instruction 5 (1)

Question 1

Hedging receivables (money market hedge) five step procedure

Answer 1

1) today, borrow present value of your receivable

2) convert this into the home currency ($) at the current spot rate

3) invest the $ amount in the US (at risk free)

4) After 1 year, collect your receivable and use it to repay the pound loan

Question 2

Hedging receivables money market hedge

Answer 2

Money market hedge is nearly identicaly to the forward market hedge

Is it surprising? What happens if they were not identical?

There would be arrbitrage opportunity (interest rate parity doesnt hold)

Question 3

call option

Answer 3

Right to buy

Call gives the holder the right, but not the obligation, to buy a certain amount of a foreign currency at a specific exchange rate up to or at the maturity date

Question 4

Put option

Answer 4

Right to sell

Put gives the holder the sell, but not the obligation, to buy a certain amount of a foreign currency at a specific exchange rate up to or at the maturity date

Question 5

Option market hedge (hedging receivables)

Answer 5

In general, the firm can buy a foreign currency

Call –> to hedge its foreign currency payables

Put –> to hedge the receivables

Question 6

Hedging receivables all together

Answer 6

1) In the unhedged position, you have unlimited loss and gain (bet against appreciation of pound next year)

2) Forward hedge: assures receiving a certain amount in one year; future spot exchange becomes irrelevant

3) money market hedge: guarantees receiving a certain amount now or more in one year; the future spot exchange rate becomes irrelevant

4) Option market hedge: assures receiving at least the option execution price or more if the future spot exchange rate excess the exercise exchange rate. (you control downside risk while retaining the upside potential)

Question 7

what if your FX position was on illiquid currencies?

hedging illiquid currencies are very costly or sometimes impossible

Financial markets of developing countries are usually highly regulated and underdeveloped

Answer 7

Solution: cross hedging

It is a technique to manage the minor currency exposure of firm

Cross hedging involves a hedging position in one asset by taking a position of another asset

Question 8

cross hedging minor currency exposure

Answer 8

Invest in something highly correlated with the value of that currency

E.g. invest in yen instead of won because they move together

Question 9

currency swap contract

Answer 9

an agreement to exchange one currency for another at a predetermined exchange rate (swap rate)

Question 10

A swap contract is like

Answer 10

a portfolio of forward contracts with different maturities

Question 11

lead-lag strategy

Answer 11

if a currency is appreaciating –> hard currency

Pay those bills denominated in that currency early (lead)

Let customers pay late (lag)

If a currency is depreciating –> soft currency

Give incentives to customer who owe you in that currency to pay early (lead)

Pay your obligations denominated in that currency as late as your contracts will allow (lag)

Question 12

Who performs lead-lag strategy

Answer 12

Usually among the subsidiaries of the same multiational companies

The lead/lag strategy can be employed more effectively to deal with intrafirm payables and receivables, such as material costs, rents, royalties, interests and dividends etc.

Question 13

Exposure netting

Answer 13

Do not consider deals in isolation, but aggregate positions in each currency

Positions in different currencies may yield a cross-hedge (e.g. being short yen and long korean won)

Trade-offs between accuracy of hedge and fees

Firms use reinvoice center, a financial subsidiary: a mechanism for exposure management functions

Question 14

theory of comparative advantage

Answer 14

Economic well being improves if countries produce goods they have a comparative advantage in, and then trade

Assumes free trade and immobile factors of production

Not absolute production capability but relative efficiency