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MANAGING EXPOSURE TO EXCHANGE RATE FLUCTIATION

MANAGING EXPOSURE TO EXCHANGE RATE FLUCTIATION. TYPES TRANSACTION EXPOSURE ECONOMIC EXPOSURE TRANSLATION EXPOSURE

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MANAGING EXPOSURE

TO EXCHANGE

RATE FLUCTIATION

TYPES

TRANSACTION EXPOSURE

ECONOMIC EXPOSURE

TRANSLATION EXPOSURE

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

IS HEDGING WORTHWHILE ?

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

OPTION CONTRACT HEDGE

FUTURE CONTRACT HEDGE

FORWARD CONTRACT HEDGE

SWAP CONTRACT HEDGE

LONG-TERM HEDGING

LONG-TERM FORWARD CONTRACTS

CURRENCY SWAPS

HOW TO REDUCE TRANSACTION EXPOSURE

LEADING AND LAGGING

CROSS HEDGING

CURRENCY DIVERSIFICATION

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

CURRENCY DIVERSIFICATION

RECEIVABLES Accepting payment in several currencies

from receivables (rather than a few currencies) can reduce the firm’s exposure.

PAYABLES

Making payment in several currencies for the payables (rather than a few currencies) can reduce the firm’s exposure.