Page 164 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 10: Management of Operating/Economic Exposure

10.1 Foreign Currency Hedging Strategies Notes

There are several financial strategies which can be used to minimise exchange risks. An MNC
can hedge its foreign exchange exposure in a number of ways. One method involves the interbank
market which offers spot and forward transactions. These contracts specify the purchases and
sale of currencies at a certain price, either for immediate or future delivery. If the company
wants a standardised contract, it may choose to buy (sell) either a futures contract or an options
contract. The standardisation feature provides market liquidity, making it easy to enter and exit
the market at any time.

Notes For an MNC with a network of subsidiaries, subsidiaries with strong currencies
should delay or lag the remittances of dividends, royalties and fees to other subsidiaries.
Those in weak currency countries should try to lead, or promptly pay their liabilities and
reduce their asset exposure.

Foreign currency hedging is a risk reducing strategy. Like all hedging strategies, it involves
taking two offsetting, opposite positions, in two different parallel markets. In general the firm
can choose between internal and external hedges. Internal hedges include leading and lagging
of payments and foreign currency accounts while external hedges include derivatives such as
forwards, futures, options and swaps. Forward FX contracts (FEC) are the simplest of the external
hedges and the most used. The popularity may be partly explained by their simplicity of use,
over the counter trading that permits exact specifications regarding dates and amounts and
minimal explicit cost.

10.1.1 Internal Hedging Strategies

Internal hedging strategies are described below:

Netting

Netting is a technique of optimizing cash flow movements with the joint efforts of subsidiaries.
The process involves the reduction of administration and transaction costs that result from
currency conversion. Netting, as a technique of optimizing cash flows, has become important in
the context of a highly coordinated international interchange of materials, parts and finished
products among the various units of the MNC with many affiliates both buying from and
selling to each other. The important point here is that there is a definite cost associated with
cross-border fund transfer, including the cost of purchasing and conversion of foreign exchange.
Netting helps in minimising the total volume of intercompany fund flow.

Leading and Lagging

It is a technique that manipulates accounts receivable and accounts payable to take advantage of
exchange rate fluctuations. This is a speculative technique and the rule is to lead out of and lag
into the weak currency, and lead into and lag out of the strong currency.

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Caution MNCs can accelerate (lead) or delay (lag) the timing of foreign currency payments
by modifying the credit terms extended by one unit to another. Leading and lagging is
adopted by MNCs in order to reduce foreign exchange exposure or to increase available
working capital.

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