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Lesson Objectives• Different kinds of currency options and their uses• Hedging with currency options• Internal hedging strategies like neeting, offsetting, leading

and lagging.• Speculation in foreign exchange and money marketsCurrency options provide a more flexible means to covertransactions exposure. A contracted foreign currency outflow canbe hedged by purchasing a call option (or selling a put option)on the currency while -an inflow an be hedged by buying a putoption.(Or writing a call option. This is a “covered call”strategy).Options are particularly useful for hedging uncertain cash flows,i.e. cash flows that are contingent on other events. Typicalsituations are:1. International tenders: Foreign exchange inflows will

materialise only if the bid is.’ successful. If execution of the”contract also involves purchase of materials, equipment, etc.from third coun-tries, there are contingent foreign currencyoutflows too.

2. Foreign currency receivables with substantial default risk orpolitical risk-e.g. the host govern-ment of a foreignsubsidiary” might suddenly impose restrictions on dividendrepatriation;

3. Risky portfolio investment: A funds manager say in UKmight hold a portfolio of foreign stocks/ bonds currentlyworth say DEM 50 million, which he is planning to liquidatein six months time. If he sells DEM 50 million forward andthe portfolio declines in value because of a falling Germanstock market and rising interest rates, he will find himself tobe over insured and short in DEM.

We will discuss a few more examples of the use of options. Wewill particularly focus on the com-parison of options withforward hedge both with reference to an open position.• On June 1, a UK firm has a DEM 5,00,000 payable due on

September 1. The market rates are as follows: -DEM/GBP Spot: 2.8175/85

90-day Swap points: 60/55• September calls with a strike of 2.82 (DEM/GBP) are

available for a premium of O.20p per DEM. We will evaluatethe forward hedge versus purchase of call options both withreference to an open position.

1. Open positionSuppose the firm decides to leave the payable unheeded. Ifat maturity the £IDEM spot rate is ST’ the sterling value ofthe payable is (5,00,OdO)ST’ In figure 13.1 this appears asa straight line through the origin. -

2. Forward hedge -If the fulfill buys DEM 5:00,000 forward at the offer rate ofDEM2.8130/£ or £0.3557/DEM, the value of the payable is £(5,00,000 x 0.3557)= £1,77,850. This is shown as a horizontal line in Figure13.1.

3. A Call option.Instead the firm buys call options on DEM 5,00,000 for atotal premium expense of £1000.At maturity, its cash outflow will be£[(5,00,060)ST + 1Q:f_] for ST::; 0.3546and £[(5,00,OOO)(0.3546) + 1025]= £178325 for ST 0.3546We have assumed here that the premium expense is financedby a 90-day borrowing at 10%.Figure 13.1 illustrates.Open position and forward hedge are equivalent if thematurity GBP/DEM spot rate equals the forward rate at thebeginning, viz. 0.3557. If it is higher, the firm is better offwith a forward Call option and open position are equivalentwhen(5,00,000) St = (0.3546) (500000) + 1025i.e. when St = 0.3537. At higher values, call option is better.Call option and forward are equivalent when(5,00,000) St + 1025 = (0.3537)(500000)i.e. when ST = 0.3567. At lower values than this the optionalternative is better because of its one-way privilege – thefirm can buy DEM in the spot market letting the optionlapse.Figure 13.2 shows gains/losses of forward and call relativeto the open position. For forward, the relative gain is£ [(ST- 0.3537 )(5,00,000)],while for the call relative gain is -£1025 for ST< 0.3546and £ [(5,00,000)(ST-0.35465) – 1025 ] for ST >=0.3546The call option becomes attractive relative to an openposition for values of ST beyond 0.3567. Relative to theforward hedge, the call option is better I if the DEMdepreciates below 0.3537. The maximum gain from theforward hedge, relative to the call is(5,00,000)(0.3546) + 1025 – (0.3557)(5,00,000 = £475whereas, if the DEM depreciates sharply, call option canresult in substantial savings. For instance at ST = 0.3520,saving from the call over the forward is £825.

LESSON 29:HEDGING WITH CURRENCY OPTIONS

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Value of Open position the payable Call option

Forward

0.3537 S(T) 0.3567 0.3557 0.3546

Figure 13.1.

Forward

Gain(+)

Call

0 0.3567 0.3557 0.3537

Loss(-)

Fig 13.2 Gain & Losses from Alternative Hedging StrategiesThus whether the firm should choose the call option strategy,the forward hedge or leave the expo-sure unhedged dependsupon the view it takes of future spot rate. It might do aprobabilistic mean variance analysis to compare the forward-hedge with the call if it can assign. subjective probabilities tofuture values of the spot rate. Thus suppose its forecast of ST

can be summarised as follows:ST Probability0.3557 0.600.3510 0.300.3590 0.10

The firm considers the most probable value of maturity spot tobe equal to the current forward rate. But it thinks that there is a30% chance of a very slurp depreciation of the DEM (possiblybecause it thinks that the Bundesbimk is shortly going-to cutinterest rates to stimulate the economy) and a 10% chance of avery sharp appreciation. The expected cost with forward hedge,

relative to an open posi-tion is then higher by£540 and its standard deviation is 1279.6. Foran option, the expected cost is lower by £475with a standard deviation of’602.5. Thus inthe mean-variance framework, call’ optionshould be the preferred choice because of itssmaller expected cost and smaller variance. Ifhowever, the probabilities-s are changed to0.60,0.20 and 0.20, the choice is not clear; theforward hedge now has a’, smaller expectedcost-compared to the call option (-140 and -255_respectively) but a much larger variance.The choice now depends upon the firm’s risk-return preferences:In the appendix to this chapter we brieflypresent a more rigorous analysis of this choice.

• A US firm has bid for a contract to supply computers andrelated equipment to a German buyer. The contract is valuedat DEM 5 million. The outcome of the competitive tenderbidding will be known one month from now and the

equipment is t6 be supplied over two monthsfollowing the award of contract with paymentbeing made on completion of delivery.The firm would like to cover the potentialexposure. Also, the management has decided thatany cover obtained must be offset if the firm isnot awarded the contract.The current market rates are:DEM/$ spot: 1.50 90-day forward: 1.46(We are ignoring two-sided quotes. It does notmake any substantive difference).A put option on DEM with a strike price of DEM1.45 per $ and maturity of 90 days is available for apremium of 2.8 or $0.028 per DEM.

The firm wishes to evaluate the following two alternatives:1. Sell DEM 5 million 90-day forward at DEM 1.46 per USD.

If at the end of the month the bid is not successful, thecontract will be offset by a 2-month forward purchase at thethen ruling rate.

2. Purchase a put option 4 . If the contract is not awarded, closeout by selling put options. (Assume that the options arebought on an options exchange).The firm must pay an up-front premium of $1,75,000.If the contract is awarded, the original hedge is carried tomaturity.

Under each contingency, viz. the firm gets the contract and doesnot get the contract we will evaluate the two alternatives. In eachcase we will consider three exchange rate, scenarios.1. The bid is unsuccessful.

The firm unwinds the hedge by either purchasing DEM 5million 60-days forward if the initial choice was a forwardcontract or by selling put options. We consider the gain/lossfrom each choice under the following three exchange ratescenarios at the end of one month:

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A. DEM has depreciated B. Spot rate unchanged C. DEM has appreciated

- DEMJUSD Spot: 1.60 60-day forward:. 1.62 1.45, 2-month put 7 - DEM/USD Spot: 1.50 60-day forward: 1.48 1.45, 2-month put 2.3 -- DEM/USD Spot: 1.37 60-day forward: 1.35 1.45, 2-month put 0.02

Scenario A :Forward hedge-Firm unwinds by purchasing forward at 1.62.Realizes a gain of $3382385 two months hence.-’Put options-Firm sells puts on DEM 5 million at $0.07 per DEMfor a total premium income of $3,50,000 accruing right away.Scenario B :Forward hedge-Unwound at 1.48. Gain of $46,279 twomonths henge.Put options-Sell puts. Premium income $1,] 5,000 right away.Scenario C :Forward hedge-Unwound at a loss of $279046 two months hence.Put option-Premium income of $1000 right away.We have assumed that the forward hedge is unwound by meansof another forward which matures at the same time as theoriginal contract.

Cash flows under this contingency are summarised below:

Scenario Time Forward Puts

0 0 -140000 A 1 350000 2 3 338238 0 0 -140000

B 1 115000 2 3 46280 0 0 -140000

C 1 2 3 -279046 1000

Thus in the event of the bid being unsuccessful, the firm risks alarge ,loss if the DEM sharply appreciates in the interim and ithas covered the uncertain inflow with a forward contract. Withan option, at worst, its maximum loss is limited to the up-front premium.2. The bid is successful.

If the bid is successful, the put option hedge offers anadvantage if over the next three months the DEMexperiences a sharp appreciation. If the ,DEM remainsunchanged or depreciates, the for-ward contract is moreadvantageous since it is costless to enter into.The firm in tendering a bid will wish to know how toincorporate the element of currency risk. It can attempt to

estimate the future spot rate and quote a foreign currencyprice based on this forecast; if it overestimates the weaknessof DEM (underestimates its strength) it runs the risk ofsubmitting an uncompetitive bid. In the reverese case, itsprofit margins will shrink. It can decide on a hedging devicesuch as a put option and load t-he expected cost of thehedge into its price.

The timing, amount and the exercise price of the put optionshould be chosen to correspond to the forward contract whichthe firm might have bought had the receivable not been uncer-tain. This may not always be possible with exchange tradedoptions. Cost of the put option can be reduced by buying anout-of-the money option with lower strike and hence lowerpremium. Cor-respondingly, the level of protection againstdepredation is reduced. Alternatively, the firm need not hedge theentire amount; if it is a frequent bidder for certain types ofcontracts, it will have built-up some experience pertaining to theprobability of success at various bid levels. It can reduce the costof hedge by buying a put to cover only a fraction of the expectedreceivable reflecting the probability of success.The final example illustrates the use of range forward contracts :Consider the case of a French firm which has importedmicroelectronic components from a Japanese supplier. Theinvoice is for ¥250,000,OOO due in 180 days.

The market rates are as follows:JPYIFRF Spat: 25.9740 (FRF/JPY: 0.0385)I80-days forward: 25.6410 (FRF/JPY: 0.0390)

(For expositional convenience we have ignored two way rates.Assume these are offer rates for the yen).The firm, buys a range forward. This involves buying a call andselling a put. The strike price for the Formicas FRF/JPY 0.0395with a premium of FRF 0.0006 per yen or FRF 1,50,000 for¥250,000,000. for the, latter, the strike is FRF/JPY 0.0380 andpremium is FRF 0.0004 per yen or FRF 1,0.0,000 for the entirepayable. The net premium payment is thus FRF 50,0007. Thefollowing table shows the FRF outflows on settlement of thepayable with an open position, a forward hedge and- the rangeforward, for various values of the maturity spot8.French Franc Outflow for ¥250,000,000 Payable

Mfi1y Spot Open Forward - Range (FRFI¥) Position Hedge Forward 0.0370 9250000 9750000 9550000 0.0375 9375000 9750000 9550000 0.0380 9500000 9750000 9550000 0.0385 9625000 9750000 9675000 0.0390 9750000 9750000 9800000 0.0395 9875000 9750000 9925000 0.0400 10000000 9750000 9925000 0.0405 11250000 9750000 9925000

Note: These calculations do not incorporate the interestforegone on the net premium payment in the case of the rangeforward.

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Thus if the firm does not expect a sharp depreciation of theyen. a range forward provides’ a relatively cheap way of protect-ing itself against yen appreciation without giving up theopportu-nity to gain from yep depreciation at least up to apoint. -(Yen depreciation below the strike price of the writtenput yields no extra benefit).These examples serve to bring out the point that optionsrepresent a flexible hedging tool enabling the firm to incorpo-rate its views on exchange rate movements and its risk-returnpreferences in the hedging decision.

Hedging With Currency FuturesHedging contractual foreign currency flows with currency futuresis in many respects, similar Jo hedging with forward contracts.A receivable is hedged by selling futures while a payable ishedged by buying futures.A futures hedge differs from a forward hedge because of theintrinsic features of futures contracts. Since”, amounts anddelivery dates for futures are standardized” a perfect futureshedge is generally not possible. Also futures unlike forwards’:give-rise intermediatecashtflows due to the mark-ing-to-marketfeature. ‘Due to a much larger turnover, the bid-ask spreads aretighter in the forward markets. Futures contracts require adeposit to be posted. (Even forward contracts may require acom-pensating bank balance or a line of credit) there are alsobrokerage fees to be paid with futures contracts.The advantage of futures over forwards is firstly easier accessand secondly greater liquidity. Banks will enter into forwardcontracts only with corporations (and in rare cases individuals)with the highest credit rating. Second, a futures hedge is mucheasier to unwind since there is an organised exchange with a-large turn over. For the sake of completeness, we will ofpresent to examples of hedging’ with futures.• A Short Hedge

On June-1 a British firm “orders farm equipment worth $ 5million from a US supplier. Payment is due on September 1.The market rates are:$/£ Spot: 1.7225 90:daytforward : 1.7165LIFFE September $/£ Futures: 1.7170The firm decides to hedge’ by/’selling 47 sterlifig9"”contractswith a total, value of £2,937,500= $5043687.5 at $ l.r1if 0/£.It pays a brokerage fee of £50 per contract or £2350 formthe total amount.Qn September 1 the following optic’s rule :-$/£Spot: 1.6680 September futures: 1.6650The firm buys $ 5 million at the ruling spot and closes outits futures position.Sterling outflow on spot purchase of $ 5 million=(5,000,000)/1.6680 = £2,997,601.9Gain on futures_=$(1.7170- 1.6650)(2937500),,= $152750= £91576.74 at $1.6680/£.Total sterling outlay= (299760190+ 2350.00 - 91576.14) = £2,908,375.20 Effective $/£ rate obtained by the firm is -’

= (5000000/2908375.20) = 1.7191.The hedge turns out to be better than a forward hedge. Theeffective rate with the latter would have been 1.7165. This isdespite the adverse basis movement. (As usual we have,ignored the effect of markil1g-to-market).

A Long HedgeA Japanese firm has sold a large quantity of memory chips to aUS computer marcher. The sale is invoiced in US dollars at$10,000,000, payment due in 180 days. Today is May 25. Themarket rates are:¥/$ Spot: 125.30 180-day forward: 121.50IMM December Yen futures are trading at $0.8333 per 100 yen,i.e. $104162.50’per contract, since each contract represents¥12,500,000.The firm decides to hedge by buying 98 December contractsvalued at¥1,225,000,000 =7.$10,207,900 at $0.8333 per 100 yen.The brokerage fee is $75 per contract or $7,350 for 98 contracts.On November 25, the rates are:¥/$ Spot: 120.50 December futures: 0.8549The firm sells $10,000,000 in the spot market to receive¥1,205,000,000. It closes its futures posi-tion by selling 98contracts. The gain on this is $2,64,600 [= (0.8549 - 0.8333)*125000x98] which translates into ¥31,884,300 at the spot rateof 120.50. The brokerage fee paid is worth ¥8,85,675. The totalyen inflow is therefore ¥1236 million, yielding an effective ¥/$rate of 123.60 which is better than I the forward rate. Of courseif the basis had narrowed much more, futures rate would havebeen worse than the forward rate.Currency futures are used by commercial banks to hedgepositions taken in the forward markets. With their continuoustrading in the latter, the problem of timing mismatch is notserious and the liquid-ity of the market along with the absenceof counterpart risk makes it an attractive hedging tool.

Internal Hedging StrategiesIn addition to the various market-based hedging devicesdiscussed so far, a firm may be able to reduce or eliminatecurrency exposure by means of internal strategies. We take alook at some of the commonly used or recommendedmethods.Invoicing We have already discussed above the problem ofcurrency of invoicing. A firm may be able to shift the entireexchange risk to the other party by invoicing its exports in itshome currency and insisting that its imports too be invoiced inits home currency. As we have seen above, in the presenceof well-functioning forward markets this will not yield anyadded benefit compared to. a forward hedge. \At times, it maydiminish the firm’s competitive advantage if it refuses toinvoice its cross: border sales in the buyer’s currency.“Empirically, in a study of the financial structure of foreign tradeGrassman (1973) discovered the following regularities: .1. Trade between developed countries in manufactured

products is generally invoiced in the export-er’s currency.2. Trade in primary products and capital assets is generally

invoiced in a major vehicle currency

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such as the US dollar.3. Trade between a developed and a less developed country

tends to be invoiced in the developed country’s currency.4. If a country has a higher and more volatile inflation rate than

its trading partners, there is a tendency not to use thatcountry’s currency in trade invoicing.

Table 13.1 presents- some data on the pattern of currency ofinvoicing of India’ a exports and imports.Table 13.1 Currency Composition of India’s Trade (%)

Currency

Exports (1987-88) Imports (1988-89)

US Dollar Pound Sterling Deutsche Mark Yen French Franc Swiss Franc Belgian Franc Indian Rs (External) Others

61.8 7.4 4.6 0.1 1.0 0.5 Neg. 21.7 2.9

67.6 6.0 8.0 6.9 3.5 1.5 0.2 1.8 4.5

Source: RBI Monthly Bulletin, November 1991 (Exports) IS?August 1992 (irnports), Reserve Bank of India, Bombay.Note: Imports and Exports on Bilateral account are notincluded in the above data.Another hedging tool in this context is the use of “currencycocktails” for invoicing. Thus for in- stance, a British importerof fertilizer from Germany can negotiate with the supplier thatthe invoice be partly in DEM and partly in sterling.If the parties agree on a price of say DEM 1000 per ton and thespot rate is DEM3.00/£, the price may be stated as (DEM550+£150) per ton]. This way both parties share the exposureAnother possi-bility is to use one of the standard currency basketssuch as the SDR or the ECD for invoicing trade -transactions.Basket invoicing offers the advantage. of diversification and canreduce the variance of home Clarence value of the payable orreceivable as long as there is no perfect correlation between theconstitu-ent currencies. The risk is reduced but not eliminated.Also, there is no way by which the exposure can be hedged sincethere are no forward markets (or options, etc.) in these compos-ite currencies. As a result, this technique has not become verypopular.

Netting and Offsetting A firm with receivables and payables in diverse currencies cannet out its exposure in each currency by matching receivableswith payables. Thus a firm wit!} exempts to and imports from.say Germany need not cover each transaction separately; it canuse a receivable to settle all or part of a payable and take a hedgeonly for the’ net DEM payable or receivable. Even if the timingsof the two flows do not match, it might be possible to lead orlag (see the next subsection) one of them to achieve a match.Netting also assumes importance in the context of cashmanagement in a multinational corporation with a number ofsubsidies and extensive intra-company transactions. Let usconsider a simple example of an American parent companywith subsidiaries in Germany and France. Suppose that the

German subsidiary has to make a dividend payment to theparent of OEM 2,50,000 in three months time, the parent has athree-month payable of FRF 8,50,000 to the French subsidiaryand the French subsidiary has a three-month payable of OEM3,00,000 to a German supplier {who is not a -part of themultina-tional). A netting system might work as follows. Theforecasts of spot rates three months hence are:OEM/$: 1.50 FRF/$4.80 implying FRF/OEM : 3.1 7The German subsidiary is asked to pay OEM 2,50pOO to theFrench subsidiary’s German supplier. Thus the French firm hasto hedge only the residual payable of OEM 5£),000. OEM2,50;000 converted into FRF at the forecast exchange rateamounts to FRF 7,92,500. The parent may obtain a hedge forthe residual amount of F8.F57,500. Any discrepancies between’the forecast exchange rates and the actual spot rates threemonths hence can be settled by making the necessary intra-company transfers. This suppose the actual spot rates turn outto be OEM 1.52/$ and FRF 4.75/$ implying FRF 3.l25/0EM.At this rate’ OEM 2,50,000 equals FRF 7,81,250. The parentmust pay the French subsidiary FRF 68,750 of which it hascovered FRF 57,500. This technique not only reduces theamount of exposures to be covered company-wide but alsominimizes the number and amount of currency conversionsrequired to settle intra-company payments. This latter aspect canbecome significant for a multinational with extensive networkof subsidiaries and substantial intra-company trade.To be able to use netting effectively, the company must havecontinuously updated information on inter-subsidiary pay-ments position as ‘well as payables and receivables to outsiders.One way of ensur-ing efficient information gathering is tocentralize cash management. Occasionally, a firm might find that it has a receivable in onecurrency say OEM and a payable not in the same currency but aclosely correlated currency such as the CHF. Even though CHFis not part of the EC exchange rate mechanism, the movementsin the two currencies are very closely correlated so that a loss(gain) on the payable due to an appreciation (depreciation) ofthe CHF vis-à-vis the firm’s home currency would be closelymatched by the gain (loss) on the receivable due to the apprecia-tion (depreciation) of the DEM. Such offsetting of one exposureagainst another in a closely related currency provides a naturalhedge. When the two currencies involved are part of the ERM,such as the DEM and the Belgian Franc, the offset providesalmost a perfect hedge since the latter maintains are % marginof variation vis-à-vis the former.Some countries impose rest rejections on netting as part oftheir ex ‘Change -control regulations. These may limit the scopefor netting or prohibit it altogether. It may still be possible tominimise the number of currency conversions by centralizingcash management.

Leading and Lagging Another internal way of managing transactions exposure is toshift the tim-ing of-exposures by leading or legging payablesand receivables. The general rule is leave advance payables andfag, i.e. postpone receivables in “strong” currencies and,conversely, lead receivables and lag payables in weak currencies.

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As we will see below, shifting the exposure in time is notenough; it has to be ‘combined with a borrowing/lendingtransaction or a forward transaction to complete the hedge 4-Essentially, It; adding and lagging are a response to theexistence of market imperfections.Thus suppose an American firm has a three-month OEMpayable and the firm (and everyone else) is almost sure [hat the -DEM is going to sharply appreciate against the dollar. The, firmcan offer to settle the payment immediately, i.e. forego the usual90-day credit and demand a discount for cash paymentOn the other hand, suppose it has a receivable in a weakcurrency such as the Mexican peso, it can offer a discount to theMexican buyer for immediate payment.The pertinent question is, if the covered interest parity mecha-nism is working satisfactorily, will this method of covering beequivalent to a forward hedge? Consider this example. A Frenchfirm has a 180-day payable of CHF 3,50,000. The spot rate is:ERF 3.2500/CHFThe 180-day forward is 3.3312. The Swiss supplier will give adiscount of 2.5% for cash payment. The French firm canborrow at 10% p.a. The net cost of leading the payment wouldthus be 2.5% which is equal to the 180-day premium on theCRE The interest differential is exactly captured in the forwardpremium and hence leading and forward hedge are equivalent.If some imperfections drive a significant wedge betweeneurointerest rates and domestic interest rates, then leading orlagging an exposure may turn out to be cheaper than a forwardhedge. Consider the following example:An American firm has a 180-day payable of AUD 1,000,000 toan Australian supplier. The marketrates are:AUD/USD Spot: 1.347_5 180-day forward: 1.3347EuroUS$ 180-day interest rate: 10% p.a.EuroAUD 180-day interest rate: 8% p.a.The Australian authorities have imposed a restriction onAustralian firms which prevents them from borrowing in theeuroAUD market. Similarly, non-residents cannot make money-market investments in Australia. As a consequence, thedomestic 180-day interest rate in Australia is 9.5% p.a. TheAmerican firm wants to evaluate the following four alternativehedging strategies:a. Buy AUD 1,000,000 ISO-day forward.(Forward)b. Borrow US$, convert spot to AUD, invest in a euroAUD

deposit, settle the payable with the deposit proceeds. (Moneymarket cover).

c. Borrow US$ for 180 days, convert spot to AUD, lead thepayable, get a discount. (Lead)

d. Borrow AUD in the euromarket, settle the payable, buy AUD180-day forward to payoff the loan. (Lead with a forward).Let us determine US$ outflow 180 days hence under eachstrategy.

1. Forward Cover:US$ outflow = 1000000/1.3347 = 749232.04

2. Money Market Cover:The firm must invest AUD(1000000/1.04), i.e.AUD9,61,538.46 to get AUD1,OOO,OOO on matu-rity. Toobtain this it must borrow and sell spot US$(961538.46/1.3475) = US$ 7,13,572.14. It must repayUS${713572.14(1.05)] = US$749250.75 180 days later. Thusthis strategy is as good as the forward cover.(The smalldifference is on account of rounding errors). This shouldnot be surprising since the borrowing and lending are doneat Eurorates, which in turn determine forward margins.

3. Lead:The American firm can possibly extract a discount at 9.5%p.a. from the Australian firm since this is the latter’sopportunity cost of short-term funds. Thus leading wouldrequire cash payment of AUD(lOOOOOO/1.0475) = AUD9,54,653.94. To obtain this, US$(954653.94/1.3475) = US$7,08,463.03 must be borro_ed at 10%, requiring repaymentof US$[708463.03(1.05)] = US$ 7,43,886.19.This represents a saving of US$ 5,345.85 over the forwardhedge.

4. Lead with a Forward:The firm must borrow AUD 9,54,653.94 at 8% p.a. requiringrepayment of ADD 9,92,840.10 which must be boughtforward requiring an outflow of US$ 7,43,867.61. This isequivalent to the Lead strategy. you can convince yourself thatif the American firm’s borrowing cost were higher than theEuro state, the lead with forward strategy would have beenbetter than a simple lead.In effect, leading and lagging involve trading off interest ratedifferentials against expected currency appreciation ordepreciation. In employing this strategy for intra-corporatepayments between units of a multinational account must betaken of possibly differing tax treatments of different expenseitems, exchange gains and losses as also of. differing tax ratesin different countries. Also, if a multinational parent companyrequires its subsidiaries to employ this method it may Alloccasion interfere with opti-mal cash management at the levelof a subsidiary. Suppose for instance that an American-parentask-s its Mexican subsidiary to lead a OEM payable. Thismight put the subsidiary in an awkward position if it isalready strapped for cash and has exhausted its credit lines withlocal banks. The use of leads and lags therefore mustreevaluated in the overall framework of financing andexposure management and this consideration must be kept inmind when evaluating the performance of the localmanagement. It may also adversely affect the interests of localminority shareholders. Finally there may also be some legalconstraints in free use of leading and lagging .as exposuremanagement devkes. Since it destabilizes currency markets,governments may impose restrictions on the extent to whichleading and lagging can be done.

Leads and lags in combination with netting form an importantcash management strategy for multina-tionals with extensiveintra-company payments.

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Speculation in Foreign Exchage andMoney MarketsSpeculation in contrast to hedging involves deliberately creatingpositions in order to profit from ex-change rate and/or interest-rate movements. The speculator believes that market’s forecastsas reflected in forward rates and the term structure of interestrates are “wrong”. He -hopes to profit by taking open positionsat these prices.Consider outright speculation in foreign exchange makes.Suppose a speculator believes that the DEM is going toappreciate against the dollar by 5 % over the next three -months. Further he finds that he can borrow three-monthdollars at 10% and invest three-month OEM at 8%. He canspeculate by borrowing dollars, converting spot to OEM andkeeping DEM on deposit. If his fore-cast materializes, he willbe a 2% (annualised) profit on- recon version of DEM. intodollars. Alternatively, these rates imply a 2%(annualised)premium on OEM; the speculator can fake an open longposition in forward DEM, and sell DEM three months later inthe spot market for a net annualised profit of 2%.Not hedging a receivable or payable is thus equivalent tospeculation. If a firm has a payable in a foreign currency and isconfident that the currency is going to depreciate more thanwhat is implied in the forward rate (or appreciate less) itspeculates by not covering the payable.Obviously, outright speculation is a high risk activity. The riskof an -open position depends upon the covariance of exchangeTate with other assets in the speculator’s portfolio. A speculatorwho is not risk neutral will demand a premium for undertakingthe risk. Thus he will take an open long (short) forwardposition if he expects the currency to appreciate (depreciate)more than what is implied in the forward rate. However,exchange rate risk is diversifiable and_ hence unsystematic. As aresult, the risk pre-mium-the amount by which the forward ratehas to be below or above the speculator’s expected future spotrate-is 1ikely to be quite small. Empirical investigations indicatethat it is also the-varying.Speculating with futures is quite similar to speculating withforwards. The main differences are, first, with futures since thereare intermediate cash flows, the investor must speculate oninterest rate move-ments too and second, since most futurescontrads are liquidated prior to maturity, the relevant com-parison is not between expected maturity sport ate and futuresprice. Chapter 9 contains some examples of speculating withcurrency futures.

SummaryThis chapter elaborates the various devices available for hedgingtransactions exposure. We have also addressed the question ofwhether the firm should engage in hedging itself or leave it tothe shareholders to hedge their own exposures in the light ofthe portfolio compositions, country of residence, risk prefer-ences, etc. There is a continuing debate on this issue. In perfectmarkets, with shareholders having access to instruments such asfutures, options, etc. the only valid reasons for corporate levelhedging are exploiting internal information, avoiding financialdistress and the possible adverse effect of increased risk-onmanagerial incentives.

Student’s Activity1. Discuss, with an example each, the various types of currency

exposures faced by a firm. Do you agree with the followingstatement: “ The only exposure that really matters isoperating exposure that can not be hedged , hedgingactivities are a waste of time and resources.”

. Many finance managers view forward premia/discounts ascost of hedging. Explain why this is an incorrect view.