HEDGING

PRESENTED BYAMLIN DAVID

A Presentation on

Hedging as Exchange Risk Offsetting Tool

This Session Covers

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What is HedgingTypes of HedgingExamplesComparison of Different Hedging Techniques

Defining Hedge

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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.

Types of Hedging

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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:

Forward Market Hedges:Objective: To nullify future spot rate

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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).

Examples

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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 $?

Money Market HedgesObjective: borrow/lend to lock in home currency

value of cash flow

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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

Money Market Hedges(Continued)

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82. 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.

Example

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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.

Money Market HedgeConditions for Use

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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

Comparison:Forward and Money Market Hedge

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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 rateB) Put deposits at a rate< inter-bank offshore

deposit rate.

Hedge using Swaps

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12Swap 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:

Swaps (Continued)

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13US 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.

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THANK YOU