MNCs and FOREIGN EXCHANGE EXPOSURE

The need for foreign exchange

Many companies enter into foreign exchange transactions (transactions in a foreign currency).
The need for foreign exchange arises from international trade and international investment.
A company buying goods from another country might be required to pay in a foreign currency,
such as the domestic currency of the supplier. It must therefore obtain the foreign currency to
make the payment.
A company selling goods abroad might price the goods in the buyer’s domestic currency, or in
another currency such as US dollars. When the customer pays in the foreign currency, the
company might sell the currency received in exchange for its own domestic currency;
A company investing abroad might need to obtain foreign currency to acquire or to make the
investment.
If a company in Nigeria wants to buy goods from a supplier in Germany, and the purchase price
is in euros, the Nigerian company has to buy euros from its bank in order to make the payment to
the supplier.
Similarly, if a company in Nigeria sells goods to a customer in the UK, and the price is paid in
US dollars, the company will probably sell the dollars it has received to its bank, in exchange for
naira. (Alternatively, the company could keep the dollars in a US dollar bank account, if it has
one). The company in the UK would also need to buy dollars from a bank in order to pay its
Nigerian supplier. Many foreign currencies can be bought and sold freely in the foreign
exchange markets (FX markets), which are operated world-wide by banks.
On the other hand, some currencies do not have a liquid market, and foreign companies might be
reluctant to accept payment in those currencies.
Exchange rates and volatility
Banks quote exchange rates at which they are willing to buy and sell currencies in the FX
markets. Exchange rates are quoted as a number of units of one currency (the variable currency)
in exchange for one unit of the other currency (the base currency).
Exchange rates can be very volatile. This means that exchange rates can move up or down by
large amounts, within a fairly short period of time. For example, since the euro was created in
1999, when its value was about €1 = $1.20, the exchange rate has ranged between about €1 =
$0.75 to about €1 = $1.35. Exchange rate volatility creates foreign exchange risk for anyone
involved in buying, selling, borrowing or investing foreign currency.
Foreign Exchange Exposure is risk associated with unanticipated changes in exchange rate.
Foreign currency risk can be classified into three types.

Types of Foreign Exchange Exposure

1. Translation exposure
Translation risk arises in international companies with foreign subsidiaries/branches. Income
statements and statements of financial position (balance sheets) will be denominated in the local
currency of the subsidiary and, on consolidation, will be translated into the currency of the
holding company. On translation of financial statements from one currency to another, losses or
gains arise due to exchange rate movements. Translation risk is therefore the risk of losses (or
gains) arising on the translation of the financial statements of a foreign subsidiary into the
currency of the parent company, for the purpose of preparing consolidated accounts.
2. Transaction Exposure
Transaction risk is the foreign exchange risk that arises in transactions between two parties:
where the normal transaction currency of each party is different, and
when the transaction involves a future receipt/payment between the two parties.
Transaction risk is the risk that, for any future transaction in a foreign currency, the amount
received or paid in domestic currency might be different from the amount originally expected
because of movements in the exchange rate between the date of the initial transaction and the
date of settlement (payment/receipt).
For example, transaction risk will arise when a UK company buys goods from a Chinese supplier
when the price is in US dollars, and payment is required three months after the date of the
purchase.
For the UK buyer, there is a risk that the US dollar will increase in value against the British
pound in the three months before settlement is required. If the dollar strengthens in value, the
cost in pounds of obtaining the dollars to pay the supplier will be higher than originally expected.
For the Chinese supplier, there is a risk that the US dollar will fall in value against the Chinese
Renminbi in the three months before settlement. If the dollar falls in value, the dollar receipts
will learn less in Renminbi that originally expected when the sale was made.
Volatile exchange rates increase transaction risk. Transaction risk can disrupt international trade,
and make businesses more reluctant to trade internationally, because losses arising from adverse
movements in an exchange rate reduce the profit on sales transactions, or increase costs of
purchases. The transaction loss might even offset the amount of normal trading profit.
3. Economic Exposure
Economic risk refers to the long-term movement in exchange rates caused by changes in the
competitiveness of a country. For example, over the long term the euro might increase in value
against the US dollar. If this happens, goods produced and paid for in US dollars will become
cheaper relative to goods produced and paid for in euros. US companies will therefore become
more competitive in terms of price, relative to companies in the Eurozone, because of the
exchange rate movement.
Economic risk, in the context of foreign exchange, is therefore the risk that a company might
choose to locate its operations in a country whose currency gains in value over time against the
currencies of its competitors in world markets. The consequence of an increase in the value of
the domestic currency is a loss of competitiveness.
Causes of exchange rate fluctuations
There are several approaches to explaining the causes of exchange rate fluctuations: Supply and
demand; Purchasing power parity theory; and Interest rate parity theory.
Supply and demand
Exchange rates are determined by supply and demand in the foreign exchange markets. For
example, the value of the British pound against other currencies is determined by supply and
demand for the pound.
The demand for pounds comes from buyers of British exports, who are required to pay in
pounds. Pounds are also bought by British exporters who receive payments in foreign currencies
and want to exchange their currency receipts into pounds.
Demand for pounds is also created by flows of investment capital and savings. Foreign investors
wishing to purchase investments in the UK must buy pounds to pay for their investments. UK
investors selling their foreign investments might exchange their sale receipts (in a foreign
currency) into pounds. The supply of pounds comes from individuals and organisations who
want to sell pounds in exchange for a foreign currency.
UK buyers of foreign goods who must pay in a foreign currency will sell pounds and buy the
currency they need to make the payment.
Foreign investors who sell their UK investments and receive payment in sterling will want to sell
the pounds in exchange for another currency. UK investors buying investments abroad must buy
currency (and sell pounds) to pay for the investments.
A balance of trade deficit might affect the exchange rate.
This is the difference between the value of a country’s exports of goods and services and the cost
of its imports. As a general rule if a country has a large balance of trade deficit, its currency is
likely to depreciate in value because supply of its currency from international trading operations
(e.g. from importers who need to pay in foreign currency) exceeds the demand (e.g. from foreign
buyers of exported goods).
Supply and demand for currencies explain the continual fluctuations in currency values.
However, there are other theories that explain the underlying reasons for exchange rate
movements, especially over the longer term, and an advantage of these other theories –
purchasing power parity theory and interest rate parity theory – is that they can be used to make
estimates of what exchange rates will be in the future.
EXCHANGE RATE RELATIONSHIPS
 Four-way equivalence
 Purchasing power parity theory
 Interest rate parity theory
 Other relationships
Four-way equivalence
The term ‘four-way equivalence refers to four concepts that together provide a consistent
explanation of changes in foreign exchange rates, and a method of predicting future ‘spot’
exchange rates. These four concepts are:
1. Purchasing power parity theory;
2. Interest rate parity theory;
3. The Fisher effect (which together with PPP theory makes the international Fisher effect); and
4. Expectations theory.
Four way equivalence theorem/Model/Theory
The above relationships should exist when the foreign exchange market is in equilibrium. The
model gives insight into what would happen if a variable in the equilibrium position were to
change. In situations of capital market perfection, the model would readjust instantly if any
input variable were to change. For example, if an interest rate were increased in a country.
Purchasing power parity theory
Purchasing power parity theory (PPP theory) attempts to explain changes in an exchange rate
due to the relative rate of price inflation in each country. The theory is based on the
assumption that the exchange rate will adjust to enable the same amount of goods to be
purchased in any country with a given amount of money.
Example: Purchasing power parity
At the start of a year, a basket of goods cost ₦25,000 in Nigeria. The same basket of goods
cost £100 in the UK. This implies an exchange rate of ₦250/£1. Annual inflation rates are
expected to be 8% in Nigeria and 5% in the UK.
Analysis
At the end of the year the basket of goods would cost ₦27,000 (25,000  1.08) in Nigeria and
£105 in the UK, but the same amount of goods could be purchased with equivalent amounts of
each currency. This means that the exchange rate must be ₦27,000 = £105 Therefore, the
exchange rate will be ₦27,000/105 = £1  ₦257.14/£1
PPP theory therefore predicts that if inflation is higher in one country than in another, its
exchange rate value will fall so as to restore purchasing power parity.
In reality, an exchange rate does not change in the way predicted by PPP theory because other
factors apart from price inflation affect the rate, especially in the short term. It might be
argued, however, that PPP theory provides a useful guide to the likely direction and extent of
exchange rate movements over a longer period of time.
Forecasting exchange rates with purchasing power parity theory
Purchasing power parity (PPP) theory states that the spot rates between two currencies will
change over time in relation to the rate of inflation in the countries from which the currencies
originate. The following equations describe this relationship.
Formula: Purchasing power parity
If quotes are direct: St = S0 × (1+id /1+if )
If quotes are indirect: St = S0 × (1+if /1+id)
Where:
St = Estimated spot rate at end of period
S0 = Current spot rate
if = period inflation rate in foreign currency
id = period inflation rate in domestic currency
Example: Purchasing power parity
Nigerian view: The current exchange rate for the naira and GBP is ₦250 = £1. Forecast annual
inflation in Nigeria = 8% (id from the Nigerian view point).
British view: The current exchange rate for the GBP and naira is £1 = ₦250. Forecast annual
inflation in the UK = 5% (id from the British viewpoint).
Nigerian viewpoint (direct):
St = S0 × (1+id /1+if ) = St = 250 × (1.08 /1.05) = ₦257.14 = £1. Therefore, £1 = ₦257.14
British viewpoint (indirect)
St = S0 × (1+if /1+id ) = St = 250 × (1.08 /1.05) = ₦257.14 = £1. Therefore, £1 = ₦257.14
Example: Purchasing power parity (direct quote)
The current exchange rate for the naira and the US dollar is ₦150 = $1. It is expected that the
rate of inflation in Nigeria will be 3% per year for the next few years, and in the US the rate of
inflation will be 5% per year. Purchasing power parity theory would predict that the following
movements in the exchange rate:
End of Year Spot rate at start Adjustment factor Predicted exchange rate
1 150  1.031/1.051 147.13
2 150  1.032/1.052 144.34
3 150  1.033/1.053 141.59
An alternative approach would be to construct an annual adjustment factor and apply it
periodically to each new spot rate.
Example: Purchasing power parity (direct quote)
Facts as above: Purchasing power parity theory would predict that the following movements in
the exchange rate:
End of Year Spot rate at start Adjustment factor Predicted exchange rate
1 150  1.03/1.05 147.13
2 147.13  1.03/1.05 144.34
3 144.34  1.03/1.05 141.59
Example: Purchasing power parity (indirect quote)
The current exchange rate for the British pound and the US dollar is £1 = $2. It is expected
that the rate of inflation in the UK will be 3% per year for the next few years, and in the US
the rate of inflation will be 2% per year. Purchasing power parity theory would predict that the
following movements in the exchange rate:
End of Year Spot rate at start Adjustment factor Predicted exchange rate
1 2.00  1.021/1.031 1.9806
2 2.00  1.022/1.032 1.9614
3 2.00  1.023/1.033 1.9423
Interest rate parity theory
Interest rate parity theory is based on the assumption that exchange rates will adjust to
eliminate differences in interest rates between countries.
Example: Interest rate parity
The current exchange rate between the naira and the GBP is ₦250/£1. (Therefore ₦25,000 =
£100). Annual interest rates are forecast to be 8% in Nigeria and 5% in the UK. Analysis An
investor with 25,000 in Nigeria could also invest money for one year at 8% to receive interest
and principal of 27,000 at the end of that time. An investor with £100 in the UK could invest
the money for one year to obtain principal plus interest of £105 after one year.
According to interest rate parity theory, the exchange rate after one year will be ₦27,000 =
£105. Therefore, the exchange rate will be ₦27,000/105 = £1  ₦257.14/£1.
The theory predicts that the currency of a country with a higher interest rate will depreciate in
value over time against the currency of a country with a lower interest rate.
Like PPP theory, interest rate parity theory cannot explain all exchange rate movements,
especially in the short term, but it might provide a useful guide to changes in the exchange rate
over a longer period.
Forecasting exchange rates with interest rate parity theory
Interest rate parity theory states that changes in an exchange rate are caused by differences in
interest rates between two currencies. If this is true, it should be possible to predict future spot
exchange rates from differences in expected future interest rates between the currencies.
Formula: Interest rate parity
If quotes are direct: F=S× (1+id /1+if)
indirect: F=S× (1+if /1+id)
Where:
F = Forward rate
S = Current spot rate
if = period interest rate in foreign currency
id = period interest rate in domestic currency
This formula is similar to the PPP theory formula, except that the forecast annual interest rate
is used instead of the annual forecast rate of inflation. Once again the interest rate in the
numerator always relates to S. The equation constructs a forward rate (explained in more
detail later) rather than a future spot rate. However, if the markets are in equilibrium the
forward rate would be the same as the expected future spot rate. In practice, the forward rate is
a poor predictor of actual spot rates in the future
Example: Interest rate parity (direct quote)
The current exchange rate for the South African Rand against the US dollar is 7.4000 Rand =
$1. The forecast annual interest rate for the Rand is 6% for the next 3 years and the forecast
 interest rate for the US dollar is 2%. Applying interest rate parity theory, we can predict the
exchange rate at the end of the next three years as follows:
End of Year Spot rate at start Adjustment factor Forward rate
1 7.4000  1.061/1.021 7.6901
2 7.4000  1.062/1.022 7.9918
3 7.4000  1.063/1.023 8.3052
Alternatively:
End of Year Spot rate at start Adjustment factor Forward rate
1 7.4000  1.06/1.02 7.6901
2 7.6901  1.06/1.02 7.9918
3 7.9918  1.06/1.02 8.3052
Example: Interest rate parity (indirect quote)
The current exchange rate for British pound against the euro £1/€1.2115. The forecast annual
interest rate for the British pound is 5%. The forecast annual interest rate for the euro is 2.5%.
Applying interest rate parity theory, we can predict the exchange rate at the end of the next
three years as follows:
End of Year Spot rate at start Adjustment factor Forward rate
1 1.2115  1.0251/1.051 1.1827
2 1.2115  1.0252/1.052 1.1601
3 1.2115  1.0253/1.053 1.1273
Alternatively:
End of Year Spot rate at start Adjustment factor Forward rate
1 1.2115  1.025/1.05 1.1827
2 1.1827  1.025/1.05 1.1601
3 1.1601  1.025/1.05 1.1273
Fisher effect
The economist Irving Fisher gave his name to the so-called Fisher effect and international
Fisher effect. The Fisher effect is simply that the real rate of return on an investment is the
nominal rate of return adjusted for the rate of inflation: You have seen the equation in an
earlier chapter used to link money cost of capital and real cost of capital.
 Formula: Fisher equation 1 + m = (1 + r)(1+i)
Where:
m = money cost of capital (the nominal rate)
r = real cost of capital (the real rate)
i = inflation rate
Example: Nominal rate to real rate
The nominal rate of interest is 4% and inflation is 2.5%
Therefore: (1 + m) = (1 + r) × (1 + i)
(1 + 0.04) = (1 + r) × (1 + 0.025)
(1 + r) = 1.04/1.025
r = 1.04/1.025 – 1 = 0.0146 or 1.46%
Fisher argued that investors in all countries expect the same real rate of return, after allowing
for inflation, and the difference in interest rates between two countries could be explained by
differences in the rates of inflation in those countries. This is the so-called international Fisher
effect.
Expectations theory
Expectations theory is the theory that all relevant information is reflected in the market rates
of exchange. Therefore, the forward exchange rate between two currencies reflects market
expectations about what the spot rate will be in the future.
Example: Expectations theory
The currency of Country X is the dollar and the currency of Country Y is the franc. The
current spot exchange rate is $1 = 4.00 francs.
Country X Country Y
Forecast nominal interest rate 6% 8.02%
Forecast inflation rate 5% 7%
This information can be used with four-way equivalence to make the following predictions.
Purchasing power parity predicts that the spot rate in one year’s time will be: 4.00 ×
(1.07/1.05) = 4.0762.
Interest rate parity predicts that the exchange rate in one year’s time will be: 4.00 ×
(1.0802/1.06) = 4.0762.
 The current one-year forward exchange rate is $1 = 4.0762 francs, and this is the expected spot
rate in one year’s time.
The real return on investment in Country X for the next year is: (1.06/1.05) – 1 = 0.95%.
The real return in investment in Country Y for the same period is: (1.0802/1.07) – 1 = 0.95%.

Foreign Exchange Risk Management

1. Identification and quantification of exposure
Business cycle of the company is analyzed to identify where foreign exchange risk exists. Future
cash flow which are confirm to arise out of contracts already entered and future foreign currency
cash flows which are not confirm over the time period are forecasted and measured to get the
foreign exchange exposure. After measuring the level of exposure of the company, decision is to
be made regarding what magnitude of risk is to be hedged and how much risk is to be covered.
2. Policy formulation
Effective FERM requires well-framed policies, clear objectives and parameters within which the
strategy is to be controlled. These policies should clearly mention the principles which is to be
followed and extent of hedging (risk coverage) which are needed. Objectives should set standard
for bank’s exposure to foreign exchange risk; and personnel are appointed who have the
authority to trade in foreign exchange on behalf of company; and should mention the different
currencies, which have been approved for transaction within the company. There should be some
stop loss arrangements to prevent the firm from abnormal losses if the forecasts turn out wrong.
There should be monitoring systems to detect critical levels in the foreign exchange rates where
appropriate measure is required.
3. Hedging
After formulating policies, the firm then decides about an appropriate hedging strategies keeping
in mind the principles and objectives and extent of exposure coverage. There are various
financial instruments available for the firm to mitigate its risk- futures, forwards, options and
swaps and issue of foreign debt. Hedging strategies and instruments are explained later.

4. Reporting and Review

Risk management policies are periodically reviewed based on periodic reports prepared. These
periodic reports measure the effectiveness of hedging strategy adopted by the company to
mitigate its foreign exchange exposure. The review of risk management policies are done to
judge the validity of benchmarks set; whether they are effective in controlling the exposures;
what the market trends are and whether the overall strategy is enough or change is required in it.

INTRODUCTION TO HEDGING TECHNIQUES

Foreign exchange risk is managed through two means (a) internal i.e. use of tools which are
internal to the firm such as netting, matching, etc. and (b) external techniques i.e. use of
contractual means such as forward contracts, future, option, etc. to insure against potential
exchange losses. The usage of internal techniques is also known as passive hedging, while the
latter is known as active hedging. Usage of internal tools among the group companies may at
times be difficult to practice owing to local exchange control regulations. Nevertheless, they are
worth implementing for they do not involve extra payouts while being significantly effective in
minimizing the forex exposure.
It is essential to understand the difference between forex exposure and forex risk. Foreign
exchange exposure is the sensitivity to changes in the real domestic currency value of assets,
liabilities or operating incomes to unanticipated change in exchange rates. Foreign exchange risk
exposure is quite often used interchangeably with the term ‘foreign exchange risk’, although they
are conceptually quite different. Foreign exchange risk is defined in terms of variance of
unanticipated changes in exchange rates. It is measured by the variance of the domestic currency
value of an asset, liability or operating income that is attributable to unanticipated changes in
exchange rates.

Difference between forex exposure and forex risk

No. Basis Forex Risk Forex Exposure

1. Meaning Foreign exchange risk is the change of Foreign exchange exposure is the
value in one currency relative to another degree to which a company is
which will reduce the value of affected by changes in exchange
investments denominated in a foreign rates.
currency.

2. Control Foreign exchange risks can usually be Foreign exchange exposure is

mitigated through the use of hedging difficult to manage.
techniques and using a less volatile
currency to report results.

3. Types Transaction, translation and economic Risk exposure due to imports and
 risk are types of foreign exchange risks. exports are main types of foreign
exchange exposure.

Internal Hedging Techniques :

Companies having subsidiaries in different countries or the parent company having subsidiaries
across the globe can effectively practice internal techniques to minimize foreign exchange
exposure and the eventual need for its active hedging. The important tolls of internal hedging
techniques are : i) Netting, ii) Matching, iii) Leading and lagging, iv) Price Variation, v)
Invoicing in foreign currency, vi) Asset Liability Management.
1. Netting :
It is possible to net the payments and receipts among the associated companies which trade with
one another. It involves mere settlement of inter-affiliate indebtedness for the net amount owing.
One of the simplest ways of netting is bilateral netting. It involves pairs of companies. It
basically reduces the number of inter-company payments and receipts that pass over the foreign
exchanges.
However, it poses a problem, which currency is to be used for settlement? Multilateral netting is
a little complex phenomenon though similar to bilateral netting. It involves more than two
associated companies and their debt. Hence it calls for the services of a group’s centralized
treasury. Multilateral netting results in considerable savings, since it eliminates exchange and
transfer costs. Besides reducing costs, it enables the central office to exercise control over inter-
company settlements.

Netting and Matching

a) Where two or more entities have mutual indebtedness.
b) Look at the net forex exposures before considering external hedging techniques.

Netting: Involves two or more entities within Matching : Involves two or more
companies with a formal agreement
a single group. to net off.

Matching :
Netting or matching are frequently used interchangeably. But there is a slight difference i.e.
netting refers to potential flows within the group companies, while matching extends from group
companies to third party companies too. It basically matches a company’s foreign currency
inflows with its foreign currency outflows in respect of both time and amount of flow. Receipts
in a particular currency are used to make payments in that currency alone, and thereby eliminate
the need to go through exchange markets for such conversions.
However, to practice this technique, there must be a two-way cash flow in the same foreign
currency within the group companies. For all practical purposes matching is parallel to
multilateral netting and hence calls for centralized group finance function. It is of course likely to
pose problems, uncertain timings of third party receipts and payments can delay payments but
the central treasury shall endeavor to streamline the collection of information and processing
thereof.
Leading and lagging:
Leading means paying an obligation in advance of the due date and lagging means delaying
payment of an obligation beyond its due date. It basically refers to credit terms and payment
between associate companies within a group. In forex market where exchange rates are
constantly fluctuating, the leading and lagging tactics come handy to take advantage of expected
rise / fall in exchange rates.
For instance, Company ‘A’ is a subsidiary of company ‘B’ located in India, owes money to
subsidiary ‘C’ in Canada. The bill is invoiced in US dollars and due for payment in three months
time. Assume that rupee is likely to devalue in three months time by around 20%. In such a
situation, it makes great sense to lead the payment to Canadian company in dollars, so that it
needs to part with less units of rupees today than after three months. Thus, leading becomes
pretty tempting and the converse holds good for lagging. However, it is quite essential for
companies to factor the impact of relative interest rates, expected currency movements, and after
tax effects into leading and laggings decisions.
While practicing leading and lagging the management must realize that the performance
measurement of those subsidiaries which were asked to ‘lead’ payments may suffer as they incur
losses on interest receivable and incurs interest charges on the funds ‘led’. At times, lead and lag
techniques may also be constrained by local exchange control regulations. Practicing of leading
and lagging techniques indeed goes beyond the realm of risk minimization. It amounts to taking
aggressive stances on financing viz-a-viz anticipated movements in exchange rates. For instance,
an expected devaluation of host country’s currency may make an international company borrow
locally and repay the foreign currency denominated borrowings.
d) Price Variation :
It involves increasing selling prices to counter exchange rate fluctuations. But the question is
whether a firm can raise its price in tandem with anticipated exchange rate movements. This is
only possible when the selling company is a market leader. In some South American countries,
price increase is the only legally tenable tactic of foreign exchange exposure management.

Inter-company trade transfer price variations can also be effected as a foreign exposure risk
management tool. There is of course a danger here, unless the firm maintains arm’s length price,
taxation and customs authorities may question such variations in transfer prices. Nevertheless, it
is common knowledge that multinationals attempt to maximize after tax group cash flows by
transfer pricing with the objective of minimizing tax liability and moving funds around the
world.
e) Invoicing in foreign currency :
Exporters and importers of goods always face a dilemma in deciding the currency in which the
goods are to be involved. It is obvious that sellers always prefer to invoice in their domestic
currency or the currency in which they incur cost, so that it avoids foreign exchange exposure.
On the other hand, buyers will have their own preferences for a particular currency. In the
buyer’s market, a seller hardly has any choice to invoice in his desired currency. At least, in such
situations, one should choose only the major currency in which forward markets are pretty
active. Currencies that are of limited convertibility and with a weak forward market must he
shunned.
f) Asset Liability Management :
It is used to manage balance sheet, income statement or cash flow exposures by
aggressively shifting cash inflows into currencies expected to be strong or increase exposed cash
outflows denominated in weak currencies. Alternatively, a firm may practice defensive approach,
matching of cash inflows and outflows according to currency denomination, irrespective of
whether they are in strong or weak currencies.
As a part of aggressive financing policy, c0mpanies may prefer to increase their exposure under
cash flows, debts and receivables in strong currencies and increase borrowings and trade
creditors in weak currencies. Simultaneously, they reduce exposed borrowing and trade creditors
in strong currencies.
External Hedging Techniques :
External techniques which are also known as active hedging techniques, essentially involve
contractual relationship with outside agency. Hedging is a method whereby one can reduce the
financial exposure faced in an underlying asset due to volatility in prices by taking an opposite
position in the derivatives market in order to offset the losses in the cash market by a
corresponding gain in the derivatives market. External Hedging Techniques : i) Hedging through
forward contract, ii) Hedging through future contract, iii) Hedging through options, iv) Hedging
through swaps, v) Hedging through Money Market.
Constructing a hedge essentially involves

a) Identification of the exposure one is facing

b) Measurement of that exposure , and
c) Construction of another position with the opposite exposure.

Construction of an exact opposite position to the existing risk exposure results in a perfect hedge.
Such opposing position, which they come together, automatically offset each other. But, there is
always a problem, how to strike a balance between uncertainty and the risk of opportunity loss.
The problem of setting an effective hedge ratio has two dimensions –
a) Uncertainty : If a firm does not hedge the transaction, it cannot know with certainty at
what rate of exchange it can exchange its dollar export proceeds for rupees, it could be at a better
rate or a worse rate.
b) Opportunity : If firms enter into a hedge transaction such as a forward contract they
would, of course, be certain of the rate at which they would be exchanging the export proceeds.
But now they have taken an infinite risk of ‘opportunity loss’.
During 1984, Lufthansa, a German airline, signed a contract to buy $3 billion – worth of aircraft
from an American Company – Boeing. At that time, dollar was strong and market held an
opinion that it was sure to get even stronger. In that context the CFO of Lufthansa hedged the
company’s exposure to dollar by buying a forward contract for $1.5 billion. The central ideal
behind this hedging is, if the dollar strengthens, it would lose on its aircraft contract but gain on
the forward contract. There is another interesting dimension to this hedge. Lufthansa’s cash flow
was also in effect dollar denominated and thus had a fair level of ‘natural hedge’. In this episode,
dollar weakened by around 30% during 1985 and thus the forward contract inflicted heavy losses
on the company. The moral is, deciding to hedge is one thing, and getting it right in quite
another.

There is yet another dimension to hedging, hedging has a cost. If a depreciation / devaluation of
it is unlikely, hedging will prove an ineffective way of doing business. All these complexities
associated with hedging through derivatives pose a great challenge to arrive at a right hedge
ratio.
The true purpose of hedging is to reduce the volatility of earnings and cash flows by setting pre-
defined limits on any loses. The first step under hedging through derivatives is to estimate the
size of the short position that must be held in the derivatives market – say, future market, as a
proportion of the long position held in the spot market that maximizes the firm’s expected utility,
defined over the risk and expected return of the hedge portfolio. This is the problem of
estimating the Optimal Hedge Ratio. OHR is the hedge ratio that equates the agent’s marginal
rate of substitution between the expected return and the standard deviation of the hedged
portfolio with the slope of this feasible set.
a) Hedging through forward contract :
Forward contracts obligate one party to buy the underlying at a fixed price at a certain time in the
future from a counter party who is obligated to sell the underlying at that fixed price. These are
one of the oldest and commonest hedging tools of the forex market. Consider an Indian exporter
who expects to receive US $1 million in six months. Suppose that the price of the dollar is Rs.
74.60 now. If the price of the dollar falls by 10%, the exporter loses Rs. 74 lakhs. But by selling
dollars forward the exporter locks in the current forward rate of Rs. 74.65 which means even
after dollar depreciating by 10% in the next 6 months, the exporter would still get Rs. 74.65 per
dollar. Thus, the exporter has fully hedged himself i.e. he took a financial position to reduce his
exposure to exchange rates.
b) Hedging through future contract :
Futures contract is an agreement to buy and sell a standard quantity of specific financial
instrument at a future date and at a price agreed between the parties through open outcry on the
flow of an organized financial futures exchange. The terms under the contract such as amount
maturity date, range of price movement are all standardized. A buyer of the futures contract has
the right and obligation under the contract. Under a futures contract, there will always be a buyer
and seller, whose obligation is not to each other but to a clearing house. After a transaction is
eliminated, financial futures provide a means of hedging for those who wish to lock in exchange
rates on future transactions.

Hedging through futures contract is almost akin to hedging with forward contract. An exporter
having a receivable can hedge by selling futures while a payable is hedged by buying a futures
contract. However, as the amounts and delivery dates for futures are standardized, a perfect
hedge through futures is not possible. There is another difference between hedging through
futures and forward contract, there are intermediate cash flows under futures contract owing to
‘mark-to-market’ mechanism. Such cash flows could be positive or negative.
c) Hedging through options :
Options provide hedging characteristics different from forward or futures contracts. Option
contract allows the buyer to participate in the good side of the risk, while insuring against the bad
side of the risk. An option has a right but no obligation to perform. Thus, an importer who
purchased a call option will have a right to buy the underlying i.e. dollar at the agreed price, even
if the current spot price is par above the price under option. On the other hand, if the spot price is
much less than the price under option, the option holder can ignore the option and acquire dollars
from the spot market.
Options are more suited to hedge uncertain cash flows. For instance, assume that an Indian
company is bidding for a project in a foreign country. Its forex flows will materialize only if the
bid is successful. Similarly, if an Indian investor who invested in foreign stock market and
assumes that due to falling dollar is portfolio value may decline. In all such cash flows that are
contingent upon happening a even than better be hedged through options.
d) Hedging through swaps :
Swap is a contract to exchange cash flows over the life of the contact. Swap is simply a portfolio
of forward contracts. As in the case of forward contracts, the market’s assessment of the present
value of the cash flows of a swap is zero at the initiation of the contract. Swaps could involve
currencies or interest rates. They help the corporate treasurer to manage his portfolio of
liabilities. Swaps also help businesses to arbitrage on market imperfections and thereby raise
finance at rates below market rates, otherwise available.
Whilst on hedging one should always remember that forward hedging of contractual exposures
does not removes a firm’s forex exposure. It merely, removes the uncertainty regarding the home
currency value of that particular cash flow and nothing beyond. I other words such hedging only
stabilizes the firm’s cash flows or profits.
e) Hedging through Money Market :
In imperfect markets there is always room for covered interest arbitrage opportunities. Similarly,
absence of covered interest arbitrage opportunities does not necessarily imply that forward cover
and money market cover would be same. In fact, money market hedge may sometimes prove to
be a better alternative to hedge foreign exchange risk. However, this is only possible to firms,
which have access to international money markets / Euro markets for short-term borrowings or
investments where forward premiums and interest rates are strikingly low.
For instance, assume an Indian exporter is having a receivable in dollar due for payments three
months henceforth. If the exporter had access to Euro market, he / she can borrow dollars
equivalent to the receivable amount and convert them into Indian rupees at the current Re / $
spot rate 74.49 / 48.5 and use it for domestic payments or for lending in the domestic market.
Subsequently, the amount due under the export bill / receivable can be used to pay off the Euro
loan. Such money market coverage can at times result in gain, particularly when the differences
in interest rates / forward premiums are high.