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V. Hedging Contingent Exposure A. If only certain contingencies give rise to FX rate exposure, then options can be effective insurance.

B. Example: if a firm is bidding on a hydroelectric dam project in Canada, it can hedge the Canadian-U.S. dollar exchange rate only if the company wins the contract. The firm can hedge this risk with options. Firm will buy a put in amount of contract with an expiration date equal to the announcement date of the results of the bid.

VI. Hedging Recurrent Exposure with Swaps A. Swap Contract agreement to exchange one currency for another at a predetermined exchange rate (swap rate) on a sequence of future dates. B. Swap contract is like a portfolio of forward contracts with different maturities. Maturities can range from months to 20 years. Swaps are flexible with regard to amount. C. Firms with recurring exposure can hedge at a lower cost with swaps than a program of hedging each exposure as it comes along.

VII. Hedging Through Invoice Currency The firm can shift, share, or diversify exchange rate risk: A. Shift exchange rate risk Invoice foreign sales in home currency. B. Share exchange rate risk By pro-rating the currency of the invoice between foreign and home currencies. C. Diversify exchange rate risk By using a market basket index (SDR).

VIII. Hedging Via Lead and Lag A. If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as they are paying in that currency. B. If a currency is depreciating, give incentives to customers who you in that currency to pay early; pay obligations denominated in that currency as late as your contracts will allow.

IX. Exposure Netting A. A multinational firm (MNC) should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. 1. Example: U.S. based MNC with Korean Won receivables and Japanese Yen payables. Since Yen and Won tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and buy Yen with Won. 2. This hedge is not perfect, but it may be too expensive or impractical to hedge each currency separately.

B. Setup a reinvoice center This is a financial subsidiary that nets out the intra-firm transactions. Once residual exposure is determined, then the firm implements hedging. C. Example: a U.S. MNC with three subsidiaries and the following transactions:
$20

U.S.
$40

$30 $10

Canada

$10

$35 $25 $60

$30

$40

Mexico

$20 $30

Great Britain

Bilateral Netting would reduce of foreign exchange transactions by half with re-invoice center.

U.S.

$10

Canada

$25 $15 $20

$10

Mexico

$10

Great Britain

Simplify bilateral netting with multilateral netting through a reinvoice center.

U.S.

$15

Canada

$40

Mexico

Great Britain

X. Should the Firm Hedge? A. Not everyone agrees that a firm should hedge: 1. Hedging by the firm may not add to shareholder wealth if shareholders can manage exposure themselves. 2. Hedging may not reduce the systematic risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.

B. On the other hand: in presence of market imperfections, the firm should hedge. 1. Information Asymmetry - managers may have better information than the shareholders. 2. Differential Transactions Costs - firm may be able to hedge at better prices than the shareholders. 3. Default Costs - hedging may reduce the firms cost of capital if it reduces the probability of default. 4. Taxes can be a market imperfection - corporations that face progressive tax rates may find that they pay less in taxes if they manage earnings by hedging than if they have boom and bust cycles in their earnings stream.