A Presentation on Hedging as Exchange Risk Offsetting Tool Presented by AKM Abdullah October 26, 2004

10/26/20042 This Session Covers What is Hedging Types of Hedging Examples Comparison of Different Hedging Techniques

10/26/20043 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 o ffset exchange risk arising from transaction exposure. Objective of hedging is to o ffset exchange risk arising from transaction exposure.

10/26/20044 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:

10/26/20045 Forward Market Hedges: Objective : To nullify future spot rate 2 Situations: 1. 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: 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).

10/26/20046 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 $?

10/26/20047 Money Market Hedges Objective: 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 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 Deposit the home currency at a fixed interest rate When the foreign currency is received, use it to pay off the foreign currency loan When the foreign currency is received, use it to pay off the foreign currency loan

10/26/20048 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). (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.

10/26/20049Example A US firm is expected to pay A$300,000 to an Australian supplier 3 months from now. A$ interest rate is 12% and US$ interest rate is 8%. Spot rate is 0.60A$/US$. –PV of A$: 300,000/(1+.12/4) = A$291, –Borrow (291,262.14X0.60) US$174, and convert it to A$291, at spot rate (0.60/US$) –Use the A$ to make an A$ deposit which will grow to A$300,000 in 3 months. Pay this A$300,000 on due date – Pay {174,757.28X(1+0.8/4)} US$178, with interest for settling the US$ loan.

10/26/ Money Market Hedge Conditions 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

10/26/ Comparison: Forward 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: A)Borrow at a rate> inter-bank offshore lending rate B)Put deposits at a rate< inter-bank offshore deposit rate.

10/26/ 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:

10/26/ 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.

10/26/ Questions? Have a Great Day