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Eun7e CH 008
Eun7e CH 008
Eun7e CH 008
Chapter Eight
Copyright © 2014 by the McGraw-Hill Companies,
8-1reserved.
Inc. All rights
Chapter Outline
• Forward Market Hedge
• Money Market Hedge
• Options Market Hedge
• Cross-Hedging Minor Currency Exposure
• Hedging Contingent Exposure
• Hedging Recurrent Exposure with Swap Contracts
• Hedging Through Invoice Currency
• Hedging via Lead and Lag
• Exposure Netting
• Should the Firm Hedge?
• What Risk Management Products Do Firms Use?
Importer Go
nc c
rre sti
Se od
y
Cu m e
rv s o
Do
ic e r
s
Forward
rre ign
Fo rren
y
cu
re cy
cu re
Foreign
nc
Contract
Fo
ign
Counterparty Supplier
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-3
8-3
Forward Market Hedge: Exports
• If you are going to receive foreign currency in the future, agree to sell the
foreign currency in the future at a set price by entering into short position
in a forward contract.
Exporter
Fo rren
rre ign
Cu
re cy
y
ign
Cu re
nc
Fo
nc c
rre sti
Go rvi
y
Cu m e
od ces
Se
Do
Forward
so
Foreign
r
Contract Customer
Counterparty
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-4
8-4
Importer’s Forward Market Hedge
A U.S.-based importer of Italian shoes has just ordered next year’s inventory. Payment of
€100M is due in one year. If the importer buys €100M at the forward exchange rate of $1.50/€,
the cash flows at maturity look like this:
U.S.
Importer
00
Sh
,0
oe
00
s
,5
$1
0 0 €1
0
0, ,0
00
00
€ 1, ,0
00
Forward
Italian
Contract
Counterparty Supplier
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-5
8-5
Exporter’s Futures Market Cross-Currency Hedge
Your firm is a U.K.-based exporter of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer.
Payment (in euros) is due in six months. Your firm wants to hedge the receivable into pounds.
$148,557.69
$144,230.77
€1
flows
00
,00
bic
0
yc
l es
Supplier
U.S Bank
$127,500.00
$119,047.62
shoes to a French customer. flows
€1
0
Payment is due in one year.
0,0
Interest rates in dollars are
00
sh
7.10 percent in the U.S. and
oe
s
5 percent in the euro zone.
The spot exchange rate is Customer
$1.25/€1.00. Use a money U.S Bank
market hedge to eliminate
the exporter’s exchange rate
risk. Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-13
8-13
Importer’s Money Market Cross-Currency
Hedge
Your firm is a U.K.-based importer of bicycles. You
have bought €750,000 worth of bicycles from an Italian
firm. Payment (in euros) is due in one year. Your firm
wants to hedge the payable into pounds.
– Spot exchange rates are $2/£ and $1.55/€
– The interest rates are 3% in €, 6% in $ and 4% in £, all
quoted as an APR.
What should you do to redenominate this 1-year €-
denominated payable into a £-denominated payable
with a 1-year maturity?
£586,893.20
£564,320.39
Market
€7
$1,128,640.77 flows
50
,00
bic
0
yc
l es
Supplier
U.K Bank
£7,500
£0 – £500 –£500
pdown
1
= = =−/ 1 = £500
£10,000 – £7,500 £2,500 5
S1(£/€) = £0.75/€
With a hedge ratio of –0.20 our exporter would actually be better hedged with a long position in
50 PHLX puts.
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-20
8-20
10 Puts on €10,000 (Strike £8,000) is Not a Hedge
Out-of-the-Money:
Put T = 1 Spot Market
Option S1(£/€) = £1.00/€ £100,000 Sell €100,000
Dealer K0(£/€) = £0.80/€ Buying
d s Exporter €100,000 S (£/€) = £1.00/€. 1
o o
G 0 0
0 ,0
1 0 Notice that our exporter doesn’t have
customer €
a hedge when he buys 10 put options.
Go
od £80,000
€1 s Put Option
00 S (£/€) = £0.75/€
10×p0 = £2,077.92 ,00 Buying 1
o d
Go 0 T = 1 Spot Market
,0 0 Buy €400,000
0 0 0
customer € 1 , 0 S1(£/€) = £0.75/€.
0 0
£ 3 0 0 In-the-Money Puts
Go 0 ,0 S (£/€) = £0.75/€
0 40 1
00 Buying £400,000
,00 Option
The future value of the 0 Exporter
receivable net of the cost of 50 puts is €500,000 Dealer
£88,000 = £100,000 − £10,389.61 × 1.155 or
£88,000 = £400,000 − £10,389.61 × 1.155 − £300,000
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-22
8-22
Options Hedges and Money Market Hedges and Forward
Market Hedges
• The next two slides show that the hedge of buying 50
puts has the exact same payoffs as a forward market
hedge and a money market hedge.
• Recall the story: A British exporter is owed €100,000 in one
period.
• S0(£/€) = £0.80/€, S0($/€) = $2.00/€, S0($/£) = $2.50/£
– i£ = 15½% and i€ = 5%
– In the next year, there are two possibilities:
• S1(£/€) = £1.00/€ or
• S1(£/€) = £0.75/€
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-23
8-23
Money Market Cross-Currency Hedge
Perfect hedge whether S1(£/€) = £1.00/€ or S1(£/€) = £0.75/€.
Spot Foreign
Exchange
€95,238.10 Borrow PV of €100,000 at i€ = 5%
£76,190.48
T= 1 cash
£88,000
Market flows
£76,190.48
Go ,00
€1
od 0
00
S0(£/€) = £0.80/€,
s
i£ = 15½% Customer
U.K Bank
i€ = 5%
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-24
8-24
Forward Market Cross-Currency Hedge
A U.K.-based exporter sold a €100,000 order to an
Italian retailer. Payment is due in 1 year and the
exporter used a forward hedge. S0(£/€) = £0.80/€, S0($/€) = $2.00/€,
Euro S0($/£) = $2.50/£
Forward €100,000 i£ = 15½% i€ = 5% i$ = 10%
Contract
Counterparty $209,523.81 Exporter Goods Customer
Pound
€100,000
Forward
$209,523.81
Contract £88,000
Counterparty
d s
o 0
Go ,0 0
T = 1 Spot Market
00
Supplier €1 0
Sell €25,000
0 0 0 S1(£/€) = £1.00/€.
5, 0 0
G
£2 5,
oo
€1 €2
ds
00 Call
,00 £100,000 Option
0 Buying
€125,000 Dealer
The future value of the Importer
receivable net of the cost of the call is In-the-Money Calls:
S1(£/€) = £1.00/€
£88,000 = £75,000 + £13,000 or K0(£/€) = £0.80/€
£88,000 = £100,000 + £13,000 − £25,000 Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-27
8-27
Cross-Hedging Minor Currency Exposure
• The major world currencies are the U.S. dollar,
Canadian dollar, British pound, euro, Swiss franc,
Mexican peso, and Japanese yen.
• Everything else is a minor currency (for example, the
Swedish krona).
• It is difficult, expensive, and sometimes even
impossible to use financial contracts to hedge
exposure to minor currencies.
£1.00 = $2.00
€1.00 = $1.50
SFr 1.00 = $0.90
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-31
8-31
SFr150
$150
5 0
€ 1
£150
€150
£1
50
SFr150
$1
$150
50
5 0
r 1
S F
€150
£150 Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-32
8-32
Exposure Netting
SFr150 = $135
$150
5 0
€ 1
SFr150=$135
=
£150
$225 = €150
2 5
2 5
£1
$ 1 3
$
50
$1
$3
$150
$300
50
0
00
1 5
F r
S
$225 = €150
£150 = $300 Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-33
8-33
Exposure Netting
SFr150 = $135
$150
5 0
€ 1
SFr150=$135
=
£150
$225 = €150
2 5
2 5
£1
$ 1 3
$
50
$1
$3
$150
$300
50
0
00
1 5
F r
S
$225 = €150
£150 = $300 Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-34
8-34
$135
$15
$150
2 5
$165
$75
$ 2 0
9
$1
$
$300
$225
50
$3
00
$1
$150
$135
50
3 5
$ 1
$225
$75
$300 Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-35
8-35
Exposure Netting: How to Double Check
Your Answer
• It’s always good practice to check your work.
• It’s better for you to find your mistakes than for your
professor to (or your boss!).
• You can check your work in exposure netting by
adding up each subsidiary’s debits and credits.
• When you’re done, check that you haven’t destroyed
or “created” any money.
• A new example follows for practice checking
answers.
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-36
8-36
$100
$125 +$125
+$80 $80 +$155
+$155 –$240
–$300 $100
$140
$60
2 5
$ 1
$155
$125
$1
55
$1
$100
00
$80
8 0
$100 $ $80
+$80 +$100
+$155 $125 +$125
–$375 –$465
–$40 –$160
$155 Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-37
8-37
$25 $20
+$55 +$45
–$20 $20 +$75
$60 $140
5
$5
$75
$25
$ 4
5
–$30
+$30 –$75
–$45 –$55
–$25 $30 –$160
–$40 Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-38
8-38
$100
$60 +$40
$140
$6 0
$100
0 $ 4
–$100
–$60
–$40 –$160
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-39
8-39
Alternative Solution
$60
$140
$2
$140
0
$40
–$140
–$20
–$40 –$160
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved. 8-40
8-40
Netting with Central Depository
Some firms use a central depository as a cash pool to
facilitate funds mobilization and reduce the chance of
misallocated funds.
$6 4 0
0 $1
Central
depository
$1
4 0 60
$