Chapters 8, 9, 10. Exchange Risk ExposuresSlide 1Chapter OutlineChapter Outline (continued)Forward Market HedgeFMH: an ExampleFMHFutures Market(=FMH) Cross-Currency HedgeFutures Market Cross-Currency Hedge: Step OneFutures Market Cross-Currency Hedge: Step TwoMoney Market Hedge (using a bank)MMH (A/P denominated in a FC)MMH (FC A/P), cont’dMMH (FC A/R)Options Market HedgeOptions Markets HedgeHedging Exports with Put OptionsSlide 17Slide 18Hedging Imports with Call OptionsSlide 20Slide 21Slide 22Taking it to the Next LevelOur Importer Buys a Second Call OptionSlide 25OptionsCross-Hedging Minor Currency ExposureSlide 29Hedging Contingent ExposureHedging Recurrent Exposure with SwapsContingent Exposure, cont’dHedging through Invoice CurrencyHedging via Lead and LagExposure NettingSlide 36Exposure Netting: an ExampleSlide 38Multilateral Netting: an ExampleShould the Firm Hedge?Slide 41Slide 42What Risk Management Products do Firms Use?Chapters 8, 9, 10. Exchange Risk Exposures3 Types of exposuresTransactions exposures ~ $ (HC) value of a FC contractual amount (e.g., A/R, A/P denominated in a FC) changesEconomic (Operational) Exposure ~ firm’s competitive position affectedTranslation (Accounting) Exposure ~ arises when a MNC consolidated financial statements of its foreign operations (subsidiaries and affiliates)Chapter Objective:This chapter discusses various methods available for the management of transaction exposure facing multinational firms.8Chapter EightManagement of Transaction Exposure8-2Chapter OutlineForward Market HedgeMoney Market HedgeOptions Market HedgeCross-Hedging Minor Currency ExposureHedging Contingent ExposureHedging Recurrent Exposure with Swap Contracts8-34Chapter Outline (continued)Hedging Through Invoice CurrencyHedging via Lead and LagExposure NettingShould the Firm Hedge?What Risk Management Products do Firms Use?8-4Forward Market HedgeIf you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract.If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.8-5FMH: an ExampleYou are a U.S. importer of Italian shoes and have just ordered next year’s inventory. Payment of €100M is due in one year.Question: How can you fix the cash outflow in dollars?Answer: One way is to put yourself in a position that delivers €100M in one year—a long forward contract on the euro. 8-6FMH$1.50/€Value of €1 in $ in one year$1.80/€The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position.In short, insurance on your car => a portfolio of car and insurance$0$30 m$1.20/€–$30 mLong forwardUnhedged payableHedged payable8-7Futures Market(=FMH) Cross-Currency HedgeYour firm is a U.K.-based exporter (£ HC) of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer. Payment (in euro) is due in six months. Your firm wants to hedge the receivable into pounds.Sizes of forward contracts are shown. CountryU.S. $ equiv.Currency per U.S. $Britain (£62,500) $2.0000 £0.50001 Month Forward $1.9900 £0.50253 Months Forward $1.9800 £0.50516 Months Forward $2.0000 £0.500012 Months Forward $2.1000 £0.4762Euro (€125,000) $1.4700 €0.68031 Month Forward $1.4800 €0.67573 Months Forward $1.4900 €0.67116 Months Forward $1.5000 €0.666712 Months Forward $1.5100 €0.66238-8Futures Market Cross-Currency Hedge: Step One You have to convert the €750,000 receivable first into dollars and then into pounds.If we sell the €750,000 receivable forward at the six-month forward rate of $1.50/€ we can do this with a SHORT position in 6 six-month euro futures contracts.6 contracts = €750,000€125,000/contract8-9Futures Market Cross-Currency Hedge: Step Two Selling the €750,000 forward at the six-month forward rate of $1.50/€ generates $1,125,000:9 contracts = £562,500£62,500/contract$1,125,000 = €750,000 × €1$1.50At the six-month forward exchange rate of $2/£, $1,125,000 will buy £562,500. We can secure this trade with a LONG position in 9 six-month pound futures contracts:8-10Money Market Hedge (using a bank)This is the same idea as covered interest arbitrage.1) To hedge a foreign currency A/P, buy the PV of that foreign currency amount today and make a FC deposit (=investment) today so that you can withdraw A/P when due.Buy the PV of the foreign currency payable today.Invest that amount at the foreign interest rate.At maturity your investment will have grown enough to cover your foreign currency payable.8-11MMH (A/P denominated in a FC)A U.S.–based importer of Italian bicyclesIn one year owes €100,000 to an Italian supplier.The spot exchange rate is $1.50 = €1.00The one-year interest rate in Italy is i€ = 4%$1.50 €Dollar cost today = $144,230.77 = €96,153.85 ×€100,0001.04€96,153.85 = Can hedge this payable by buyingtoday and investing €96,153.85 at 4% in Italy for one year.At maturity, he will have €100,000 = €96,153.85 × (1.04)8-12MMH (FC A/P), cont’d$148,557.69 = $144,230.77 × (1.03)With this money market hedge, we have redenominated a one-year €100,000 payable into a $144,230.77 payable due today.If the U.S. interest rate is i$ = 3% we could borrow the $144,230.77 today and owe in one year$148,557.69 =€100,000(1+ i€)T(1+ i$)T×So×8-13MMH (FC A/R)1. Calculate the PV of £y receivable at i£ £y(1+ i£)T2. Borrow the PV of the FC receivable => this is your money! $x = S($/£)× £y(1+ i£)T3. Exchange for £y(1+ i£)T4. If interested, determine the FV of $x by $x(1 + i$)T.8-14Options Market HedgeOptions provide a flexible hedge against the downside, while preserving the upside potential.To hedge a FC payable, buy calls on the currency.If the currency appreciates, your call option lets you buy the currency at the already given low exercise price of the call.To hedge a FC receivable, buy puts on the currency.If the currency depreciates, your put option lets you sell the currency for the already given high exercise price.8-15Options Markets HedgeIMPORTERS 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