Page 175 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 2. Ways to manage Transaction Exposure:
(a) Financial contracts:
(i) Forward market hedge: The firm may sell (buy) its foreign currency
receivables (payables) forward to eliminate its exchange risk exposure

(ii) Money market hedge: By lending and borrowing in the domestic and
foreign money markets
(iii) Option market hedge: The firm may buy a foreign currency call (put)
option to hedge its foreign currency payables (receivables)
(iv) Swap market hedge: As the cash flows are recurrent in a foreign currency
can be hedged using a currency swap contract, which is an agreement to
exchange one currency for another at a predetermined exchange rate,
that is, the swap rate, on a sequence of future dates.

(b) Operational techniques:
(i) Choice of the invoice currency: The firm can shift, share, or diversify
exchange risk by appropriately choosing the currency of invoice
(ii) Lead/lag Strategy: Leading and lagging foreign currency receipts and
payments. To “lead” means to pay or collect early and to “lag” means to
pay or collect late.
Reducing Economic Exposure
1. Economic exposure is the sensitivity of the future home currency value of the
Marigold’s assets and liabilities and the firm’s operating cash flow to random changes
in exchange rates.
2. Ways to manage Economic Exposure:
(a) Diversification to other markets
(b) Shifting sources of cost/revenue to other markets
(c) Restructuring operations to balance its exchange rate sensitive cash flows
4. Two US-based Companies – Pitunia Co. and RoseMary Flower, Inc., are U.S.-based MNCs
with subsidiaries in Europe that distribute Plants and Flowers (produced in the United
States) to customers throughout Latin America. Both subsidiaries purchase the products at
cost and sell the products at 120 percent mark-up. The other operating costs of the
subsidiaries are very low. Pitunia Co. has a growing and designing centre in the United
States that focuses on improving its technology. RoseMary Flower, Inc., has a similar
centre based in Europe. The parent of each firm subsidizes its respective growing and
designing centre on an annual basis. Are the two firms subject to economic exposure?
Explain which firm is subject to a higher degree of economic exposure?
Solution:
Yes, both firms are subject to economic exposure as the present value of their future cash
flows stands to be impacted by exchange rate fluctuations.
However RoseMary Flower has a relatively higher degree of economic exposure it has
great amount of assets sitting in foreign locations. Hence there is a greater chance of
fluctuating cash flows for it in future as compared to Pitunia.
5. Funky Colors Company has net receivables of 450,000 Australian dollars in 90 days. The
spot rate of the AU$ is $.961, and the Australian interest rate is 2.5 percent over 90 days.
How do you think the Australian firm could implement a money market hedge?

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