INTERNATIONNAL FINANCIAL MANAGEMENT

LESSON 29: HEDGING WITH CURRENCY OPTIONS

Lesson Objectives
2. Forward hedge If the fulfill buys DEM 5:00,000 forward at the offer rate of DEM2.8130/ or 0.3557/ DEM, the value of the payable is (5,00,000 x 0.3557) = 1,77,850. This is shown as a horizontal line in Figure 13.1. 3. A Call option. Instead the firm buys call options on DEM 5,00,000 for a total premium expense of 1000. At maturity, its cash outflow will be [(5,00,060)ST + 1Q:f_] for ST::; 0.3546 and [(5,00,OOO)(0.3546) + 1025] = 178325 for ST 0.3546 We have assumed here that the premium expense is financed by a 90-day borrowing at 10%. Figure 13.1 illustrates. Open position and forward hedge are equivalent if the maturity GBP/DEM spot rate equals the forward rate at the beginning, viz. 0.3557. If it is higher, the firm is better off with a forward Call option and open position are equivalent when (5,00,000) St = (0.3546) (500000) + 1025 i.e. when St = 0.3537. At higher values, call option is better. Call option and forward are equivalent when (5,00,000) St + 1025 = (0.3537)(500000) i.e. when ST = 0.3567. At lower values than this the option alternative is better because of its one-way privilege the firm can buy DEM in the spot market letting the option lapse. Figure 13.2 shows gains/losses of forward and call relative to the open position. For forward, the relative gain is [(ST- 0.3537 )(5,00,000)], while for the call relative gain is -1025 for ST< 0.3546 and [(5,00,000)(ST-0.35465) 1025 ] for ST >=0.3546 The call option becomes attractive relative to an open position for values of ST beyond 0.3567. Relative to the forward hedge, the call option is better I if the DEM depreciates below 0.3537. The maximum gain from the forward hedge, relative to the call is (5,00,000)(0.3546) + 1025 (0.3557)(5,00,000 = 475 whereas, if the DEM depreciates sharply, call option can result in substantial savings. For instance at ST = 0.3520, saving from the call over the forward is 825.

Different kinds of currency options and their uses Hedging with currency options Internal hedging strategies like neeting, offsetting, leading
and lagging. Speculation in foreign exchange and money markets

Currency options provide a more flexible means to cover transactions exposure. A contracted foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on the currency while -an inflow an be hedged by buying a put option.(Or writing a call option. This is a covered call strategy). Options are particularly useful for hedging uncertain cash flows, i.e. cash flows that are contingent on other events. Typical situations are: 1. International tenders: Foreign exchange inflows will materialise only if the bid is. successful. If execution of the contract also involves purchase of materials, equipment, etc. from third coun-tries, there are contingent foreign currency outflows too. 2. Foreign currency receivables with substantial default risk or political risk-e.g. the host govern-ment of a foreign subsidiary might suddenly impose restrictions on dividend repatriation; 3. Risky portfolio investment: A funds manager say in UK might hold a portfolio of foreign stocks/ bonds currently worth say DEM 50 million, which he is planning to liquidate in six months time. If he sells DEM 50 million forward and the portfolio declines in value because of a falling German stock market and rising interest rates, he will find himself to be over insured and short in DEM. We will discuss a few more examples of the use of options. We will particularly focus on the com-parison of options with forward hedge both with reference to an open position.

On June 1, a UK firm has a DEM 5,00,000 payable due on

September 1. The market rates are as follows: DEM/GBP Spot: 2.8175/85 90-day Swap points: 60/55

September calls with a strike of 2.82 (DEM/GBP) are

available for a premium of O.20p per DEM. We will evaluate the forward hedge versus purchase of call options both with reference to an open position. 1. Open position Suppose the firm decides to leave the payable unheeded. If at maturity the IDEM spot rate is ST the sterling value of the payable is (5,00,OdO)ST In figure 13.1 this appears as a straight line through the origin. -

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INTERNATIONNAL FINANCIAL MANAGEMENT

Value of the payable

Open position Call option Forward

0.3537

S(T) 0.3567 0.3557 0.3546

relative to an open posi-tion is then higher by 540 and its standard deviation is 1279.6. For an option, the expected cost is lower by 475 with a standard deviation of602.5. Thus in the mean-variance framework, call option should be the preferred choice because of its smaller expected cost and smaller variance. If however, the probabilities-s are changed to 0.60,0.20 and 0.20, the choice is not clear; the forward hedge now has a, smaller expected cost-compared to the call option (-140 and 255_respectively) but a much larger variance. The choice now depends upon the firms riskreturn preferences: In the appendix to this chapter we briefly present a more rigorous analysis of this choice.

Figure 13.1.

A US firm has bid for a contract to supply computers and

Forward Gain(+)

related equipment to a German buyer. The contract is valued at DEM 5 million. The outcome of the competitive tender bidding will be known one month from now and the equipment is t6 be supplied over two months following the award of contract with payment being made on completion of delivery.
Call

The firm would like to cover the potential exposure. Also, the management has decided that any cover obtained must be offset if the firm is not awarded the contract. The current market rates are: DEM/$ spot: 1.50 90-day forward: 1.46 (We are ignoring two-sided quotes. It does not make any substantive difference). A put option on DEM with a strike price of DEM 1.45 per $ and maturity of 90 days is available for a premium of 2.8 or $0.028 per DEM.

0 0.3567 0.3557 0.3537 Loss(-)

Fig 13.2 Gain & Losses from Alternative Hedging Strategies Thus whether the firm should choose the call option strategy, the forward hedge or leave the expo-sure unhedged depends upon the view it takes of future spot rate. It might do a probabilistic mean variance analysis to compare the forwardhedge with the call if it can assign. subjective probabilities to future values of the spot rate. Thus suppose its forecast of S T can be summarised as follows: ST 0.3557 0.3510 0.3590 Probability 0.60 0.30 0.10

The firm wishes to evaluate the following two alternatives: 1. Sell DEM 5 million 90-day forward at DEM 1.46 per USD. If at the end of the month the bid is not successful, the contract will be offset by a 2-month forward purchase at the then ruling rate. 2. Purchase a put option 4 . If the contract is not awarded, close out by selling put options. (Assume that the options are bought on an options exchange). The firm must pay an up-front premium of $1,75,000. If the contract is awarded, the original hedge is carried to maturity. Under each contingency, viz. the firm gets the contract and does not get the contract we will evaluate the two alternatives. In each case we will consider three exchange rate, scenarios. 1. The bid is unsuccessful. The firm unwinds the hedge by either purchasing DEM 5 million 60-days forward if the initial choice was a forward contract or by selling put options. We consider the gain/loss from each choice under the following three exchange rate scenarios at the end of one month:

The firm considers the most probable value of maturity spot to be equal to the current forward rate. But it thinks that there is a 30% chance of a very slurp depreciation of the DEM (possibly because it thinks that the Bundesbimk is shortly going-to cut interest rates to stimulate the economy) and a 10% chance of a very sharp appreciation. The expected cost with forward hedge,

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A. DEM has depreciated

B. Spot rate unchanged

C. DEM has appreciated

Scenario A :

- DEMJUSD Spot: 1.60 60-day forward:. 1.62 1.45, 2-month put 7 - DEM/USD Spot: 1.50 60-day forward: 1.48 1.45, 2-month put 2.3 -- DEM/USD Spot: 1.37 60-day forward: 1.35 1.45, 2-month put 0.02

estimate the future spot rate and quote a foreign currency price based on this forecast; if it overestimates the weakness of DEM (underestimates its strength) it runs the risk of submitting an uncompetitive bid. In the reverese case, its profit margins will shrink. It can decide on a hedging device such as a put option and load t-he expected cost of the hedge into its price. The timing, amount and the exercise price of the put option should be chosen to correspond to the forward contract which the firm might have bought had the receivable not been uncertain. This may not always be possible with exchange traded options. Cost of the put option can be reduced by buying an out-of-the money option with lower strike and hence lower premium. Cor-respondingly, the level of protection against depredation is reduced. Alternatively, the firm need not hedge the entire amount; if it is a frequent bidder for certain types of contracts, it will have built-up some experience pertaining to the probability of success at various bid levels. It can reduce the cost of hedge by buying a put to cover only a fraction of the expected receivable reflecting the probability of success. The final example illustrates the use of range forward contracts : Consider the case of a French firm which has imported microelectronic components from a Japanese supplier. The invoice is for 250,000,OOO due in 180 days. The market rates are as follows: JPYIFRF Spat: 25.9740 (FRF/JPY: 0.0385) I80-days forward: 25.6410 (FRF/JPY: 0.0390) (For expositional convenience we have ignored two way rates. Assume these are offer rates for the yen). The firm, buys a range forward. This involves buying a call and selling a put. The strike price for the Formicas FRF/JPY 0.0395 with a premium of FRF 0.0006 per yen or FRF 1,50,000 for 250,000,000. for the, latter, the strike is FRF/JPY 0.0380 and premium is FRF 0.0004 per yen or FRF 1,0.0,000 for the entire payable. The net premium payment is thus FRF 50,0007. The following table shows the FRF outflows on settlement of the payable with an open position, a forward hedge and- the range forward, for various values of the maturity spot8. French Franc Outflow for 250,000,000 Payable

INTERNATIONNAL FINANCIAL MANAGEMENT

Forward hedge-Firm unwinds by purchasing forward at 1.62. Realizes a gain of $3382385 two months hence.- Put options-Firm sells puts on DEM 5 million at $0.07 per DEM for a total premium income of $3,50,000 accruing right away. Scenario B : Forward hedge-Unwound at 1.48. Gain of $46,279 two months henge. Put options-Sell puts. Premium income $1,] 5,000 right away. Scenario C : Forward hedge-Unwound at a loss of $279046 two months hence. Put option-Premium income of $1000 right away. We have assumed that the forward hedge is unwound by means of another forward which matures at the same time as the original contract.

Cash flows under this contingency are summarised below: Scenario A Time 0 1 2 3 0 1 2 3 0 1 2 3 Forward 0 Puts -140000 350000

338238 0

-140000 115000

46280 0

-140000

-279046

1000

Mfi1y Spot Open (FRFI) Position 0.0370 0.0375 0.0380 0.0385 0.0390 0.0395 0.0400 0.0405 9250000 9375000 9500000 9625000 9750000 9875000 10000000 11250000

Forward Hedge 9750000 9750000 9750000 9750000 9750000 9750000 9750000 9750000

- Range Forward 9550000 9550000 9550000 9675000 9800000 9925000 9925000 9925000

Thus in the event of the bid being unsuccessful, the firm risks a large ,loss if the DEM sharply appreciates in the interim and it has covered the uncertain inflow with a forward contract. With an option, at worst, its maximum loss is limited to the upfront premium. 2. The bid is successful. If the bid is successful, the put option hedge offers an advantage if over the next three months the DEM experiences a sharp appreciation. If the ,DEM remains unchanged or depreciates, the for-ward contract is more advantageous since it is costless to enter into. The firm in tendering a bid will wish to know how to incorporate the element of currency risk. It can attempt to

Note: These calculations do not incorporate the interest foregone on the net premium payment in the case of the range forward.

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Thus if the firm does not expect a sharp depreciation of the yen. a range forward provides a relatively cheap way of protecting itself against yen appreciation without giving up the opportu-nity to gain from yep depreciation at least up to a point. -(Yen depreciation below the strike price of the written put yields no extra benefit). These examples serve to bring out the point that options represent a flexible hedging tool enabling the firm to incorporate its views on exchange rate movements and its risk-return preferences in the hedging decision.

= (5000000/2908375.20) = 1.7191. The hedge turns out to be better than a forward hedge. The effective rate with the latter would have been 1.7165. This is despite the adverse basis movement. (As usual we have, ignored the effect of markil1g-to-market).

INTERNATIONNAL FINANCIAL MANAGEMENT

A Long Hedge
A Japanese firm has sold a large quantity of memory chips to a US computer marcher. The sale is invoiced in US dollars at $10,000,000, payment due in 180 days. Today is May 25. The market rates are: /$ Spot: 125.30 180-day forward: 121.50 IMM December Yen futures are trading at $0.8333 per 100 yen, i.e. $104162.50per contract, since each contract represents 12,500,000. The firm decides to hedge by buying 98 December contracts valued at1,225,000,000 =7.$10,207,900 at $0.8333 per 100 yen. The brokerage fee is $75 per contract or $7,350 for 98 contracts. On November 25, the rates are: /$ Spot: 120.50 December futures: 0.8549 The firm sells $10,000,000 in the spot market to receive 1,205,000,000. It closes its futures posi-tion by selling 98 contracts. The gain on this is $2,64,600 [= (0.8549 - 0.8333) *125000x98] which translates into 31,884,300 at the spot rate of 120.50. The brokerage fee paid is worth 8,85,675. The total yen inflow is therefore 1236 million, yielding an effective /$ rate of 123.60 which is better than I the forward rate. Of course if the basis had narrowed much more, futures rate would have been worse than the forward rate. Currency futures are used by commercial banks to hedge positions taken in the forward markets. With their continuous trading in the latter, the problem of timing mismatch is not serious and the liquid-ity of the market along with the absence of counterpart risk makes it an attractive hedging tool.

Hedging With Currency Futures

Hedging contractual foreign currency flows with currency futures is in many respects, similar Jo hedging with forward contracts. A receivable is hedged by selling futures while a payable is hedged by buying futures. A futures hedge differs from a forward hedge because of the intrinsic features of futures contracts. Since, amounts and delivery dates for futures are standardized a perfect futures hedge is generally not possible. Also futures unlike forwards: give-rise intermediatecashtflows due to the mark-ing-to-market feature. Due to a much larger turnover, the bid-ask spreads are tighter in the forward markets. Futures contracts require a deposit to be posted. (Even forward contracts may require a com-pensating bank balance or a line of credit) there are also brokerage fees to be paid with futures contracts. The advantage of futures over forwards is firstly easier access and secondly greater liquidity. Banks will enter into forward contracts only with corporations (and in rare cases individuals) with the highest credit rating. Second, a futures hedge is much easier to unwind since there is an organised exchange with alarge turn over. For the sake of completeness, we will of present to examples of hedging with futures.
A Short Hedge

On June-1 a British firm orders farm equipment worth $ 5 million from a US supplier. Payment is due on September 1. The market rates are: $/ Spot: 1.7225 90:daytforward : 1.7165 LIFFE September $/ Futures: 1.7170 The firm decides to hedge by/selling 47 sterlifig9"contracts with a total, value of 2,937,500= $5043687.5 at $ l.r1if 0/. It pays a brokerage fee of 50 per contract or 2350 form the total amount. Qn September 1 the following optics rule :$/Spot: 1.6680 September futures: 1.6650 The firm buys $ 5 million at the ruling spot and closes out its futures position. Sterling outflow on spot purchase of $ 5 million =(5,000,000)/1.6680 = 2,997,601.9 Gain on futures_=$(1.7170- 1.6650)(2937500) ,,= $152750= 91576.74 at $1.6680/. Total sterling outlay = (299760190+ 2350.00 - 91576.14) = 2,908,375.20 Effective $/ rate obtained by the firm is -

Internal Hedging Strategies

In addition to the various market-based hedging devices discussed so far, a firm may be able to reduce or eliminate currency exposure by means of internal strategies. We take a look at some of the commonly used or recommended methods. Invoicing We have already discussed above the problem of currency of invoicing. A firm may be able to shift the entire exchange risk to the other party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency. As we have seen above, in the presence of well-functioning forward markets this will not yield any added benefit compared to. a forward hedge. \At times, it may diminish the firms competitive advantage if it refuses to invoice its cross: border sales in the buyers currency. Empirically, in a study of the financial structure of foreign trade Grassman (1973) discovered the following regularities: . 1. Trade between developed countries in manufactured products is generally invoiced in the export-ers currency. 2. Trade in primary products and capital assets is generally invoiced in a major vehicle currency

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such as the US dollar. 3. Trade between a developed and a less developed country tends to be invoiced in the developed countrys currency. 4. If a country has a higher and more volatile inflation rate than its trading partners, there is a tendency not to use that countrys currency in trade invoicing. Table 13.1 presents- some data on the pattern of currency of invoicing of India a exports and imports. Table 13.1 Currency Composition of Indias Trade (%)
Currency US Dollar Pound Sterling Deutsche Mark Yen French Franc Swiss Franc Belgian Franc Indian Rs (External) Others Exports (1987-88) 61.8 7.4 4.6 0.1 1.0 0.5 Neg. 21.7 2.9 Imports (1988-89) 67.6 6.0 8.0 6.9 3.5 1.5 0.2 1.8 4.5

German subsidiary has to make a dividend payment to the parent of OEM 2,50,000 in three months time, the parent has a three-month payable of FRF 8,50,000 to the French subsidiary and the French subsidiary has a three-month payable of OEM 3,00,000 to a German supplier {who is not a -part of the multina-tional). A netting system might work as follows. The forecasts of spot rates three months hence are: OEM/$: 1.50 FRF/$4.80 implying FRF/OEM : 3.1 7 The German subsidiary is asked to pay OEM 2,50pOO to the French subsidiarys German supplier. Thus the French firm has to hedge only the residual payable of OEM 5),000. OEM 2,50;000 converted into FRF at the forecast exchange rate amounts to FRF 7,92,500. The parent may obtain a hedge for the residual amount of F8.F57,500. Any discrepancies between the forecast exchange rates and the actual spot rates three months hence can be settled by making the necessary intracompany transfers. This suppose the actual spot rates turn out to be OEM 1.52/$ and FRF 4.75/$ implying FRF 3.l25/0EM. At this rate OEM 2,50,000 equals FRF 7,81,250. The parent must pay the French subsidiary FRF 68,750 of which it has covered FRF 57,500. This technique not only reduces the amount of exposures to be covered company-wide but also minimizes the number and amount of currency conversions required to settle intra-company payments. This latter aspect can become significant for a multinational with extensive network of subsidiaries and substantial intra-company trade. To be able to use netting effectively, the company must have continuously updated information on inter-subsidiary payments position as well as payables and receivables to outsiders. One way of ensur-ing efficient information gathering is to centralize cash management. Occasionally, a firm might find that it has a receivable in one currency say OEM and a payable not in the same currency but a closely correlated currency such as the CHF. Even though CHF is not part of the EC exchange rate mechanism, the movements in the two currencies are very closely correlated so that a loss (gain) on the payable due to an appreciation (depreciation) of the CHF vis--vis the firms home currency would be closely matched by the gain (loss) on the receivable due to the appreciation (depreciation) of the DEM. Such offsetting of one exposure against another in a closely related currency provides a natural hedge. When the two currencies involved are part of the ERM, such as the DEM and the Belgian Franc, the offset provides almost a perfect hedge since the latter maintains are % margin of variation vis--vis the former. Some countries impose rest rejections on netting as part of their ex Change -control regulations. These may limit the scope for netting or prohibit it altogether. It may still be possible to minimise the number of currency conversions by centralizing cash management.

INTERNATIONNAL FINANCIAL MANAGEMENT

Source: RBI Monthly Bulletin, November 1991 (Exports) IS? August 1992 (irnports), Reserve Bank of India, Bombay. Note: Imports and Exports on Bilateral account are not included in the above data. Another hedging tool in this context is the use of currency cocktails for invoicing. Thus for in- stance, a British importer of fertilizer from Germany can negotiate with the supplier that the invoice be partly in DEM and partly in sterling. If the parties agree on a price of say DEM 1000 per ton and the spot rate is DEM3.00/, the price may be stated as (DEM 550+150) per ton]. This way both parties share the exposure Another possi-bility is to use one of the standard currency baskets such as the SDR or the ECD for invoicing trade -transactions. Basket invoicing offers the advantage. of diversification and can reduce the variance of home Clarence value of the payable or receivable as long as there is no perfect correlation between the constitu-ent currencies. The risk is reduced but not eliminated. Also, there is no way by which the exposure can be hedged since there are no forward markets (or options, etc.) in these composite currencies. As a result, this technique has not become very popular.

Netting and Offsetting

A firm with receivables and payables in diverse currencies can net out its exposure in each currency by matching receivables with payables. Thus a firm wit!} exempts to and imports from. say Germany need not cover each transaction separately; it can use a receivable to settle all or part of a payable and take a hedge only for the net DEM payable or receivable. Even if the timings of the two flows do not match, it might be possible to lead or lag (see the next subsection) one of them to achieve a match. Netting also assumes importance in the context of cash management in a multinational corporation with a number of subsidies and extensive intra-company transactions. Let us consider a simple example of an American parent company with subsidiaries in Germany and France. Suppose that the
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Leading and Lagging

Another internal way of managing transactions exposure is to shift the tim-ing of-exposures by leading or legging payables and receivables. The general rule is leave advance payables and fag, i.e. postpone receivables in strong currencies and, conversely, lead receivables and lag payables in weak currencies.

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As we will see below, shifting the exposure in time is not enough; it has to be combined with a borrowing/lending transaction or a forward transaction to complete the hedge 4Essentially, It; adding and lagging are a response to the existence of market imperfections. Thus suppose an American firm has a three-month OEM payable and the firm (and everyone else) is almost sure [hat the DEM is going to sharply appreciate against the dollar. The, firm can offer to settle the payment immediately, i.e. forego the usual 90-day credit and demand a discount for cash payment On the other hand, suppose it has a receivable in a weak currency such as the Mexican peso, it can offer a discount to the Mexican buyer for immediate payment. The pertinent question is, if the covered interest parity mechanism is working satisfactorily, will this method of covering be equivalent to a forward hedge? Consider this example. A French firm has a 180-day payable of CHF 3,50,000. The spot rate is: ERF 3.2500/CHF The 180-day forward is 3.3312. The Swiss supplier will give a discount of 2.5% for cash payment. The French firm can borrow at 10% p.a. The net cost of leading the payment would thus be 2.5% which is equal to the 180-day premium on the CRE The interest differential is exactly captured in the forward premium and hence leading and forward hedge are equivalent. If some imperfections drive a significant wedge between eurointerest rates and domestic interest rates, then leading or lagging an exposure may turn out to be cheaper than a forward hedge. Consider the following example: An American firm has a 180-day payable of AUD 1,000,000 to an Australian supplier. The market rates are: AUD/USD Spot: 1.347_5 180-day forward: 1.3347 EuroUS$ 180-day interest rate: 10% p.a. EuroAUD 180-day interest rate: 8% p.a. The Australian authorities have imposed a restriction on Australian firms which prevents them from borrowing in the euroAUD market. Similarly, non-residents cannot make moneymarket investments in Australia. As a consequence, the domestic 180-day interest rate in Australia is 9.5% p.a. The American firm wants to evaluate the following four alternative hedging strategies: a. Buy AUD 1,000,000 ISO-day forward.(Forward) b. Borrow US$, convert spot to AUD, invest in a euroAUD deposit, settle the payable with the deposit proceeds. (Money market cover). c. Borrow US$ for 180 days, convert spot to AUD, lead the payable, get a discount. (Lead) d. Borrow AUD in the euromarket, settle the payable, buy AUD 180-day forward to payoff the loan. (Lead with a forward). Let us determine US$ outflow 180 days hence under each strategy. 1. Forward Cover: US$ outflow = 1000000/1.3347 = 749232.04

2. Money Market Cover: The firm must invest AUD(1000000/1.04), i.e. AUD9,61,538.46 to get AUD1,OOO,OOO on matu-rity. To obtain this it must borrow and sell spot US$(961538.46/ 1.3475) = US$ 7,13,572.14. It must repay US${713572.14(1.05)] = US$749250.75 180 days later. Thus this strategy is as good as the forward cover.(The small difference is on account of rounding errors). This should not be surprising since the borrowing and lending are done at Eurorates, which in turn determine forward margins. 3. Lead: The American firm can possibly extract a discount at 9.5% p.a. from the Australian firm since this is the latters opportunity cost of short-term funds. Thus leading would require cash payment of AUD(lOOOOOO/1.0475) = AUD 9,54,653.94. To obtain this, US$(954653.94/1.3475) = US$ 7,08,463.03 must be borro_ed at 10%, requiring repayment of US$[708463.03(1.05)] = US$ 7,43,886.19. This represents a saving of US$ 5,345.85 over the forward hedge. 4. Lead with a Forward: The firm must borrow AUD 9,54,653.94 at 8% p.a. requiring repayment of ADD 9,92,840.10 which must be bought forward requiring an outflow of US$ 7,43,867.61. This is equivalent to the Lead strategy. you can convince yourself that if the American firms borrowing cost were higher than the Euro state, the lead with forward strategy would have been better than a simple lead. In effect, leading and lagging involve trading off interest rate differentials against expected currency appreciation or depreciation. In employing this strategy for intra-corporate payments between units of a multinational account must be taken of possibly differing tax treatments of different expense items, exchange gains and losses as also of. differing tax rates in different countries. Also, if a multinational parent company requires its subsidiaries to employ this method it may All occasion interfere with opti-mal cash management at the level of a subsidiary. Suppose for instance that an American-parent ask-s its Mexican subsidiary to lead a OEM payable. This might put the subsidiary in an awkward position if it is already strapped for cash and has exhausted its credit lines with local banks. The use of leads and lags therefore must reevaluated in the overall framework of financing and exposure management and this consideration must be kept in mind when evaluating the performance of the local management. It may also adversely affect the interests of local minority shareholders. Finally there may also be some legal constraints in free use of leading and lagging .as exposure management devkes. Since it destabilizes currency markets, governments may impose restrictions on the extent to which leading and lagging can be done. Leads and lags in combination with netting form an important cash management strategy for multina-tionals with extensive intra-company payments.

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Speculation in Foreign Exchage and Money Markets

Speculation in contrast to hedging involves deliberately creating positions in order to profit from ex-change rate and/or interestrate movements. The speculator believes that markets forecasts as reflected in forward rates and the term structure of interest rates are wrong. He -hopes to profit by taking open positions at these prices. Consider outright speculation in foreign exchange makes. Suppose a speculator believes that the DEM is going to appreciate against the dollar by 5 % over the next three months. Further he finds that he can borrow three-month dollars at 10% and invest three-month OEM at 8%. He can speculate by borrowing dollars, converting spot to OEM and keeping DEM on deposit. If his fore-cast materializes, he will be a 2% (annualised) profit on- recon version of DEM. into dollars. Alternatively, these rates imply a 2%(annualised) premium on OEM; the speculator can fake an open long position in forward DEM, and sell DEM three months later in the spot market for a net annualised profit of 2%. Not hedging a receivable or payable is thus equivalent to speculation. If a firm has a payable in a foreign currency and is confident that the currency is going to depreciate more than what is implied in the forward rate (or appreciate less) it speculates by not covering the payable. Obviously, outright speculation is a high risk activity. The risk of an -open position depends upon the covariance of exchange Tate with other assets in the speculators portfolio. A speculator who is not risk neutral will demand a premium for undertaking the risk. Thus he will take an open long (short) forward position if he expects the currency to appreciate (depreciate) more than what is implied in the forward rate. However, exchange rate risk is diversifiable and_ hence unsystematic. As a result, the risk pre-mium-the amount by which the forward rate has to be below or above the speculators expected future spot rate-is 1ikely to be quite small. Empirical investigations indicate that it is also the-varying. Speculating with futures is quite similar to speculating with forwards. The main differences are, first, with futures since there are intermediate cash flows, the investor must speculate on interest rate move-ments too and second, since most futures contrads are liquidated prior to maturity, the relevant comparison is not between expected maturity sport ate and futures price. Chapter 9 contains some examples of speculating with currency futures.

Students Activity
1. Discuss, with an example each, the various types of currency exposures faced by a firm. Do you agree with the following statement: The only exposure that really matters is operating exposure that can not be hedged , hedging activities are a waste of time and resources.

INTERNATIONNAL FINANCIAL MANAGEMENT

. Many finance managers view forward premia/discounts as cost of hedging. Explain why this is an incorrect view.

Summary
This chapter elaborates the various devices available for hedging transactions exposure. We have also addressed the question of whether the firm should engage in hedging itself or leave it to the shareholders to hedge their own exposures in the light of the portfolio compositions, country of residence, risk preferences, etc. There is a continuing debate on this issue. In perfect markets, with shareholders having access to instruments such as futures, options, etc. the only valid reasons for corporate level hedging are exploiting internal information, avoiding financial distress and the possible adverse effect of increased risk-on managerial incentives.
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