Lecture_07_2007

Lecture_07_2007 - International Finance FINA 5331 Lecture 7...

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International Finance FINA 5331 Lecture 7: Hedging Foreign Exchange Risk William J. Crowder Ph.D.
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Simple Hedging Strategies Activity to Hedge Strategy Payable in domestic currency Nothing, no FX risk. Payable in foreign currency Accelerate payment if foreign currency expected to appreciate. Delay payment if foreign currency expected to depreciate. Receivable in domestic currency No FX risk. Receivable in foreign currency Accelerate payment if foreign currency expected to depreciate. Delay payment if foreign currency expected to appreciate.
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A Little More Sophisticated Hedging Strategies Activity to Hedge Strategy Payable in domestic currency Nothing, no FX risk. Payable in foreign currency Borrow at the domestic interest rate i and convert the proceeds to foreign currency. Lend at the foreign interest rate i * . When payable comes due, sell foreign asset and make payable. Use domestic currency reserved for payable to pay off loan. Receivable in domestic currency No FX risk. Receivable in foreign currency Borrow amount of receivable at the foreign interest rate i * and convert the proceeds to domestic currency. When receivable is paid, use foreign currency to pay off loan.
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Hedging FX Risk Hedging will reduce or eliminate risk. But it will also eliminate profitable FX movements. Example – If you have a payable due in foreign currency in 90 days, a domestic depreciation will increase your domestic currency costs. But if the domestic currency appreciates over the 90 day period, your costs fall!
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Hedging FX Risk Q - So why hedge? If hedging eliminates potential FX gains, why do it? A - Are you in business to sell widgets or are you a FX market speculator? By not hedging FX risk, you are playing a risky game in a business that might not be your expertise. Stick to what you know best. Leave the FX speculation to the dealers and traders.
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Forward Contracts A forward exchange rate is the price of a money to be delivered at a future date Forward contracts are established between a bank and a customer and specify amount and date as well as the exchange rate A forward premium exists when the forward price > spot price a forward discount exists when the forward price < spot price Premiums and discounts may be quoted at annual rates to be comparable to interest rates Suppose the 90 day forward rate on the ¥/$ = 98, the current spot rate = 100 Is the dollar selling at a premium or discount? What is the discount or premium in percent per annum? FP = ((F-S)/S)(360/n) ((98-100)/100)(4) = (.02)(4) = .08 or 8% per annum
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Forward Contracts It is important to remember that no money exchanges hands until the forward contract matures. How does the seller of the forward (usually a bank) ensure reciprocal payment from contract counterparty?
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Futures Contracts: Preliminaries A futures contract is like a forward contract: It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today.
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Lecture_07_2007 - International Finance FINA 5331 Lecture 7...

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