Risk Management III: Hedging

Ian Garrett

BMAN30060
International Finance

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Quick Recap Of The Story So Far I
Foreign exchange exposure:
Transaction exposure
Translation exposure
Economic/operating exposure
This is about exposure to movements in the exchange rate and the
effect this may have on firm value
foreign exchange risk
exchange rate volatility

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Quick Recap Of The Story So Far II
Techniques for managing exposure:
Internal techniques
techniques internal to the firm
netting, matching, invoicing currency and so forth
External techniques
involve transacting with a third party (usually a bank or other financial
institution)
tend to be more formal transactions (contractual)
involve transactions costs

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Quick Recap Of The Story So Far III

We looked at external techniques for exposure management. In

particular, we looked at
1 Forwards
2 Futures
3 Options
4 Swaps

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Roadmap

We will now turn our attention to how we might use these external
techniques to hedge exchange rate risk.
We will focus on forwards (and therefore, implicitly, futures) and
options
We have already seen how currency swaps can work as a hedge
recall that they “lock in” a series of exchange rates
Interest rate swaps hedge interest rate risk rather than FX risk
we have seen how these can swap floating rate obligations for fixed rate
obligations
Money market hedges

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Why Do We Need To Be Aware Of This? I
McDonald’s
The Company enters into cash flow hedges to reduce the expo-
sure to variability in certain expected future cash flows. To pro-
tect against the reduction in value of forecasted foreign currency
cash flows (such as royalties denominated in foreign currencies),
the Company uses foreign currency forwards to hedge a portion of
anticipated exposures.

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Why Do We Need To Be Aware Of This? II
Yum! (perhaps better known to you as the owners of the KFC, Pizza
Hut and Taco Bell brands)
We have entered into foreign currency forward and swap contracts
with the objective of reducing our exposure to earnings volatil-
ity arising from foreign currency fluctuations associated with cer-
tain foreign currency denominated intercompany receivables and
payables. The notional amount, maturity date, and currency of
these contracts match those of the underlying intercompany receiv-
ables or payables. Our foreign currency contracts are designated
cash flow hedges as the future cash flows of the contracts are ex-
pected to offset changes in intercompany receivables and payables
due to foreign currency exchange rate fluctuations.

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Why Do We Need To Be Aware Of This? III

BT
We enter into forward currency contracts to hedge foreign currency
capital purchases, purchase and sale commitments, interest ex-
pense and foreign currency investments. The commitments hedged
are principally denominated in US dollar, euro and Asia Pacific re-
gion currencies. As a result, our exposure to foreign currency arises
mainly on non-UK subsidiary investments and on residual currency
trading flows.

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Hedging Transaction Exposure With Forwards I
Using currency forward contracts is the most direct and popular way
of hedging transaction exposure.
If the firm is going to have foreign currency payables in the future, it
should take a long position in a forward contract.
If the firm is going to have foreign currency receivables in the future, it
should take a short position in a forward contract.

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Hedging Transaction Exposure With Forwards II
Let’s Do Some Numbers:
Assume that a US-based company imports from a British company
and has placed their order for next year.
Payment of £100 million is due in one year (accounts payable) and the
forward exchange rate is USD1.50/GBP.
How can the company use a forward contract to hedge its transaction
exposure?
The company should take a position that delivers £100 million in one
year – a long forward contract on the GBP.

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Hedging Transaction Exposure With Forwards III
How Does This Work?

1 Suppose the company chooses not to hedge.

What if the GBP appreciates against the USD?
suppose the exchange rate moves to USD1.80/GBP.
the cost is now USD180m as opposed to USD150m
What if the GBP depreciates against the USD?
suppose the exchange rate moves to USD1.20/GBP.
the cost is now USD120m as opposed to USD150m
The importer is better off if the GBP depreciates but worse off if it
appreciates

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Hedging Transaction Exposure With Forwards IV
Gains and Losses to The Unhedged Position Diagramatically

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Hedging Transaction Exposure With Forwards V
1 Suppose the company takes a long position on a one year forward
contract.
If the exchange rate moves to USD1.80/GBP, the firm will make a
$30m profit
If the exchange rate moves to USD1.20/GBP, the firm will make a
$30m loss

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Hedging Transaction Exposure With Forwards VI
Gains and Losses to The Forward Position Diagramatically

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Hedging Transaction Exposure With Forwards VII
What Happens If The Firm Hedges?

The main point is that if the firm enters into a forward contract, there
is no risk in the sense that the firm knows exactly what the exchange
rate will be
for the forward hedge, in a plot of costs or revenues on the y axis
against possible values of the exchange rate on the x axis, the line is a
horizontal flat line
ex post, of course, the firm may gain, lose, or be no worse off
depending on what happens with the exchange rate
ex ante, of course, we do not know which state of the world will occur
with regard to the exchange rate
With the forward, the firm knows what the exchange rate will be

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Hedging Transaction Exposure With Forwards VIII

What About Receivables Rather Than Payables?

Reverse the above

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What About Futures?

In the above, the firm could have used a futures contract rather than a
forward contract to hedge.
Practically, however, there are difficulties in using futures contracts:
Futures contracts are standardised in terms of contract size, delivery
date, so the firm can only hedge approximately
There are interim cash flows prior to the maturity date of the futures
contract due to the marking-to-market mechanism of this type of
contract (see the session on forwards, futures and options)

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Hedging Transaction Exposure With Options I
One limitation of forward hedges is that they completely eliminate
exchange rate exposure as well as any potential gain from favourable
exchange rate changes.
Options provide a flexible hedge against the downside, while preserving
the upside potential.
To hedge foreign currency payables, 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 foreign currency receivables 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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Hedging Transaction Exposure With Options II
Back To The Numbers. . .

Suppose that the firm in the example above can purchase a one year
call option with an exercise price of USD1.50 per GBP, at a cost of
USD0.05 per GBP
To hedge their £100m payable, they will pay $5m for the call option
What do the profit diagrams look like?

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Hedging Transaction Exposure With Options III
The Unhedged Payables Position

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Hedging Transaction Exposure With Options IV
The Profit To The Long Call Option Position

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Hedging Transaction Exposure With Options V
What Happens If The Firm Hedges?
Combine the unhedged payables and call profit graphs (red line is the
hedged position):

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Hedging Transaction Exposure With Options VI
If the exchange rate increases to USD1.80/GBP, the importer makes
$25m on the call but loses $30m on the payable for a maximum loss of
$5 million.
This can be thought of as an insurance premium.
The firm can still profit from exchange rate decreases but has a hedge
against exchange rate increases.
The break even point of the portfolio is USD1.45/GBP.

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Hedging Transaction Exposure With Options VII
What About Receivables Rather Than Payables?

Reverse the above

This means buying a put option rather than a call option

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Hedging Transaction Exposure With Options VIII

Diagramatically:

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We Don’t Necessarily Need Derivatives: Money Market
Hedges I
Transaction exposure can be hedged by lending and borrowing in the
domestic and foreign money markets.
The firm may lend (borrow) in foreign currency to hedge its foreign
currency payables (receivables), thereby matching its assets and
liabilities in the same currency.
The first important step in money market hedging is to determine the
amount of foreign currency to lend. Since the maturity value of
lending should be the same as the payable, the amount to be
computed is the discounted present value of the payable.

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We Don’t Necessarily Need Derivatives: Money Market
Hedges II
Some Numbers Again

Our importer still has payables of £100m in one year’s time

Assume the spot exchange rate is USD1.40/GBP
Assume one-year interest rates in the UK and US are
i£ = 4% and i$ = 7% respectively

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We Don’t Necessarily Need Derivatives: Money Market
Hedges III
To hedge this payable, the importer will lend
£100,000,000
1.04 = £96, 153, 846 at 4% in the UK and receive £100,000,000
after one year
To get £96,153,846 now, they will need
£96, 153, 846 × (USD1.40/GBP) = $134, 615, 385
They can borrow this at 7% and pay back
$134, 615, 385 × (1.07) = $144, 038, 462 in one year

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We Don’t Necessarily Need Derivatives: Money Market
Hedges IV

Bring all this together:

1 Borrow $134,615,385 at 7% in the US today in order to purchase
£96,153,846
2 Convert $134,615,385 into £96,153,846 at the current spot exchange
rate of USD1.40/GBP.
3 Lend (invest) £96,153,846 in the pound money market at 4%.
4 Collect £100,000,000 after one year and use it to pay the British
exporter.
5 Repay $144,038,462 for the initial borrowing

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Cross-Hedging I
A firm with receivables or payables in major currencies can easily use
forward, options or money market contracts.
The major currencies are the: U.S. dollar, Canadian dollar, British
pound, Euro, Swiss franc, and Japanese yen.
A firm with receivables or payables in minor currencies may find it
difficult, expensive or impossible to use financial contracts to hedge.
Financial markets in developing countries tend to be relatively
underdeveloped and highly regulated.
In such a case, cross-hedging may be useful

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Cross-Hedging II

Cross-Hedging involves hedging a position in one asset by taking a

position in another asset that is correlated with the underlying asset
The effectiveness of cross-hedging depends upon how well the assets
are correlated (the stability and strength of this correlation)

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Hedging Strategy I
Generally, financial managers of MNCs must decide on a strategy to
undertake before the exchange rate changes but how will they choose
among the strategies?
Two criteria can be utilized to help choose the strategy
Risk tolerance of the firm, as expressed in its stated policies
Expectations: expected direction of and size of movement of the
exchange rate

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Hedging Strategy II

There were four alternatives available to manage the account payable

in the example above:
1 Unhedged position: outcomes unknown
2 Forward market hedge: assured of paying £100m in one year at the
forward rate of USD1.50/GBP i.e. using $150m
3 Money market hedge: assured of paying £100m at maturity using
$144,038,462 in one year.
4 Options market hedge: paying £100m at maturity using $150m if the
future exchange rate is greater than USD1.50/GBP and using less than
$150m if the future rate is less than USD1.50/GBP

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 Reading
Much of the reading for this material is standard textbook stuff but you
can supplement your reading by following up references in the relevant
chapters below. Pretty much any International Financial Management or
International Finance text will have chapters or sections in chapters on
hedging.
Bekaert, G. and R.J. Hodrick (2018), International Financial Management,
3rd ed., Cambridge University Press, chapter 3, section 3.3, chapter 20,
sections 20.2 and 20.4, and chapter 6, section 6.4.
Eun, C.S, B.G. Resnick and T. Chuluun (2021), International Financial
Management, 9th ed., McGraw-Hill, US, chapters 8 and 9 (the chapters on
Management of Economic Exposure, and Management of Transaction
Exposure), and the section, “Management of Translation Exposure” in
chapter 10 (see the note on the next slide also.)

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Note that with Eun and Resnick (or variants thereof), the chapter numbers may
differ depending on which version you have. The chapter titles, however, stay the
same. To illustrate, on my bookshelf at home I have Eun, C.S., B.G. Resnick and
S. Sabberwhal (2012), International Finance Global Edition. The relevant chapter
numbers in this version are 12, 13 and 14. However, the titles of the chapters are
the same as in Eun, Resnick and Chuluun (2021).

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