholders.
Default Costs
Hedging may reduce the firms cost of capital if it reduces the probability of default.
What Risk Management Products do Firms Use?
Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts. The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.
12
Airbus’s Dollar Exposure
Airbus sold an A400 aircraft to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned about the Euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.05/€ and six month forward exchange rate is $1.10/€. Airbus can buy a six-month put option on U.S. dollars with a strike price of €0.95/$ for a premium of €0.02 per U.S. dollar. Currently, six-month interest rate is 2.5 percent in the euro zone and 3.0 percent in the U.S.
Compute the proceeds if Airbus decides to hedge using a forward contract. If Airbus decides to hedge using money market instruments, what action does it need to take? What would be the proceeds from the sales? If Airbus decides to hedge using put options on U.S. dollars, what would be the expected euro proceeds? Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.
Thank You!!!
13
doc_248497414.pdf