NOTE:

Section 1, 2 and 3 will explain the theory (it will not asked in paper)
Section 4 shows the calculation (asked in paper)
Table of Contents

Executive Summary...................................................................................................................3
1. Introduction............................................................................................................................4
2. Why hedging Exchange Rate risk .........................................................................................4
3. Techniques of hedging Exchange Rate risk.......................................................................5
3.1 Billing in US dollars......................................................................................................6
3.2 Currency Forward contracts............................................................................................6
3.3 Currency Future contracts...............................................................................................7
3.4 Currency Option contracts..............................................................................................7
3.5 Hedging through Money Market ....................................................................................8
4. Calculations of three chosen approaches ..............................................................................8
4.1 Billing in US dollars.......................................................................................................9
4.2 Currency Forward contracts.............................................................................................9
4.3 Money Market Hedge....................................................................................................10
4.4 Recommended approach.............................................................................................11
5. Forward exchange fixed V/S forward exchange option contracts ......................................11
5.1 Option but not obligation ..............................................................................................11
5.2 Premium.........................................................................................................................12
5.3 Trading ..........................................................................................................................12
5.4 Execution Time .............................................................................................................12
References................................................................................................................................14
Executive Summary:

Exchange rate risk is one of the most important factors managers should consider while

dealing in outside the country in foreign currency. To reduce the volatility in future cash

flows and to protect from losses due to change in currency rates stimulates the firm to go

for a hedging strategy to cater currency risk problem. Billing in home currency,

Forwards, Futures, Options and hedging through money markets are the potential

strategies firm can adopt to hedge their currency risk. Giving right to purchase or sale not

the obligation, paying premium at the time of contract and to some extent the flexibility

in exercising the contract are the potential factors that discriminate Currency forward

options with currency forward fixed contracts. The right to buy or sale allows the firm to

minimize the risk and maximize the profits as compared to option contract at the cost of

premium paid at the time of contract. In the case of firm it was found that the selecting

forward contract is the best hedging strategy as company can get maximum proceeds in

dollars from this strategy as compared to billing in US dollars or money market hedge.
Company can earn 33306022.4 dollars from forward contract which is 744399.5 dollars

more than billing in US dollar strategy and 342602.6 dollars more than money market

strategy.

1. Introduction:

Today this is a world of globalization where firms are broadening their activities across

the boundaries and not restricted themselves for local operations only. Access to new

markets, raw materials, new technology, to seek production efficiency, diversification and

to avoid political and regulatory risks are the potential factors that stimulate the firms to

go global (Brigham and Houston, 2008:747).

While dealing in across the border a number of factors like exchange rate risk, political

risk, regulatory risk, cultural and language differences can affect the decision making of

managers. Exchange rate risk is one of the most important factors in this respect.

Exchange rate is the specified units of a given currency that are equal to the one unit of

another currency. So whenever international financial managers are dealing in foreign

currency instead of their local currency, an analysis of exchange rate risk should make to

assess the real value of transaction.

2. Why hedging Exchange Rate risk:

Exchange rate risk management becomes more critical for the firms dealing in import and

export where change in currency rate can lead to a volatile cash flow. It was Adler and

Dumas who have explain the exchange rate exposure phenomena as the volatility in cash

flows because of unexpected increase or decrease in foreign exchange rate (1984).

As a key source of uncertainty for companies exchange rates evidenced a volatility of ten

times of inflation rate and four times of interest rate all over the world (Jorion, 1990).

Froot et al. have found that volatility in the cash flows due to change in exchange rates

can lead to a shortage of finance and as a result direct the company for costly external

financing (1993). Though researchers found a small economical and significant effect

between firms value and the change in exchange risk (Griffin and Stutz, 2001) but still it

increases opportunity cost and the uncertainty about the future cash flows. So hedging

exchange rate risk is very important to avoid this uncertainty of losses. As the firm is

expecting to receive 500 million Mexican pesos in next 6 months while those Pesos will

be used in home country. So after receiving those pesos they have to convert into dollars

to use in US. Today if company receives those 500 Poses and converted it on spot bid rate

(rate at which you can buy Dollars in exchange of other specified currency at the spot)

then firm will receive 500000000 / 15.3555 = 32561622.9 dollars. But firm will get these

Pesos in next 6 month and what will happen if the spot bid rate does change? Now

suppose if the Mexican Pesos depreciated after 6 month and spot bid rate changes from

15.3555 to 15.5 Poses/Dollar and firm converted those Poses into Dollar then the firm

will receive 500000000 / 15.5 = 32258064.5 Dollars which is 303558.4 (32561622.9 -

32258064.5 = 303558.4) less than today amount of Dollars if converted. So it is very

important to manage this risk arises due to change in exchange rate and hedging

exchange rate risk to avoid future cash flow volatility.

3. Techniques of hedging Exchange Rate risk:

Above illustration shows the importance of hedging exchange rate risk especially when

foreign currency is expected to appreciate for an importer or depreciation in foreign

currency for an exporter while payments or receipts are made in foreign currency. Firms

use derivative instruments to hedge their exchange rate risk and to avoid the volatility in

their cash flows all over the world (Froot et al., 1993). Following are techniques to hedge

exchange rate in this respect.

3.1 Billing in home currency:

While dealing in foreign exchange currencies in their operations one can deal in three

different currencies

1. Home Currency

2. Counter partys home currency

3. Third country currency

Dealing with home currency transaction is the easiest way to hedge the currency risk as

whenever the payment is paid you will receive in home currency and no need to convert

it with other currency that can lead to volatile cash flows, but this holds true if home

currency is stronger and expected to appreciate with respect to that currency (Grath,

2008:98). While if foreign currency is expected to appreciate i.e. forward rate is less than

spot rate then you can hedge yourself through forward contracts with more returns.

3.2 Currency Forwards:

It is an obligatory sale or purchase agreement of a specified number of units of a currency

with a specified exchange rate in replace of another currency at a future date. The agreed

rate can be different from spot rate but it did not assure that on that future date spot price

of that currency will be same as this forward rate. This forward rate is been determined

according to interest rates and to market situation plus bank commission (Grath,

2008:98). These are over the counter contracts and time period of the transaction should

be more than 2 days after transaction and in the foreign exchange market nearly 10

percent of all transactions are forward contracts (Homaifar, 2004:41). It is an obligation

on both the parties and at the maturity of contract one party has to sale and other has to

purchase that specified numbers of units at that agreed price. In these contracts one can

hedge his exchange rate risk by transferring it to the counter party. Currency forward

contracts allows a firm to hedge its exchange rate risk by locking the price to be paid

against foreign currency as the value of that currency may appreciate over time (Madura,

2006). For example as firm is expected to receive 500 million Pesos whose spot rate is

15.3555 and we made a 6 month forward contract whose rate is 15.0123 and hedge our

risk. Now whatever the spot price will be after 6 months bank is obligatory to exchange

those Pesos at 15.0123 exchange rates and risk has been transferred to bank. If the spot

rate at that time is more than forward rate then bank will enjoy premium and if the

exchange rate falls than forward rate than risk bank will bear losses. Though currency

rate risk is been catered in forwards with customized options but as these are over the

counter contracts usually made by bank, so the risk of default of that bank is associated

and on the other hand liquidity before maturity of these contracts are also been an issue to

be considered.
3.3 Futures Contract

Having all features of forward contracts but standardized features along with trading in

exchange makes it different from forwards. As Futures are traded on exchange, so the risk

of default is guaranteed by that exchange. Unlike forwards these are standardized

contracts where you just have to choose your contract.

3.4 Currency Options:

These are the contracts in which the buyer of option has the right, but not the compulsion

to sale or buy a specified number of units of a currency at a agreed rate during some

future date (Grath, 2008:101). Unlike forward or futures it did not create obligations to

the party to execute the contract but it provides the right to the option holder whether to

execute the contract or not at the time of maturity. A call option provides to its owner the

right to purchase while a put option gives the right to sell a specified number of foreign

currency in exchange of home currency at a particular price (also called strike price), on

or before some specified expiration date (Marcus, 2004:656). Option holder has to pay

some premium at the time of contract but at the withdrawal option holder will loss that

premium. Both options at over the counter and tradable options are available. Suppose

you buy a put option to sell 5oo million Mexican Poses after 6 month with a premium of

$1000 at the rate of 15.2 Poses / Dollar and today spot price is 15.3555 Poses / Dollar.

Now after 6 months total value of option will be $32893736.8 (500000000 / 15.2 -

$1000). You will exercise the put option if the spot rate at that time will be at least

15.2004 poses / dollars (500000000 / 32893736.8) as at this level there is no profit and no

loss. So decrease in spot rate at that time from this level will increase the profitability in
dollars while any increase from this level will lead to withdraw from option as it will

increase the loss.

3.5 Hedging through Money Market:

It is a process by which one can borrow and deposits different currencies in different

countries having different interest rates to eliminate the currency risk. Here the logic is

different interest rates in different countries and we try to cater our currency risk through

those interest rate differentials.

4. Calculations of three chosen approaches:

Bid Rate Ask Rate

Spot rate (Peso/USD) 15.3555 15.3561

Six months forward (Peso/USD) 15.0123 15.0134

Six months interest rates U.S Mexico

Deposit 3.1% p.a. 1.6% p.a.

Borrowing 5.1% p.a. 2.6% p.a.

4.1 Billing in US Dollars:

As firm is expecting 500 million Mexican poses in next 6 months. Now if firm contracted

with its customer to pay in US dollars then today he will fix dollar amount to be paid

after 6 months according to current spot rate as given.

Dollars to be paid = 500000000 / 15.3555 = 32561622.9 US Dollars

Now after 6 months company will receive 32561622.9 dollars from its customer and

company has hedged himself to this amount of dollars. Now whatever the exchange rate

will be after 6 months company will receive 32561622.9 dollars.

4.2 Currency Forward Contract:

Another option that can be used to hedge currency risk is forward contract. After entering

a six month forward contract company can lock the exchange price of 15.0123 poses per

dollar. Now whatever the price will be after 6 month company can exchange those 500

million poses into dollars at 15.0123 poses per dollar. So after 6 month company will

receive following amounts.

Receipts from customers = 500000000 poses

Covert to Dollar at Forward rate = 500000000 / 15.0123

= 33306022.4 Dollars

So after entering forward contract company has locked the conversion price at 15.0123

and can convert those 500 million poses into 33306022.4 Dollars after 6 months.

4.3 Money Market Hedge:

Company can also go for a money market hedge where firm can borrow from Mexican

money market for 6 months against some interest rate to be paid and convert this amount

into Dollars. Then deposit this amount in home country money market for 6 months for

some interest. When receive those 500 million poses from its customer, return the loan

borrowed from Mexican money market and also receive money deposited in home

country money market with interest. This all process is completed in following way

Step 1

Borrow required Poses from Mexican market = 500000000 / [1 + (0.026 * 6/12)]

= 500000000 / 1.013

= 493583416 poses

Step 2
Covert these Poses into Dollars at current spot rate = 493583416 / 15.3555

= 32143754.1 Dollars

Step 3

Deposit these Dollars into home money market at 5.1% p.a.

Step 4

Now after 6 months firms repayment of loan (Principle + interest) from Mexican market

becomes due

Amount due to Mexican money market = Principle + Interest

= 493583416 + 6416584

= 500000000 Poses

Company will repay its 500000000 Poses loan after receiving from its customer.

Company also will receive his deposited 32143754.1 Dollars along with 5.1% p.a.

interest rate.

Amount Receive from Home money market = Principle + Interest

= 32143754.1 + (32143754.1 * 0.051 *

6/12) = 32143754.1 + 819665.73

= 32963419.8 Dollars

So after 6 months company will receive a total of 32963419.8 Dollars.

4.4 Recommended approach:

Company should go for forward contract to hedge its currency rate risk as company will

receive maximum amount of dollars after 6 month in this approach. If company goes for

billing in US dollars then it will receive 32561622.9 dollars which is not a good option as

the forward rate is less than spot rate and company can gain 33306022.4 Dollars through
forward contract even more than the proceeds will receive from money market hedge

approach. In exercising the forward contract company can hedge his currency risk and

also will earn 744399.5 (33306022.4 - 32561622.9) dollars more than billing n US dollar

option and 342602.6 (33306022.4 - 32963419.8) more than the money market option.

5. Forward exchange fixed V/S forward exchange option contracts:

Following are the critical features that distinguish these two Forward exchange fixed and

forward exchange option contracts.

5.1 Option but not obligation:

The main feature that differentiate forward option contract with forward fixed contract is

the right to execute the contract and not the obligation. In option contract option holder

can cancel the contracts while loosing his premium amount (Grath, 2008:101). This

feature of option provides option holder more flexible risk management as he can cancel

the deal if observing low proceeds of amount and also can got high profits if the

exchange spot rate increases as compared to strike price (option exchange rate). While in

forward you make a 100% hedge and lack at one price.

5.2 Premium:

No premium is required to enter in a forward contract while for a forward option contract

premium is required which act as insurance premium determined and varying according

to interest rate level, market condition, time period of contract and expected fluctuations

in currency Grath, 2008:102). This feature of options can make it costly as compared to

forwards. But on the other hand it can also provide an opportunity for high profits. Unlike

options there is no such premium required to enter in a forward contract but a little

margin or commission.
5.3 Trading:

Forwards are available in over the counter market while options can be accessed through

both traditional and over the counter market. So both tailor made and standardized option

contracts are available.

5.4 Exercise Time:

As it is very difficult for an importer to figure out the exact time of payment or proceeds

will receive in foreign currency, so option contract also can provide this kind of

flexibility. For example if today (1 April) you but an option for 6 months at a strike rate

of 15.43 Poses / Dollars and in agreement it is given that you can exercise this agreement

from 1st September to 30th September. Now you have more flexibility in exercising the

contract according to your need during the month of September. But in the case of

forward contract you fix a future date and the contract will be exercised on that particular

date.
References:

Adler, M., and B. Dumas (1984), Exposure to Currency Risk: Definition and Measurement, Financial
Management, 13: 41-50

Brigham and Houston (2008), Fundamentals of financial management, (10th Ed)

Froot, K.A., D.S. Scharfstein, and J.C. Stein (1993), Risk Management: Coordinating Corporate In-
vestment and Financing Policies, Journal of Finance, 48: 1629-1658

Grath, A (2008), The hand book of International Trade and Finance, US: Kogan Page Limited

Griffin, J.M., and R.M. Stutz (2001), International Competition and Exchange Rate Shocks: A Cross-
Country Industry Analysis of Stock Returns, Review of Financial Studies, 14: 215-241

Homaifar G.A. (2004), Managing Global Financial and Foreign Exchange Rate Risk,
John Wiley & Sons, Inc

Jorion, P. (1990), The Exchange Rate Exposures of US Multinationals, Journal of

Business, 63, 331-345

Madura, J. (2006), Financial Markets and Institutions, Ohio: Thomson South Western