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Chapter_13 - Chapter Outline Forward Market Hedge Money...

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Chapter Outline Forward Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts
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Chapter Outline (continued) Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use?
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Forward Market Hedge If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.
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You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year. Question: How can you fix the cash outflow in dollars? Forward Market Hedge: an Example Answer: One way is to put yourself in a position that delivers £100M in one year— a long forward contract on the pound .
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Forward Market Hedge $1.50/£ Value of £1 in $ in one year Suppose the forward exchange rate is $1.50/£. If he does not hedge the £100m payable, in one year his gain (loss) on the unhedged position is shown in green. $0 $1.20/£ $1.80/£ –$30 m $30 m Unhedged payable The importer will be better off if the pound depreciates: he still buys £100 m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/£ But he will be worse off if the pound appreciates.
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Forward Market Hedge $1.50/£ Value of £1 in $ in one year $1.80/£ If he agrees to buy £100m in one year at $1.50/£ his gain (loss) on the forward are shown in blue. $0 $30 m $1.20/£ –$30 m Long forward If you agree to buy £100 million at a price of $1.50 per pound, you will lose $30 million if the price of a pound is only $1.20. If you agree to buy £100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80.
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Forward Market Hedge $1.50/£ Value of £1 in $ in one year $1.80/£ The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. $0 $30 m $1.20/£ –$30 m Long forward Unhedged payable Hedged payable
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Money Market Hedge This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. It’s more efficient to buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable.
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Money Market Hedge The importer of British woolens can hedge his £100 million payable with a money market hedge: 1. Borrow $112.05 million in the U.S. 2. Translate $112.05 million into pounds at the spot rate S ($/£) = $1.25/£ 3.
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