Managing transaction exposure

Question 1

Describe what selective hedging will involve for an MNCs

Answer 1

MNC must identify its degree of transaction
exposure. MNC 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.
Many MNCs use selective hedging, in which they consider each type of transaction separately

Question 2

What methods might an MNC use to hedge part of all of its known payables

Answer 2

Forward or futures hedge
Money market hedge
Currency option hedge

Question 3

Describe what a forward contract will set out for an MNC

Answer 3

A forward contract is negotiated
between the firm and a financial institution. The contract will specify the:
▪ currency that the firm will pay
▪ currency that the firm will receive
▪ amount of currency to be received by the firm
▪ rate at which the MNC will exchange currencies
(called the forward rate)
▪ future date at which the exchange of currencies will occurH

Question 4

How can a forward or futures hede on payables work?

Answer 4

Allows an MNC to lock in a specific exchange rate at which it can purchase a currency and hedge payables. Hedging allows
MNCs to more accurately forecast future cash flows so that they can make better decisions regarding the amount of financing they will need.

Question 5

What is a money market hedge?

Answer 5

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
▪ Borrow funds in the home currency and
▪ Invest in the foreign currency

Question 6

Compare and contrast money market hedge to forward hedge

Answer 6

Since the results of both hedges are known beforehand, the firm can implement the one that is more feasible. If IRP holds and there are no transaction costs, the money market hedge will yield the same results as the forward hedge

Question 7

What is a currency call option

Answer 7

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. he MNC has the flexibility to let the option expire and obtain the currency at the existing spot rate when payables are due.

Question 8

What are the costs/advantages and disadvantages of call options

Answer 8

Advantage: provides an effective hedge
Disadvantage: premium must be paid
MNC can incorporate forecasts of the spot rate to more accurately estimate the cost of hedging with call options

Question 9

Compare hedging with call options to forward or money market hedging

Answer 9

The cost of the forward hedge or money market hedge can be determined with certainty.
The currency call option hedge has different
outcomes depending on the future spot rate at the time payables are due.

Question 10

How does one numerical evaluate a hedging decision

Answer 10

Evaluate the hedge decision by estimating the real cost of hedging versus the cost if not hedged.

Question 11

How can you select the optimal hedging technique?

Answer 11

Consider whether futures or forwards are preferred.
Consider desirability of money market hedge versus futures/forwards based on cost.
Assess the feasibility of a currency call option based on estimated cash outflows.
Consider no hedge for payables - even if MNCs knows their future parables may decide not to hedge.

Question 12

Real cost of hedging formula

Answer 12

Cost of hedging payables - cost of payables if not hedged

Question 13

What do forward or futures hedges allow an MNC to do on receivables

Answer 13

Forward or futures hedge on receivables
allows the MNC to lock in the exchange rate at which it can sell a specific currency.
Money market hedge on receivables involves borrowing the currency that will be received and using the receivables to pay off the loan.

Question 14

Formula to asses the cash inflow in $ of receivables using a forward hedge

Answer 14

Receivables x forward rate

Question 15

Explain when firm might invest any funds coming from borrowing in a money market hedge

Answer 15

If the MNC does not need any short-term funds to support existing operations, it can still obtain a loan, convert the funds to dollars, and invest the dollars in the money market

Question 16

Define a put option hedge on receivables

Answer 16

Put option hedge on receivables provides the right to sell a specified amount of a particular currency at a specified strike price by a specified expiration date

Question 17

Describe the costs, advantages an disadvantages of put options to hedge receivables

Answer 17

Advantage: provides an effective hedge
Disadvantage: premium must be paid
MNC can use currency forecasts to more accurately estimate the dollar cash inflows to be received when hedging with put options

Question 18

How to consider an optimal technique for hedging receivables

Answer 18

Consider whether futures or forwards are preferred.
Consider desirability of money market hedge versus futures/forwards based on cost.
Assess the feasibility of a currency put option based on estimated cash outflows.
Consider no hedge - MNC may know what its future receivables will be yet
still decide not to hedge.

Question 19

How can one evaluate the hedging decisions reached for receivables

Answer 19

Evaluating the hedge decision by estimating
the real cost of hedging receivables versus the cost of receivables if not hedged.

Question 20

Review how to use future hedge to hedge payables and receivables

Answer 20

Payables: Purchase currency futures contract representing the currency and amount related to payable
Receivables: Sell a currency futures contract representing the currency and amount of receivable

Question 21

Review how to use forward hedge to hedge payables and receivables

Answer 21

Payables: Negotiate and purchase forward contract for amount fo foreign currency needed to cover payables
Receivables: Negotiate and sell a forward contract for amount of foreign currency that will be received in receivables

Question 22

Review how to use money market hedge to hedge payables and receivables

Answer 22

Payables: Borrow local currency and convert to the currency denominating payable. Invest these funds until they are needed.
Receivables: Borrow the currency denominating receivables, convert it to the local currency and invest it. Then pay off the loan with cash inflows from the receivables.

Question 24

Review how to use currency option hedge to hedge payables and receivables

Answer 24

Payables: Purchase currency call option representing the currency and amount related to payables
Receivables: purchase a currency put option representing the currency and amount related to receivables.

Question 25

What is a limitation of hedging an uncertain payment

Answer 25

Some international transactions involve an
uncertain amount of foreign currency, leading to overhedging.
If the actual payment on a transaction is less than the expected payment, the MNC over-hedged and is partially exposed to exchange rate movements

Question 26

What are alternative hedging techniques

Answer 26

Leading and Lagging: adjusting the timing of a payment or disbursement to reflect expectations about future currency movements.
Cross-Hedging: hedging by using a currency
that serves as a proxy for the currency in which the MNC is exposed.
Currency Diversification: Diversifying business among numerous countries