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 DAY It can use the principle & interest to make the payment of payables

CONTINUED MNC needs GBP after 1 year It has USD 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 + I d ) Where D= DEPOSIT AMOUNT = ? P= AMOUNT OF PAYABLES (IN FOREIGN CURRENCY) = I d =INTEREST IN FOREIGN DEPOSIT = 10% D = GBP / ( 1+ 10%) = GBP THE DEPOSIT AMOUNT = GBP

CONTINUED If current spot rate of GBP = $1.50 To set deposit MNC needs $ (GBP * 1.50= USD ) SO YOU HAVE STILL $ REMAINING ( – = USD )

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 1 % interest for 30 days Convert the USD to $ 0.44 Deposit the CHF in Swiss bank for % After 30 days use the CHF to make the payment Use the USD to repay the US loan

formula D = P / (1 + I d ) Where D= DEPOSIT AMOUNT = ? P= AMOUNT OF PAYABLES (IN FOREIGN CURRENCY) =CHF I d =INTEREST IN FOREIGN DEPOSIT = 0.5% D = CHF / ( %) = CHF THE DEPOSIT AMOUNT = CHF

CONTINUED BORROW USD CONVERT USD INTO $ 0.44 IT EQUALS TO CHF (437811/ 0.44) DEPOSIT CHF FOR 30 DAYS IT WILL BE EQUAL TO CHF AFTER 30 DAYS USE THE CHF TO PAY FOR THE PAYABLES OF CHF THEN PAY THE US LOAN * (1 +1 %) = USD 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 : I f 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 : I f 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.