Post on 14-Jan-2015
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Foreign currency exposure and
risk management…
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what exposure means…
That part of company’s volume of business which may get affected by movements in exchange rates-
May / may not be favourable Unpredictable - One can only forecast a strong probability.. How fast the exchange rate moves….
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what exposure means…
ERR is inherent in the business of all multinational enterprises as they are to make or receive payments in foreign currencies
Hence foreign exchange risk has become an integral part of the management activities of any MNC
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Types of exposures….
Accounting Exposures
Transaction Exposure Translation Exposure
Operating / Economic Exposure
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Transaction exposure
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Different types of transactions
Transactions that can have an impact on currencymovements…
Trade related Export bills receivables / Import Bills Payable Advance payments – exports
Loan repayments Repatriation of investments
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Different types of transactions
Transactions that can have an impact on currencymovements…
Interest payments / receivables Inward remittances Whether these transactions will be concluded before
the next balance sheet
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Transaction Exposure
How it generated When it is generated and how it ends
Conceived at the time of quoting a price in foreign currencyGiven birth when the quotation is acceptedAnniversaries – on due dates and if not met on due dates crystallizes into an exposure…Final stage – extinguished when FC bought / sold
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Transaction Exposure Risk
“Risk in adverse movement of exchange rates from the time the transaction is budgeted till the time of exposure is extinguished – by sale / purchase of a foreign currency against domestic currency….”
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Impact of Transaction Exposure..
It will be of short term in nature
Will have an impact on cash flow of a company
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Impact of Transaction Exposure..
It will be of short term in nature
Will have an impact on cash flow of a company
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Hedging Transaction Exposure
Since exposure arises due to unanticipated movement ofexchange rate , entering into a financial counter-transactionat a future point in time is known as hedging
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Basic Objectives of Formulating Hedging Strategy
Hedging is an attempt to reduce the losses due to unexpected or unanticipated changes in exchange rate
But hedging has associated costs; therefore costs are to be weighed against returns and the fulfillment of objective of maximisation of value of the firm
Firms by nature are risk takers therefore the hedging strategy is not to eliminate total risk but to maximise the value of the firm
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Hedging Transaction Exposure
The amount receivable ( exports) is technically referred as long position
The amount payable ( imports) is technically referred as short position
The MNCs will have both types of positions
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Hedging Transaction Exposure
The basic rule of hedging is:
The payables (short position) in a currency in the future isto be hedged with buying (long position) in the samecurrency in the forward; and receivables (long position) ina currency in the future is to be hedged with selling (shortposition) the same currency in the forward
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Instruments of Hedging
1. Forward contract 2. Money market hedge
3. Future contract4. Option contract5. Currency invoicing6. Exposure netting7. Currency Risk Sharing
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Forward ContractA forward contract is an agreement made today between
a buyer and a seller to exchange the commodity or instrument for cash at a predetermined future date at a price agreed upon today
In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity
No money changes hands at the time the deal is signed
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Forward Contract Forward contracts are not traded on an exchange, they are
said to trade over the counter (OTC)
The secondary market do not exist for the forward contracts and faces the problem of liquidity andnegotiability
Forward contracts face counter party risk
The longer the time period, larger is the counterparty riskwww.StudsPlanet.com
Hedging with Forward contract● Suppose an importer has imported a machine worth $ 1,00,000● The machine is expected to arrive in a month when the amount
is payable● The current exchange rate is $1= Rs. 46.75● He expects to move the rate to $1= Rs. 47.75● He checks the forward market and finds that one month
forward rate is $1= Rs. 47.50● The importer buys $1,00,000 as the dollar was cheaper in the
forward market as compared to his own perception
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Money Market Hedge
Money market hedge involves mixing of foreign exchange and money markets to hedge at the minimum cost
It involves taking advantage of disequilibrium between the two markets
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Money Market HedgeOne possibility:
The importer buys that amount of dollars in the spot market which when deposited in the US at US interest grows to $1,00,000 in one month
Second possibility:
The importer buys $1,00,000 in the forward market and to make the payment in Indian rupees, deposits that much amount in the bank deposit to grow to honour the contract
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Futures Contract
A futures contract is a financial security, issued by an organised exchange to buy or sell a commodity, security or currency at a predetermined future date at a price agreed upon today
Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price
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Futures Contract
The contract expires on a pre-specified date which is called the expiry date of the contract
On expiry, futures can be settled by delivery of the underlying asset or cash
The futures contract relates to a given quantity of the underlying asset and only whole contracts can be traded
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Currency Futures
Currency Futures means a standardised foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract
Currency future contracts allow investors to hedge against foreign exchange risk
Reserve Bank of India Act, 1934 permitted currency futures trading with effect from August 6, 2008.
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Forwards Vs. Futures
Two parties negotiate a forward transaction
Futures is structured as two transactions
Party BParty A
Party A Party B
ClearingHouse
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Difference between Forward Hedge and a Future Hedge
Forward Market Hedge Future Hedge
Contracts executed by banks Contracts executed by brokerage houses of future exchanges
Tailor-made contracts Standardised contracts
Price quoted reflects banker’s perception of future price
Price paid is determined by forces of demand and supply
Contract bilateral between two parties
Contract with the future exchange
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Options
‘ An option is a contractual agreement that gives the option buyer the right, but not the obligation, to purchase (call option) or to sell (put option) a specified instrument at a specified price at any time of the option buyers choosing by or before a fixed date in the future
The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium
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Options
Seller (writer) Purchaser (holder)
Premium
Striking or exercise price
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Options
European Option: The holder of the option can only exercise his right ( if he so desire)
on the expiration date
American Option : The holder can exercise his right any time between purchase date and
expiration date
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OptionsCall Option :
A call option gives the buyer the right to buy a fixed number of shares/commodities at the exercise price upto the date of expiration of the contract
Put Option:A put option gives the buyer the right to sell a fixed number of shares/commodities at the exercise price upto the date of expiration of the contract
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Options ExampleCurrent price of oil is $65 per barrel. An airlines company feels oil prices might rise 6 months later &wishes to hold an option to buy oil 6 months hence at, at most $67. An oil refinery feels prices will fall 6 months later & wishes to holdan option to sell oil 6 months hence at, at least $67. Both companies approach the exchange and place their orders.Exchange has options which fulfill the requests at $67 per barrel.1. What is the expiration period ?2. Is Airline Company a holder or writer ?3. Is Oil Refinery a holder or writer ?4. What option type does Airline Company hold ? 5. What option type does Oil Refinery hold ? 6. What are the Strike Prices ?
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Features of Options
The option is exercisable only by the owner, namely the buyer of the optionThe owner has limited liabilityOptions have high degree of risk to the option writersOptions involve buying counter positions by the option sellersOptions are popular because they allow the buyer profits from favourable movements in exchange rate
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Call Option - Example
Call option grants the owner the right to purchase a specified financial instrument for a specified strike price over a specified period of time
I buy a call today for $0.33 for 15 barrels oil, strike price $50, exercise date June 1 2010 Today’s oil price is $49 per barrel.
Tomorrow If the oil price is $52 my intrinsic value = $2, option premium = $0.45 (say)
MTM (mark-to-market) = $(0.45 - 0.33)*15 = $0.12*15 = $1.80
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Call Option - Example
If the oil price is $60 on June 1 2010 (the spot price) then I would exercise my option (i.e. buy the oil from the counter-party).
I could then sell oil in the open market for $60, i.e. the payoff would be worth $10; my profit would be $10 minus the premium I paid for the option $0.33 = $9.67.
Net gain = $9.67*15 = $145.05www.StudsPlanet.com
Call Option - Example
If however the spot price is $40 then I would not exercise the option. I would buy the stocks in the open market for $40, why waste $50 on it? The option would expire worthless
Thus, in any future state of the world, I am certain not to lose money on the underlying by owning the option; my loss is limited to the premium I have paid.
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Put Option - Example Put option grants the owner the right to sell a specified
financial instrument for a specified strike price over a specified period of time.
I buy a put option today at $ 0.5 to sell 10 coal per metric tons on June 1, 2010, at $50 per metric ton. Today coal price is $48 per metric tons.
Tomorrow If the share price is $49 my intrinsic value = $1, option premium = $0.6 (say)
MTM (mark-to-market) = $(0.6 - 0.5)*10 = $0.1*10 = $1www.StudsPlanet.com
Put Option - Example
On June 1, 2010 the coal price is $40 (spot price) I would exercise my option (i.e. sell the share to the counter-party)
I could then buy coal in the open market for $40, i.e. the payoff would be $10; my profit would be $10 minus the premium of $ 4.5 I paid for the option = $0.5.
Net gain = $0.5*10 = $5
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Put Option - ExampleIf, however, the spot price is more than the strike price, say, $60,
then I would not exercise the option. I would sell such a share in the open market for $60, and earn more than I would by selling through the option.
My option would be worthless and I would have lost the premium
for the option.
Thus, in any future state of the world, I am certain not to lose money by owning the option; my loss is limited to the premium I have paid.
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Option Benefits
Holder (Buyer who has gone Long)
Writer (Seller who has gone Short)
Call Right to Buy No Obligation Premium Pay
No RightObligation to SellPremium Receive
Put Right to SellNo Obligation Premium Pay
No RightObligation to Buy Premium Receive
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Hedging with Options
In the case of hedging with options, if the price surpass the expectations, only then the option is exercised and the hedge comes into operation
This kind of hedging is usually resorted when there is a possibility of non-performance of contract
The cost involved in purchasing an option is called premium
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Hedge through Currency Invoicing
If during the negotiation of an import contract, an importer of a country having weak currency may get goods invoiced in domestic currency and the exporter from this country should invoice goods in strong currency
The risk shifts from one party to the other
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Exposure Netting
Netting means the net of payables and receivables
The exposure, if netted, is reduced so also the cost of hedge
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Currency Risk Sharing
It is the practice of introducing a clause in the transaction contract
The parties would declare a neutral zone within which the risk is not shared
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MNCs and Transaction Exposure Management
The companies dealing in multicurrency environment or multicurrency cash flows need to prepare cash budgets to know the exact extent of transaction exposure
The net transaction exposure is arrived at on quarterly basis
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Foreign currency inflow-outflow cash budget
Q-1 Q-2 Q-3 Q-4 Total
RECEIPTS
American Dollars ($) 300 280 320 400 1300
British Pound(BP) 20 25 18 40 103
Canadian Dollars(C$) 40 25 45 45 155
DISBURSEMENTS 0
American Dollars ($) 200 160 240 300 900
British Pound(BP) 40 15 20 40 115
Canadian Dollars(C$) 20 40 75 20 155
Japanese Yen (JPY) 10 30 20 20 80
NET EXPOSURE 0
American Dollars ($) 100 120 80 100 400
British Pound(BP) -20 10 -2 0 -12
Canadian Dollars(C$) 20 -15 -30 25 0
Japanese Yen (JPY) -10 -30 -20 -20 -80www.StudsPlanet.com
MNCs and Transaction Exposure Management
The net positive transaction exposure (+ ve flows) indicates strengthening of domestic currency against foreign currency ($) will cause loss to the firm and depreciation makes it profitable
The net negative transaction exposure (- ve flows) indicates strengthening of domestic currency against foreign currency ($) will give profit to the firm and weakening of domestic currency would cause the loss
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Hedging Transaction Exposure of MNCs
MNCs by nature are risk takers and they take risk when adequate compensation is present in the venture
In a multicurrency environment, it is not necessary that foreign exchange risk to be zero for international business to become attractive for the firm
Strategies to decrease transaction exposure:
International Diversification Hedging
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Thank YouBest of Luck….
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