Hedging will be understood to mean a transaction undertaken specifically to offset some exposure arising out of the firm's usual operations

Speculation will refer to deliberate creation of a position for the express purpose of generating a profit from exchange rate fluctuations, accepting the added risk

Management of transactions exposure has two significant dimensions ◦ The treasurer must decide whether and to what

extent an exposure should be explicitly hedged ◦ The treasurer must evaluate alternative hedging

strategies

The net exposure in a given currency at a given date is

(the total inflows) – (total outflows) to be settled on that date ) The Cost of a Forward Hedge

◦ Common fallacy to claim that the cost of forward hedging is the forward discount or premium

◦ The ex-ante value of the payable if the firm does not hedge should be considered.

◦ The relevant comparison is between the forward rate and the expected spot rate on the day the transaction is to be settled

◦ If speculators are risk neutral and there are no transaction costs, . the forward rate at time t for transactions maturing at T equals the expectation at time t, of the spot rate at time T

Ft,T = Set,T

◦ If the speculators in the foreign exchange market are not risk neutral

Ft,T > Set,T or Ft,T < Se

t,T◦ Even in the case when speculators are not risk

neutral the expected cost of hedging with forwards is zero except for the fact that bid/offer spreads are somewhat wider in forwards than in spot

Hedging with Currency Futures

◦ Hedging contractual foreign currency flows with currency futures is in many respects similar to hedging with forward contracts

◦ A futures hedge differs from a forward hedge because of the intrinsic features of futures contracts standardization Since amounts and delivery dates

for futures are standardized, a perfect futures hedge is generally not possible

Basis risk - imperfect correlation between spot and futures prices RBI REFERENCE RATE SETTLED !

Intermediate- Futures unlike forwards, give rise to cash flows due to the marking-to-market feature

HEDGING LONG AND SHORT EXPOSURES WITH FUTURES

Change In value of portfolio

Change In value of price

Change In value of price

Change In value of portfolio

hedge

exposure

exposure

hedge

Currency Appreciation (long)exposure with

SHORT hedgeExporter’s hedge

Currency Depreciation (short)exposure with

LONG hedgeImporter’s hdge

◦ The advantage of futures over forwards is firstly easier access and secondly greater liquidity

◦ Currency futures are used by commercial banks to hedge positions taken in the forward markets

◦ Most corporations use OTC forwards to hedge transactions exposures arising out of operations

A receivable is hedged by selling a future A payable is hedged by buying a future

8

EXAMPLES OF HEDGING FOREIGN CURRENCYEXAMPLE 1: A LONG HEDGEON JULY 1, AN AMERICAN AUTOMOBILE DEALER ENTERS INTO A CONTRACT TO IMPORT 100 BRITISH SPORTS CARS FOR GBP 28,000 EACH. PAYMENT WILL BE MADE IN BRITISH POUNDS ON NOVEMBER 1.

RISK EXPOSURE: IF THE GBP APPRECIATES RELATIVE TO THE USD THE IMPORTER’S COST WILL RISE.

TIME SPOT FUTURES

JUL. 1 S(USD/GBP) = 1.3060 LONG 46 DEC GBP FUTURES@62,500

CURRENT COST = USD3,656,800 FOR F = USD1.2780/GBP

DO NOTHING

NOV. 1 S(USD/GBP) = 1.4420 SHORT 46 DEC BP FUTURES

COST = 28,000(1.4420)(100) FOR F = USD1.4375/GBP

= USD4,037,600 PROFIT: (1.4375 - 1.2780)62,500(46) = USD458,562.50

INCREASED COST =USD 380,000

ACTUAL COST = USD3,579,037.50* brokerage fee?

46 780)62,500(1.2

3,656,800 =n sizecontract

9

EXAMPLE 2: A SHORT HEDGEA US MULTINATIONAL COMPANY’S ITALIAN SUBSIDIARY WILL GENERATE EARNINGS OF EUR 2,516,583.75 AT THE END OF THE QUARTER - MARCH 31. THE MONEY WILL BE DEPOSITED IN THE NEW YORK BANK ACCOUNT OF THE FIRM IN U.S. DOLLARS.

RISK EXPOSURE: IF THE DOLLAR APRECIATES RELATIVE TO THE EURO THERE WILL BE LESS DOLLARS TO DEPOSIT.

TIME CASH FUTURES

FEB. 21 S(USD/EUR) = 1.18455 F(JUN) = USD1.17675/EUR

CURRENT SPOT VALUE F = 125,000(1.17675) = USD147,093.75

= USD2,981,019.28 n = 2,981,019.28/147,093.75 = 20.

DO NOTHING SHORT 20 JUN EUR FUTURES

MAR 31 S(EUR/USD) = 1.1000 LONG 20 JUN EUR FUTURES

DEPOSIT 2,768,242.125 F(JUN) = USD1.10500

PROFIT: (1.17675 -1.10500)125,000(20) = USD179,375

TOTAL AMOUNT TO DEPOSIT USD 2,947,617.125

A 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 market basket index

Trade between developed countries in manufactured products is generally invoiced in the exporter's currency

Trade in primary products and capital assets is generally invoiced in a major vehicle currency such as the US dollar.

Trade between a developed and a less developed country tends to be invoiced in the developed country's currency.

If a country has a higher and more volatile inflation rate than its trading partners, there is a tendency not to use that country's currency in trade invoicing

Suppose that Boeing is scheduled to deliver an aircraft to British airways at the beginning of each year for the next five years. British Airways, in turn, is scheduled to pay ￡ 10,000,000 to Boeing on December 1 of each year for five years. In this case, Boeing faces a sequence of exchange risk exposures.

If Boeing invoices $15 million(home currency) rather than ￡ 10 million for the sale of the aircraft, then it does not face exchange exposure anymore. However, the exchange exposure does not disappear but merely shifts to the British importer.

British Airways now has an account payable denominated in U.S. dollars.

Risk shifting :

Instead of shifting the exchange exposure entirely to British Airways, Boeing can also share the exposure with British Airways , for example, invoicing half of the bill in U.S. dollars and the remaining half in British pounds, that is , $7.5 million and ￡ 5 million. In this case, the magnitude of Boeing’s exchange exposure is reduced by half.

As a practical matter, however, the firm may not be able to use risk shifting or sharing as much as it wishes to for fear of losing sales to competitors.

Also if the currencies of both the exporter and the importer are not suitable for settling international trade, neither party can resort to risk shifting/sharing to deal with exchange exposure.

Risk sharing :

The firm can diversify exchange exposure to some extent by using currency basket units such as the SDR as the invoice currency.

Often, multinational corporations and sovereign entities are known to float bonds denominated either in the SDR or in the ECU prior to the introduction of the euro.

For example, the Egyptian government charges for the use of the Suez Canal using the SDR. Obviously, these currency baskets are used to reduce exchange exposure.

Definition The settlement of obligations between two

parties that processes the combined value of transactions. It is designed to lower the number of transactions required. For example, if Bank A owed Bank B $100,000, and Bank B owed Bank A $25,000, the value after netting would be a $75,000 transfer from Bank A to Bank B ($100,000 - $25,000).

In 1984, Lufthansa, a German airline, signed a contract to buy $3 billion worth of aircraft from Boeing and entered into a forward contract to purchase $1.5 billion forward for the purchase of hedging against the expected appreciation of the dollar against the German mark. This decision, however, suffered from a major flaw: A significant portion of Lufthansa's cash flows was also dollar-denominated. As a result, Lufthansa's net exposure to the exchange risk might not have been significant. Lufthansa had a so-called “natural hedge.”

In 1985, the dollar depreciated substantially against the mark and, as a result, Lufthansa experienced a major foreign exchange loss from settling the forward contract. This episode shows that when a firm has both receivables and payables in a given foreign currency, it should consider hedging only its net exposure.

So far, we have discussed exposure management on a currency-by-currency basis. In reality, a typical multinational corporation is likely to have a portfolio of currency positions. For instance, a U.S. firm may have an account payable in euros and, at the same time, an account receivable in Swiss francs. If the euro and franc move against the dollar almost in lockstep, the firm can just wait until these accounts become due and then buy euros spot with francs. It can be wasteful and unnecessary to buy euros forward and sell francs forward. In other words, if the firm has a portfolio of currency positions, it makes sense to hedge residual exposure rather than hedge each currency position separately.

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.

If the firm would like to apply exposure netting aggressively, it helps to centralize the firm’s exchange exposure management function in one location.

Many multinational firms use a re-invoice center. Which is a financial subsidiary that nets out the intra-firm transactions.

Once the residual exposure is determined, then the firm implements hedging.

Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions:

$10 $35 $40$30

$20

$25 $60

$40$10

$30

$20$30

Bilateral Netting would reduce the number of foreign exchange transactions by half:

$10 $35 $40$30

$20

$40

$30

$20$30

$20$30$10

$40$30$10

$30$20

$60

$10 $35$25

$60

$40$20

$25 $10

$25 $10$15

$10

A major reason for netting is that it adds additional security in the event of a bankruptcy to either party. By netting, in the event of bankruptcy, all of the swaps are executed instead of only the profitable ones for the company going through the bankruptcy. For example, if there was no bilateral netting, the company going into bankruptcy could collect on all in the money swaps while saying they can't make payment on the out of the money swaps due to the bankruptcy.

Definition A transaction which closes an investor’s

position with another transaction. For example, an options investor could close a sold call option by buying a call option for the same number of shares.

To reduce an investor's net position in an investment to zero, so that no further gains or losses will be experienced from that position.

To “lead” means to pay or collect early, whereas to “lag” means to pay or collect late.

The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and benefit from the appreciation of the hard currency.

For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables.

It is more attractive to use for the payments between associate companies within a group.

Leading and lagging are aggressive foreign exchange management tactics designed to take the advantage of expected exchange rate changes.

However this technique requires some form of speculation due to the need to identify the movement of the exchange rates.

Say for example a company bought a consignment of rice from India payable in USD which is expected to appreciate in the coming weeks. It will be the best interest for the company to pay up as soon as possible before the USD appreciates further

This is what we call leading currency payments

The lead/lag strategy can be employed more effectively to deal with intra-firm payables and receivables, such as material costs, rents, royalties, interests, and dividends, among subsidiaries of the same multinational corporation.

Since managements of various subsidiaries of the same firm are presumably working for the good of the entire firm, the lead/lag strategy can be applied more aggressively.

lezione_profPIOTRMISZTAL.ppt http://ec.europa.eu/economy_finance/

publications/publication11475_en.pdf http://highered.mcgraw-hill.com/sites/dl/

free/0070912289/235906/new_chapter_13.pdf