Page 165 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes Companies generally accelerate the payments of hard currency payables and delay the payments
of soft currency payables so as to reduce foreign exchange exposure. Thus, companies use the
lead/lag strategy to reduce transaction exposure by paying or collecting foreign finance
obligations early (lead) or late (lag) depending on whether the currency is hard or soft. The act
of leading and lagging reflects the expectations about the future currency movements by the
MNCs.

10.1.2 External Hedging Strategies
These strategies can be understood in the following manner:

Currency Futures
A currency future is the price of a particular currency for settlement at a specified future date.
Currency futures are traded on future exchanges and the exchanges where the contracts are
fungible (or transferable freely) are very popular. The two most popular future exchanges are
the Singapore International Monetary Exchange (SIMEX) and the International Money Market,
Chicago (IMM). Other exchanges are in London, Sydney, Frankfurt, New York, Philadelphia,
etc.
Futures contracts are traded on an exchange through brokers. The contracts are standardised
with respect to the quality and quantity of the underlying asset, the expiration date and where
and how delivery is made. Futures are rarely closed with the delivery of the underlying asset –
buyers and sellers usually prefer to close their contract by reversing their positions on the
market. In other words, buyers of a futures contract sell another futures contract with the same
characteristics, while sellers of a futures contract buy another futures contract which has the
same characteristics. By reversing their positions, buyers or sellers close their positions. Any
gain or loss obtained from closing the futures contract is used to offset losses or gains on the
actual market.

Currency Forwards

A Forward contract is a negotiated agreement between two parties. They are tailor-made contracts
that are not traded on organised exchanges and are useful to cover forward receivables and
payables where the exact date of such transactions is not fixed or known. Forwards do not
require an initial payment when signing the contract (except for a minor administrative fee, if
the other party is a financial institution) and are generally closed with the delivery and payment
of the underlying asset.

Options

Options are basically derivative instruments that derive their values from the underlying
instrument that they represent. There are two types of options: call options and put options. A
call option gives the buyer the right, but not the duty, to purchase an underlying asset, reference
rate or index at a particular price before a specified date. A put option gives the buyer the ability,
but not the obligation, to sell an underlying asset, reference rate, or index at a particular price to
a specified date.
Options trade both in organised exchanges and over-the counter and a large amount of option
trading is conducted privately between two parties who find that contracting with each other is
preferable. They can be standardised or tailor-made. Options could be of two types – European
and American style. American style option is one which can be exercised by the buyer on or
before the expiration date. The European kind of option is one which can be exercised by the
buyer on the expiration day only and not anytime before that.

160 LOVELY PROFESSIONAL UNIVERSITY