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International Finance

International Finance. Hedging Transaction Exposure Bill Reese. Learning Objectives. In this unit we will learn: How to hedge foreign exchange transaction exposure through: Forward contracts Futures contracts Options on futures contracts Money market hedges. Transaction Exposure.

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International Finance

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  1. International Finance Hedging Transaction Exposure Bill Reese

  2. Learning Objectives • In this unit we will learn: • How to hedge foreign exchange transaction exposure through: • Forward contracts • Futures contracts • Options on futures contracts • Money market hedges

  3. Transaction Exposure • Daimler Chrysler wants to build new plant in Germany • Construction bids to be in euros • Your firm bids €100 million • Spot rate at time of bid is 1.22 $/€ • $122 million

  4. Transaction Exposure • One month later – you find out you won the bid • XR is now 1.15 $/€ • $115 million – lost $7 million • Eight months to build plant • Three more months to be paid • This is transaction exposure

  5. Simple Hedge • As much as possible – match assets and liabilities in same currency • Pay for building supplies and wages in euros • If euro depreciates – so does cost of building the plant

  6. Hedging • Forward contract • Futures contract • Option on futures contract • Money market hedge

  7. Forward Contract • Euros receivable is an asset • Need to create a euro liability • Forward contract to sell €100 million in one year • Locks in XR • Usually contract with a bank

  8. Futures Contract • Standardized forward contract at an exchange • Traded on Chicago Mercantile Exchange • €125,000 per contract • Delivery last month of each quarter

  9. Futures Contract • Advantages of Futures Contract • No hunting for counterparty • No counterparty default risk • Actual delivery not necessary

  10. Futures Contract • Disadvantages of Futures Contract • Standardized contract • Size • Delivery date • Currency • Marked-to-market

  11. Options on Futures • Suppose you hedge with futures contract • Short 800 contracts at 1.10 $/€ • Lock-in sale of €100 million for $110 million • 800 contracts at €125,000/contract

  12. Options on Futures • What if spot rate at delivery is 1.30 $/€? • Regret • Euro appreciated • Lost opportunity for gain • Futures contract is insurance

  13. Options on Futures • Option on futures contract is best of both worlds • Enter contract if euro depreciates • Do not enter contract if euro appreciates • There is a catch

  14. Options on Futures • Premium • Paid at time you purchase option • Based on • Futures contract XR(strike price) • Current spot XR • Volatility of XR • Time till expiration of option • Interest rates

  15. Options on Futures • Advantage over futures contract • Choice (option) of entering into futures contract • Disadvantage relative to futures contract • Premium

  16. Money Market Hedge • Create a liability to offset asset • Want to owe €100 million in a year • Borrow PV of €100 million • Convert borrowed euros to dollars at spot rate

  17. Money Market Hedge • Assume • Annual interest rate is 5% • Spot rate is 1.22 $/€

  18. Money Market Hedge • PV = FV / (1+r)t • = €100 million / 1.05 • = €95.238 • Convert to $ at spot rate €95.238 x 1.22 $/€ = $116.19 million today

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