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LEARNING SUBJECTS

CHAPTER 2

POLICIES FOR HEDGING HEDGING EXPOSURE TO HEDGING EXPOSURE TO

TRANSACTION EXPOSURE PAYABLES RECEIVABLES

Lecturer: Dr. Tien Trung, Nguyen 1 Lecturer: Dr. Tien Trung, Nguyen 2

POLICIES FOR HEDGING TRANSACTION EXPOSURE

❖Hedging most of the exposure:

- MNCs hedge most of their exposure so that their value is not highly influenced by
exchange rates.

- Hedging most of the transaction exposure allows MNCs to forecast their future cash PART I
flows more accurately.
❖Selective hedging:

- MNCs use selective hedging for each type of transaction separately.

- MNCs hedge transactions when they believe that they can improve their expected cash
flows.

Lecturer: Dr. Tien Trung, Nguyen 3 Lecturer: Dr. Tien Trung, Nguyen 4

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HEDGING EXPOSURE TO PAYABLES 1. FORWARD/FUTURES HEDGE ON PAYABLES

Hedging techniques to hedge the payables: Forward and futures contracts allow an MNC to lock in a specific
❖ Forward/Futures hedge exchange rate at which it can purchase a specific currency and
❖ Money market hedge therefore allow it to hedge payables denominated in a foreign
❖ Currency option hedge currency.

Lecturer: Dr. Tien Trung, Nguyen 5 Lecturer: Dr. Tien Trung, Nguyen 6

Example:
2. MONEY MARKET HEDGE ON PAYABLES

Coleman Co. is a US-based MNC that will need 100,000 euros in 1 year. It ❖A money market hedge on payables involves taking a money market
could obtain forward contract to purchase the euros in 1 year. The 1-year
position to cover future payables position.
forward rate is $1.20, the same rate as currency futures contracts on euros.
❖A money market hedge requires two money market positions:
If Coleman purchases euros 1-year forward, its dollar cost in 1 year is:
(1)borrowed funds in the home currency.
(2)a short-term investment in the foreign currency.

❖Cost in $ = Payables x Forward rate = 100,000 euros x

$1.20 = $120,000
Lecturer: Dr. Tien Trung, Nguyen 7 Lecturer: Dr. Tien Trung, Nguyen 8

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Example: Example:

If Coleman Co. needs 100,000 euros in 1 year, it could

convert dollars to euros and deposit the euros in a bank
Assuming a spot rate of today is
today. Assuming that it could earn 5 percent on this deposit, it $1.18, the dollars needed to make the
would need to establish a deposit of 95,238 euros in order to
have 100,000 euros in 1 year, as shown below: deposit today are estimated below:
❖Deposit amount to hedge payables = 100,000 euros/ (1 + ❖Deposit amount in dollars = 95,238 euros x $1.18 =
0.05) = 95,238 euros. $112,381.
Lecturer: Dr. Tien Trung, Nguyen 9 Lecturer: Dr. Tien Trung, Nguyen 10

Example:
3. CALL OPTION HEDGE ON PAYABLES

Assuming that Coleman can borrow dollars at an ❖A currency call option provides the right to buy a specified
interest rate of 8 percent, it would borrow the funds amount of a particular currency at a specified price (called

needed to make the deposit, and at the end of the the strike price or exercise price) within a given period of
time.
year it would repay the loan:
❖ The currency call option does not obligate its owner to buy

❖Dollar amount of loan repayment = $112,381 x (1+ 0.08) = the currency at that price.
$121,371.
Lecturer: Dr. Tien Trung, Nguyen 11 Lecturer: Dr. Tien Trung, Nguyen 12

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Example: Example:

❖Coleman Co. considers hedging its payable of 100,000 euros in 1 year. It could ❖ If the spot rate at the time the payables are due is less than the exercise price of $1.20, Coleman

purchase call options on 100,000 euros so that it can hedge its payables. Assume that would not exercise the call option, so the cost of hedging would be equal to the spot rate at that
time, along with the premium paid for the call option.
the call options have an exercise price of $1.20, a premium of $0.03, and an expiration
❖ For example, it the spot rate was $1.16 at the time payables were due, Coleman would pay that
date of 1 year from now (when the payables are due).
spot rate along with the $0.03 premium per unit.
❖Coleman can create a contingency graph for the call option hedge as shown in the
❖ At any spot rate more than or equal to the exercise price of $1.20, Coleman would exercise the
exhibit. The horizontal axis shows several possible spot rates of the euro that could
call option, and the cost of hedging would be equal to the price paid per euro ($1.20) along with
occur at the time payables are due, while the vertical axis shows the cost of hedging the premium of $0.03 per euro paid for the call option. Thus, the cost of hedging is $1.23 if the
per euro for each of those possible spot rates. spot rate at the time payable are due is beyond the exercise price of $1.20.

Lecturer: Dr. Tien Trung, Nguyen 13 Lecturer: Dr. Tien Trung, Nguyen 14

3. CALL OPTION HEDGE ON PAYABLES Example:

Recall that Coleman Co. considers hedging its payables of 100,000

euros with a call option that has an exercise price of $1.20, a premium
of $.03, and an expiration date of 1 year from now. Also assume that
Coleman’s forecast for the spot rate of the euro at the time payables
are due is as follows:
❖$1.16 (20% probability)
❖$1.22 (70% probability)
❖$1.24 (10% probability)
Lecturer: Dr. Tien Trung, Nguyen 15 Lecturer: Dr. Tien Trung, Nguyen 16

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Example: 4. COMPARING HEDGE TYPES ON PAYABLES

❖Expected value of cost = ($119,00 x 20%) + ($123,000 x 70%) +

($123,000 x 10%) = $122,200
Lecturer: Dr. Tien Trung, Nguyen 17 Lecturer: Dr. Tien Trung, Nguyen 18

HEDGING EXPOSURE TO RECEIVABLES

Hedging techniques to hedge the receivables:

❖ Forward/Futures hedge
❖ Money market hedge
PART II
❖ Currency option hedge

Lecturer: Dr. Tien Trung, Nguyen 19 Lecturer: Dr. Tien Trung, Nguyen 20

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Example:
1. FORWARD/FUTURES HEDGE ON RECEIVABLES

Forward contracts and futures contracts allow an MNC to lock in a specific Viner Co. is a U.S.–based MNC that will receive 200,000 Swiss francs in 6

exchange rate at which it can sell a specific currency and, therefore, allow it months. It could obtain a forward contract to sell SF200,000 in 6 months.
to hedge receivables denominated in a foreign currency. The 6-month forward rate is $.71, the same rate as currency futures
contracts on Swiss francs. If Viner sells Swiss francs 6 months forward, it
can estimate the amount of dollars to be received in 6 months:

❖Cash inflow in $ = Receivables x Forward rate = SF200,000

x $0.71 = $142,000
Lecturer: Dr. Tien Trung, Nguyen 21 Lecturer: Dr. Tien Trung, Nguyen 22

Example:
2. MONEY MARKET HEDGE ON RECEIVABLES

❖Recall that Viner Co. will receive SF200,000 in 6 months. Assume that it can
A money market hedge on receivables involves borrowing the
borrow funds denominated in Swiss francs at a rate of 3 percent over a 6-month
currency that will be received and using the receivables to pay off
period. The amount that it should borrow so that it can use all of its receivables
the loan. to repay the entire loan in 6 months is:

❖Amount to borrow = SF200,000/(1+0.03) = SF194,175

Lecturer: Dr. Tien Trung, Nguyen 23 Lecturer: Dr. Tien Trung, Nguyen 24

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Example: Example:

❖If Viner Co. obtains a 6-month loan of SF194,175 from a bank, it will If Viner Co. does not need any funds to support existing
owe the bank SF200,000 in 6 months. It can use its receivables to operations, it can convert the Swiss francs that it borrowed
repay the loan. The funds that it borrowed can be converted to
into dollars. Assume the spot exchange rate is presently $.70.
dollars and used to support existing operations.
When Viner Co. converts the Swiss francs, it will receive:
❖If the MNC does not need any short-term funds to support existing
operations, it can still obtain a loan as explained above, convert the
funds to dollars, and invest the dollars in the money market.

❖Amount of dollars received from loan = SF194,175 x $0.7 = $135,922.

Lecturer: Dr. Tien Trung, Nguyen 25 Lecturer: Dr. Tien Trung, Nguyen 26

Example:
3. PUT OPTION HEDGE ON RECEIVABLES

Then the dollars can be invested in the money market. A put option allows an MNC to sell a specific amount of currency at a

Assume that Viner Co. can earn 2 percent interest over a 6- specified exercise price by a specified expiration date. An MNC can
purchase a put option on the currency denominating its receivables and
month period. In 6 months,
lock in the minimum amount that it would receive when converting the
receivables into its home currency.

❖The investment will be worth= $135,922 x 1.02 = $138,640.

Lecturer: Dr. Tien Trung, Nguyen 27 Lecturer: Dr. Tien Trung, Nguyen 28

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Example: 3. PUT OPTION HEDGE ON RECEIVABLES

❖Recall that Viner Co. considers hedging its receivables of

SF200,000 in 6 months. It could purchase put options on
SF200,000, so that it can hedge its receivables.
❖Assume that the put options have an exercise price of
$.70, a premium of $.02, and an expiration date of 6
months from now (when the receivables arrive). Viner
can create a contingency graph for the put option hedge.

Lecturer: Dr. Tien Trung, Nguyen 29 Lecturer: Dr. Tien Trung, Nguyen 30

Example: Example:

At any spot rate less than or equal to the exercise price of $.70, Viner would exercise the put option
Viner Co. considers purchasing a put option contract on Swiss francs,
and would sell the Swiss francs at the exercise price of $.70. After subtracting the $.02 premium
per unit, Viner would receive $.68 per unit from selling Swiss francs. At any spot rate more than the
with an exercise price of $.72 and a premium of $.02. It has developed
exercise price, Viner would let the put option expire and would sell the francs at the spot rate in the the following probability distribution for the spot rate of the Swiss franc
foreign exchange market. For example, if the spot rate was $.75 at the time receivables were due,
in 6 months:
Viner would sell the Swiss francs at that rate. It would receive $.73 after subtracting the $.02
premium per unit. ❖$0.71 (30% probability)
❖$0.74 (40% probability)
❖$0.76 (30% probability)

Lecturer: Dr. Tien Trung, Nguyen 31 Lecturer: Dr. Tien Trung, Nguyen 32

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Example: 4. COMPARING HEDGE TYPES ON RECEIVABLES

❖Expected value of cash to be received = ($140,000 x 30%) + ($144,000 x 40%) +

($148,000 x 30%) = $144,000

Lecturer: Dr. Tien Trung, Nguyen 33 Lecturer: Dr. Tien Trung, Nguyen 34

5. SUMMARY OF HEDGING TECHNIQUES

PART III

Lecturer: Dr. Tien Trung, Nguyen 35 Lecturer: Dr. Tien Trung, Nguyen 36

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EXERCISES AND APPLICATIONS EXERCISES AND APPLICATIONS

❖Exercise 1: Forward versus Money Market Hedge on Payables ❖Exercise 2: Forward versus Money Market Hedge on Receivables.
Assume the following information Assume the following information

Assume that the Santa Barbara Co. in the United States will need 300,000 ringgits in 90 Assume that Riverside Corp. from the United States will receive 400,000 pounds in
days. It wishes to hedge this payables position. Would it be better off using a forward 180 days. Would it be better off using a forward hedge or a money market hedge?
hedge or a money market hedge? Substantiate your answer with estimated costs for each
Substantiate your answer with estimated revenue for each type of hedge.
type of hedge.
Lecturer: Dr. Tien Trung, Nguyen 37 Lecturer: Dr. Tien Trung, Nguyen 38

EXERCISES AND APPLICATIONS EXERCISES AND APPLICATIONS

❖Exercise 3: Comparison of Techniques for Hedging ❖Exercise 3: Comparison of Techniques for Hedging
Receivables. Receivables.
a. Assume that Carbondale Co. expects to receive S$500,000 in 1 Assume that 1-year put options on Singapore dollars are available, with an exercise price of $.63

year. The existing spot rate of the Singapore dollar is $.60. The and a premium of $.04 per unit. One-year call options on Singapore dollars are available with an
exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates:
1-year forward rate of the Singapore dollar is $.62. Carbondale
created a probability distribution for the future spot rate in 1
year as follows:

Given this information, determine whether a forward hedge, a money market hedge, or a currency
options hedge would be most appropriate. Then compare the most appropriate hedge to an
unhedged strategy, and decide whether Carbondale should hedge its receivables position.

Lecturer: Dr. Tien Trung, Nguyen 39 Lecturer: Dr. Tien Trung, Nguyen 40

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EXERCISES AND APPLICATIONS

❖Exercise 3: Comparison of Techniques for Hedging Receivables.

b. Assume that Baton Rouge, Inc., expects to need S$1 million in 1 year. Using
any relevant information in part (a) of this question, determine whether a forward
hedge, a money market hedge, or a currency options hedge would be most
appropriate. Then, compare the most appropriate hedge to an unhedged strategy,
and decide whether Baton Rouge should hedge its payables position.

Lecturer: Dr. Tien Trung, Nguyen 41

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