International Financial

Management

Foreign Exchange Risk Management

Part II

1
 Managing transaction exposure

• Proactive measures
Forward contracts
Money Market hedge
.

2
 Managing Transaction Exposure

Eg. X company (US) is awarded a contract to

sell product A to a Company B on 31st Dec –
year 2 ,on 31st Dec - year 1, X company will
receive payment of DM 25 million for these
products.
How to hedge X company’s DM exposure?

3
 Managing Transaction Exposure

• X company can enter into a forward contract

to sell 25 million DM for delivery in one year.
• Money market hedge. – borrow 25 million
DM for one year, converting it into $ and
investing in securities which matures on 31st
December- year 2.

4
 Forward Market Hedge

• In a foreign market hedge, a company that is

long a foreign currency will sell the foreign
currency forward, where as a that is short a
foreign currency will buy the currency
forward.

5
 Forward Market Hedge

• Example – X company
• Assume current spot rate is 1DM= 0.40$
• One year forward rate is 1DM= 0.3828$
• Possible outcomes of forward market hedge

6
 Forward Market Hedge
Spot Exchange Value of Gain (loss) Total Cash
Rate the original on forward Flow
receivable contract
$

DM 1= $ 0.40 10,000,000 (430,000) 9,570,000

DM 1= $ 0.3828 9,570,000 0 9,570,000
DM 1= $ 0.36 9,000,000 570,000 9,570,000

7
 Forward Market Hedge

• Regardless of what happens to the future

spot rate, above table shows that the X
company still gets to collect $9.57 million on
product A.

8
 Arbitrage

• Assume X company believes that the despite

of one year forward rate of $.3828, the DM
will actually be worth about $.3910 on 31st
December- year 2
• Then it is profitable to buy DM forward
contract at $.3828 and on 31st Dec,
completing the transaction by selling DM in
the spot market at $ .3910. 9
 Arbitrage
• If X company correct, it will earn (0.3910-
0.3828) $0.0082 per DM sold.
• Total award
• DM 25 million x 0.0082= $205,000

10
 Arbitrage
• However, forward rate is likely to be an
unbiased estimate of the future spot rate.
Therefore, unless X company has some
special information about the future spot rate ,
it should accept the forward rate.

11
 Money Market Hedge

• An alternative to a forward market hedge is to

use a money market hedge.

• Money market hedge involves simultaneous

borrowings and lending activities in two different
currencies to lock the in the dollar value of a
future foreign currency cash flow.

12
 Money Market Hedge
• Eg. Suppose DM and $ interest rates are 15%
and 10% respectively.

• Using a money market hedge X company will

borrow DM 21.74 million for one year.

• 25/1.15= 21.74

13
 Money Market Hedge
• If Spot rate is DM1 = $0.40 , DM 21.74= $ 8.7
(21.74 x 0.40)

• X company can invest this $ 8.7 for one year.

• On December 31st X company will receive $

9.57

• $8.7 x 1.10 = $9.57

14
 Money Market Hedge
• X Company will use these Dollars to payback
the DM 21.74 x 1.15= DM 25 it owes in
principle and interest.

• The gain or loss on the money market hedge

can be calculated simply by subtracting the cost
of repaying the DM debt from the Dollar value
investment.

15
 Money Market Hedge
• If end of year spot rate is $0.40, the DM 25
million in principle and interest will cost $ 10
million to repay. ( DM 25,000,000 x 0.40)

• The return on investment is only 9.57 million.

• Loss is $ 430,000 (10 - 9.57)

16
 Money Market Hedge
Spot Exchange Value of Gain (loss) Total Cash
Rate the original on money Flow
receivable market hedge
$

DM 1= $ 0.40 10,000,000 (430,000) 9,570,000

DM 1= $ 0.3828 9,570,000 0 9,570,000
DM 1= $ 0.36 9,000,000 570,000 9,570,000

17
 Internal Hedging Strategies

• Invoicing- A firm may be able to shift the entire

exchange risk to the other party by invoicing its
exports in its local currency and insisting that its
imports too be invoiced in its home currency.

18
 Internal Hedging Strategies

• Netting- A firm with receivables and payables in

diverse currencies can net out its exposure in
each currency by matching receivables with
payables

19
 Internal Hedging Strategies

• Leading and lagging- shift the timing of exposure

by leading or lagging payables and receivables.

• General rule

lead payables and lag receivables in

strong/hard currencies

lead receivables and lag payables in

weak/soft currencies

20
 Economic Exposure

• The degree to which a firm’s present value of the

future cash flows can be influenced by exchange
rate fluctuations.

• Even purely domestic firms are affected by

economic exposure.

21
 Economic Exposure to Exchange Rate
Fluctuations

Inflows Impact of Impact of

Currency Currency
Appreciation Depreciation

Local sales Decrease Increase

Exports Decrease Increase
Interest received from Decrease Increase
foreign investment

22
 Economic Exposure to Exchange Rate
Fluctuations

Outflows Impact of Impact of

Currency Currency
Appreciation Depreciation

Imports (local Currency) No change No change

Imports (foreign Currency) Decrease Increase
Interest paid on foreign loan Decrease Increase

23
 Measuring Economic Exposure

• Sensitivity of earnings to exchange rates

Subjectively predicting the each income

statement item based on forecast exchange
rates.

24
 Measuring Economic Exposure

• Sensitivity of earnings to exchange rates

By reviewing how earnings forecast in the in

the income statement changes in response to
alternative exchange rate scenarios, the firm
can assess the influence of currency
movements on its earnings and cash flows.

25