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Hedging Foreign Exchange Exposures
Hedging Foreign Exchange Exposures
Hedging Foreign Exchange Exposures
BY MRINMOY 1121610
Hedging Strategies
Recall that most firms (except for those involved in currency-trading) would prefer to hedge their foreign exchange exposures. But, how can firms hedge?
(1) Financial Contracts Forward contracts (also futures contracts) See Appendix 1 for a discussion of forward contracts. Options contracts (puts and calls) Borrowing or investing in local markets. (2) Operational Techniques Geographic diversification (spreading the risk)
Forward Contracts
These are foreign exchange contracts offered by market maker banks.
They will sell foreign currency forward, and They will buy foreign currency forward Market maker banks will quote exchange rates today at which they will carry out these forward agreements.
These forward contracts allow the global firm to lock in a home currency equivalent of some fixed contractual foreign currency cash flow.
These contracts are used to offset the foreign exchange exposure resulting from an initial commercial or financial transaction.
What is the potential problem for the U.S. firm if it decides not hedge (i.e., not to cover)?
Problem for the U.S. firm is in assuming the risk that the euro might weaken over this period, and in 30 days it will be worth less (in terms of U.S. dollars) than it is now. This would result in a foreign exchange loss for the firm.
Global firm knows exactly what the home currency equivalent of a fixed amount of foreign currency will be in the future. However, global firm cannot take advantage of a favorable change in the foreign exchange spot rate.
Options contracts are either written by global banks (market maker banks) or purchased on organized exchanges (e.g., the Chicago Mercantile Exchange). Options contracts provide the global firm with:
(1) Insurance (floor or ceiling exchange rate) against unfavorable changes in the exchange rate, and additionally (2) the ability to take advantage of a favorable change in the exchange rate. This latter feature is potentially important as it is something a forward contract will not allow the firm to do.
Put Option:
Important advantage:
Options provide the global firm which the potential to take advantage of a favorable change in the spot exchange rate.
Recall that this is not possible with a forward contract.
Important disadvantage:
Options can be costly:
Firm must pay an upfront non-refundable option premium which it loses if it does not exercise the option.
Recall there are no upfront fees with a forward contract.
This fee must be considered in calculating the home currency equivalent of the foreign currency. This cost can be especially relevant for smaller firms and/or those firms with liquidity issues.
Global firm expecting to receive foreign currency in the future (long position):
Will take out a loan (i.e., borrow) in the foreign currency equal to the amount of the long position. Will convert the foreign currency loan amount into its home currency at the spot exchange rate. And eventually use the long position to pay off the foreign currency denominated loan.
Specific Strategy for foreign currency in the Global firm needing to pay out a Short Position future (short position).
Will borrow in its home currency (an amount equal to its short position at the current spot rate). Will convert the home currency loan into the foreign currency at the spot rate. Will invest in a foreign currency denominated asset And eventually use the proceeds from the maturing financial asset to pay off the short position.
See Appendix 3 for more discussion of this borrowing and lending strategy.
Because transaction exposures have known foreign currency cash flows and thus they are easy to hedge with financial contracts However, economic foreign exchange exposures do not provide the firm with this known cash flow information.
Recall that economic exposure is long term and involves unknown future cash flows.
So this type of exposure is difficult to hedge with the financial contracts we have discussed thus far. What can the firm do to manage this economic exposure?
Firm can employ an operational hedge. This strategy involves global diversification of production and/or sales markets to produce natural hedges for the firms unknown foreign exchange exposures. As long as exchange rates with respect to these different markets do not move in the same direction, the firm can stabilize its overall cash flow.
Perhaps the estimated impact is so small as not to be of a concern. Or, perhaps the firm is convinced it can benefit from its exposure.