A Presentation on Hedging as Exchange Risk Offsetting Tool

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A Presentation onHedging as Exchange Risk
Offsetting Tool

• Presented by
• AKM Abdullah
• October 26, 2004

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This Session Covers

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

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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.

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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

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Forward Market HedgesObjective To nullify
future spot rate

• 2 Situations
• 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).

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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 ?

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Money Market HedgesObjective 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

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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.

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Example

• A US firm is expected to pay A300,000 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) A291,262.14
• Borrow (291,262.14X0.60) US174,757.28 and
  convert it to A291,262.14 at spot rate
  (0.60/US)
• Use the A to make an A deposit which will grow
  to A300,000 in 3 months. Pay this A300,000 on
  due date
• Pay 174,757.28X(10.8/4) US178,252.43 with
  interest for settling the US loan.

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Money Market HedgeConditions 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

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ComparisonForward 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
• Borrow at a rategt inter-bank offshore lending
  rate
• Put deposits at a ratelt inter-bank offshore
  deposit rate.

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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

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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.

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• Questions?
• Have a Great Day