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Money Market Hedge

International Finance

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muhammad atif
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20 views1 page

Money Market Hedge

International Finance

Uploaded by

muhammad atif
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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202 PA RT T H R E E FOREIGN EXCHANGE EXPOSURE AND MANAGEMENT

But forward hedging eliminates exchange exposure. In other words, the firm can elimi-
nate foreign exchange exposure without sacrificing any expected dollar proceeds from
the foreign sale. Under this scenario the firm would be inclined to hedge as long as it is
averse to risk. Note that this scenario becomes valid when the forward exchange rate is
an unbiased predictor of the future spot rate.1
Under the second scenario, where the firm’s expected future spot exchange rate is
less than the forward rate, the firm expects a positive gain from forward hedging. Since
the firm expects to increase the dollar proceeds while eliminating exchange exposure,
it would be even more inclined to hedge under this scenario than under the first sce-
nario. The second scenario, however, implies that the firm’s management dissents
from the market’s consensus forecast of the future spot exchange rate as reflected in
the forward rate.
Under the third scenario, on the other hand, where the firm’s expected future spot
exchange rate is more than the forward rate, the firm can eliminate exchange exposure
via the forward contract only at the cost of reduced expected dollar proceeds from the
foreign sale. Thus, the firm would be less inclined to hedge under this scenario, other
things being equal. Despite lower expected dollar proceeds, however, the firm may still
end up hedging. Whether the firm actually hedges or not depends on the degree of risk
aversion; the more risk averse the firm is, the more likely it is to hedge. From the per-
spective of a hedging firm, the reduction in the expected dollar proceeds can be viewed
implicitly as an “insurance premium” paid for avoiding the hazard of exchange risk.
The firm can use a currency futures contract, rather than a forward contract, to
hedge. However, a futures contract is not as suitable as a forward contract for hedg-
ing purpose for two reasons. First, unlike forward contracts that are tailor-made to the
firm’s specific needs, futures contracts are standardized instruments in terms of con-
tract size, delivery date, and so forth. In most cases, therefore, the firm can only hedge
approximately. Second, due to the marking-to-market property, there are interim cash
flows prior to the maturity date of the futures contract that may have to be invested at
uncertain interest rates. As a result, exact hedging again would be difficult.

Money Market Hedge


Transaction exposure can also be hedged by lending and borrowing in the domestic
and foreign money markets. Generally speaking, the firm may borrow (lend) in foreign
currency to hedge its foreign currency receivables (payables), thereby matching its
assets and liabilities in the same currency. Again using the same example presented
above, Boeing can eliminate the exchange exposure arising from the British sale by
first borrowing in pounds, then converting the loan proceeds into dollars, which then
can be invested at the dollar interest rate. On the maturity date of the loan, Boeing is
going to use the pound receivable to pay off the pound loan. If Boeing borrows a par-
ticular pound amount so that the maturity value of this loan becomes exactly equal to
the pound receivable from the British sale, Boeing’s net pound exposure is reduced to
zero, and Boeing will receive the future maturity value of the dollar investment.
The first important step in money market hedging is to determine the amount of
pounds to borrow. Since the maturity value of borrowing should be the same as the
pound receivable, the amount to borrow can be computed as the discounted present
value of the pound receivable, that is, £10 million/(1.09) 5 £9,174,312. When Boeing
borrows £9,174,312, it then has to repay £10 million in one year, which is equivalent

1
As mentioned in Chapter 6, the forward exchange rate will be an unbiased predictor of the future spot rate if
the exchange market is informationally efficient and the risk premium is not significant. Empirical evidence
indicates that the risk premium, if it exists, is generally not very significant. Unless the firm has private
information that is not reflected in the forward rate, it would have no reason for disagreeing with the
forward rate.

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