Transaction exposure Flashcards
What are some alternatives way to manage transaction exposure?
Remain unhedged
Hedge in the forward market
Hedge in the money market
Hedge in the option market
Explain what it means to remain unhedged
You accept the transaction risk. Normally, if the firm has a strong believe in it’s own forecast, that will have a positive outcome resulting in a gain – i.e., forecasting the spot rate at the due date to be at least as good as at the point of sale. However, a firm cannot be sure that their forecast will hold.
In the end, the amount of money a firm makes/losses dependens on the spot rate at due date. Potential for either foreign exchange loss or gain
Explain what it means to hedge in the forward market
A forward hedge involves a forward (or futures) contract and a source of funds to fulfil that contract.
The forward contract is entered into at the time the transaction exposure is created.
A forward contract is an agreement to exchange currencies of different countries as a specific future date and at a specified forward rate (typically deal made with a financial institution). This means that the monetary amount received in the end is fixed by the agreed upon forward rate.
When a foreign currency denominated sale is made, it is booked at the spot rate of exchange existing on the booking date.
Explain what it means to hedge in the money market
A money market hedge involves a contract and a source of funds to fulfil that contract.
The firm seeking to construct a money market hedge borrows in one currency and exchanges the proceeds for another currency. In the case of taking a loan, the firm should convert the foreign currency from the loan to its own currency at spot rate, and then repay the loan when it get’s its foreign denominated asset
The money market hedge works as a hedge by matching assets and liabilities according to their currency of denomination.
Firms gets a foreign-denominated liability to offset foreign-denominated asset.
If a firm gets a receivable they should hedge in the money market by taking a loan in that foreign currency. In contrast, if a firm creates a payable, it should hedge in the money market by investing in an interest-bearing account money in that foreign currency.
The benefit compared to forward hedge, is that the company can generate returns on the loan, depending on how they use the loan.
how to compare forward hedge and money market hedge?
The structure of a money market hedge resembles that of a forward hedge.
The difference is that the cost of the money market hedge is determined by different interest rates than the interest rates used in the formation of the forward rate.
There is a possibility to generate return from the loan in a money market hedging, and both type of hedging has no FX risk, because the rate of exchange is fixed. To compare the two hedging, one need to look at how the firm use the loan it takes in money market hedging.
The firm can either re-invest in the firm
Substitute for an equal “home” currency loan
Invest in “home” money market
Choose the option that gives the highest value in “home” currency
How do you find the break-even investment rate?
see p.86
Explain what it means to hedge in the options market
A firm buy a financial option, which is a contract giving the purchaser the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specific time period.
A Put option is the option to sell - use for receivable
A call option is the option to buy - use for payable
This means that at the due date, the firm can choose wether to exercise its option or not, based on what is most profitable.
This type of hedging minimize downside risk and makes it possible to potentially benefit from foreign currency appreciation/depreciation – depending on wether it is a receivable or payable. However, the firm must look at the opportunity cost of hedging in the option market (opposite to when hedging in the money market). Because you need to pay an amount immediately for the option, which you then cannot use for anything else, while in the money market you get access to money you can invest with.
The value in the end dependents on the spot rate at the due date.
if the future spot rate is smaller than the strike price the firm should exercise a put option. Otherwise, the firm should not exercise the put option.
What is the cost of an option?
t is equal to the size of the option X premium X spot rate.
How to calculate the future value of an option?
cost of option * (1+r)
Is the potential downside higher in money and forward market hedging compared to hedging in the option market?
Generally, the downside is lower than in the money and forward market, but the unlimited upside potential might compensate for this.
How to decide what type of hedging is best?
see p.88
What other parameter influence the decision of hedging other than future spot rate?
Risk aversion
Financial situation of the firm
Size of expsure vs size of the firm
Confidence in own forecast
What are the main characteristics of remaining unhedged?
Complete freedom, no costs, but no safety net.
Big firms that can afford to do so, when risk is relatively low
What are the main characteristics of forward market hedging?
Set future price, complete safety, but no potential benefit.
One off for small firms that cannot afford other options
What are the main characteristics of money hedging?
Fix-it-myself solution, if everything goes right, no risk and benefit from interim investment (careful – no benefit if opposite position)
Hedging on a continual basis due to frequent sales/purchases abroad (matching)
