European options can only be exercised on the expiration date while American options can be exercised at any time up to and including the expiration date.Chapter 8 –•Three main types of currency exposures: Transaction, economic, and translation.Transaction Exposure:Defined as the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Also regarded as Short-term economic exposure. Arises from fixed-price contracting in a world where exchange rates are changing normally. (PG 198 and ex on PG 199)Economic exposure:Defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Anticipating changes in exchange rates that would have been already discounted and reflect in the firms value. (PG 198)Translation exposure:The potential that the firm’s consolidated financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries financial statements from local currencies to the home currency. (PG 198 EX on PG 198)• Ways of hedging transaction exposure with financial products: forward market hedge, money market hedge, option market hedge.Forward Market Hedge: Used as a way of hedging transaction exposure. The may sell (buy) its foreign currency receivables (payables) forward to eliminate it exchange risk exposure.
(Example on PG 200) EX for buyers(import): If you expect to owe foreign currency in the future, you can hedge by agreeing today to buy the foreign currency in the future at a set price by entering into a long position in a forward contract. EX for seller(export): If you are going to receive foreign currency in the future, agree to sell the foreign currency in the future at a set price by entering into short position in a forward contract. To figure out the gain or losses from Forward hedging: Gain = (Forward exchange rate – spot rate on maturity date) x Amount receivable Money Market Hedge: With this method we can hedge funds by lending and borrowing in the domestic foreign money markets. Firms may borrow in foreign currency to hedge it foreign currency receivables (payables), thereby matching it assets and liabilities in the same currency. (Example on Page 202 -203) Steps to Hedge using Money Market: 1 Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable. 2 Convert the foreign currency into domestic currency at the spot exchange rate. 3 Invest the domestic currency on deposit. 4 Collect the currency receivable and, repay the foreign currency loan. 5 Receive the maturity value of the investment, which would guarantee the proceeds. Option market hedge: Currency options provide such a flexible “optional” hedge against exchange exposure. Generally speaking, the firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables). The options hedge allows the firm to
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