management of transaction exposure

Management of transaction exposure

Juhi kashyapRoll no. 20

MBA-IB

Techniques of hedging transaction exposure•Hedging with forward market•Hedging with currency options•Hedging with money market•Hedging with swaps

Money market hedge

Hedging with money market

Borrows local currency

Convert local currency into

foreign currency

Invest converted

amount for same time

frame

Borrows the currency in which the receivables are

denominated

Convert borrowed currency into local

currency

Invest with the same time frame

Importer-Hedging payables Exporter-Hedging receivables

$144,230.77

Importer’s Money Market Hedge: Cash Flows Now and at Maturity

Importer

Supplier

bicycles

Spot Foreign Exchange

Market

€100,000

$144,230.77

€96,153.85

U.S Bank$1

48,5

57.6

9

Italia Bank

€100,000

T= 1 cash

flows

deposit i€ = 4%

€96,153.85

$119,047.62

Exporter’s Money Market Hedge

Exporter

Customer

shoes


Market€100,000

$119,047.62

€95,238.10

U.S Bank$1

27,5

00.0

0

Crédit Agricole

€100,000

T= 1 cash

flows

deposit i$ = 7.10%

€95,238.10Borrow i€ = 5%

An American exporter has just sold €100,000 worth of shoes to a French customer. Payment is due in one year.Interest rates in dollars are 7.10 percent in the U.S. and 5 percent in the euro zone.The spot exchange rate is $1.25/€1.00. Use a money market hedge to eliminate the exporter’s exchange rate risk.

Importer’s Money Market Cross-Currency Hedge: Cash Flows Now and at Maturity

Importer

Supplier

bicycles


Market €750,000

£564,320.39

$1,128,640.77


Market

$1,128,640.77

€728,155.34 €728,155.34 deposit i€ = 3%

U.K Bank

£564,320.39 £586

,893

.20

Italia Bank

€750,000

T= 1 cash

flows

Options

Options•To hedge a foreign currency payable buy

calls on the currency. Ex-Importer▫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 . Ex-Exporter▫If the currency depreciates, your put option

lets you sell the currency for the exercise price

Options Market Hedge

$1.50/€Value of €1 in $

in one year

Suppose the forward exchange rate is $1.50/€.

If an importer who has to pay €100m does not hedge the 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 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.

Options Markets HedgeProfit

loss

–$5m$1.55/€

Long call on €100m

Suppose our importer buys a call option on €100m with an exercise price of $1.50 per pound.

He pays $.05 per euro for the call.

$1.50/€

Value of €1 in $ in one year

Value of €1 in $ in one year


loss

–$5m

$1.45 /€


The payoff of the portfolio 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 against unfavorable increases in the exchange rate.

$1.50/€ Unhedged payable

$1.20/€

$25m

–$30 m

$1.80/€Value of €1 in $

in one year


loss

–$5 m

$1.45/€


If the exchange rate increases to $1.80/€ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of $5 million.

This can be thought of as an insurance premium.

$1.50/€ Unhedged payable

$25 m

Hedging Exports with Put Options•Show the portfolio payoff of an

exporter who is owed £1 million in one year.

•The current one-year forward rate is £1 = $2.

•Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2. ▫The cost of this option is $0.05 per

pound.

8-14

15

S($/£)360

–$2m

$2

Long

receiv

able

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

Hedge

d rec

eivab

le8-15

Options Markets Hedge

IMPORTERS who OWE foreign currency in the future 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 his imports.

▫ 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 in foreign 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.

ExampleIndian importer imports good worth US $ 1,000 and

has to make payments after 90 days

• Spot rate is Rs 40/US $• Interest rate on borrowing in India and the USA is 6

% pa• Interest rate on deposit /investment 5%• A 90 day call option is having a strike price of Rs

39.60 and a premium of Rs 0.05 per $• A 90 day put option is having strike price of Rs 39.80

and a premium of Rs 0.05 per $• Spot rate at 90th day Rs 39.80/US $

ANY QUESTION ???

Thank you…

management of transaction exposure

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