Hedging an uncertain amount Concepts and examples.

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Presentation transcript:

Hedging an uncertain amount Concepts and examples

Objective Explain and illustrate the challenges of hedging an uncertain amount

The issue Hedging transaction exposure when the amount in question is known is a challenging task. Unknown factor: exchange rate unknown Hedging transaction exposure when the amount in question is unknown is an even more challenging task Unknown factors: exchange rate and market value of transaction amount

Exemplification On January 4, an American firm is bidding for a contract to construct a large sports complex in London. The bid must be submitted in pounds. The American firm plans to make a bid of L 25 m. The payment will be made as soon as the winner is chosen, at the end of April. The firm fears that the pound will depreciate against the dollar by the time the winner is chosen.

Alternatives Do nothing Forward cover Option cover

Analysis

Analysis

Analysis

Analysis

Analysis

Remarks Expect exchange rate to move against you? Use a forward hedge Expect exchange rate to move in your favor? Use an option hedge

Money Market Hedge

Simple money market hedge Forward contract replica aka synthetic forward

Simple money market hedge: Exemplification On March 31, Martech sells a gas turbine generator to Crown, a UK firm. The turbine costs L 1,000,000. The payment of the turbine is due on June 30. Worst case scenario: appreciating dollar

MMH vs. forward hedge

Analysis

Analysis

Remarks The results of the forward hedge and MMH are virtually the same. Caveat?

Caveat If Interest Rate Parity does not hold, MMH will produce different results than forward hedging.