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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