Chapter 11 - Managing Transaction Exposure Flashcards
Chap Objectives
Describe common policies for hedging transaction exposure.
Compare the techniques commonly used to hedge payables.
Compare the techniques commonly used to hedge receivables.
Describe limitations of hedging.
Suggest other methods of reducing exchange rate risk when hedging techniques are not available.
Policies for Hedging Transaction Exposure
Transaction exposure exists when contractual transactions cause a multinational corporation (MNC) to either need or receive a specified amount of a foreign currency at a specified time in the future.
*MNCs may consider hedging contractual transactions denominated in foreign currencies.
*By managing transaction exposure, MNCs may increase future cash flows, or at least reduce the uncertainty surrounding their cash flows.
An MNC’s policy for hedging transaction exposure depends in part on its degree of risk aversion.
Hedging Most of the Exposure:
–> Hedging most of the transaction exposure allows M N Cs to more accurately forecast future cash flows (in their home currency) so that they can make better decisions regarding the amount of financing they will need.
Selective Hedging (consider each type of transaction separately):
–> M N C must first identify its degree of transaction exposure.
M N C must consider the various techniques to hedge the exposure so that it can decide which hedging technique is optimal and whether to hedge its transaction exposure.
Hedging Exposure to Payables
An MNC may decide to hedge part or all of its payables transactions denominated in foreign currencies so that it is insulated from the possible appreciation of those currencies.
An M N C may decide to hedge part or all of its known payables transactions using:
- Forward or futures hedge
- Money market hedge
- Currency option hedge
Forward or Futures Hedge on Payables
Allows an M N C to lock in a specific exchange rate at which it can purchase a currency and hedge payables. A forward contract is negotiated between the firm and a financial institution. The contract will specify the:
1. currency that the firm will pay.
2. currency that the firm will receive.
3. amount of currency to be received by the firm.
4. rate at which the M N C will exchange currencies (called the forward rate).
5. future date at which the exchange of currencies will occur.
Example:
*The same process would apply if futures contracts were used instead of forward contracts. The futures rate is typically close to the forward rate.
*Thus, the main difference is that futures contracts are standardized and can be purchased on an exchange, whereas a forward contract is negotiated between the MNC and a commercial bank.
*Forward contracts
Money Market Hedge on Payables
Money Market Hedge on Payables
- Involves taking a money market position to cover a future payables position.
- If a firm prefers to hedge payables without using its cash balances, then it must
–> Borrowed funds in the home currency and
–> Short-term investment in the foreign currency. - Money market hedge versus forward hedge
–> Since the results of both hedges are known beforehand, the firm can implement the one that is more feasible.
–> If interest rate parity (IRP) holds and there are no transaction costs, the money market hedge will yield the same results as the forward hedge. Because the forward premium on the forward rate reflects the interest rate differential between the two currencies, the hedging of future payables with a forward contract would yield similar results as borrowing at the home interest rate and investing at the foreign interest rate.
Call Option Hedge on Payables
A currency call option provides the right to buy a specified amount of a particular currency at a specified strike price or exercise price within a given period of time.
The currency call option does not obligate its owner to buy the currency at that price. The M N C has the flexibility to let the option expire and obtain the currency at the existing spot rate when payables are due.
