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Hedging Transaction Exposure. Forward Contracts. Forward contracts are purchases/sales of currencies to be delivered at a specific forward date (30,90,180, or 360 days) Example CAD/USD .7641 1 month .7583 3 months .7563 6 months .7537 12 months .7525.

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## Hedging Transaction Exposure

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**Forward Contracts**• Forward contracts are purchases/sales of currencies to be delivered at a specific forward date (30,90,180, or 360 days) • Example CAD/USD .7641 1 month .7583 3 months .7563 6 months .7537 12 months .7525 Forward contracts are individualized agreements between the bank and the customer**Futures Contracts**• Forward contracts are written on an individual basis. Futures are standardized, traded commodities (Chicago Mercantile Exchange) • JPY: 12,500,000 Yen • GBP: 62,500 Pounds • Euro: 125,000 Euro • CAD: 100,000 Canadian Dollars**To hedge or not to hedge….that is the question”**Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate: $1.88 90 Day Forward: $1.85 (-1.6%) If you were to “lock in” your price with the forward/futures contract, you would pay $185,000 for the goods (with certainty)**Suppose you have the following forecast for the percentage**change in the British pound over the upcoming 90 days e % Change in e ($/GBP) Mean: -1.6% Std. Dev: 2% -1.6% %Change [ -3.6% , 0.4%] [ -5.6% ,2.4%] [ -7.6%, 4.4%]**Given a standard deviation, we can approximate a**distribution for the exchange rate in 90 days. Current Spot Rate: $1.88**Given the distribution of exchange rates, we can estimate**the expected cost of the hedge Current Spot Rate: $1.88 Expected Value: $0**From the previous table, we can show the distribution of**gains from the hedge If forward rates are unbiased, most of the weight will be at zero!**Money Market Hedges**Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate = $1.88 British 90 Day Interest Rate = 2.6% US 90 Day interest rate = 1%**Money Market Hedges**Spot Rate = $1.88 British 90 Day Interest Rate = 2.6% US 90 Day interest rate = 1% Today 90 Days • Borrow $183,236 @ 1% for 90 Days • Convert to GBP @ $1.88 • Invest in 90 Day British Asset @ 2.6% • Collect GBP 100,000 to pay for imports • Pay of loan + interest = $185,000 GBP 100,000 $1.88 = $183,236 (1.01) = $185,000 1.026 Present Value of 100,000 in 90 days**Money Market Hedges**Forward/Futures Hedge VS. Recall Covered Interest Parity Forward Rate (1+i*)F = (1+i) e Spot Rate If covered interest parity holds (and it does!), then the forward rate reflects the interest differential and the money market hedge is identical to the forward/future hedge!**Currency Options**• With options, you have the right to buy/sell currency, but not the requirement • Call: The right to buy at a specific “strike price” • Put: The right to sell at a specific “strike price” • The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option. • The buyer must pay an up front price for the contract**Payout from a Call**• Suppose you buy a 30 day call on 125,000 Euros at a strike price of $1.20 • For spot rates less than $1.20, the option is worthless (“out of the money”) • If the spot rate is $1.25, your profit is ($.05)*($125,000) = $6,250**Payout from a Put**• Suppose you buy a put on 125,000 Euros at a strike price of $1.20 • For spot rates greater than $1.20, the option is worthless (“out of the money”) • For example, if the spot rate is $1.15, your profit is ($.05)*($125,000) = $6,250**Hedging with Options**Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate: $1.88 3 Month Call w/strike price of $1.85 is selling at a premium of $.05 (GBP 100,000) You pay $.05(100,000) = $5,000 today. Your cost of GBP in 90 days = MIN [ spot rate, $1.85]**Remember, you pay (.05)*100,000 = $5,000 Today!**Current Spot Rate: $1.88 Expected Value: -$3,070**The option hedge is more expensive on average, but protects**you from large negative outcomes! Option Hedge**Cross Hedging**Suppose that you have entered an agreement to buy PLN 100,000 (Polish Zloty) worth of imports. ($1 = 3.17PLN). Zloty futures are not traded. What do you do? You notice that the Zloty is highly correlated with the Euro (E 1 = 4.09 PLN) Act as if you are hedging (100,000/4.09) = E 24,454**Some more advanced hedging strategies…**Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. You are in the process of negotiating a deal to sell GBP 200,000 worth of goods to Britain. Case #1: The export deal falls through and you will need to buy GBP 100,000 in one 90 days Case #2: The export deal succeeds and you will need to sell GBP 100,000 in one 90 days How do you hedge this?**A currency straddle is a combination of a put (the right to**sell) and a call (the right to buy) Value Value Cost = $0.06/L Cost = $0.06/L e ($/L) e ($/L) 1.85 1.85 Value Cost = $0.12/L(L 100,000) = $12,000 e ($/L) 1.85**Currency Straddles: Four Possibilities**• NCF = L100,000, e > $1.85 • Let Put Expire • Buy $ in Spot Market • Buy GPB with Call • Sell GBP in Spot Market • NCF = L100,000, e < $1.85 • Let Call Expire • Use Put to sell GBP • NCF = - L100,000, e > $1.85 • Let Put Expire • Use Call to Buy GBP • NCF = - L100,000, e < $1.85 • Let Call Expire • Buy GBP in Spot Market • Sell GBP with Put**Straddles hedge your exposure under all circumstances, but**are very expensive (in this case, $12,000 in premium costs) Value Value Cost = $0.04/L Cost = $0.03/L e ($/L) e ($/L) 1.89 1.84 Value Cost = $0.07/L(L 100,000) = $7,000 Un-hedged Region e ($/L) 1.84 1.89**Another way to save money is to only hedge particular ranges**(i.e. a 95% confidence interval!) Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Value Value Cost = $0.05/L Cost = $0.08/L e ($/L) e ($/L) 1.85 1.89**You could hedge the range from $1.85 to $1.89 by selling a**call w/ a strike price of $1.85 and using the proceeds to buy a call with a strike price of $1.89 Value Value Cost = $0.05/L Cost = $0.08/L e ($/L) e ($/L) 1.85 1.89 Value Cost = $0.08 - $0.05 = $0.03 e ($/L) 1.85 1.89**Hedging…the possibilities are endless!**There are many different types of hedges available. Each hedge has a cost and a level of protection. Its your choice to decide what coverage you need and how much you are willing to pay for it!!

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