International Financial Management

P G Apte
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 Introduction
• Management of transactions exposure
• Hedging will be understood to mean a transaction
undertaken specifically to offset some exposure arising out
of the firm's usual operations
• Speculation will refer to deliberate creation of a position
for the express purpose of generating a profit from
exchange rate fluctuations, accepting the added risk
• Management of transactions exposure has two
significant dimensions
– The treasurer must decide whether and to what extent
an exposure should be explicitly hedged
– The treasurer must evaluate alternative hedging
strategies

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Hedging Transactions Exposure with
Forward Contracts
• The net exposure in a given currency at a given date is the
difference between the total inflows and total outflows to
be settled on that date
• The cost of a Forward Hedge
– Common fallacy to claim that the cost of forward
hedging is the forward discount or premium
– The forward hedge must be compared not with today's
spot rate but the ex-ante value of the payable if the firm
does not hedge
– The relevant comparison is between the forward rate
and the expected spot rate on the day the transaction is
to be settled

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Hedging Transactions Exposure with
Forward Contracts
– If speculators are risk neutral and there are no
transaction costs, . the forward rate at time t for
transactions maturing at T equals the expectation at
time t, of the spot rate at time T
Ft,T = Set,T
– If the speculators in the foreign exchange market are
not risk neutral
Ft,T > Set,T or Ft,T < Set,T
– Even in the case when speculators are not risk neutral
the expected cost of hedging with forwards is zero
except for the fact that bid/offer spreads are somewhat
wider in forwards than in spot
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 Hedging Transactions Exposure with
Forward Contracts
• Choice of Invoice Currency
– Choice of invoice currency has important implications
for operating exposure of the exporter/importer but the
foreign exchange risk component of it is relatively
unimportant provided both parties have access to well
functioning, liquid forward markets
– The choice of currency of invoicing is often dictated by
marketing considerations and exchange control factors
– Any gains from the choice of currency of invoicing
made by one party are always at the expense of the
other party

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 Hedging Transactions Exposure with
Forward Contracts
• Exposures with uncertain timing
– The timing of the exposure may be uncertain
though the amount is known with certainty
– Option forwards are generally an expensive
device to deal with exposures with uncertain
timing and using swaps may turn out to be
cheaper
– Book a fixed date contract, roll it over with a
swap if exposure is extended.

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Exposures Maturing at Different Dates
• A firm has exposures in a particular foreign currency
maturing at different dates. Some are inflows some outflows.
On some dates there are both inflows and outflows.
• The firm can hedge the net exposure at each date with a
separate forward contract.
• Can all the exposures be hedged with a single forward
contract?
• It can be done provided either that interest rates for all future
periods are known with certainty or contracts known as
Forward Rate Agreements (FRA) are available in the currency
of exposure.

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 Hedging with the Money Market
• Close connection between Eurodeposit markets and
forward exchange premiums and discounts on account of
covered interest arbitrage
• Firms which have access to international money markets
for short-term borrowing as well as investment, can use the
money market for hedging transactions exposure
• To hedge receivable – Borrow FC, convert spot to HC,
repay FC loan with receivable.
• To hedge payable - Borrow HC, convert spot to FC,
deposit, use deposit to settle payable, repay HC loan

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Hedging with Money Market : An Example
Suppose a Swiss firm has a 90-day USD payable of USD
10,000,000. It has access to Eurodeposit markets in CHF as well
as USD. To cover this exposure it can execute the following
sequence of transactions :
1. Borrow CHF in the Zurich money market for 90 days.
2. Convert spot to USD
3. Deposit USD in a bank earning interest for 90 days
4. Use the maturing deposit to settle payable; repay CHF loan
If CIP holds will this be any different from forward cover?

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Hedging with Money Market : An Example
Suppose
USD/CHF Spot: 1.5650/55 90-day forward: 1.5435/60
CHF interest rates : 2.50/2.60 Euro$ interest rates : 8.00/8.20
These rates do not imply a covered interest arbitrage opportunity.
Let us compare forward cover against the money market cover.
With forward cover, each USD bought will lead to an outflow of
CHF 1.5460, 90 days later.
To have USD 1.0 90 days later, deposit USD(1.0/1.02) today.
= USD 0.9804

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Hedging with Money Market : An Example
To To cover using the money market, for each EUR of
receivable,
Bor borrow EUR 1/[1+(0.055/4)]
= EUR 0.9864. Sell this spot to get USD(0.9864×0.9062)
= USD 0.8939.
Pay off the EUR loan when the receivable matures.
Thus with money market cover, there is a net gain of USD 0.0008
per EUR of receivable or USD 8000 for the 10 million Euro
receivable.

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 Hedging with the Money Market
• Absence of covered interest arbitrage opportunities does
not necessarily imply that forward cover and money
market cover would be equivalent if the firm has access to
interest rates other than Euromarket rates which govern
spot-forward margins
• Sometimes the money market hedge may turn out to be the
more economical alternative because of some constraints
imposed by governments e.g. not allowing non-residents to
invest in home money markets or forcing resident firms to
borrow HC only in home money markets etc. These create
a wedge between home money market rates and
Euromarket rates for the same currency.
• Cost saving opportunities do arise from time to time. Must
be examined before deciding on a hedging device
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 Hedging with Currency Options
• Currency options provide a more flexible means to cover
transactions exposure
• Options are particularly useful for hedging contingent
exposures e.g. bidding for foreign contracts -Foreign
exchange inflows/outflows will materialize only if the bid
is successful
• Foreign currency receivables with substantial default risk
or political risk
• Risky portfolio investment e.g. foreign equities portfolio
• Options permit limited risk speculation

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Hedging with Currency Options
A US firm has a 90 day EUR 1m payable
Spot EUR/USD : 0.8950 90-day Fwd: 0.8725
A 90-day European call on EUR ATMF (At-the-Money-
Forward) : $0.03.
Outflow at 90 days:
Open position: $(S90) m
Forward : $0.8725m
Option: If S90 > 0.8725: $(0.8725+0.03)m

If S90 ≤ 0.8725: $(S90+0.03)m

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 Hedging with Currency Options
Open Position Option
Outflow
($ Mill)
Forward

0.8425 0.8725 0.9025 S90

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 Hedging with CurrencyFutures
• Hedging with currency futures
– Hedging contractual foreign currency flows with
currency futures is in many respects similar to hedging
with forward contracts
– A futures hedge differs from a forward hedge because
of the intrinsic features of futures contracts
• Since amounts and delivery dates for futures are
standardized, a perfect futures hedge is generally not
possible
• Basis risk - imperfect correlation between spot and
futures prices
• Futures unlike forwards, give rise to intermediate
cash flows due to the marking-to-market feature

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 Hedging with Currency Futures

– The advantage of futures over forwards is

firstly easier access and secondly greater
liquidity
– Currency futures are used by commercial banks
to hedge positions taken in the forward markets
– Most corporations use OTC forwards to hedge
transactions exposures arising out of operations
– Chapter 9 contains examples of hedging with
futures

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 Internal Hedging Strategies
• Some of the commonly used or recommended
methods
– Invoicing : A firm may be able to shift the
entire exchange risk to the other party by
invoicing its exports in its home currency and
insisting that its imports too be invoiced in its
home currency
• Trade between developed countries in
manufactured products is generally invoiced
in the exporter's currency

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Internal Hedging Strategies

• Trade in primary products and capital assets is

generally invoiced in a major vehicle currency such
as the US dollar
• Trade between a developed and a less developed
country tends to be invoiced in the developed
country's currency
• If a country has a higher and more volatile inflation
rate than its trading partners, there is a tendency not
to use that country's currency in trade invoicing
• Another hedging tool in this context is the use of
"currency cocktails" for invoicing
• Still another possibility is risk sharing

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 Internal Hedging Strategies
Risk Sharing via a Price Adjustment Clause
A French firm has imported computers fro a US supplier.
Invoice is for EUR 10m. If at settlement EUR/USD is between
0.87 and 0.89, French firm pays USD equivalent of EUR 10m
at a rate of USD 0.88 per EUR.
If rate falls to say 0.83, the two parties share the loss (to US
firm) 50-50: French firm pays USD equivalent of EUR 10m
using a rate of USD 0.86 per USD. [0.88- 0.5(0.87-0.83)]
If rate rises to say 0.97 again the gain to US firm is shared 50-
50. French firm pays USD equivalent of EUR 10m using a
rate of USD 0.92 per EUR [0.88+0.5(0.97-0.89)]
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 Internal Hedging Strategies
– Netting and Offsetting: A firm with receivables
and payables in diverse currencies can net out
its exposure in each currency by matching
receivables with payables
• Netting also assumes importance in the context of
cash management in a multinational corporation
with a number of subsidiaries and extensive intra-
company transactions
• To be able to use netting effectively, the company
must have continuously updated information on
inter-subsidiary payments position as well as
payables and receivables to outsiders

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Internal Hedging Strategies
• Some countries impose restrictions on netting as
part of their exchange control regulations
• Leading and Lagging: The general rule is lead i.e.
advance payables and lag i.e. postpone receivables
in "strong" currencies and, conversely, lead
receivables and lag payables in weak currencies
• Leading and Lagging involve trading off interest
rate differentials against expected currency
appreciation or depreciation – leading a payable has
interest savings (demand discount for early
payment); lagging has interest cost (Supplier will
include interest cost in the invoice). Reverse for
receivables.
• Compare interest gain/cost against forward
premia/discounts
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Internal Hedging Strategies
• The use of leads and lags must be evaluated in the
overall framework of financing and exposure
management.
• Leading/Lagging may interfere with cash
management, customer relations and effective use of
credit lines for some subsidiaries
• This consideration must be kept in mind when
evaluating the performance of the local
management. It may also adversely affect the
interests of local minority shareholders
• There may also be some legal constraints in free use
of leading and lagging as exposure management
devices since it may put pressure on a currency
which is already under attack.
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 Internal Hedging Strategies
• Leads and lags in combination with netting form an
important cash management strategy for multinationals
with extensive intra-company payments
•Typical hedging situation and the dilemmas facing the
decision maker :
- Should the exposure be hedged? Fully or partially?
- What is the optimum hedge?
- What will be the performance benchmark?
- How will it affect margins? Cashflows?
•Importance of having a clearly articulated risk policy
cannot be overemphasized

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 Speculation in Foreign Exchange and
Money Markets

• Speculation in contrast to hedging involves deliberately

creating positions in order to profit from exchange rate
and/or interest rate movements
• Outright speculation in foreign exchange markets a high-
risk activity
• The risk of an open position depends upon the covariance
of exchange rate with other assets in the speculator's
portfolio
• Not hedging a transactions exposure can also be seen as
speculation.

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