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Hedging As Exchange Risk Offsetting Tool

This presentation discusses various hedging techniques used as tools to offset exchange rate risk. It covers forward contracts, money market hedges using borrowing and lending, hedging with currency swaps, and hedging with futures and options. Examples are provided to illustrate how different hedging methods work, such as using forward contracts to lock in exchange rates for expected foreign currency receipts and payments. A comparison is made between forward and money market hedges in terms of their costs and benefits for firms.

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Vinayak Myakal
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45 views14 pages

Hedging As Exchange Risk Offsetting Tool

This presentation discusses various hedging techniques used as tools to offset exchange rate risk. It covers forward contracts, money market hedges using borrowing and lending, hedging with currency swaps, and hedging with futures and options. Examples are provided to illustrate how different hedging methods work, such as using forward contracts to lock in exchange rates for expected foreign currency receipts and payments. A comparison is made between forward and money market hedges in terms of their costs and benefits for firms.

Uploaded by

Vinayak Myakal
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 14

A Presentation on

Hedging as Exchange Risk


Offsetting Tool
Presented by
AKM Abdullah

October 26, 2004


This Session Covers

What is Hedging
Types of Hedging
Examples
Comparison of Different Hedging
Techniques

10/26/2004 2
Defining Hedge

Hedge refers to an offsetting contract


made in order to insulate the home
currency value of receivables or payables
denominated in foreign currency.

Objective of hedging is to offset exchange


risk arising from transaction exposure.

10/26/2004 3
Types of Hedging
1. Forward Market Hedges: use forward
contracts to offset exchange rate exposure
2. Money Market Hedges: use borrowing and
lending in the money markets
3. Hedging with Swaps: use combination of
forward and money market instruments
4. Hedging with Foreign Currency Futures:
5. Hedging with Foreign Currency Options:

10/26/2004 4
Forward Market Hedges:
Objective: To nullify future spot rate
2 Situations:
1. Expected Inflows of Foreign Currency:
Make forward contracts to sell the foreign currency at
a specified rate to insulate against depreciation of
value of that foreign currency (in terms of home
currency).
2. Expected Outflows of Foreign Currency:
Make forward contracts to buy the foreign currency at
a specified rate to insulate against appreciation of
value of the currency (in terms of home currency).

10/26/2004 5
Examples
1. A US firm is expected to receive 200,000
UK pound in 60 days from a UK buyer. UK
pound may depreciate against US $ in 60
days.
What to Do for offsetting the risk of receiving less
amount of US $?

2. A US firm will have to pay 400,000 Euros


in 30 days to a German seller. Euro may
appreciate against US $ in 30 days.
What to do for offsetting the risk of spending more US $?
10/26/2004 6
Money Market Hedges
Objective: borrow/lend to lock in home
currency value of cash flow

1. Expected Inflow of Foreign Currency:

 Borrow present value of the foreign currency at a


fixed interest and convert it into home currency
 Deposit the home currency at a fixed interest rate
 When the foreign currency is received, use it to
pay off the foreign currency loan

10/26/2004 7
Money Market Hedges
(Continued)
2. Expected Outflow of Foreign Currency:

– Determine PV of the foreign currency to be paid


(using foreign currency interest rate as the discount rate).
– Borrow equivalent amount of home currency (considering
spot exchange rate)
– Convert the home currency into PV equivalent of the
foreign currency (in the spot market now) and make a
foreign currency deposit
– On payment day, withdraw the foreign currency deposit
(which by the time equals the payable amount) and make
payment.

10/26/2004 8
Example
A US firm is expected to pay A$300,000 to an
Australian supplier 3 months from now. A$
interest rate is 12% and US$ interest rate is 8%.
Spot rate is 0.60A$/US$.

– PV of A$: 300,000/(1+.12/4) = A$291,262.14


– Borrow (291,262.14X0.60) US$174,757.28 and convert it to
A$291,262.14 at spot rate (0.60/US$)
– Use the A$ to make an A$ deposit which will grow to
A$300,000 in 3 months. Pay this A$300,000 on due date
– Pay {174,757.28X(1+0.8/4)} US$178,252.43 with interest for
settling the US$ loan.

10/26/2004 9
Money Market Hedge
Conditions for Use

Firms have access to money market for


different currencies
The dates of expected future cash flows
and money market transaction maturity
match
Offshore currency deposits or Eurocurrency
deposits are main money market hedge
instruments

10/26/2004 10
Comparison:
Forward and Money Market Hedge
The covered interest parity implies that a firm
cannot be better off using money market
hedge compared to forward hedge.
In reality, firms find use of forward contracts
more profitable than use of money market
instruments; because firms:

A) Borrow at a rate> inter-bank offshore lending rate


B) Put deposits at a rate< inter-bank offshore deposit
rate.

10/26/2004 11
Hedge using Swaps
Swap refers to exchange of an agreed amount of a
currency for another currency at a specific future
date. This is equivalent to currency forward contract
in a sophisticated way.

For example: a US firm has receivable in Euro from a


Belgian buyer; so it is looking for euro denominated liability
to hedge the receivable.
On the other hand, a Belgian firm exports to USA and has
US$ denominated receivable; it needs US$ liability to hedge
receivables in US$.

The two firms can agree that:


10/26/2004 12
Swaps (Continued)
US firm borrows (say $100,000) at 11%
Belgian firm borrows($100,000/E0.6 per $)
166,667 euros at 10%
US firm receives euros from buyer and give it to
the Belgian firm so that it (Belgian) can repay
euro denominated loan.
The Belgian firm receives US$ from buyer and
give it to the US firm so that it (US firm) can repay
US$ denominated loan.

– Both firms lock in current spot rate for future


payments by swapping receivables.
10/26/2004 13
Questions?

Have a Great Day

10/26/2004 14

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