Management of transaction exposure

Juhi kashyap Roll no. 20 MBA-IB

Techniques of hedging transaction exposure

Hedging with forward market Hedging with currency options Hedging with money market Hedging with swaps

Money market hedge

Hedging with money market

Importer-Hedging payables
Borrows local currency

Exporter-Hedging receivables
Borrows the currency in which the receivables are denominated

Convert local currency into foreign currency

Convert borrowed currency into local currency

Invest converted amount for same time frame

Invest with the same time frame

Importers Money Market Hedge: Cash Flows Now and at Maturity

Spot Foreign Exchange Market

96,153.85 Importer $144,230.77 $148,557.69 $144,230.77

deposit i = 4%

96,153.85
100,000

Italia Bank

T= 1 cash flows

Supplier

U.S Bank

Exporters Money Market Hedge

Spot Foreign Exchange Market

95,238.10

Exporter

95,238.10
Borrow i = 5%

Crdit Agricole

$119,047.62
deposit i$ = 7.10%

100,000 $127,500.00
T= 1 cash flows

An American exporter has just sold 100,000 worth of shoes to a French customer. Payment is due in one year. Interest rates in dollars are 7.10 percent in the U.S. and 5 percent in the euro zone. The spot exchange rate is $1.25/1.00. Use a money market hedge to eliminate the exporters exchange rate risk.

U.S Bank

$119,047.62

Customer

Importers Money Market Cross-Currency Hedge: Cash Flows Now and at Maturity
Spot Foreign $1,128,640.77 Exchange 728,155.34 Market 728,155.34 Importer deposit i = 3% Italia Bank Spot Foreign Exchange Market

$1,128,640.77

586,893.20

564,320.39 564,320.39

750,000
T= 1 cash flows

U.K Bank

Supplier

Options

Options
To hedge a foreign currency payable buy calls on the currency. Ex-Importer
If the currency appreciates, your call option lets you buy the currency at the exercise price of the call.

To hedge a foreign currency receivable buy puts on the currency . Ex-Exporter

If the currency depreciates, your put option lets you sell the currency for the exercise price

Options Market Hedge

Suppose the forward exchange rate is $1.50/. $30m If an importer who has to pay 100m does not $0 hedge the payable, in one year his gain $30m (loss) on the unhedged position is shown in green.

The importer will be better off if the euro depreciates: he still buys 100m but at an exchange rate of only $1.20/ he saves $30 million relative to $1.50/

Value of 1 in $ $1.20/ $1.50/ $1.80/ in one year

But he will be worse off if the euro appreciates.

Unhedged payable

Options Markets Hedge

Suppose our importer buys a call option on 100m with an exercise price of $1.50 per $5m pound. He pays $.05 per euro for the loss call.
Profit Long call on 100m

$1.55/ $1.50/

Value of 1 in $ in one year

Options Markets Hedge

The payoff of the portfolio of a call and a payable is shown in red. $25m He can still profit from decreases in the exchange rate $5m below $1.45/ but has a hedge against unfavorable loss increases in the exchange rate. Profit Long call on 100m

$1.20/ $1.45 / $1.50/

Value of 1 in $ in one year

Unhedged payable

Options Markets Hedge

Profit If the exchange rate increases to $1.80/ the importer makes $25 m $25 m on the call but loses $30 m on the payable for a maximum loss $5 m of $5 million. $30 m This can be thought of as an insurance loss premium. Long call on 100m

$1.45/ $1.50/

Value of 1 in $ $1.80/ in one year

Unhedged payable

Hedging Exports with Put Options

Show the portfolio payoff of an exporter who is owed 1 million in one year. The current one-year forward rate is 1 = $2. Instead of entering into a short forward contract, he buys a put option written on 1 million with a maturity of one year and a strike price of 1 = $2.
The cost of this option is $0.05 per pound.

8-14

Options Market Hedge:

Exporter buys a put option to protect the dollar value of his receivable.
$1,950,000

$50k $2 $2.05

S($/)360 Long put

$2m
15

8-15

Options Markets Hedge

IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS.
If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.

EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS.
If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.

Example
Indian importer imports good worth US $ 1,000 and has to make payments after 90 days Spot rate is Rs 40/US $ Interest rate on borrowing in India and the USA is 6 % pa Interest rate on deposit /investment 5% A 90 day call option is having a strike price of Rs 39.60 and a premium of Rs 0.05 per $ A 90 day put option is having strike price of Rs 39.80 and a premium of Rs 0.05 per $ Spot rate at 90th day Rs 39.80/US $

Thank you