Download hedging through invoice currency

FOREIGN EXCHANGE RISK
MANAGEMENT
RAJESH KUMAR. S
•
HEDGING AGAINST FOREIGN EXCHANGE
EXPOSURE
FORWARD MARKET / FUTURES MARKET
/ OPTIONS MARKET
CURRENCY SWAPS
INTEREST RATE SWAP
CROSS CURRENCY SWAP
HEDGING THROUGH CURRENCY OF INVOICING
HEDGING THROUGH SELECTION OF SUPPLYING
COUNTRY
HEDGING AGAINST FOREIGN
EXCHANGE EXPOSURE
Currency risk when a firm faces
contractual CFs fixed (invoiced) in another
currency - receive or pay fixed amount of
foreign currency in the future, i.e. any
receivable (AR), or payable (AP) in a
foreign currency.
Source of currency risk ?
• Example - case of steel
An automobile manufacturer purchases huge quantities of steel as raw
material for automobile production. The automobile manufacturer enters
into a contractual agreement to export automobiles three months hence
to dealers in the East European market.
Suppose that the contractual obligation has been fixed at the time of
signing the contractual agreement for exports. The automobile
manufacturer is now exposed to risk in the form of increasing steel
prices.
Increasing steel prices
If steel prices increase, this would result in increase in the value of the
futures contracts, which the automobile manufacturer has bought.
Hence, he makes profit in the futures transaction. But the automobile
manufacturer needs to buy steel in the physical market to meet his
export obligation. This means that he faces a corresponding loss in the
physical market. But this loss is offset by his gains in the futures market.
.
Decreasing steel prices
• If steel prices decrease, this would result in a decrease in
the value of the futures contracts, which the automobile
manufacturer has bought. Hence, he makes losses in the
futures transaction. But the automobile manufacturer needs
to buy steel in the physical market to meet his export
obligation.
This means that he faces a corresponding gain in the
physical market. The loss in the futures market is offset by
his gains in the physical market. Finally, at the time of
purchasing steel in the physical market, the automobile
manufacturer can square off his position in the futures
market by selling the steel futures contract.
FORWARD
MARKET
A Contract between two parties obligating each to
exchange a particular good or instrument at a set
price on a future date.
It’s an OTC agreement.
In forward market hedge , a company that is long
in a foreign currency will sell the foreign currency
forward whereas a company that is short in
foreign currency will buy the currency forward.
Perfect , covered , squared
Open or uncovered
FUTURES
MARKET
OPTIONS MARKET
•
OPTIONS (PUT & CALL)
General rules
1. When the quantity of a foreign currency cash outflow is
known , buy the currency forward, when quantity is
unknown buy call option.
2.When the quantity of a foreign currency cash inflow is
known, sell the currency forward, when the quantity is
unknown , buy a put option on the currency.
3. When the quantity of foreign currency cash flow is partially
known and partially uncertain , use a forward contract to
hedge the known portion and an option to hedge the
maximum value of the uncertain remainder.
EXPOSURE NETTING
Offsetting exposure in one currency with exposure in
same or another currency , where exchange rates are
expected to move in such way that losses(gains) on the
first exposed position should be offset by gains (losses)
on the second currency exposure.
CURRENCY SWAPS
• A currency swap is an exchange of payments in
one currency for stream of payments in another
currency over given period of time.
Benefits : It eliminates all foreign exchange
exposure in the currency you are swapping ,
while creating a cash flow in a currency which
would be more acceptable from cash
management viewpoint.
Dollars received
from
ongoing operations
Japanese yen
Received from
subsidiary
Dollar
payments
Yen
payments
US multinational
Dollar
payments
US multinational
Issues dollar
Denominated
bonds
To investors
Dollar
payments
Yen
payments
Japanese
multinational
Yen
payments
Japanese multinational
Issues yen
denominated
bonds to investors
INTEREST RATE SWAPS
• A interest rate swap is a contractual agreement entered
into between two counterparties under which each agrees
to make periodic payment to the other for an agreed period
of time based upon a notional amount of principal.
Plain vanilla swap
They are typically an exchange of floating rate interest
obligations for fixed rate interest obligations
• Eg: Consider two companies A and B.
Company A wants to obtain medium term four years
financing at fixed rate .
Company B wants to borrow floating rate dollars.
Company A
CompanyB
Differential
Fixed
11.70%
10.75%
95 basis
points
Floating
LIBOR + 3/8
%
LIBOR + 1/4
%
12.5 basis
points
Soln
A borrows floating rate funds at LIBOR + 3/8 and sells it to B at LIBOR
B borrows fixed rate money at 10.75% and sells it to A at 11.00%
CROSS CURRENCY SWAPS
• Suppose a manufacturer, XYZ Company, is building a new
plant in European country using term fixed rate financing.
Suppose further that XYZ, having little access to the
european capital markets, concludes that borrowing US
Dollars from a domestic bank offers the most cost-effective
source of financing.
• XYZ can fund in US Dollars (USD) and then convert to Euro
using a Cross Currency Swap. XYZ will make an initial
exchange of USD for Euro at the current spot exchange rate
with an agreement to re-exchange at the same rate when
the swap terminates in 7 years. In this way, the company is
not exposed to exchange rate risk when closing out the
swap and paying down the loan.
HEDGING THROUGH
CURRENCY OF INVOICING
HEDGING THROUGH INVOICE CURRENCY
Assume that Boeing has a contract to build five 747s for
British Airways, and deliver one each year for the next 5
years, and receive pound 10m per plane. By negotiating
and adjusting terms of the invoice, Boeing can shift, share
or diversify currency risk.
a) If Boeing can invoice in USD, then it has eliminated
currency risk for itself and shifted it to British
Airways. Now if S = $1.50/pound ,
British Airways has a $15m AP and Boeing has a $15m AR.
HEDGING THROUGH MIXED
CURRENCY INVOICING
b) Boeing could split (share) the currency risk with British
Airways by invoicing 50% in USD and 50% in BP: $7.5m +
£5m for each plane, and each company shares half the
risk.
Invoice in a basket of currencies to diversify and reduce
currency risk with a portfolio of currencies: e.g. SDRs ($,
?,?,?,?; weights are 38%, 37%, 13%, 12%) or in the past,
ECUs (11 currencies). Companies can issue bonds
denominated in SDRs or ECU (prior to euro) to diversify
risk, Egyptian govt. charges in SDRs for passage through
the Suez Canal. Invoicing in currency baskets can be a
useful hedging tool when no forward or currency contracts
are available
• SPEEDING/SLOWING AR AND AP IN FOREIGN
CURRENCY
General rules:
For AR (Accounts Receivable) in foreign currency: Speed up
(or lead) collections of depreciating currencies (e.g., peso
ARs), and Slow down (or lag) collections of appreciating
currencies (e.g., Euro ARs).
For AP (Accounts Payable) in foreign currency: Speed up
(or lead) payments of appreciating foreign currencies (e.g.
Euro APs, when dollar is depreciating), and Slow down (or
lag) payments of depreciating currencies (e.g., Mexican
peso APs when dollar is appreciating).
HEDGING THROUGH SELECTION
OF SUPPLYING COUNTRY
• Eg Aviva corporation might buy its denim cloth in
currencies in which it sells its jeans.
Aviva could buy the denim in various currencies in
rough proportion to volume of sales in those
currencies.
i.e total value of jeans that it sells in that market
should be netted against its denim purchases.
CAREER IN
HEDGE FUNDS