8 management of transaction exposure
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INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Fifth Edition
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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Chapter Objective:
This chapter discusses various methods available
for the management of transaction exposure facing
multinational firms.This chapter ties together chapters 5, 6, and 7.
8Chapter EightManagement of
Transaction Exposure
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Chapter Outline
Forward Market Hedge
Money Market Hedge
Options Market Hedge Cross-Hedging Minor Currency Exposure
Hedging Contingent Exposure
Hedging Recurrent Exposure with SwapContracts
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3
Chapter Outline (continued)
Hedging Through Invoice Currency
Hedging via Lead and Lag
Exposure Netting Should the Firm Hedge?
What Risk Management Products do Firms Use?
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Forward Market Hedge
If you are going to owe foreign currency in the
future, agree to buy the foreign currency now by
entering into long position in a forward contract.
If you are going to receive foreign currency in the
future, agree to sell the foreign currency now by
entering into short position in a forward contract.
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Forward Market Hedge: an Example
You are a U.S. importer of Italian shoes and have
just ordered next years inventory. Payment of
100M is due in one year.
Question: How can you fix the cash outflow in
dollars?
Answer: One way is to put yourself in a positionthat delivers100M in one yeara longforward contract on the euro.
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6
Forward Market Hedge
$1.50/
Value of1 in $
in one year
Suppose the
forward exchange
rate is $1.50/.
If he does not
hedge the100m
payable, in one
year his gain
(loss) on the
unhedged position
is shown in green.
$0
$1.20/ $1.80/
$30m
$30m
Unhedged
payable
The importer will be better off ifthe euro depreciates: he still
buys100m but at an exchange
rate of only $1.20/ he saves$30 million relative to $1.50/
But he will be worse off if
the pound appreciates.
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Forward Market Hedge
$1.50/
Value of1 in $
in one year$1.80/
If he agrees
to buy100m
in one year at
$1.50/ hisgain (loss) on
the forward
are shown in
blue.
$0
$30m
$1.20/
$30m
Long
forward
If you agree to buy100 million at a
price of $1.50 per pound, you will lose
$30 million if the price of the euro falls
to $1.20/.
If you agree to buy100
million at a price of$1.50/, you will make
$30 million if the price of
the euro reaches $1.80.
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Forward Market Hedge
$1.50/
Value of1 in $
in one year$1.80/
The red line
shows the
payoff of the
hedgedpayable. Note
that gains on
one position are
offset by losseson the other
position.
$0
$30 m
$1.20/
$30 m
Long
forward
Unhedged
payable
Hedged payable
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Futures Market Cross-Currency Hedge
Your firm is a U.K.-based exporter of
bicycles. You have sold
750,000 worth of
bicycles to an Italianretailer. Payment (in
euro) is due in six
months. Your firm
wants to hedge thereceivable intopounds.
Sizes of forward
contracts are shown.
Country
U.S. $
equiv.
Currency
per U.S. $
Britain (62,500) $2.0000 0.5000
1 Month Forward $1.9900 0.5025
3 Months Forward $1.9800 0.5051
6 Months Forward $2.0000 0.500012 Months Forward $2.1000 0.4762
Euro (125,000) $1.4700 0.6803
1 Month Forward $1.4800 0.6757
3 Months Forward $1.4900 0.6711
6 Months Forward $1.5000 0.6667
12 Months Forward $1.5100 0.6623
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Futures Market Cross-Currency Hedge:
Step One
You have to convert the750,000 receivable first
into dollars and then into pounds.
If we sell the750,000 receivable forward at the
six-month forward rate of $1.50/ we can do this
with a SHORT position in 6 six-month euro
futures contracts.
6 contracts = 750,000125,000/contract
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Futures Market Cross-Currency Hedge:
Step Two
Selling the750,000 forward at the six-monthforward rate of $1.50/ generates $1,125,000:
9 contracts =562,500
62,500/contract
$1,125,000 =750,000 1
$1.50
At the six-month forward exchange rate of $2/,
$1,125,000 will buy 562,500.
We can secure this trade with a LONG position in
9 six-month pound futures contracts:
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Money Market Hedge
This is the same idea as covered interest arbitrage.
To hedge a foreign currency payable, buy a bunch
of that foreign currency today and sit on it.
Buy the present value of the foreign currency payable
today.
Invest that amount at the foreign rate.
At maturity your investment will have grown enough tocover your foreign currency payable.
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Money Market Hedge
A U.S.based importer of Italian bicycles
In one year owes100,000 to an Italian supplier.
The spot exchange rate is $1.50 =1.00
The one-year interest rate in Italy is i = 4%
$1.501.00
Dollar cost today = $144,230.77 =96,153.85
100,000
1.0496,153.85 =Can hedge this payable by buying
today and investing96,153.85 at 4% in Italy for one year.
At maturity, he will have100,000 =96,153.85 (1.04)
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Money Market Hedge
$148,557.69 = $144,230.77 (1.03)
With this money market hedge, we have
redenominated a one-year100,000 payable into
a $144,230.77 payable due today.
If the U.S. interest rate is i$ = 3% we could borrowthe $144,230.77 today and owe in one year
$148,557.69 =100,000
(1+ i)T (1+ i$)
TS($/)
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Money Market Hedge: Step One
Suppose you want to hedge a payable in the amount
of y with a maturity ofT:
i. Borrow $x at t= 0 on a loan at a rate ofi$ per year.
$x = S($/) y(1+ i)T
0 T
$x $x(1 + i$)T
Repay the loan in Tyears
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Money Market Hedge: Step Two
at the prevailing spot rate.
y
(1+ i)T
ii. Exchange the borrowed $x for
Invest at ifor the maturity of the payable.y(1+ i)T
At maturity, you will owe a $x(1 + i$)T.
Your British investments will have grown to y. Thisamount will service your payable and you will have no
exposure to the pound.
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Money Market Hedge
1. Calculate the present value of y at iy
(1+ i)T
2. Borrow the U.S. dollar value of receivable at the spot rate.
$x = S($/) y(1+ i)
T3. Exchange for y
(1+ i)T
4. Invest at ifor Tyears.y
(1+ i)T
5. At maturity your pound sterling investment pays your
receivable.
6. Repay your dollar-denominated loan with $x(1 + i$)T.
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Money Market Cross-Currency Hedge
Your firm is a U.K.-based importer of bicycles.
You have bought750,000 worth of bicycles froman Italian firm. Payment (in euro) is due in one year.
Your firm wants to hedge the payable intopounds. Spot exchange rates are $2/ and $1.55/
The interest rates are 3% in, 6% in $ and 4% in ,all quoted as an APR.
What should you do to redenominate this 1-year-denominated payable into a -denominatedpayable with a 1-year maturity?
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Money Market Cross-Currency Hedge
Sell pounds for dollars at spot exchange rate, buy euro at spotexchange rate with the dollars, invest in the euro zone for oneyear at i = 3%, all such that the future value of the investmentequals750,000.
Using the numbers we have:Step 1: Borrow 564,320.39 at i = 4%,
Step 2: Sell pounds for dollars, receive $1,128,640.78
Step 3: Buy euro with the dollars, receive728,155.34
Step 4: Invest in the euro zone for 12 months at 3% APR
(the future value of the investment equals750,000.)
Step 5: Repay your borrowing with 586,893.20
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Money Market Cross-Currency Hedge
Where do the numbers come from?
586,893.20 = 564,320.39 (1.04)
728,155.34 =750,000
(1.03)
$1,128,640.77 =728,155.34 1
$1.55
564,320.39 = $1,128,640.77 $21
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Options Market Hedge
Options provide a flexible hedge against thedownside, while preserving the upside potential.
To hedge a foreign currency payable buy calls on
the currency. If the currency appreciates, your call option lets you buy
the currency at the exercise price of the call.
To hedge a foreign currency receivable buy puts
on the currency. If the currency depreciates, your put option lets you sell
the currency for the exercise price.
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Options Market Hedge
$1.50/
Value of1 in $
in one year
Suppose the
forward exchangerate is $1.50/.
If an importer who
owes100m does
not hedge the
payable, in one
year his gain (loss)
on the unhedgedposition is shown
in green.
$0
$1.20/ $1.80/
$30m
$30m
Unhedged
payable
The importer will be better off if
the euro depreciates: he still buys
100m but at an exchange rate of
only $1.20/ he saves $30 million
relative to $1.50/
But he will be worse off if
the euro appreciates.
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Options Markets Hedge
Profit
loss
$5m$1.55/
Long call on
100mSuppose our
importer buys a
call option on
100m with anexercise price
of $1.50 per
pound.
He pays $.05
per euro for the
call.
$1.50/
Value of1 in $
in one year
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Value of1 in $
in one year
Options Markets Hedge
Profit
loss
$5m
$1.45 /
Long call on
100mThe payoff of theportfolio of a call
and a payable is
shown in red.
He can still profit
from decreases in
the exchange rate
below $1.45/ but
has a hedge againstunfavorable
increases in the
exchange rate.
$1.50/ Unhedged
payable
$1.20/
$25m
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$30 m
$1.80/Value of1 in $
in one year
Options Markets Hedge
Profit
loss
$5 m
$1.45/
Long call on
100m
If the exchange
rate increases to$1.80/ the
importer makes
$25 m on the callbut loses $30 m onthe payable for a
maximum loss of
$5 million.
This can be
thought of as an
insurance
premium.
$1.50/ Unhedged
payable
$25 m
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Options Markets Hedge
IMPORTERS who OWE
foreign currency in thefuture should BUY CALL
OPTIONS. If the price of the currency goes
up, his call will lock in an upper
limit on the dollar cost of hisimports.
If the price of the currency goes
down, he will have the option to
buy the foreign currency at a
lower price.
EXPORTERS with accounts
receivable denominated inforeign currency should BUY
PUT OPTIONS. If the price of the currency goes down,
puts will lock in a lower limit on the
dollar value of his exports. If the price of the currency goes up, he
will have the option to sell the foreign
currency at a higher price.
With an exercise price denominated in local currency
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Hedging Exports with Put Options
Show the portfolio payoff of an exporter whois owed 1 million in one year.
The current one-year forward rate is 1 = $2.
Instead of entering into a short forwardcontract, he buys a put option written on 1million with a maturity of one year and astrike price of 1 = $2. The cost of this option is $0.05 per pound.
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Options Market Hedge:
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S($/)360
$2m
$2
Long put
$1,950,000
$50k
Options Market Hedge:Exporter buys a put option to protect the dollar
value of his receivable.
$50k
$2.05
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Th h b i
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29
S($/)360
$2
The exporter who buys a put option to protect
the dollar value of his receivable
$50k
$2.05
has essentially purchased a call.
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Hedging Imports with Call Options
Show the portfolio payoff of an importer who owes
1 million in one year.
The current one-year forward rate is 1 = $1.80; but
instead of entering into a long forward contract, He buys a call option written on 1 million with an
expiry of one year and a strike of 1 = $1.80 The
cost of this option is $0.08 per pound.
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Forward Market Hedge:
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31LOSS
(TOTAL)
GAIN
(TOTAL)
S($/)360
Long
currencyforward
Accounts Payable = Short
Currency position
Forward Market Hedge:Importer buys 1m forward.
This forward hedgefixes the dollar value
of the payable at
$1.80m.$1.80
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Options Market Hedge:
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$1.8m
S($/)360
$1.80
Call
$80k
$1.88
$1,720,000
$1.72
Call option limits
thepotential cost of
servicing the payable.
Options Market Hedge:Importer buys call option on 1m.
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O i t h b ll t t t hi lf
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33
S($/)360
$1.80
$1,720,000
$1.72
Our importer who buys a call to protect himself
from increases in the value of the pound creates a
synthetic put option on the pound.
He makes money if the pound falls in value.
$80k
The cost of this insurance policy is $80,000
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Taking it to the Next Level
Suppose our importer can absorb small amounts
of exchange rate risk, but his competitive position
will suffer with big movements in the exchange
rate. Large dollar depreciations increase the cost of his
imports
Large dollar appreciations increase the foreign currency
cost of his competitors exports, costing him customersas his competitors renew their focus on the domestic
market.
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Our Importer Buys a Second Call Option
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35
p y p
S($/)360
$1.80
$1,720,000
$1.72
$80k
This position is called a straddle
$1.64 $1.96
$1,640,000
$160k
2ndCall
$1.88
Importers synthetic put
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Suppose instead that our importer is willing to
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S($/)360
$1.80
$1,720,000
$1.72
risk large exchange rate changes but wants to
profit from small changes in the exchange rate,
he could lay on a butterfly spread.
$80k
A butterfly spread is analogous to an interest rate collar; indeed its
sometimes called a zero-cost collar. Selling the 2 puts comes close
to offsetting the cost of buying the other 2 puts.
$2
buy a put $2 strike
butterfly spread
Sell 2 puts $1.90 strike.
$1.90
Importers synthetic put
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37
Options
A motivated financial engineer can create almost
any risk-return profile that a company might wish
to consider.
Straddles and butterfly spreads are quite common. Notice that the butterfly spread costs our importer
quite a bit less than a nave strategy of buying call
options.
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Cross-Hedging
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C oss edg g
Minor Currency Exposure
The major currencies are the: U.S. dollar,
Canadian dollar, British pound, Euro, Swiss franc,
Mexican peso, and Japanese yen.
Everything else is a minor currency, like the Thaibhat.
It is difficult, expensive, or impossible to use
financial contracts to hedge exposure to minorcurrencies.
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Cross-Hedging
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g g
Minor Currency Exposure
Cross-Hedging involves hedging a position in one
asset by taking a position in another asset.
The effectiveness of cross-hedging depends upon
how well the assets are correlated. An example would be a U.S. importer with liabilities in
Swedish krona hedging with long or short forward
contracts on the euro. If the krona is expensive when the
euro is expensive, or even if the krona is cheap when theeuro is expensive it can be a good hedge. But they need
to co-vary in a predictable way.
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Hedging Contingent Exposure
If only certain contingencies give rise to exposure,
then options can be effective insurance.
For example, if your firm is bidding on a
hydroelectric dam project in Canada, you willneed to hedge the Canadian-U.S. dollar exchange
rate only if your bid wins the contract. Your firm
can hedge this contingent risk with options.
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Hedging Recurrent Exposure
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g g p
with Swaps
Recall that swap contracts can be viewed as a
portfolio of forward contracts.
Firms that have recurrent exposure can very likely
hedge their exchange risk at a lower cost withswaps than with a program of hedging each
exposure as it comes along.
It is also the case that swaps are available inlonger-terms than futures and forwards.
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Hedging through
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g g g
Invoice Currency
The 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
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Hedging via Lead and Lag
If a currency is appreciating, pay those bills
denominated in that currency early; let customers
in that country pay late as long as they are paying
in that currency. If a currency is depreciating, give incentives to
customers who owe you in that currency to pay
early; pay your obligations denominated in that
currency as late as your contracts will allow.
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Exposure Netting
A multinational firm should not consider deals inisolation, but should focus on hedging the firm asaportfolio of currency positions. As an example, consider a U.S.-based multinational
with Korean won receivables and Japanese yenpayables. Since the won and the yen tend to move insimilar directions against the U.S. dollar, the firm canjust 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.
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Exposure Netting
Many multinational firms use a reinvoice center.
Which is a financial subsidiary that nets out the
intrafirm transactions.
Once the residual exposure is determined, then thefirm implements hedging.
In the following slides, a firm faces the following
exchange rates: 1.00 = $2.00
1.00 = $1.50
SFr 1.00 = $0.908-45
Exposure Netting
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150
150
150
150
$150
$150
SFr150
SFr150
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SFr150 SFr1$0.90 = $135150 1
$2.00 = $300 150 1$1.50 = $225
Exposure Netting
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150
150
150
150
$150
$150
SFr150
SFr150
$135
$135
$300
$
300
$2
25
$225$225
$225
$300
$
300
$150
$150
$135
$135
8-47
Exposure Netting
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$225
$225
$300
$
300
$150
$150
$135
$135
$15
$75
$75
$165
$75
$165
$75
$15
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Exposure Netting
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$75
$165
$75
$15$15
$
180
=$
165
+$
15
$180
$180
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50
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries andthe following foreign exchange transactions:
$10 $35 $40$30
$20
$25 $60
$40
$10
$30
$20$30
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Exposure Netting: an Example
Bilateral Netting would reduce the number offoreign 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
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Multilateral Netting: an Example
Consider simplifying the bilateral netting with multilateralnetting:
$25 $10$20
$10
$10$10
$15 $10
$10
$30 $15$10
$10
$40$15
$15$40$40
$15
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S i ?
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Should the Firm Hedge?
Not everyone agrees that a firm should hedge:
Hedging by the firm may not add to shareholder wealth
if the shareholders can manage exposure themselves.
Hedging may not reduce the non-diversifiable risk ofthe firm. Therefore shareholders who hold a diversified
portfolio are not helped when management hedges.
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Sh ld h Fi H d ?
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Should the Firm Hedge?
In the presence ofmarket imperfections, the firmshould hedge. Information Asymmetry
The managers may have better information than the
shareholders.
Differential Transactions Costs The firm may be able to hedge at better prices than the
shareholders.
Default Costs Hedging may reduce the firms cost of capital if it reduces the
probability of default.
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Sh ld th Fi H d ?
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Should the Firm Hedge?
Taxes can be a large market imperfection. Corporations that face progressive tax rates may find
that they pay less in taxes if they can manage earnings
by hedging than if they have boom and bust cycles in
their earnings stream.
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What Risk Management Products do
Fi U ?
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Firms Use?
Most U.S. firms meet their exchange riskmanagement needs with forward, swap, and
options contracts.
The greater the degree of internationalinvolvement, the greater the firms use of foreign
exchange risk management.
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