Page 166 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 10: Management of Operating/Economic Exposure

Options are different from forwards and futures in that they give their holder the right – and not Notes
the obligation – to buy or sell the underlying instrument. This right or privilege conveys to the
buyer an advantage over the seller, since the buyer decides whether to exercise the option or
not. The seller must either sell the underlying instrument at the striking price if he or she has
sold a call option, or buy the underlying instrument at the striking price if he or she has sold a
put option. The buyer will pay a premium to the seller for the privilege.
If a business plans to purchase an asset and expects the price to increase, then he or she can use
buying a call option to hedge against an increase in the price of the underlying asset, without
losing the advantages of a price decline. If the price was to decline, the buyer would simply not
exercise the option; he or she would then trade the underlying asset at the cash market price. In
contrast, buying a put option can be used to hedge against a reduction in price in the underlying
asset without losing the advantage of a price increase.

Swap

A swap is a contract between two counterparties to exchange two streams of payments for an
agreed period of time. They may be of two types – currency swap and interest rate swap.

Currency Swap: It is referred to a simple swap of currencies between two firms in two countries.
A currency swap stays off the books because it does not involve interest, gains, or losses.
Interest Rate Swap: An interest rate swap is a contractual agreement entered into between two
counterparties under which each agrees to make periodic payment to the other for an agreed
period of time based upon a national amount of principal. The principal amount is notional
because there is no need to exchange actual amounts of principal in a single currency transaction:
there is no foreign exchange component to be taken account of. Equally, however, a notional
amount of principal is required in order to compute the actual cash amounts that will be
periodically exchanged.

Thus, an interest rate swap is a financial contract between two parties exchanging or swapping
a stream, of interest payments on a notional principal amount on multiple occasions during a
specified period. Such contracts generally involve the exchange of fixed-to-floating or floating-
to-floating rates of interest. Accordingly, on each payment date that occurs during the swap
period a cash payment based on the differential between fixed and floating rates, is made out by
one party involved in the contract to another.

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.

Thus a money market hedge involves taking a money market position to cover a future payables
or receivables position. For payables the two strategies could be:
1. Borrow in the home currency (optional)

2. Invest in the foreign currency

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