Hedging

The Management of Exposure

Learning Objectives
Transaction Exposure Hedging -Defined Techniques of Hedging Translation exposure Economic exposure

Transaction Exposure
A firm has certain contractually fixed payments and receipts in foreign currency such as export receivables, import payables, interest payable on foreign currency loans etc An unanticipated change in the exchange rate has an impact Favorable/adverse on its cash flows, such exposures are known as transaction exposures The foreign currency values of these items are contractually fixed, they do not vary with the exchange rate, hence it is known as contractual exposure

Some typical situations

A currency has to be converted in order to make or receive payment for goods or services A currency has to be converted to repay a loan or make an interest payment or conversely receive a repayment or an interest payment. A currency has to be converted to make a dividend payment

Example
A firm receives an export order, it fixes a price, manufactures a product, makes the shipment and gives 90 days credit to the buyer who will pay in his currency. the company has a transaction exposure from the time it accepts the order, till the time the payment is received and converted into domestic currency. If the foreign currency appreciates before the payment is received, the company makes an exchange gain and if it depreciates the company makes an exchange loss

Volatility

Hedging
Transaction exposure offsetting Tool

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. In case of a receivable, what if the foreign currency depreciates against the home currency, I would receive less home currency In Case of a payable, what if the foreign currency appreciates against the home currency, I would have to pay more home currency Objective of hedging is to offset exchange risk arising from
transaction exposure

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 currency options 5. Internal Hedging Techniques

Forward market hedges Objective: To Nullify future spot rate

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).

Customized arrangements

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 $? Enter into a Forward contract to sell the UK pound at a specified rate and thereby protect yourself against the depreciated spot rate

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 $? Enter into a forward contract to buy Euro at a specified rate and thereby protect yourself against the appreciated spot rate

Money Market Hedges

Objective: borrow/lend to lock in home currency value of cash flow Expected Inflow of Foreign Currency:
Borrow foreign currency in the money market for the stipulated period Convert the same into home currency at spot rate Use the home currency in operations of the business such as pay off some loan or finance inventory etc When the receivable is settled after the stipulated period in the foreign currency pay off the foreign currency loan borrowed.

Example
Suppose a US firm has a 90- day receivable of Euro 10,00,000, to cover this exposure it will Borrow Euro in the money market for 90 days Convert it into home currency at the spot rate USD Use the converted money in its operations After 90 days when the EUR receivable is settled , pay off the EUR loan

Hedging 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. For example: a US firm has receivable in Euro from a Belgian buyer;
so it is looking for euro denominated liability/payable to hedge the receivable. What if the Euro depreciates against the dollar? On the other hand, a Belgian firm exports to USA and has US$ denominated receivable; it needs US$ liability/payable to hedge receivables in US$. What if the US $ depreciates against the Euro

The two firms can agree that:

Swaps- Continued
US firm borrows (say $100,000) at 11% Belgian firm borrows($100,000/E0.6 per $) 166,667 euros at 10% US firm receives euros from buyer and give it to the Belgian firm so that it (Belgian) can repay euro denominated loan. The Belgian firm receives US$ from buyer and give it to the US firm so that it (US firm) can repay US$ denominated loan. Both firms lock in current spot rate for future payments by swapping receivables

Options Market Hedge

The firm is uncertain whether the hedged foreign currency cash inflow or outflow will materialize Currency options obviate the problem A put option gives the buyer the right, but not the obligation to sell the specified currency at a specified price up to the expiration date

Options Market Hedge

A call option is the right , but not the obligation to buy a foreign currency at a specified price up to the expiration date. A Call option is valuable, for example, when a firm has offered to buy a foreign asset such as another firm at a fixed foreign currency price, but is uncertain whether its bid will be accepted and whether the foreign currency outflow will materialize. If it materializes it would exercise the option and buy the foreign currency and pay off the price , if it does not materialize the option would not be exercised.

Internal Hedging techniques

Transaction exposure sometimes can be taken care of without resorting to any forwards/options.

Internal Hedging Techniques

Leads and Lags Netting and Matching

Leading and Lagging

Leading and lagging
adjust the timing of payments or receipts
expects currency change to affect receivables or payables

leading, moves up transaction lagging, postpones transaction The general rule is to lead payables and Lag receivables in strong currency and lead receivables and lag payables in weak currency.

Example
Suppose an American firm has a three month EUR payable and the firm is sure that EUR is going to appreciate against dollar. EUR in this case becomes the strong currency and as it is a payableApplying the rule- Lead payables in strong currency- The American firm will propose to make the payment immediately and demand a discount for cash payment.

Netting and offsetting

A firm with receivables and payables in diverse currencies can net out exposure in each currency by matching receivables and payables Thus a firm with exports to and imports from an Australian company need not cover each transaction separately. It can use a receivable to settle all or part of the payable and then take a hedge only for the net A $ payable and receivable

Example
An American company with imports and exports from Australia An American company is supposed to pay A $ 50,000 to an Australian exporter and the same time it is to receive A $ 30,000 on account of the exports made by it to an Australian importer. The company may ask its importer to pay A $ 30,000 to the Australian exporter. It will now have to obtain a hedge only for A $ 20,000

Translation Exposure
Translation exposure also called as balance sheet exposure, it is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the near future The difference between the two exposures is that the transaction exposure has an impact on the cash flows, while translation has no direct impact on the cash flows.

Translation exposure
Translation exposure typically arises when a parent multinational company is required to consolidate a foreign subsidiaries financial statements with the parents own statements after translating the subsidiaries statements from its functional currency to home currency.

Example
Suppose an Indian company has a UK subsidiary, At the beginning of the parents financial year, the subsidiary has real estate , inventory and cash valued at $1,000,000, $200,000 and $150,000, The spot rate is Rs 68 per $, by the close of the financial year these have changed to $950000, $205,000 and $160,000 respectively, however during the year, there has a drastic depreciation of $ to 65, if the parent is required to translate the subsidiary balance sheath from dollar into rupees at the current exchange rate it has suffered a translation loss, the translation value of the assets has declined from Rs 9.18 Crore to Rs 8.57 Crore Note that no cash movement is involved in this.

Translation exposure Contd

The Translation losses and gains are therefore notional accounting losses and gains

Economic exposure
A managerial concept rather than an accounting concept Affects the competitive position of the company in market and hence its profits Example: If the company's competitors are lets say using British imports and the pound weakens , the company loses its competitiveness[ or vice versa if the pound were to become strong]

Thanks for your attention . . .