Week 10 Flashcards
When does transaction exposure occur?
Whenever a company is purchasing or selling on credit goods or services priced in foreign currencies, borrowing or lending funds with repayment in a foreign currency, being a party in an outstanding forward contract,
or acquiring assets or incurring liabilities denominated in foreign currencies.
How can we use a forward or futures contract to hedge our currency account payables?
Enter into a forward or futures contract to buy the amount of foreign currency we need. This means we will have no uncertainty, allowsing us to know exactly how much home currency will be needed to make the payment.
How can we use the money market to hedge our account payables?
An account payable is a foreign current liability, if we create a foreign currency current asset we can offset the exchange risk. So we invest the present value of the foreign currency account payable at the foreign investment rate, we calculate the home currency cost of this, and use it to purchase the foreign currency.
How do we use an options hedge for our foreign account payables?
We take out a call option on the foreign currency, giving us the right to buy it at the strike price if the foreign currency appreciates. This limits our upside risk, we can buy at the spot price if the foreign currency is less than the strike price. Our cost of the call is how many units we buy * the unit price * our opportunity cost (how much we could have invested the premium for). We will also have the cost of buying the currency at the expiration date.
What is a point of indifference with regards to hedging?
Points of indifference are the points where the cost of one hedging strategy is the same as another.
What is the point of indifference between a forward and money market hedging strategy?
The interest rate(opportunity cost) required for the money market hedge to cost the same as the forward contract. If this rate is higher than the WACC of the firm then the money market hedge will always be cheaper than forward contract for that firm, because the opportunity cost will never reach the point of indifference.
What is the point of indifference between a forward and call contract?
forward rate - cost of call contract premium = foreign currency required * spot rate. The spot rate is the point of indifference and is given by (forward rate - cost of call contract) divided by the currency required.
What is the point of indifference between a call contract and money market hedge?
money market cost - cost of call contract premium = foreign currency required * spot rate, solving for the spot rate.
How do we use a forward or futures contract to hedge receivables?
Receivables will have to be converted into the home currency, this means we will enter a forward contract to sell, fixing the price today at which the foreign currency will be sold at when the receivable is paid, allowing us to know exactly how much home currency will be received from the next payment.
How do we use the money market to hedge our receivables?
Accounts receivable is a current asset, by creating a foreign current liability we can offset the exchange risk, to do this we borrow the present value of the foreign currenct accouns receivable and convert it to home currency, we use the cash today for business operation and payback the foreign currency liability with the foreign currency receivable payment at maturity. This means there is no uncertainty.
What are our potential opportunity costs?
WACC, the lending rate, and the investing rate.
How can we use options to hedge our receivables?
Buy a put, giving us the option to sell our receivables at the strike price if the foreign currency depreciates / is less than the strike price. This limits our downside risk, while still allowing us to profit if the foreign currency has appreciated by selling in the spot market instead.
The cost of the put option is the price per unit * number of units. The value in some amount of time is this value *the opportunity cost + our sell rate(either spot or strike rate, depending on which is higher.
What does it mean for a money market and forward market hedging strategy for receivables?
If the opportunity cost rate is less than all the firm’s possible opporunity costs the money market will always be prefered.
What are some of the limitations of hedging?
Some international transactions involve an uncertain amount of foreign currency, leading to overhedging.
- The continual short-term hedging of repeated transactions may have limited effectiveness as it won’t protect us against long term price changes.
- Some banks can only offer forward contracts for up to 5 to 10 years on commonly traded currencies.
What are some alternative hedging techniques?
Leading and lagging involves changing the timing on a payment or receivable request ot reflect expectations about future currency movements. Leading involves paying a foreign currency early before the home currency appreciates, and lagging involves delaying paying a foreign currency payable until the home currency appreciates. Companies will use these if governments allow them.
Cross-hedging involves taking a hedge position with a highly correlated currency in which the payment or receivable its dure, this is done to reduce transaction exposure when the currency cannot be hedged.
Currency diversification involves diversifying business among currencies to reduce the foreign exchange risk. This is most beneficial with uncorrelated currencies.
