Hedging Concepts

A Presentation on
Hedging as Exchange Risk

Offsetting
Too
l
PRESENTED
BY
Dr Saumya
This Session
Covers 2
● What is Hedging
● Types of Hedging
● Examples
● Comparison of Different Hedging
Techniques
2
Defining
Hedge 3
Hedge refers to an offsetting contract made

in order to insulate the home currency value
of receivables or payables denominated in
foreign currency.
Objective of hedging is to offset

exchange risk arising from
transaction exposure.
3
Types of
Hedging4
1. Forward Market Hedges: use forward

contracts to offset exchange rate
exposure
2.Money Market Hedges: use borrowing and
lending in the money markets
3.Hedging with Swaps: use combination of
forward and money market instruments
4. Hedging with Foreign Currency Futures:
5.Hedging with Foreign Currency Options:
4
Forward Market Hedges:
Objective: To nullify future spot
rate 5
2 Situations:
1. Expected Inflows of Foreign Currency:
Make forward contracts to sell the foreign
currency at a specified rate to insulate
against depreciation of value of that foreign
currency (in terms of home currency).
2. Expected Outflows of Foreign Currency:
Make forward contracts to buy the foreign
currency at a specified rate to insulate
against appreciation of value of the
currency (in terms of home currency).
5
Exampl
es 6
1.A US firm is expected to receive 200,000
UK pound in 60 days from a UK buyer. UK
pound may depreciate against US $ in 60
days.
What to Do for offsetting the risk of receiving less

amount of US $?
2.A US firm will have to pay 400,000 Euros

in 30 days to a German seller. Euro may
appreciate against US $ in 30 days.
What to do for offsetting the risk of spending
more US $?
6
Money Market
Objective: borrow/lend
Hedgesto lock in home currency
value of cash flo7
w
1. Expected Inflow of Foreign

Currency:
● Borrow present value of the foreign currency
at a fixed interest and convert it into home
● currency
● Deposit the home currency at a fixed interest
rate
When the foreign currency is received, use it to
pay off the foreign currency loan
7
Money Market
(Continued)
Hedges 8
2. Expected Outflow of Foreign
Currency:
Determine PV of the foreign currency to be paid
(using foreign currency interest rate as the
discount rate).
Borrow equivalent amount of home currency
(considering spot exchange rate)
Convert the home currency into PV equivalent
of the foreign currency (in the spot market
now) and make a foreign currency deposit
On payment day, withdraw the foreign currency
deposit (which by the time equals the payable
amount) and make payment.
8
Exampl
e 9
A US firm is expected to pay A$300,000 to an
Australian supplier 3 months from now. A$ interest
rate is 12% and US$ interest rate is 8%. Spot rate is
0.60A$/US$.
PV of A$: 300,000/(1+.12/4) = A$291,262.14

Borrow (291,262.14X0.60) US$174,757.28 and
convert it to A$291,262.14 at spot rate (0.60/US$)
Use the A$ to make an A$ deposit which will grow
🞆 to
PayA$300,000 in 3 months. Pay
{174,757.28X(1+0.8/4)} this A$300,000
US$178,252.43 on
with
due datefor settling the US$ loan.
interest
9
Money Market
Conditions for Use
Hedge 10
● Firms have access to money market for

different currencies
● The dates of expected future cash flows and
money market transaction maturity match
● Offshore
currency deposits or
Eurocurrency
deposits are main money market hedge
instruments
10
Compariso
Forwardn:
and Money Market
Hedge
● The covered interest 11
parity implies that a
firm cannot be better off using money
market hedge compared to forward
● hedge.
In reality, firms find use of forward
contracts more profitable than use of
money market instruments; because
firms:
A) Borrow at a rate> inter-bank offshore
lending rate
B) Put deposits at a rate< inter-bank offshore
deposit rate.
11
Hedge using
● Swap refers to exchange of an1a2 greed amount of a
Swaps
currency for another currency at a specific future
date. This is equivalent to currency forward contract
in a sophisticated way.
● For example: a US firm has receivable in Euro from

a Belgian buyer; so it is looking for euro
denominated liability to hedge the receivable.
On the other hand, a Belgian firm exports to USA and
has US$ denominated receivable; it needs US$
liability to hedge receivables in US$.
The two firms can agree that:
12
Swaps
● US firm borrows (say(Continued)
$100,000)
1
at 11%
● Belgian firm borrows($100,000/E0.6
3 per $) 166,667
euros at 10%
● US firm receives euros from buyer and give it to
the Belgian firm so that it (Belgian) can repay euro
denominated loan.
● The Belgian firm receives US$ from buyer and give it
to the US firm so that it (US firm) can repay US$
denominated loan.in current spot rate for future
Both firms lock
payments by swapping receivables.
13
1
4
THANK
YOU
14

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A Presentation on

Hedging as Exchange Risk

Hedge refers to an offsetting contract made

Objective of hedging is to offset

1. Forward Market Hedges: use forward

What to Do for offsetting the risk of receiving less

2.A US firm will have to pay 400,000 Euros

1. Expected Inflow of Foreign

PV of A$: 300,000/(1+.12/4) = A$291,262.14

● Firms have access to money market for

● For example: a US firm has receivable in Euro from

The two firms can agree that:

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