1. Hedging Transaction Exposure Bill Reese International Finance 1

2. Learning Objectives In this unit we will learn:  How to hedge foreign exchange transaction exposure through: Forward contracts Futures contracts Options on futures contracts Money market hedges 2

3. Transaction Exposure Daimler Chrysler wants to build new plant in Germany  Construction bids to be in euros  Your firm bids €100 million  Spot rate at time of bid is 1.22 $/€  $122 million 3

4. Transaction Exposure One month later – you find out you won the bid  XR is now 1.15 $/€  $115 million – lost $7 million  Eight months to build plant  Three more months to be paid  This is transaction exposure 4

5. Simple Hedge As much as possible – match assets and liabilities in same currency  Pay for building supplies and wages in euros If euro depreciates – so does cost of building the plant 5

6. Hedging Forward contract Futures contract Option on futures contract Money market hedge 6

7. Forward Contract Euros receivable is an asset Need to create a euro liability Forward contract to sell €100 million in one year Locks in XR Usually contract with a bank 7

8. Futures Contract Standardized forward contract at an exchange Traded on Chicago Mercantile Exchange €125,000 per contract Delivery last month of each quarter 8

9. Futures Contract Advantages of Futures Contract  No hunting for counterparty  No counterparty default risk  Actual delivery not necessary 9

10. Futures Contract Disadvantages of Futures Contract  Standardized contract Size Delivery date Currency  Marked-to-market 10

11. Options on Futures Suppose you hedge with futures contract  Short 800 contracts at 1.10 $/€  Lock-in sale of €100 million for $110 million 800 contracts at €125,000/contract 11

12. Options on Futures What if spot rate at delivery is 1.30 $/€? Regret Euro appreciated Lost opportunity for gain Futures contract is insurance 12

13. Options on Futures Option on futures contract is best of both worlds Enter contract if euro depreciates Do not enter contract if euro appreciates There is a catch 13

14. Options on Futures Premium  Paid at time you purchase option  Based on Futures contract XR(strike price) Current spot XR Volatility of XR Time till expiration of option Interest rates 14

15. Options on Futures Advantage over futures contract  Choice (option) of entering into futures contract Disadvantage relative to futures contract  Premium 15

16. Money Market Hedge Create a liability to offset asset Want to owe €100 million in a year Borrow PV of €100 million Convert borrowed euros to dollars at spot rate 16

17. Money Market Hedge Assume  Annual interest rate is 5%  Spot rate is 1.22 $/€ 17

18. Money Market Hedge PV = FV / (1+r)t = €100 million / 1.05 = €95.238 Convert to $ at spot rate €95.238 x 1.22 $/€ = $116.19 million today 18