Foreign currency exposure into 3 types:
Transaction Exposure – the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Short-term exposure when it faces contractual cash flows that are fixed in foreign currencies. Unlike economic exposure well defined: the magnitude of transaction exposure is the same as the amount of foreign currency that is receivable or payable. Alternative ways of hedging transaction exposure using various financial contracts and operational techniques:
Financial Contracts
- Forward Market Hedge
- Money market hedge
- Option market hedge
- Swap market hedge
Forward market Hedge
Most popular of hedging transaction exposure is by currency forward contracts. The firm may sell or buy its foreign currency receivables (payables) forward to eliminate its exchange risk exposure. Gains and losses from forwarding hedging can be computed as follows: Gain= (F-St) x L10 Million. Ex post in nature. No one can know for sure what the future spot rate will be beforehand. The firm must decide whether to hedge or not to hedge ex-ante. 3 alternative scenarios: (St denotes the firm’s expected spot exchange rate for the maturity date).
Operational techniques
- Choice of the invoice currency
- lag strategy-A foreign exchange management strategy consisting of delaying payments or receipts in a foreign currency, on the expectation of the evolution of the foreign exchange rate. Opposite: Lead strategy-This strategy implies that firms will pay off foreign currency debts and collect foreign currency receipts early. This, typically, because the local currency is expected to weaken.
- Exposure netting-Offsetting exposures in one currency with exposures in the same or another currency, when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure.
- Economic Exposure- the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Changes in exchange rates can have a profound effect on the firms competitive position in the world market and thus on its cash flows and market value.
- Translation exposure-the potential that the firms’ consolidated financial statements can be affected by changes in exchange rates. Involves translation of subsidiaries’ financial statements from local currencies to the home currency. Resultant translation gains and losses represent the accounting system’s attempt to measure economic exposure ex-post. It does not provide a good measure of ex-ante economic exposure.
Forward market Hedge
Most popular of hedging transaction exposure is by currency forward contracts. The firm may sell or buy its foreign currency receivables (payables) forward to eliminate its exchange risk exposure. Gains and losses from forwarding hedging can be computed as follows: Gain= (F-St) x L10 Million. Ex post in nature. No one can know for sure what the future spot rate will be beforehand. The firm must decide whether to hedge or not to hedge ex-ante. 3 alternative scenarios: (St denotes the firm’s expected spot exchange rate for the maturity date)
1. St=F, gains or losses are 0.
A firm can eliminate foreign exchange exposure without sacrificing any expected dollar proceeds from the foreign sale. The firm would be inclined to hedge as long as it is averse to risk. Valid when the forward exchange rate is an unbiased predictor of the future spot rate.
2. St<F
Firm’s expected future spot exchange rate is less than the forward rate; the firm expects a positive gain from forwarding hedging. Since the firm expects to increase the dollar proceeds, while eliminating exchange exposure, it would be even more inclined to hedge under this scenario than under the first scenario. Implies that the firm’s management issues from the market’s consensus forecast of the future spot exchange rate as reflected in the forehand rate.
3. St>f
A firm can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds for the foreign sale. Firm less inclined to hedge under this scenario. From the perspective of a hedging firm, the reduction in the expected dollar proceeds can be viewed implicitly as an “insurance premium” paid for avoiding the hazard of exchange risk. The firm can use a currency futures contract, rather than a forward contract, to hedge. A future contract is not as suitable as a forward contract for hedging purpose for:
1. Unlike forwarding contracts that tailor-made to firms specific needs, future contracts are standardized instruments in terms of contract size, delivery date, etc. Can hedge only approximately.
2. Due to the marketing-to-marketing property, there are interim cash flows prior to the maturity date of the futures contract that may have to be invested at uncertain interest rates.
Money Market Hedge
A firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency. Transactions: Borrow pounds-the maturity value of borrowing should be the same as the pound receivable; the amount to borrow can be computed as the discounted present value of the pound receivable. Buy dollar spot with pounds, invest in the United States, Collect pound receivable=Net Cash Flow. Apart from possible transactions, it is fully self-financing.
Options Market Hedge
The shortcoming of forwarding and money market hedges is that these methods completely eliminate exchange exposure. Currency options provide such a flexible “optional” hedge against exchange exposure. The firm (receivables). The main advantage of options hedging is that the firm can decide whether to exercise the option based on the relaxed spot exchange rate on the expiration date. The options hedge allows the firm to limit the downside risk while preserving the upside potential. When a firm has an account payable rather than a receivable, in terms of foreign currency, the firm can set a ceiling for the future dollar cost of buying the foreign currency amount by buying a call option on the foreign currency amount. Break-even spot rate.