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Questions and Answers
What is the primary task that a firm must undertake when transaction exposure exists?
What is the primary task that a firm must undertake when transaction exposure exists?
Which approach involves consolidating subsidiary reports to assess transaction exposure for an MNC?
Which approach involves consolidating subsidiary reports to assess transaction exposure for an MNC?
What technique is used to mitigate transaction exposure by establishing an offsetting currency position?
What technique is used to mitigate transaction exposure by establishing an offsetting currency position?
How can a firm potentially reduce its transaction exposure at the subsidiary level?
How can a firm potentially reduce its transaction exposure at the subsidiary level?
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What must a firm do first if it decides to hedge its transaction exposure?
What must a firm do first if it decides to hedge its transaction exposure?
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What will XYZ Inc. receive in Euros from selling a forward contract worth $1 million at a forward rate of $1.10/€?
What will XYZ Inc. receive in Euros from selling a forward contract worth $1 million at a forward rate of $1.10/€?
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What is required in a money market hedge when covering payables?
What is required in a money market hedge when covering payables?
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When is it sufficient to take just one money market position for hedging?
When is it sufficient to take just one money market position for hedging?
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What condition must hold for a money market hedge to yield the same result as a forward hedge?
What condition must hold for a money market hedge to yield the same result as a forward hedge?
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What does the forward premium on a forward rate reflect?
What does the forward premium on a forward rate reflect?
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Which hedging technique involves the use of standardized contracts with fixed delivery dates set by an exchange?
Which hedging technique involves the use of standardized contracts with fixed delivery dates set by an exchange?
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How do futures and forward hedges primarily differ in their application?
How do futures and forward hedges primarily differ in their application?
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Which exchange is noted as the dominant trader and biggest outlet for currency speculators?
Which exchange is noted as the dominant trader and biggest outlet for currency speculators?
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What is a key characteristic of a money market hedge?
What is a key characteristic of a money market hedge?
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Which of the following statements is true about futures and forward contracts?
Which of the following statements is true about futures and forward contracts?
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Study Notes
Exchange Rate Risk Management: Transaction Exposure
- Exchange rate (ER) risk arises from fluctuations in currency values, impacting company performance and asset values.
- ER risk management involves strategies to mitigate the impact of these fluctuations on a company's operations.
- Companies monitor their operations to determine their exposure to ER fluctuations.
- ER exposure describes the degree to which a company is affected by exchange rate changes.
- Exposure identification and measurement are crucial for effective risk management.
- Decisions are made on how to minimize negative impacts of exposure.
Managing Exposures
- Three types of exposure exist: Transaction, Operating, and Accounting.
- Transaction exposure involves the sensitivity of a firm to contractually-bound future foreign-currency cash flows.
- Operating exposure measures the extent to which ER fluctuations can alter future operating cash flows.
- Translation exposure arises from converting foreign operation financial statements into a home currency.
Outline: Transaction Exposure
- Managing transaction exposure involves:
- Identifying transaction exposure levels.
- Explaining hedging techniques commonly used.
- Evaluating advantages and disadvantages of hedging techniques employed.
- Exploring alternative methods for reducing ER risk when hedging tools aren't feasible.
Transaction Exposure
- Transaction exposure exists when upcoming cash transactions (receivables & payables) are affected by exchange rate fluctuations.
- Three tasks are necessary when transaction exposure exists:
- Identifying the degree of transaction exposure.
- Deciding whether to hedge the exposure.
- Choosing among available hedging techniques.
Identifying Net Transaction Exposure
- Centralized vs. Decentralized Approach:
- Centralized approach consolidates subsidiary reports to identify overall MNC net positions in different foreign currencies.
- Decentralized approach may be applied by a firm headquartered at HQ to track cash flows, and make hedging decisions.
- Firms aiming to reduce transaction exposure may price exports in the same currency as imports.
Techniques to Eliminate Transaction Exposure
- Hedging involves counteracting the risk of exposure by using tools such as:
- Futures hedge
- Forward hedge
- Money market hedge
- Currency option hedge
- MNCs compare these hedging techniques' potential cash flows before selecting the most appropriate one.
Futures Contracts Infrastructure
- Chicago Mercantile Exchange (CME) is a dominant currency speculation trading hub, with contracts similar to commodities.
- Other important outlets include London Financial Futures Exchange (LIFFE), New York Mercantile Exchange, Singapore International Monetary Exchange, others.
Forward Hedge
- Forward contracts lock in future exchange rates instead of relying on futures contracts.
- Forward contracts serve for large transactions, while futures are for standardized, smaller ones.
- Companies, like DuPont, often use large amounts, covering open currency positions.
Forward Hedge Example
- A company (XYZ Inc.) receiving $1 million payment after six months, sells a $1 million forward contract to hedge.
- Spot price & 6-month forward rate are used to determine the equivalent Euro amount receivable.
Money Market Hedge
- Money market hedging involves utilizing money market instruments to cover transaction exposures.
- Two positions are often necessary:
- Payables: Borrow in home currency, invest in foreign currency.
- Receivables: Borrow in foreign currency, invest in home currency.
- Firms with excess cash may not require borrowing when hedging payables; likewise, firms needing cash may not invest when hedging receivables.
Interest Rate Parity (IRP)
- When IRP holds (and transaction costs negate), money market is equivalent to a forward hedge- providing equivalent results.
- This results from forward premium reflection of interest rate differentials between involved currencies.
Techniques to Eliminate Transaction Exposure (Currency Options)
- Currency options (call/put) hedge transaction exposure by not requiring exercise.
- Options protect against adverse exchange movements while potentially benefitting from favorable ones.
- Premium paid for options must justify the expected benefits.
Currency Option Example
- ABC Inc., with 90-day £100,000 payables, can use a call option with an $1.40/£ exercise price and $0.04/unit premium.
- Different scenarios (spot rates) illustrate how the option impacts potential loss/gain.
Techniques to Eliminate Transaction Exposure (Summary)
- Tables summarizing different hedging techniques (futures, forwards, money market, currency options).
Alternative Hedging Techniques
- Leading and Lagging (internal technique):
- Leading involves expediting payments, while lagging defers them.
- Both methods aim to mitigate currency fluctuations by adjusting payment timing.
- Cross-hedging involves using a highly correlated currency to hedge against the risk on another.
- Currency diversification involves venturing into various currency dealings, with low or neutral correlation between currencies.
Non-Traditional Hedging Techniques
- Currency straddle: Long call and long put options on the same currency, same strike/expiration date.
- Strangle: Same as straddle with different strike prices.
- Bull spread: Options strategy maximizing gains if underlying asset's price rises.
- Bear spread: Options strategy maximizing gains if underlying asset's price declines.
Impact of Hedging Transaction Exposure
- Hedging decisions affect MNC enterprise value, using a complex formula considering expected cash flows and exchange rates, along with the weighted average cost of capital.
Limitations of Hedging
- Over-hedging can result if an international firm's foreign currency transactions are uncertain in amount.
- Hedging repeated transactions can reduce long-term effectiveness.
- Hedging frequently correlates with spot rates and periods, impacting currency exchanges in strong fluctuation cycles.
Hedging Long-Term Transaction Exposure
- Long-term forward contracts (with long maturities) are options for creditworthy customers.
- Currency swaps involve two parties exchanging currencies over time with agreed exchange rates and dates.
- Parallel/back-to-back loans involve currency exchanges between two parties, with a promise for re-exchange at a specified future date.
Real Cost of Hedging
- Formula for hedging payables/receivables, comparing hedging vs. no-hedging costs while considering future spot rates, including probabilities.
- MNCs typically use hedging when the real cost of hedging is favorable.
Impact of Hedging (Summary and Conclusion)
- Over-hedging risk mitigation is a factor firms take into consideration.
- Comparison of hedging costs and results to other hedging techniques as part of MNC's strategy.
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Description
Test your knowledge on exchange rate risk management, focusing on transaction exposure and its impact on firms. This quiz covers strategies for mitigating risks associated with currency fluctuations and the types of exposure that exist in a business context. Understand how companies can better manage their operations amidst volatile exchange rates.
