To see why suppose that you do no netting at all then

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To see why, suppose that you do no netting at all. Then, you must sell DM 100,000 30-day forward and buy DM 140,000 30-day forward to hedge your exchange risk. Now suppose that your debtor defaults on 03-16, i.e., you don't get the DM 100,000 cash-in that was due to your
company. Since you had sold forward DM 100,000, you must deliver them. To do so, you must go and buy them on the spot market, where you will face a spot rate which can be anything. On the other hand, suppose that you had netted out the cash-ins and cash-outs, and hedged the remainder, i.e., bought only DM 40,000 forward. If your debtor defaults, then in this case on 03- 15 you do not have the DM 100,000 that you were hoping to use to pay your creditor. Hence, you must get them on the spot market, at a rate that again can be anything. Put differently, regardless of your netting, you face the same risk when you use forward or futures. The bottom line of the previous paragraph is that the only cost-effective way to eliminate all foreign-exchange risk here is to use options for the hedging of cash-ins, and buying forward or futures contracts for the hedging of cash-outs. If your company thinks its debtors are safe credit risks, then you should recommend same-currency netting and the hedging of the remainder with forwards/futures. The netting out of DM cash-outs against DG cash-ins is also pretty riskless, and may be safely made. The use of mismatched futures, though, should be discouraged. NOTE THE MATERIAL IN PART C. BELOW IS DOES NOT CONSTITUTE EXAM MATERIAL; IT IS PRESENTED SOLELY TO ILLUSTRATE THE PRACTICES OF MANY CORPORATIONS c. Suppose that your company is more interested in minimizing hedging costs than hedging. What could you recommend? What risks would the company be exposed to?
9
10 Suppose that you believe the historical correlation ¥/DM against the $ will continue: can you use this assumption for hedging decisions? The answer is "yes", because you can then use the anticipated movements of the $ value of your ¥ cash-outs to "hedge" part of the variation in the $ value of your DM cash-ins. You will need, however, to make your own predictions about the future behavior of exchange rates. A few calculations are helpful to see this.

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