MANAGING EXPOSURE TO EXCHANGE RATE FLUCTIATION
Jan 04, 2016
TRANSACTION EXPOSURE
THE FIRM FACES FOLLOWING MAJOR TASKS:
TO IDENTIFY THE DEGREE OF TRANSACTION EXPOSURE
TO DECIDE WETHER TO HEDGE THIS EXPOSURE
TO DECIDE WETHER TO HEDGE : PART OF THE EXPOSURE
OR
COMPLETELY
TO CHOOSE AMONG THE VARIOUS TECHNIQUES AVILABLE
HEDGING
“The act of eliminating exposure to exchange rate fluctuation is referred to as Hedging”.
IFM
By
Jeff Madura
HOW TO ELIMINATE TRANSACTION EXPOSURE
MOST COMMONLY USED TECHNIQUES ARE
INVESTING OR BORROWING STRATEGY
INVOICING STRATEGY
MONEY MARKET HEDGE
OPTION CONTRACT HEDGE
FUTURE CONTRACT HEDGE
FORWARD CONTRACT HEDGE
SWAP CONTRACT HEDGE
INVESTING OR BORROWING STRATEGY
TO HEDGE PAYBLES: If excess cash is available ,convert it to the currency
denominating payables and invest the funds until they are needed to cover the payables
TO HEDGE RECEIVABLES: If there is a need to borrow funds ,borrow the currency
denominating its receivables and convert these funds to its home currency for use.Then , pay off the loan with cash inflows due to receivables.
EXAMPLE
If a US firm expects future payables in GBP
If excess cash is available
It could deposit the funds in UK bank
The deposit will provide interest
AT THE END OF THE DAYIt can use the principle & interest to make the payment of payables
CONTINUED
MNC needs GBP 550000 after 1 year
It has USD 1000000 for 1 year (excess cash available )
MNC will set up a UK deposit in GBP (interest rate is 10%)
After 1 year the deposit & interest will generate the amount needed for payables
Formula for deposit
D = P / (1 + Id)WhereD= DEPOSIT AMOUNT = ?P= AMOUNT OF PAYABLES (IN FOREIGN CURRENCY) =550000
Id=INTEREST IN FOREIGN DEPOSIT = 10%
D = GBP 550000 / ( 1+ 10%) = GBP 500000
THE DEPOSIT AMOUNT = GBP 500000
CONTINUED
If current spot rate of GBP = $1.50
To set deposit MNC needs $ 750000 (GBP 500000* 1.50= USD 750000)
SO YOU HAVE STILL $ 250000 REMAINING
( 1000000 – 750000 = USD 250000 )
INVOICING STRATEGY
TO HEDGE PAYABLES Invoicing exports in the same currency In which you have payables (for imports)
TO HEDGE RECEIVABLES Imported goods should be invoiced in the
same currency That is received from exports.
MONEY MARKET HEDGE
TO HEDGE PAYABLES Borrow local currency and convert to currency denominating
payables. invest these funds until they are needed to cover the payables.
TO HEDGE RECEIVABLES Borrow the currency denominating the receivables and
convert it to the local currency and invest it. Then, pay off the loan with cash inflows from the receivables.
EXAMPLE
IF THE MNC IS EXPECTING PAYABLES IN CHF AFTER
30 DAYS (NO EXCESS CASH IS AVAILABLE)
IT CAN TAKE THE BENEFIT OF MONEY MARKET HEDGE
i.e.
Borrow USD from US bank @ 1 % interest for 30 days
Convert the USD to CHF @ $ 0.44
Deposit the CHF in Swiss bank for 30 days @ 0.5%
After 30 days use the CHF to make the payment
Use the USD to repay the US loan
formula
D = P / (1 + Id)WhereD= DEPOSIT AMOUNT = ?
P= AMOUNT OF PAYABLES (IN FOREIGN CURRENCY) =CHF 1000000
Id=INTEREST IN FOREIGN DEPOSIT = 0.5%
D = CHF 1000000 / ( 1+ 0.5%)
= CHF 1000000
THE DEPOSIT AMOUNT = CHF 995025
CONTINUED
BORROW USD 437811 CONVERT USD INTO CHF @ $ 0.44
IT EQUALS TO CHF 995025 (437811/ 0.44)
DEPOSIT CHF 995025 FOR 30 DAYS
IT WILL BE EQUAL TO CHF 1000000
AFTER 30 DAYS USE THE CHF 1000000
TO PAY FOR THE PAYABLES OF CHF
THEN PAY THE US LOAN
437811 * (1 +1 %) = USD 442189 LOAN
LEADING & LAGGING
LEADING : If the currency in which there are payables is
expected to appreciate .
Make the payment before time
(so that you may pay before the exchange rate may increase)
LAGGING : If the currency in which there are payables is
expected to depreciate .
Delay the payment
(so that the exchange may decline)
CROSS-HEDGING
If you have to pay for imports after 60 days
Currency in which the payment is denominated is expected to appreciate.
Forwards ,Futures, Options are not available for this currency.
SOLUTION :Find the currency which is highly & positively correlated to this currency (and in which the contracts are also available)
Make the contract in the correlated currency