Page 110 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 7: Management of Transaction Exposure

In situations where funds to fulfil the contract are not available but have to be purchased in the Notes
spot market at some future date, such a hedge is considered to be “open” or “uncovered”.
It involves considerable risk as the hedger purchases foreign exchange at an uncertain future
spot rate in order to fulfil the forward contract.

7.3.2 Money Market Hedge

A Money Market Hedge involves simultaneous borrowing and lending activities in two different
currencies to lock in the home currency value of a future foreign currency cash flow. The
simultaneous borrowing and lending activities enable a company to create a home-made forward
contract.
The firm seeking the money market hedge borrows in one currency and exchanges the proceeds
for another currency. If the funds to repay the loan are generated from business operation then
the money market hedge is covered. Otherwise, if the funds to repay the loan are purchased in
the foreign exchange spot market then the money market hedge is uncovered or open.
Suppose that on January 1, GE is awarded a contract to supply turbine blades to Lufthansa, the
German airline. On December 31, GE will receive payment of DM 25 million for this contract.
Further, suppose that DM and US $ interest rates are 15% and 10% respectively. Using a money
market hedge, GE will borrow DM 25/1.15 million = DM 21.74 million for one year, convert it
into $8.7 million in the spot market (spot exchange rate is DM 1 = $0.40) and invest them for one
year. On December 31, GE will receive 1.10 × $8.7 million = $9.57 million from its dollar
investment. GE will use these dollars to pay back the 1.15 × DM 21.74 million = DM 25 million
it owes in interest and principal.

7.3.3 Options Market Hedge

In many circumstances, the firm is uncertain whether the hedged foreign currency cash inflow
or outflow will materialise. Currency options obviate this problem.
There are two kinds of options – put options and call options.
A put option gives the buyer the right, but not the obligation, to sell a specified number of
foreign currency units to the option seller at a fixed price up to the option’s expiration date.
Alternatively, a call option is the right, but not the obligation, to buy a foreign currency at a
specified price, upto the expiration date.
A call option is valuable, for example, when a firm has offered to buy a foreign asset, such as
another firm, at a fixed foreign currency price but is uncertain whether its bid will be accepted.
The general rules to follow when choosing between currency options and forward contracts for
hedging purposes are summarised as follows:

1. When the quantity of a foreign currency cash outflow is known, buy the currency forward,
when the quantity is unknown, buy a call option on the currency.
2. When the quantity of a foreign currency cash inflow is known, sell the currency forward,
when the quantity is unknown, buy a put option on the currency.
3. When the quantity of foreign currency cash flow is partially known and partially uncertain,
use a forward contract to hedge the known portion and an option to hedge the maximum
value of the uncertain remainder.

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