Foreign currency exposure into 3
types:
1.
Transaction Exposure-the
sensitivity of “realized” domestic currency values of the firm’s contractual
cash flows denominated in foreign currencies to unexpected exchange rate
changes. Short-term exposure when it faces contractual cash flows that
are fixed in foreign currencies. Unlike economic exposure well defined:
the magnitude of transaction exposure is the same as the amount of foreign
currency that is receivable or payable. Alternative ways of hedging transaction
exposure using various financial contracts and operational techniques:
Financial Contracts
§ Forward Market Hedge
§ Money market hedge
§ Option market hedge
§ Swap market hedge
Forward market Hedge
Most popular of hedging transaction
exposure is by currency forward contracts. The firm may sell or buy its
foreign currency receivables (payables) forward to eliminate its exchange risk
exposure. Gains and losses from forward hedging can be computed as
follows: Gain= (F-St) x L10 Million. Ex post in nature. No
one can know for sure what the future spot rate will be beforehand. The
firm must decide whether to hedge or not to hedge ex ante. 3 alternative
scenarios: (St denotes the firm’s expected spot exchange rate for the maturity
date).
Operational techniques
1.
Choice of the invoice currency
2.
lag strategy-A foreign exchange
management strategy consisting of delaying payments or receipts in a foreign
currency, on the expectation of the evolution of the foreign exchange rate.
Opposite: Lead strategy-This strategy implies that firms
will pay off foreign currency debts and collect foreign currency receipts
early. This, typically, because the local currency is expected to weaken.
3.
Exposure netting-Offsetting exposures in one currency with exposures in the same or
another currency, when exchange rates are expected to move in
such a way that lossesor gains on the first exposed position should be offset by gains or losses on the second
currency exposure.
4.
Economic Exposure- the extent to
which the value of the firm would be affected by unanticipated changes in
exchange rates. Changes in exchange rates can have a profound effect on
the firms competitive position in the world market and thus on its cash flows
and market value.
5.
Translation exposure-the potential
that the firms’ consolidated financial statements can be affected by changes in
exchange rates. Involves translation of subsidiaries’ financials statements
from local currencies to the home currency. Resultant translation gains
and losses represent the accounting system’s attempt to measure economic
exposure ex post. It does not provide a good measure of ex ante economic
exposure.
Forward market Hedge
Most popular of hedging transaction
exposure is by currency forward contracts. The firm may sell or buy its
foreign currency receivables (payables) forward to eliminate its exchange risk
exposure. Gains and losses from forward hedging can be computed as follows:
Gain= (F-St) x L10 Million. Ex post in nature. No one can
know for sure what the future spot rate will be beforehand. The firm must
decide whether to hedge or not to hedge ex ante. 3 alternative scenarios:
(St denotes the firms expected spot exchange rate for the maturity date)
1. St=F,
gains or losses are 0.
Firm can eliminate foreign exchange
exposure without sacrificing any expected dollar proceeds from the foreign
sale. The firm would be inclined to hedge as long as it is averse to
risk. Valid when the forward exchange rate is an unbiased predictor of
the future spot rate.
2. St<F
Firm’s expected future spot
exchange rate is less than the forward rate; the firm expects a positive gain
from forward hedging. Since the firm expects to increase the dollar
proceeds, while eliminating exchange exposure, it would be even more inclined
to hedge under this scenario than under the first scenario. Implies that
the firm’s management issues from the market’s consensus forecast of the future
spot exchange rate as reflected in the forehand rate.
3. St>f
Firm can eliminate exchange
exposure via the forward contract only at the cost of reduced expected dollar
proceeds for the foreign sale. Firm less inclined to hedge under this
scenario. From perspective of a hedging firm, the reduction in the
expected dollar proceeds can be viewed implicitly as an “insurance premium”
paid for avoiding the hazard of exchange risk. The firm can use a
currency futures contract, rather than a forward contract, to hedge. A
future contract is not as suitable as a forward contact for hedging purpose
for:
1. Unlike
forward contracts that tailor-made to firms specific needs, future contracts
are standardized instruments in terms of contract size, delivery date, et.
Can hedge only approximately.
2. Due to
the marketing-to-marketing property, there are interim cash flows prior to the
maturity date of the future contract that may have to be invested at uncertain
interest rates.
Money Market Hedge
Firm may borrow (lend) in foreign
currency to hedge its foreign currency receivables (payables), thereby matching
its assets and liabilities in the same currency. Transactions: Borrow
pounds-the maturity value of borrowing should be the same as the pound
receivable; the amount to borrow can be computed as the discounted present
value of the pound receivable. Buy dollar spot with pounds, invest in the
United States, Collect pound receivable=Net Cash Flow. Apart from
possible transactions, it is fully self-financing.
Options Market Hedge
Shortcoming of forward and
money market hedges is that these methods completely eliminate exchange
exposure. Currency options provide such a flexible “optional” hedge
against exchange exposure. The firm (receivables). Main advantage
of options hedging is that the firm can decide whether to exercise the option
based on the relaxed spot exchange rate on the expiration date. The
options hedge allows the firm to limit the downside risk while preserving the
upside potential. When a firm has an account payable rather than a
receivable, in terms of a foreign currency, the firm can set a ceiling for the
future dollar cost of buying the foreign currency amount by buying a call
option on the foreign currency amount. Break-even spot rate. globalsocialmediamarketing.com
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