Hedging will be understood to mean a transaction

undertaken specifically to offset some exposure

arising out of the firm's usual operations
Speculation will refer to deliberate creation of a
position for the express purpose of generating a
profit from exchange rate fluctuations, accepting the
added risk
Management of transactions exposure has two
significant dimensions
The treasurer must decide whether and to what
extent an exposure should be explicitly hedged
The treasurer must evaluate alternative hedging
strategies

The net exposure in a given currency at a given date
is
(the total inflows) (total outflows)
to be settled on that date )
The Cost of a Forward Hedge
Common fallacy to claim that the cost of forward
hedging is the forward discount or premium
The ex-ante value of the payable if the firm does
not hedge should be considered.
The relevant comparison is between the forward
rate and the expected spot rate on the day the
transaction is to be settled


If speculators are risk neutral and there are no
transaction costs, . the forward rate at time t for
transactions maturing at T equals the expectation
at time t, of the spot rate at time T
F
t,T
= S
e
t,T
If the speculators in the foreign exchange market
are not risk neutral
F
t,T
> S
e
t,T
or F
t,T
< S
e
t,T

Even in the case when speculators are not risk
neutral the expected cost of hedging with forwards
is zero except for the fact that bid/offer spreads
are somewhat wider in forwards than in spot


Hedging with Currency Futures

Hedging contractual foreign currency flows with
currency futures is in many respects similar to hedging
with forward contracts
A futures hedge differs from a forward hedge because
of the intrinsic features of futures contracts
standardization Since amounts and delivery dates for
futures are standardized, a perfect futures hedge is
generally not possible
Basis risk - imperfect correlation between spot and
futures prices RBI REFERENCE RATE SETTLED !
Intermediate- Futures unlike forwards, give rise to
cash flows due to the marking-to-market feature
HEDGING LONG AND SHORT EXPOSURES WITH
FUTURES
Change In value of
portfolio
Change In value of
price
Change In value of
price
Change In value of
portfolio
hedge
exposure
exposure
hedge
Currency Appreciation
(long)exposure with
SHORT hedge
Exporters hedge
Currency Depreciation
(short)exposure with
LONG hedge
Importers hdge

The advantage of futures over forwards is
firstly easier access and secondly greater
liquidity
Currency futures are used by commercial
banks to hedge positions taken in the forward
markets
Most corporations use OTC forwards to hedge
transactions exposures arising out of
operations
A receivable is hedged by selling a future
A payable is hedged by buying a future

8
EXAMPLES OF HEDGING FOREIGN CURRENCY
EXAMPLE 1: A LONG HEDGE
ON JULY 1, AN AMERICAN AUTOMOBILE DEALER ENTERS INTO A CONTRACT TO IMPORT
100 BRITISH SPORTS CARS FOR GBP 28,000 EACH. PAYMENT WILL BE MADE IN BRITISH
POUNDS ON NOVEMBER 1.
RISK EXPOSURE: IF THE GBP APPRECIATES RELATIVE TO THE USD THE IMPORTERS
COST WILL RISE.
TIME SPOT FUTURES
JUL. 1 S(USD/GBP) = 1.3060 LONG 46 DEC GBP FUTURES@62,500
CURRENT COST = USD3,656,800 FOR F = USD1.2780/GBP
DO NOTHING


NOV. 1 S(USD/GBP) = 1.4420 SHORT 46 DEC BP FUTURES
COST = 28,000(1.4420)(100) FOR F = USD1.4375/GBP
= USD4,037,600 PROFIT: (1.4375 - 1.2780)62,500(46)
= USD458,562.50
INCREASED COST =USD 380,000
ACTUAL COST = USD3,579,037.50* brokerage fee?

46
780) 62,500(1.2
3,656,800
= n size contract
9
EXAMPLE 2: A SHORT HEDGE
A US MULTINATIONAL COMPANYS ITALIAN SUBSIDIARY WILL GENERATE EARNINGS
OF EUR 2,516,583.75 AT THE END OF THE QUARTER - MARCH 31. THE MONEY WILL BE
DEPOSITED IN THE NEW YORK BANK ACCOUNT OF THE FIRM IN U.S. DOLLARS.
RISK EXPOSURE: IF THE DOLLAR APRECIATES RELATIVE TO THE EURO THERE WILL
BE LESS DOLLARS TO DEPOSIT.
TIME CASH FUTURES
FEB. 21 S(USD/EUR) = 1.18455 F(JUN) = USD1.17675/EUR
CURRENT SPOT VALUE F = 125,000(1.17675) = USD147,093.75
= USD2,981,019.28 n = 2,981,019.28/147,093.75 = 20.
DO NOTHING SHORT 20 JUN EUR FUTURES

MAR 31 S(EUR/USD) = 1.1000 LONG 20 JUN EUR FUTURES
DEPOSIT 2,768,242.125 F(JUN) = USD1.10500
PROFIT: (1.17675 -1.10500)125,000(20) =
USD179,375
TOTAL AMOUNT TO DEPOSIT USD 2,947,617.125
A firm can shift, share, or diversify:

-Shift exchange rate risk:
by invoicing foreign sales in home currency

-Share exchange rate risk:
by pro-rating the currency of the invoice between
foreign and home currencies

-Diversify exchange rate risk:
by using a market basket index

Trade between developed countries in manufactured
products is generally invoiced in the exporter's
currency
Trade in primary products and capital assets is
generally invoiced in a major vehicle currency such as
the US dollar.
Trade between a developed and a less developed
country tends to be invoiced in the developed
country's currency.
If a country has a higher and more volatile inflation
rate than its trading partners, there is a tendency not
to use that country's currency in trade invoicing

Suppose that Boeing is scheduled to deliver an aircraft
to British airways at the beginning of each year for the
next five years. British Airways, in turn, is scheduled to
pay 10,000,000 to Boeing on December 1 of each
year for five years. In this case, Boeing faces a
sequence of exchange risk exposures.
If Boeing invoices $15 million(home currency) rather
than 10 million for the sale of the aircraft, then it
does not face exchange exposure anymore. However,
the exchange exposure does not disappear but merely
shifts to the British importer.
British Airways now has an account payable
denominated in U.S. dollars.
Risk shifting :
Instead of shifting the exchange exposure entirely to British
Airways, Boeing can also share the exposure with British
Airways , for example, invoicing half of the bill in U.S.
dollars and the remaining half in British pounds, that is ,
$7.5 million and 5 million. In this case, the magnitude of
Boeings exchange exposure is reduced by half.
As a practical matter, however, the firm may not be able to
use risk shifting or sharing as much as it wishes to for fear
of losing sales to competitors.
Also if the currencies of both the exporter and the importer
are not suitable for settling international trade, neither
party can resort to risk shifting/sharing to deal with
exchange exposure.

Risk sharing :
The firm can diversify exchange exposure to some extent
by using currency basket units such as the SDR as the
invoice currency.
Often, multinational corporations and sovereign entities
are known to float bonds denominated either in the SDR or
in the ECU prior to the introduction of the euro.
For example, the Egyptian government charges for the use
of the Suez Canal using the SDR. Obviously, these currency
baskets are used to reduce exchange exposure.

Definition
The settlement of obligations between two
parties that processes the combined value of
transactions. It is designed to lower the
number of transactions required. For
example, if Bank A owed Bank B $100,000,
and Bank B owed Bank A $25,000, the value
after netting would be a $75,000 transfer
from Bank A to Bank B ($100,000 - $25,000).

In 1984, Lufthansa, a German airline, signed a
contract to buy $3 billion worth of aircraft from
Boeing and entered into a forward contract to
purchase $1.5 billion forward for the purchase of
hedging against the expected appreciation of the
dollar against the German mark. This decision,
however, suffered from a major flaw: A significant
portion of Lufthansa's cash flows was also dollar-
denominated. As a result, Lufthansa's net exposure to
the exchange risk might not have been significant.
Lufthansa had a so-called natural hedge.
In 1985, the dollar depreciated substantially against the mark
and, as a result, Lufthansa experienced a major foreign
exchange loss from settling the forward contract. This episode
shows that when a firm has both receivables and payables in a
given foreign currency, it should consider hedging only its net
exposure.
So far, we have discussed exposure management on a currency-
by-currency basis. In reality, a typical multinational corporation
is likely to have a portfolio of currency positions. For instance, a
U.S. firm may have an account payable in euros and, at the
same time, an account receivable in Swiss francs. If the euro and
franc move against the dollar almost in lockstep, the firm can
just wait until these accounts become due and then buy euros
spot with francs. It can be wasteful and unnecessary to buy
euros forward and sell francs forward. In other words, if the firm
has a portfolio of currency positions, it makes sense to hedge
residual exposure rather than hedge each currency position
separately.
A multinational firm should not consider
deals in isolation, but should focus on
hedging the firm as a portfolio of currency
positions.
As an example, consider a U.S.-based multinational
with Korean won receivables and Japanese yen
payables. Since the won and the yen tend to move
in similar directions against the U.S. dollar, the firm
can just wait until these accounts come due and
just buy yen with won.
Even if its not a perfect hedge, it may be too
expensive or impractical to hedge each currency
separately.
If the firm would like to apply exposure
netting aggressively, it helps to centralize the
firms exchange exposure management
function in one location.
Many multinational firms use a re-invoice
center. Which is a financial subsidiary that
nets out the intra-firm transactions.
Once the residual exposure is determined,
then the firm implements hedging.
Consider a U.S. MNC with three subsidiaries and
the following foreign exchange transactions:
$10 $35 $40 $30
$20
$25
$60
$40
$10
$30
$20
$30
Bilateral Netting would reduce the number of
foreign exchange transactions by half:
$10 $35 $40 $30
$20
$40
$30
$20
$30
$20
$30
$10
$40 $30
$10
$30
$20
$60
$10 $35 $25
$60
$40
$20
$25
$10
$25
$10
$15
$10
A major reason for netting is that it adds
additional security in the event of a bankruptcy
to either party. By netting, in the event of
bankruptcy, all of the swaps are executed
instead of only the profitable ones for the
company going through the bankruptcy. For
example, if there was no bilateral netting, the
company going into bankruptcy could collect
on all in the money swaps while saying they
can't make payment on the out of the money
swaps due to the bankruptcy.
Definition
A transaction which closes an investors
position with another transaction. For
example, an options investor could close a
sold call option by buying a call option for the
same number of shares.
To reduce an investor's net position in an
investment to zero, so that no further gains
or losses will be experienced from that
position.

To lead means to pay or collect early, whereas to
lag means to pay or collect late.

The firm would like to lead soft currency receivables
and lag hard currency receivables to avoid the loss
from depreciation of the soft currency and benefit
from the appreciation of the hard currency.

For the same reason, the firm will attempt to lead the
hard currency payables and lag soft currency payables.

It is more attractive to use for the payments between
associate companies within a group.

Leading and lagging are aggressive foreign exchange
management tactics designed to take the advantage of
expected exchange rate changes.

However this technique requires some form of
speculation due to the need to identify the movement
of the exchange rates.
Say for example a company bought a consignment of
rice from India payable in USD which is expected to
appreciate in the coming weeks. It will be the best
interest for the company to pay up as soon as possible
before the USD appreciates further

This is what we call leading currency payments
The lead/lag strategy can be employed more
effectively to deal with intra-firm payables and
receivables, such as material costs, rents, royalties,
interests, and dividends, among subsidiaries of the
same multinational corporation.

Since managements of various subsidiaries of the same
firm are presumably working for the good of the entire
firm, the lead/lag strategy can be applied more
aggressively.

lezione_profPIOTRMISZTAL.ppt
http://ec.europa.eu/economy_finance/public
ations/publication11475_en.pdf
http://highered.mcgraw-
hill.com/sites/dl/free/0070912289/235906/
new_chapter_13.pdf