Measuring and managing exchange rate exposure L10

Question 1

Hedging techniques

Answer 1

• Forward or futures hedge
• Money market hedge
• Currency option hedge

Question 2

Money market hedge

Answer 2

• taking a money market position to cover a future payment/receipt.
• e.g., to hedge against a future foreign payment a firm can borrow funds in the home currency and Invest in the foreign currency earning interest until the payment matures

Question 3

Currency option hedge

Answer 3

• provides the right to buy/sell a specified amount of a particular currency at a specified strike price within a given period of time

Question 4

Forward or futures hedge

Answer 4

• using a forward contract to lock in the value of a future payment/receipt

Question 5

Arguments against hedging

Answer 5

• Hedging-as-Irrelevant (Modigliani and Miller)
• Hedging is costly

Question 6

Arguments for hedging

Answer 6

• Lowers exchange rate risk
• Improves investment decisions
• Can reduce firm’s expected taxes

Question 7

Hedging-as-Irrelevant - Modigliani and Miller

Answer 7

• It only changes non-systematic risk, no effect on firm’s value
• Investors can hedge on their own – equity positions
• Relies on “Perfect Markets” story

Question 8

Hedging is costly

Answer 8

• Bid-ask spread: larger in forward market
• Salaries and monitoring costs to evaluate hedging alternatives

Question 9

The real exchange rate risk of a net exporter

Answer 9

A competitive dilemma:
- Raise prices: lose market share
- Lower prices: lose profits

Question 10

Major factor that determines a firm’s response to exchange rate changes

Answer 10

• Price elasticity of demand for its product

Question 11

(Pro-hedging) Improves investment decisions

Answer 11

• Provides definite stream of income to finance investment
• Otherwise + NPV projects may be missed

Question 12

Can reduce firm’s expected taxes

Answer 12

• stable income =>
• predictable tax environment
• maximise tax benefits through strategic income management
• reduced risk of high taxes/penalties from income volatility

Question 13

Alternative Hedging techniques

Answer 13

• Leading and Lagging
• Cross-Hedging
• Currency Diversification

Question 14

Leading and Lagging

Answer 14

• Adjusting the timing of a payment or disbursement to reflect expectations about future currency movements

Question 15

Cross-Hedging

Answer 15

Hedging by using a proxy currency for the currency in which the MNC is exposed

Question 16

Currency Diversification

Answer 16

Reducing exposure by diversifying business across numerous countries

Question 17

Evidence on Firm’s Hedging Behaviour

Answer 17

• Large R&D firms hedge
• Highly levered firms hedge
• Firms with higher dividend yields hedge
• Hedging more common in large firms
  -Firms with greater growth opportunities more likely to use derivatives
• Some evidence to suggest hedging increases firm value