instruction 5 (1) Flashcards
Hedging receivables (money market hedge) five step procedure
1) today, borrow present value of your receivable
2) convert this into the home currency ($) at the current spot rate
3) invest the $ amount in the US (at risk free)
4) After 1 year, collect your receivable and use it to repay the pound loan
Hedging receivables money market hedge
Money market hedge is nearly identicaly to the forward market hedge
Is it surprising? What happens if they were not identical?
There would be arrbitrage opportunity (interest rate parity doesnt hold)
call option
Right to buy
Call gives the holder the right, but not the obligation, to buy a certain amount of a foreign currency at a specific exchange rate up to or at the maturity date
Put option
Right to sell
Put gives the holder the sell, but not the obligation, to buy a certain amount of a foreign currency at a specific exchange rate up to or at the maturity date
Option market hedge (hedging receivables)
In general, the firm can buy a foreign currency
Call –> to hedge its foreign currency payables
Put –> to hedge the receivables
Hedging receivables all together
1) In the unhedged position, you have unlimited loss and gain (bet against appreciation of pound next year)
2) Forward hedge: assures receiving a certain amount in one year; future spot exchange becomes irrelevant
3) money market hedge: guarantees receiving a certain amount now or more in one year; the future spot exchange rate becomes irrelevant
4) Option market hedge: assures receiving at least the option execution price or more if the future spot exchange rate excess the exercise exchange rate. (you control downside risk while retaining the upside potential)
what if your FX position was on illiquid currencies?
hedging illiquid currencies are very costly or sometimes impossible
Financial markets of developing countries are usually highly regulated and underdeveloped
Solution: cross hedging
It is a technique to manage the minor currency exposure of firm
Cross hedging involves a hedging position in one asset by taking a position of another asset
cross hedging minor currency exposure
Invest in something highly correlated with the value of that currency
E.g. invest in yen instead of won because they move together
currency swap contract
an agreement to exchange one currency for another at a predetermined exchange rate (swap rate)
A swap contract is like
a portfolio of forward contracts with different maturities
lead-lag strategy
if a currency is appreaciating –> hard currency
Pay those bills denominated in that currency early (lead)
Let customers pay late (lag)
If a currency is depreciating –> soft currency
Give incentives to customer who owe you in that currency to pay early (lead)
Pay your obligations denominated in that currency as late as your contracts will allow (lag)
Who performs lead-lag strategy
Usually among the subsidiaries of the same multiational companies
The lead/lag strategy can be employed more effectively to deal with intrafirm payables and receivables, such as material costs, rents, royalties, interests and dividends etc.
Exposure netting
Do not consider deals in isolation, but aggregate positions in each currency
Positions in different currencies may yield a cross-hedge (e.g. being short yen and long korean won)
Trade-offs between accuracy of hedge and fees
Firms use reinvoice center, a financial subsidiary: a mechanism for exposure management functions
theory of comparative advantage
Economic well being improves if countries produce goods they have a comparative advantage in, and then trade
Assumes free trade and immobile factors of production
Not absolute production capability but relative efficiency
