Page 168 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 10: Management of Operating/Economic Exposure

If funds to fulfil the forward contract are available on hand or are due to be received by the Notes
business, the hedge is considered “covered,” “perfect” or “square” because no residual foreign
exchange risk exists. Funds on hand or to be received are matched by funds to be paid.
In situations where funds to fulfil the contract are not available but have to be purchased in the
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.

Example: Assume the following information:
90 day U.S. interest rate = 4%

90 day Canada interest rate = 3%
90 day forward rate of Canadian dollar = $.400
Spot rate of Canadian dollar = $.405
Assume that Jason Co. in the United States will need 400,000 C$ in 90 days. The company wishes
to hedge this payables position. Would it be better for the company to use forward hedge or
money market hedge? Calculate estimated costs for each type of hedge.
Solution:

Money Market Hedge
Deposit 400000/1.03 = 388349 C$ into a Canadian Bank so that it amounts to 4000000 C$ in 90
days
To deposit 388349 C$, the firm has to borrow 388349 × 0.405 = USD 157281

To repay USD 157281, the firm will need 157281 × 1.04 = USD 163572 in 90 days
Forward Market Hedge
Pay out USD 400000 × 0.4 = USD 160000 in 90 days
Since the firm has to payout lesser money in a forward hedge, it should go for forward hedge.

Self Assessment

Fill in the blanks:
1. …………………… is a technique of optimising cash flow movements with the joint efforts
of subsidiaries.
2. Leading and Lagging is a technique that manipulates accounts receivable and accounts
payable to take advantage of exchange rate …………………….
3. A currency future is the price of a particular currency for settlement at a specified
…………………… date.
4. An …………………… 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.
5. Currency Swap is referred to a simple swap of …………………… between two firms in
two countries.

6. The act of leading and lagging reflects the …………………… about the future currency
movements by the MNCs.

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