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Hedging Transaction Exposure
Bill Reese
International Finance
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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
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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
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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
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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
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Hedging
Forward contract Futures contract Option on futures contract Money market hedge
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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
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Futures Contract
Standardized forward contract at an exchange
Traded on Chicago Mercantile Exchange• €125,000 per contract• Delivery last month of each quarter
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Futures Contract
Advantages of Futures Contract No hunting for counterparty No counterparty default risk Actual delivery not necessary
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Futures Contract
Disadvantages of Futures Contract Standardized contract
Size Delivery date Currency
Marked-to-market
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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
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Options on Futures
What if spot rate at delivery is 1.30 $/€?• Regret
Euro appreciated Lost opportunity for gain
• Futures contract is insurance
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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
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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
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Options on Futures
Advantage over futures contract Choice (option) of entering into futures contract
Disadvantage relative to futures contract Premium
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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
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Money Market Hedge
Assume Annual interest rate is 5% Spot rate is 1.22 $/€
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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
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