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MANAGING EXPOSURE TO EXCHANGE RATE FLUCTIATION

MANAGING EXPOSURE TO EXCHANGE RATE FLUCTIATION. TYPES. TRANSACTION EXPOSURE ECONOMIC EXPOSURE TRANSLATION EXPOSURE. TRANSACTION EXPOSURE. THE FIRM FACES FOLLOWING MAJOR TASKS: TO IDENTIFY THE DEGREE OF TRANSACTION EXPOSURE TO DECIDE WETHER TO HEDGE THIS EXPOSURE

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MANAGING EXPOSURE TO EXCHANGE RATE FLUCTIATION

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  1. MANAGING EXPOSURE TO EXCHANGERATE FLUCTIATION

  2. TYPES • TRANSACTION EXPOSURE • ECONOMIC EXPOSURE • TRANSLATION EXPOSURE

  3. TRANSACTION EXPOSURE THE FIRM FACES FOLLOWING MAJOR TASKS: • TO IDENTIFY THE DEGREE OF TRANSACTION EXPOSURE • TO DECIDE WETHER TO HEDGE THIS EXPOSURE • TO DECIDE WETHER TO HEDGE : PART OF THE EXPOSURE OR COMPLETELY • TO CHOOSE AMONG THE VARIOUS TECHNIQUES AVILABLE

  4. HEDGING • “The act of eliminating exposure to exchange rate fluctuation is referred to as Hedging”. IFM By Jeff Madura

  5. IS HEDGING WORTHWHILE ?

  6. HOW TO ELIMINATE TRANSACTION EXPOSURE MOST COMMONLY USED TECHNIQUES ARE • INVESTING OR BORROWING STRATEGY • INVOICING STRATEGY • MONEY MARKET HEDGE • OPTION CONTRACT HEDGE • FUTURE CONTRACT HEDGE • FORWARD CONTRACT HEDGE • SWAP CONTRACT HEDGE

  7. INVESTING OR BORROWING STRATEGY • TO HEDGE PAYBLES: If excess cash is available ,convert it to the currency denominating payables and invest the funds until they are needed to cover the payables • TO HEDGE RECEIVABLES: If there is a need to borrow funds ,borrow the currency denominating its receivables and convert these funds to its home currency for use. • Then , pay off the loan with cash inflows due to receivables.

  8. EXAMPLE • If a US firm expects future payables in GBP • If excess cash is available • It could deposit the funds in UK bank • The deposit will provide interest • AT THE END OF THE DAY • It can use the principle & interest to make the payment of payables

  9. CONTINUED • MNC needs GBP 550000 after 1 year • It has USD 1000000 for 1 year (excess cash available ) • MNC will set up a UK deposit in GBP (interest rate is 10%) • After 1 year the deposit & interest will generate the amount needed for payables

  10. Formula for deposit D = P / (1 + Id) Where D= DEPOSIT AMOUNT = ? P= AMOUNT OF PAYABLES (IN FOREIGN CURRENCY)=550000 Id=INTEREST IN FOREIGN DEPOSIT = 10% D = GBP 550000 / ( 1+ 10%) = GBP 500000 THE DEPOSIT AMOUNT = GBP 500000

  11. CONTINUED • If current spot rate of GBP = $1.50 • To set deposit MNC needs $ 750000 (GBP 500000* 1.50= USD 750000) • SO YOU HAVE STILL $ 250000 REMAINING ( 1000000 – 750000 = USD 250000 )

  12. INVOICING STRATEGY • TO HEDGE PAYABLES Invoicing exports in the same currency In which you have payables (for imports) • TO HEDGE RECEIVABLES Imported goods should be invoiced in the same currency That is received from exports.

  13. MONEY MARKET HEDGE • TO HEDGE PAYABLES Borrow local currency and convert to currency denominating payables. invest these funds until they are needed to cover the payables. • TO HEDGE RECEIVABLES Borrow the currency denominating the receivables and convert it to the local currency and invest it. Then, pay off the loan with cash inflows from the receivables.

  14. EXAMPLE • IF THE MNC IS EXPECTING PAYABLES IN CHF AFTER • 30 DAYS (NO EXCESS CASH IS AVAILABLE) IT CAN TAKE THE BENEFIT OF MONEY MARKET HEDGE i.e. • Borrow USD from US bank @ 1 % interest for 30 days • Convert the USD to CHF @ $ 0.44 • Deposit the CHF in Swiss bank for 30 days @ 0.5% • After 30 days use the CHF to make the payment • Use the USD to repay the US loan

  15. formula D = P / (1 + Id) Where D= DEPOSIT AMOUNT = ? P= AMOUNT OF PAYABLES (IN FOREIGN CURRENCY)=CHF 1000000 Id=INTEREST IN FOREIGN DEPOSIT = 0.5% D = CHF 1000000 / ( 1+ 0.5%) = CHF 1000000 THE DEPOSIT AMOUNT = CHF 995025

  16. CONTINUED BORROW USD 437811 CONVERT USD INTO CHF @ $ 0.44 IT EQUALS TO CHF 995025 (437811/ 0.44) DEPOSIT CHF 995025 FOR 30 DAYS IT WILL BE EQUAL TO CHF 1000000 AFTER 30 DAYS USE THE CHF 1000000 TO PAY FOR THE PAYABLES OF CHF THEN PAY THE US LOAN 437811 * (1 +1 %) = USD 442189 LOAN

  17. OPTION CONTRACT HEDGE

  18. FUTURE CONTRACT HEDGE

  19. FORWARD CONTRACT HEDGE

  20. SWAP CONTRACT HEDGE

  21. LONG-TERM HEDGING • LONG-TERM FORWARD CONTRACTS • CURRENCY SWAPS

  22. HOW TO REDUCE TRANSACTION EXPOSURE • LEADING AND LAGGING • CROSS HEDGING • CURRENCY DIVERSIFICATION

  23. LEADING & LAGGING • LEADING : If the currency in which there are payables is expected to appreciate . Make the payment before time (so that you may pay before the exchange rate may increase) • LAGGING : If the currency in which there are payables is expected to depreciate . Delay the payment (so that the exchange may decline)

  24. CROSS-HEDGING • If you have to pay for imports after 60 days • Currency in which the payment is denominated is expected to appreciate. • Forwards ,Futures, Options are not available for this currency. SOLUTION : • Find the currency which is highly & positively correlated to this currency (and in which the contracts are also available) • Make the contract in the correlated currency

  25. CURRENCY DIVERSIFICATION • RECEIVABLES Accepting payment in several currencies from receivables (rather than a few currencies) can reduce the firm’s exposure. • PAYABLES Making payment in several currencies for the payables (rather than a few currencies) can reduce the firm’s exposure.

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