FX_Risk_Hedging.ppt

8/22/2019 FX_Risk_Hedging.ppt

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Slide 1

FX Risk Management

Transaction Exposure Overview

The three major foreign exchange exposures

Foreign exchange transaction exposure

Pros and cons of hedging foreign exchange transactionexposure

Alternatives of managing significant transactionexposure

Practices and concerns of foreign exchange riskmanagement


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Slide 2

Foreign Exchange Exposure Types of foreign exchange exposure

Transaction Exposuremeasures changes in the value ofoutstanding financial obligations due to exchange rate changes

Operating Exposurealso called economic exposure, measuresthe change in the present value of the firm resulting from any

change in expected future operating cash flows caused by an

unexpected change in exchange rates

Translation Exposurealso called accounting exposure, is thechanges in owners equity because of the need to translate

financial statements of foreign subsidiaries into a single

reporting currency for consolidated financial statements Tax Exposureas a general rule only realizedforeign losses are

deductible for purposes of calculating income taxes


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Slide 3

Foreign Exchange Exposure

Moment in time when exchange rate changes

Time

Accounting exposure

Changes in reported owners equity

in consolidated financial statements

caused by a change in exchange rates

Operating exposure

Change in expected future cash flows

arising from an unexpected change in

exchange rates

Transaction exposureImpact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange rates


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Slide 4

Why Hedge - the Pros & Cons

Opponents of hedging give the following reasons: Shareholders are more capable of diversifying risk than themanagement of a firm

Currency risk management does not increase the expected cashflows of a firm

Management often conducts hedging activities that benefitmanagement at the expense of shareholders

Managers cannot outguess the market

Managements motivation to reduce variability is sometimes

driven by accounting reasons Efficient market theorists believe that investors can see through

the accounting veil and therefore have already factored the

foreign exchange effect into a firms market valuation


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Slide 5


Proponents of hedging give the following reasons: Reduction in the risk of future cash flows improves theplanning capability of the firm

Reduction of risk in future cash flows reduces the

likelihood that the firms cash flows will fall below anecessary minimumavoiding bankruptcy costs

Management has a comparative advantage over theindividual investor in knowing the actual currency riskof the firm

Markets are usually in disequilibirum because ofstructural and institutional imperfections

Reduction in variability of income reduces a firmsoverall tax burden


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Slide 6

Expected Value, E(V)Net Cash F low (NCF )NCF

Hedging reduces the variability of expected cash flows about the mean of the distribution.

This reduction of distribution variance is a reduction of risk, but who benefits from it.

Unhedged

Hedged



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Slide 7

Measurement of Transaction

Exposure Transaction exposure measures gains or losses that

arise from the settlement of existing financial

obligations, namely

Purchasing or selling on credit goods or services whenprices are stated in foreign currencies

Borrowing or lending funds when repayment is to bemade in a foreign currency

Being a party to an unperformed forward contract and Otherwise acquiring assets or incurring liabilities

denominated in foreign currencies


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Slide 8

Purchasing or Selling on Open Account

Suppose Trident Corporation sells merchandise on openaccount to a Belgian buyer for1,800,000 payable in 60 days

Further assume that the spot rate is $0.9000/ and Trident

expects to exchange the euros for1,800,000 x $0.9000/ =

$1,620,000 when payment is received (assuming no change inexchange rate)

Transaction exposure arises because of the risk that Trident willreceive something other than $1,620,000 expected

If the euro weakens to $0.8500/, then Trident will receive$1,530,000

If the euro strengthens to $0.9600/, then Trident will receive$1,728,000


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Slide 9


Trident might have avoided transaction exposure byinvoicing the Belgian buyer in US dollars, but this

might have caused Trident not being able to book the

sale

Even if the Belgian buyer agrees to pay in dollars,

however, Trident has not eliminated transaction

exposure, instead it has transferred it to the Belgian

buyer whose dollar account payable has an unknowneuro value in 60 days


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Slide 10


Quotation Exposure

Time between quoting

a price and reaching a

contractual sale

Backlog Exposure

Time it takes to fill the

order after contract is

signed

Billing Exposure

Time it takes to get

paid in cash after A/R

is issued

Seller quotes a

price to buyer

t1

Buyer places

firm order withseller at

offered price

t2

Seller ships

product andbills buyer

t3

Buyer settles

A/R with cashin amount of

currency

quoted at t1

t4

Life Span of a Transaction Exposure


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Slide 11

Borrowing and Lending

A second example of transaction exposure ariseswhen funds are loaned or borrowed

Example: PepsiCos largest bottler outside the US is

located in Mexico, Grupo Embotellador de Mexico

(Gemex)

On 12/94, Gemex had US dollar denominated debt of$264 million

The Mexican peso (Ps) was pegged at Ps3.45/$ On 12/22/94, the government allowed the peso to float

due to internal pressures and it sank to Ps4.65/$


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Slide 12

Borrowing and Lending

Gemexs peso obligation now looked like this

Dollar debt mid-December, 1994:$264,000,000 Ps3.45/$ = Ps910,800,000

Dollar debt in mid-January, 1995:$264,000,000 Ps5.50/$ = Ps1,452,000,000

Dollar debt increase measured in Ps Ps541,200,000

Gemexs dollar obligation increased by 59% due to

transaction exposure


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Slide 13

Other Causes of Transaction

Exposure When a firm buys a forward exchange contract, it

deliberately creates transaction exposure; this risk is

incurred to hedge an existing exposure

Example: US firm wants to offset transaction exposureof 100 million to pay for an import from Japan in 90days

Firm can purchase 100 million in forward market to

cover payment in 90 days


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Slide 14

Hedging Alternatives

Transaction exposure can be managed bycontractual, operating, orf inancial hedges

Contractual hedges: forward, money market, futures,and options

Operating and financial hedges use risk-sharingagreements, leads and lags in payment terms, swaps,and other strategies

A natural hedgerefers to an offsetting operating cash

flow A f inancial hedgerefers to either an offsetting debt

obligation or some type of financial derivative suchas a swap


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Slide 15

Foreign Currency Derivatives

Derivatives drive their values from the underlying asset

They might be used for two distinct management objectives: Speculationthe financial manager takes a position in the

expectation of profit

Hedgingthe financial manager uses the instruments to reduce

the risks of the corporations cash flow In the wrong hands, derivatives can cause a corporation to

collapse (Barings, Allied Irish Bank), but used wisely they

allow a financial manager the ability to plan cash flows

The derivatives we will consider are: Foreign Currency Futures

Foreign Currency Options


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Slide 16

Foreign Currency Futures

A foreign currency futures contractis an alternativeto a forward contract

It calls for future delivery of astandard amountofcurrency at afixed time and price

These contracts are traded on exchanges with thelargest being the Chicago Mercantile Exchange (CME)

Contract Specifications:

Size of contractcalled the notional principal, tradingin each currency must be done in an even multiple

Method of stating exchange ratesAmerican termsare used; quotes are in US dollar cost per unit offoreign currency, also known as direct quotes


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Slide 17

Foreign Currency Futures

Contract Specifications Maturity datecontracts mature on the 3rd Wednesday

of January, March, April, June, July, September,

October or December

Last trading daycontracts may be traded through thesecond business day prior to maturity date

Collateral & maintenance marginsthe purchaser ortrader must deposit an initial margin or collateral

At the end of each trading day, the account is marked to

marketand the balance in the account is either credited

if value of contracts is greater or debited if value of

contracts is less than account balance


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Slide 18

Foreign Currency Futures Contract Specifications

Settlementonly 5% of futures contracts are settled byphysical delivery, most often buyers and sellers offset

their position prior to delivery date by taking offsetting

positionsThe complete buy/sell or sell/buy is termed a round turn

Commissionscustomers pay a single commission totheir broker to execute a round turn

Use of a clearing house as a counterpartyAllcontracts are agreements between the client and the

exchange clearing house. Therefore, there is no

counter-party risk


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Slide 19

Using Foreign Currency Futures

If an investor wishes to speculate on the movement ofa currency can pursue one of the following strategies

Short positionselling a futures contract based onview that currency will fall in value

Long positionpurchase a futures contract based onview that currency will rise in value


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Slide 20

Using Foreign Currency Futures

Example (cont.): Amy believes that the value of thepeso will fall, so she sells a March futures contract

By taking ashortposition on the Mexican peso, Amy

locks-in the right to sell 500,000 Mexican pesos atmaturity at a set price above their current spot price

Amy sells one March contract for 500,000 pesos at

the settle price: $0.10958/Ps

Value at maturity (Short position) =Notional principal (SpotFutures)


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Slide 21

Using Foreign Currency Futures To calculate the value of Amys position we use the following

formula

Using the settle price from the table and assuming a spot rateof $0.09450/Ps

at maturity, Amys profit is

If Amy believed that the Mexican peso would rise in value,she would take a long position on the peso

Using the settle price from the table and assuming a spot rateof $0.11500/Psat maturity, Amys profit is

Value at maturity (Short position) =Notional principal (SpotFutures)

Value =Ps500,000 ($0.09450/Ps$0.10958/Ps) = $7,540

Value at maturity (Long position) = Notional principal (SpotFutures)

Value = Ps500,000 ($0.11500/Ps $0.10958/Ps) = $2,710


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Slide 22

Foreign Currency Futures Versus Forward

ContractsForward Markets Futures Markets

Contract size Customized. Standardized.

Delivery date Customized. Standardized.

Participants Banks, brokers, MNCs. Publicspeculation not encouraged

Banks, brokers, MNC. Qualifiedpublic speculators.

Security deposit Compensating bank balances or

credit lines needed

Small security deposit required

Clearingoperation

Handled by individual banks andbrokers

Handled by exchange clearinghouse.Daily settlements.

Marketplace Worldwide Central exchange

Regulation Self-regulating. Commodity Futures TradingCommission (CFTC) and National

Futures AssociationLiquidation Mostly settled by actual delivery Mostly settled by offsetting

transactions

TransactionCosts

Banks bid/ask spread Negotiated brokerage fees


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Slide 23


A foreign currency optionis a contract giving thepurchaser of the option the right to buy or sell a givenamount of currency at a fixed price per unit for aspecified time period

The most important part of clause is the right, but notthe obligation to take an action

Two basic types of options, callsand putsCallbuyer has right to purchase currency

Put

buyer has right to sell currency The buyer of the option is the holderand the seller of

the option is termed the writer


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Slide 24


Every option has three different price elements The strikeorexercise priceis the exchange rate at

which the foreign currency can be purchased or sold

The premium, the cost, price or value of the option

itself paid at time option is purchased Spot exchange rate in the market

There are two types of option maturities

American optionsmay be exercised at any time duringthe life of the option

European optionsmay not be exercised until thespecified maturity date


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Slide 25


Options may also be classified as per their payouts At-the-money (ATM)options have an exercise price

equal to the spot rate of the underlying currency

I n-the-money (ITM )

options may be profitable,excluding premium costs, if exercised immediately

Out-of-the-money (OTM)options would not beprofitable, excluding the premium costs, if exercised


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Slide 26

Foreign Currency Options Markets

Over-the-Counter (OTC) MarketOTC options are mostfrequently written by banks for US dollars against British

pounds, Swiss francs, Japanese yen, Canadian dollars and theeuro

Main advantage is that they are tailored to purchaser Counterparty risk exists Mostly used by individuals and banks

Organized Exchangessimilar to the futures market,currency options are traded on an organized exchange floor

The Chicago Mercantile and the Philadelphia Stock Exchangeserve options markets

Clearinghouse services are provided by the OptionsClearinghouse Corporation (OCC)


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Slide 27

Tridents Transaction Exposure CFO of Trident, has just concluded a sale to Regency, a British

firm, for 1,000,000

The sale is made in March for settlement due in June (3 months) Assumptions

Spot rate is $1.7640/

3-month forward rate is $1.7540/ (a 2.27% discount)

Tridents cost of capital is 12.0%

UK 3 month borrowing rate is 10.0% p.a.

UK 3 month investing rate is 8.0% p.a.

US 3 month borrowing rate is 8.0% p.a.

US 3 month investing rate is 6.0% p.a.

June put option in OTC market for 1,000,000; strike price $1.75/;priced at $0.0265/

Tridents foreign exchange advisory service forecasts future spot rate in 3months to be $1.7600/

The budget rate (lowest acceptable amount) is based on an

exchange rate of $1.7000/


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Slide 28

Tridents Transaction Exposure

Trident faces four possibilities: Remain unhedged

Hedge in the forward market

Hedge in the money market Hedge in the futures market

Hedge in the options market


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Slide 29


Unhedged position If the future spot rate is $1.76/, then Trident will

receive 1,000,000 x $1.76/ = $1,760,000 in 3

months

However, if the future spot rate is $1.65/, Trident willreceive only $1,650,000 well below the budget rate

T id t T ti E


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Slide 30

Tridents Transaction Exposure Forward Market hedge

A forward hedge involves a forward contract

The forward contract is entered at the time the A/R is created, in thiscase in March

When this sale is booked, it is recorded at the spot rate.

In this case the A/R is recorded at a spot rate of $1.7640/, thus

$1,764,000 is recorded as a sale for Trident If the firm wants to cover this exposure with a forward contract, then

the firm will sell 1,000,000 forward today at the $1.7540/

In 3 months, Trident will received 1,000,000 and exchange thosepounds at $1.7540/ receiving $1,754,000

This sum is $6,000 less than the uncertain $1,760,000 expected fromthe unhedged position

This would be recorded in Tridents books as a foreign exchange lossof $10,000 ($1,764,000 as booked, $1,754,000 as settled)

T id t T ti E


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Slide 31

Tridents Transaction Exposure Money Market hedge

To hedge in the money market, Trident will borrowpounds in London, convert the pounds to dollars andrepay the pound loan with the proceeds from the sale

To calculate how much to borrow, Trident needs to discountthe PV of the 1,000,000 to today

1,000,000/1.025 = 975,610Trident should borrow 975,610 today and in 3 months

repay this amount plus 24,390 in interest (1,000,000)from the proceeds of the sale

Trident would exchange the 975,610 at the spot rate of$1.7640/ and receive $1,720,976 at once (today)

This hedge creates a pound denominated liability that isoffset with a pound denominated asset thus creating abalance sheet hedge


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Slide 32

Tridents Transaction Exposure In order to compare the forward hedge with the money market

hedge, we must analyze the use of the loan proceeds

Remember that the loan proceeds may be used today, but the fundsfor the forward contract may not

Because the funds are relatively certain, comparison is possible inorder to make a decision (the comparison is made on future values)

Three logical choices exist for an assumed investment rate for thenext 3 months First, if Trident is cash rich the loan proceeds might be invested at the

US rate of 6.0% p.a.

Second, the loan proceeds can be substituted for an equal dollar loanthat Trident would have otherwise taken for working capital needs ata rate of 8.0% p.a.

Third, the loan proceeds can be invested in the firm itself in whichcase the cost of capital is 12.0% p.a.


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Slide 33


Because the proceeds in 3 months from the forward hedge willbe $1,754,000, the money market hedge is superior to the

forward hedge if the proceeds are used to replace a dollar loan

(8%) or conduct general business operations (12%)

The forward hedge would be preferable if the loan proceedsare invested at (6%)

We will assume the cost of capital as the reinvestment rate

Received today Invested in Rate Future value in 3 months

$1,720,976 Treasury bill 6% p.a. or 1.5%/quarter $1,746,791

$1,720,976 Debt cost 8% p.a. or 2.0%/quarter $1,755,396

$1,720,976 Cost of capital 12% p.a. or 3.0%/quarter $1,772,605


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Slide 34

Tridents Transaction Exposure A breakeven investment rate can be calculated

between forward and money market hedge

0.0192r

$1,754,000r)(1x$1,720,976

proceeds)(forwardrate)(1xproceeds)(Loan

=

=+

=+

7.68%100x90

360x0192.0 =

To convert this 3 month rate to an annual rate,

In other words, if Trident can invest the loan proceeds at a rate

equal to or greater than 7.68% p.a. then the money market

hedge will be superior to the forward hedge


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Slide 35


1.68 1.70 1.74 1.761.72 1.821.801.78 1.861.84

Value in US dollars of

Tridents 1,000,000 A/R

1.68

Ending spot exchange rate (US$/)

1.70

1.72

1.74

1.76

1.78

1.80

1.82

1.84

Money market hedge

yields $1,772,605

Forward rate

is $1.7540/

Forward contract hedge

yields $1,754,000

Uncovered yieldswhatever the ending

spot rate is in 90 days

T id t T ti E


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Slide 36

Tridents Transaction Exposure Futures market hedge

Trident could also cover the 1,000,000 exposure by selling futures

contracts now at say $1.7540/ - most futures contracts are notdelivered therefore instead of spot rate you would have purchase

price of the futures contract below

If spot rate is $1.7600/ then the result of futures position is:Value at maturity (Short position) =Notional principal (SpotFutures)

Value at maturity (Short position) =1,000,000 ($1.7600/$1.7540/ )

Value at maturity (Short position) =$6,000

The loss on futures would reduce the value of receivable

Value of receivable = 1,000,000 $1.7600/ = $1,760,000 The net value of receivable is:

$1,760,000$6,000 = $1,754,000

Implied exchange rate of conversion is

$1,754,000 / 1,000,000 = $1.7540/ (Rate at which we sold futurescontracts.


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Slide 37

Tridents Transaction Exposure Option market hedge

Trident could also cover the 1,000,000 exposure bypurchasing a put option. This provides the upside

potential for appreciation of the pound while limiting

the downside risk

Given the quote earlier, a 3-month put option can bepurchased with a strike price of $1.75/ and a premium

of $0.0265/

The cost of this option would be

$26,460$0.0265/x1,000,000

optionofcost(premium)xoption)of(Size

=

=



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Slide 38

Trident s Transaction Exposure Because we are using future value to compare the various hedging

alternatives, we need future value of the option cost in 3 months

Using a cost of capital of 12% p.a. or 3.0% per quarter, thepremium cost of the option as of June would be

$26,460 1.03 = $27,254 or $27,254 / 1,000,000 = $0.0273/

Since the upside potential is unlimited, Trident would not exercise

its option at any rate above $1.75/ and would convert pounds todollars at the spot market

If the spot rate is $1.76/, Trident would exchange pounds on the

spot market to receive 1,000,000 $1.76/ = $1,760,000 less the

premium of the option ($27,254) netting $1,732,746 If the pound depreciates below $1.75/, Trident would exercise the

put option and exchange 1,000,000 at $1.75/ receiving

$1,750,000 less the premium of the option netting $1,722,746


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Slide 39

Tridents Transaction Exposure As with the forward and money market hedges, a

breakeven price on the option can be calculated

The upper bound of the range is determined bycomparison of the forward rate

The pound must appreciate above $1.754/ forward rateplus the cost of the option, $0.0273/, to $1.7813/

The lower bound of the range is determined bycomparison to the strike price

If the pound depreciates below $1.75/, the net proceeds

would be $1.75/ less the cost of $0.0273/ or $1.722/Note that the following graph shows the net proceeds of

the option contract under varying exchange rates. Netproceeds are not same of a put option payoff diagrambecause we have exposure to the underlying asset ()


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Slide 40


Put Option Strike Price ATM Option $1.75/

Option cost (future cost) $27,254

Proceeds if exercised $1,750,000

Minimum net proceeds $1,722,746

Maximum net proceeds unlimited

Breakeven spot rate (upside) $1.7813/

Breakeven spot rate (downside) $1.7221/

A B C D E


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Slide 41Cell E5 Entry is =IF(A5


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Slide 42


$1,660,000

$1,680,000

$1,700,000

$1,720,000

$1,740,000

$1,760,000

$1,780,000

$1,800,000

$1,820,000

$1,840,000

$1,860,000

$1,880,000

$1,900,000

$1,920,000

1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85 1.86 1.87 1.88 1.89 1.90

Exchange Rate ($/)

NetProceeds

Unhedged MM Forward Put Option


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Slide 43

Strategy Choice and Outcome Trident, like all firms, must decide on a strategy to

undertake before the exchange rate changes but how achoice can be made among the strategies?

Two criteria can be utilized:

Risk tolerance- of the firm,as expressed in its stated

policies and Viewpointmanagers view on the expected direction

and distance of the exchange rate

Trident now needs to compare the alternatives and

their outcomes in order to choose a strategy There were four alternatives available to manage this

account receivable


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Slide 44

Strategy Choice and Outcome

Hedging Strategy Outcome/Payout

Remain uncovered Unknown

Forward Contract hedge @ $1.754/ $1,754,000

Money market hedge @ 8% p.a. $1,755,396

Money market hedge @ 12% p.a. $1,772,605

Put option hedge @ strike $1.75/

Minimum if exercised $1,722,746

Maximum if not exercised Unlimited


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Slide 45

Managing an Account Payable

The choices are the same for managing a payable Assume that the 1,000,000 was an account payable in

90 days

Remain unhedgedTrident could wait the 90 days

and at that time exchange dollars for pounds to pay

the obligation

If the spot rate is $1.7600/ then Trident would pay

$1,760,000 but this amount is not certain


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Slide 46


Use a forward market hedgeTrident couldpurchase a forward contract locking in the $1.754/

rate ensuring that their obligation will not be more

than $1,754,000

Use a money market hedgethis hedge is distinctly

different for a payable than a receivable

Here Trident would exchange US dollars at the spot

rate and invest them for 90 days in pounds The pound obligation for Trident is now offset by a

pound asset for Trident with matching maturity


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Slide 47

Managing an Account Payable Using a money market hedge

To ensure that exactly 1,000,000 will be received in 3months, discount the principal by 8% p.a.

6980,392.1=

360

90x0.08+1

1,000,000

.77$1,729,411$1.7640/x6980,392.1 =

This 980,392.16 would require $1,729,411.77 at thecurrent spot rate


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Slide 48


Using a money market hedge Finally, carry the cost forward 90 days using the cost

of capital in order to compare the payout from themoney market hedge

12.294,781,1$360

90x12.01x77.411,729,1$

This is higher than the forward hedge of $1,754,000thus unattractive



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Slide 49

Managing an Account Payable Futures market hedge

Trident could also cover the 1,000,000 exposure by buying futures

contracts now at say $1.7540/ If spot rate is $1.7600/ then the result of futures position is:

Value at maturity (Long position) = Notional principal (SpotFutures)

Value at maturity (Long position) = 1,000,000 ($1.7600/$1.7540/)

Value at maturity (Long position) = $6,000 The gain on futures would reduce the value of payable

Value of payable =1,000,000 $1.7600/ =$1,760,000 The net value of payable is:

$1,760,000 + $6,000 =$1,754,000 Implied exchange rate of conversion is

$1,754,000 / 1,000,000 = $1.7540/ (Rate at which we boughtfutures contracts.


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Slide 50


Using an option hedgeinstead of purchasing a putas with a receivable, you want to purchase a calloption on the payable

The total cost of an ATM call option with strike price

of $1.75/ and a premium of $0.0265/:

Carried forward 90 days the premium amount is$26,460 1.03 = $27,254 or $27,254 / 1,000,000 =

$0.0273/

$26,460$0.0265/x1,000,000

optionofcost(premium)xoption)of(Size

=

=


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Slide 51


Using a call option hedge If the spot rate is less than $1.75/ then the option

would be allowed to expire and the 1,000,000 would

be purchased on the spot market

If the spot rate rises above $1.75/ then the optionwould be exercised and Trident would exchange the

1,000,000 at $1.75/ less the option premium for the

payable

Exercise call option (1,000,000 $1.75/) $1,750,000

Call option premium (carried forward 90 days) $27,254

Total maximum expense of call option hedge $1,777,254

A B C D E


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Slide 52Cell E5 Entry is =IF(A5>$C$2,($C$2+$C$3)*$C$1,(A5+$C$3)*$C$1)

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

2122

23

24

25

26

27

Exposure 1,000,000

Call Exercise 1.75

Call Premium 0.0273 (FV)

Spot Rate Unhedged MM Forward Call Option

1.68 $1,680,000 $1,781,294 $1,754,000 $1,707,254

1.69 $1,690,000 $1,781,294 $1,754,000 $1,717,254

1.70 $1,700,000 $1,781,294 $1,754,000 $1,727,254

1.71 $1,710,000 $1,781,294 $1,754,000 $1,737,254

1.72 $1,720,000 $1,781,294 $1,754,000 $1,747,254

1.73 $1,730,000 $1,781,294 $1,754,000 $1,757,254

1.74 $1,740,000 $1,781,294 $1,754,000 $1,767,254

1.75 $1,750,000 $1,781,294 $1,754,000 $1,777,254

1.76 $1,760,000 $1,781,294 $1,754,000 $1,777,254

1.77 $1,770,000 $1,781,294 $1,754,000 $1,777,254

1.78 $1,780,000 $1,781,294 $1,754,000 $1,777,254

1.79 $1,790,000 $1,781,294 $1,754,000 $1,777,254

1.80 $1,800,000 $1,781,294 $1,754,000 $1,777,254

1.81 $1,810,000 $1,781,294 $1,754,000 $1,777,254

1.82 $1,820,000 $1,781,294 $1,754,000 $1,777,254

1.83 $1,830,000 $1,781,294 $1,754,000 $1,777,254

1.84 $1,840,000 $1,781,294 $1,754,000 $1,777,2541.85 $1,850,000 $1,781,294 $1,754,000 $1,777,254

1.86 $1,860,000 $1,781,294 $1,754,000 $1,777,254

1.87 $1,870,000 $1,781,294 $1,754,000 $1,777,254

1.88 $1,880,000 $1,781,294 $1,754,000 $1,777,254

1.89 $1,890,000 $1,781,294 $1,754,000 $1,777,254

1.90 $1,900,000 $1,781,294 $1,754,000 $1,777,254


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Slide 53


$1,660,000

$1,680,000

$1,700,000

$1,720,000

$1,740,000

$1,760,000

$1,780,000

$1,800,000

$1,820,000

$1,840,000

$1,860,000

$1,880,000

$1,900,000

$1,920,000

1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85 1.86 1.87 1.88 1.89 1.90

Exchange Rate ($/)

NetProceed

s

Unhedged MM Forward Call Option

Risk Management in Practice


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Slide 54

Risk Management in Practice Which Goals?

The treasury function of most firms is usual considered a cost center;

it is not expected to add to the bottom line However, in practice some firms treasuries have become aggressivein currency management and act as profit centers

Which Exposures?

Transaction exposures exist before they are actually booked yet

some firms do not hedge this backlog exposure However, some firms are selectively hedging these backlog

exposures and anticipated exposures

Which Contractual Hedges?

Transaction exposure management programs are generally dividedalong an option-line; those which use options and those that do not

Also the amount of risk covered may vary. Tare areproportionalhedgingpolicies that state which proportion and type of exposure isto be hedged by the treasury

Example


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Example Dragon Inc, of Moorhead purchased a Korean company that produces plastic

nuts and bolts for auto manufacturers. The purchase price was Won7,030

million. Won1,000 million has already been paid and the remaining Won6,030million is due in six months. The current spot rate is Won1,200/$, and the 6-

month forward rate is Won1,260/$

Additional data:

Six-month Korean interest rate: 16.00% p.a.

Six-month US interest rate: 4.00% p.a. Six-month call option on Korean Won at 1,260 with a premium of

Won33.33/$

Six-month put option on Korean Won at 1200 with a premium ofWon41.67/$

Dragon can invest at the rates given above or borrow at 2% p.a. above thoserates. Dragons cost of capital is 25%.

Compare hedging alternatives and make a recommendation.

FX_Risk_Hedging.ppt

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