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Hedging Transaction Exposure

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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  1. Hedging Transaction Exposure

  2. 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

  3. 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

  4. 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)

  5. 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%]

  6. Given a standard deviation, we can approximate a distribution for the exchange rate in 90 days. Current Spot Rate: $1.88

  7. Given the distribution of exchange rates, we can estimate the expected cost of the hedge Current Spot Rate: $1.88 Expected Value: $0

  8. 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!

  9. 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%

  10. 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

  11. 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!

  12. 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

  13. 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

  14. 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

  15. 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]

  16. Remember, you pay (.05)*100,000 = $5,000 Today! Current Spot Rate: $1.88 Expected Value: -$3,070

  17. The option hedge is more expensive on average, but protects you from large negative outcomes! Option Hedge

  18. Hedging Techniques

  19. 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

  20. 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?

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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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