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International Finance In Class Exercise. Managing Foreign Exchange Risk. The Nature of Hedging. In the last 3 weeks, we have: 1.Developed a number of measures of exposure 2.Constructed measures of the risks associated with these exposures

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International Finance In Class Exercise

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International FinanceIn Class Exercise

Managing Foreign Exchange Risk

The Nature of Hedging

In the last 3 weeks, we have:

1.Developed a number of measures of exposure

2.Constructed measures of the risks associated with these exposures

3.Determined how to identify the appropriate exposure to hedge among a portfolio of exposures.

4.Reviewed the advantages and disadvantages of a number of financial instruments that can aid us in hedging these exposures.

The Nature of Hedging

We have also discussed the following:

1. Why hedge?

2. What kinds of risks should we focus on to hedge?

3. At what horizon should the hedging take place?

4.What can be done from the operational side to manage foreign exchange risks?

5.Appropriate overall approaches to managing foreign exchange risk at a multinational.

A. Under what circumstances would the one-year forward rate be equal to the current spot rate?

Group Project

B. If Jaguar can sell all 100K cars at $50K, what is the pound revenue at the spot rate? The gain or loss on the forward contract? The net gain to Jaguar?

Group Project

C. What if Jaguar has to cut its price to $45K, what is the pound revenue at the spot rate? The gain or loss on the forward contract? The net gain to Jaguar?

Group Project

What Risks Should be Hedged?

Economic exposure is ultimately what the firm should be concerned with

Indeed, even transaction exposures should be evaluated in terms of whether they are associated with an underlying economic exposure.

When considering hedging a known outflow or cost, the firm must evaluate the revenue side operations; when considering a known inflow or revenue, the firm needs to evaluate the cost side.

Whenever the currency movement affects revenues and costs equally, only the profit margin is truly exposed.

What Risks Should be Hedged?

For treating economic exposure, financial hedges have two main shortcomings:

1. Horizon. Outside of swaps, most financial hedges become quite expensive over longer horizons. While swaps can provide an inexpensive way to construct a series of long-dated forward contracts, they require accurate assessment of future cash flows.

For hedging uncertain future cash flows, long-term futures contracts are unavailable, and the costs of long-term options will be prohibitively large.

What Risks Should be Hedged?

2. Real vs. Nominal. Financial hedges can only hedge nominal amounts. If there are real changes in home currency costs and revenues, nominal hedges may be quite ineffective.

As we have seen, real and nominal exchange rates coincide reasonably well in developed countries, but the correspondence is usually weak for emerging economies.

Economic Exposure in the Long Run

Recall that economic exposure is only concerned with changes in the market value of the firm that result from real exchange rate changes.

Hence, if RPPP holds in the long run, changes in the real exchange rate should balance out in the long run.

This is what we saw with most of the developing countries that saw large short-term swings in the real exchange rate.

Thus, long-term hedging activity may not be needed or productive.

Where then is the value in hedging economic exposure?

Economic Exposure in the Long Run

Recall that most of the arguments for hedging activities focus on the short-run:

1. Ensuring that the firm (or manager) gets to the long run.

2.Minimizing systematic shareholder risks.

3. Achieving short-run tax, monitoring, and investment efficiencies.

Hence, a shorter-horizon perspective that focuses on the economic exposure of highly-known nominal cash flows may be reasonable after all. In other words, only exposures which pose a material threat to the value of the firm’s periodic cash flows should be hedged.

Marketing Management

Pricing. If firms have some flexibility to adjust prices and ‘pass-through’ the exchange rate effects, they will want to do so in responding to exchange rate changes.

Specifically, firms selling in overvalued currencies will want to lower the local currency price to capture larger market share, while those operating in undervalued currencies will raise prices to maintain profit margins.

Firms in more competitive industries face less flexibility in terms of their pricing schedules.

Foreign Exchange Risk Management

1. Focus attention on risks which have a material impact on the expected value and systematic risk of the firm to shareholders.

2. Measure exposures and risks accurately:

- recognize any potentially offsetting effects in costs, revenues, quantities, or pass-through.

- take into account offsetting movements in exposures to other currencies.

-apply appropriate measures of risk: RPPP for exposures not linked to interest rates and UIP for those that are interest sensitive (i.e. cash deposits).

Foreign Exchange Risk Management

3.Use risk management to control risks in the short-run, while relying on firm, manager, and exchange rate fundamentals to dominate in the long-run.

4.Don’t ignore opportunities to manage exchange rate risks from the operational side.

Foreign Exchange Risk Management

5.Recognize that risk management often creates more risk than it eliminates - no firm (or municipality) ever went bankrupt solely due to insufficient risk management, plenty have gone bankrupt as a result of too much.

6.Keep in mind that investment banks make more money when you worry about FX risk than when you don’t.

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