Inventario de Daños

organized at group level by the finance department so that currency income for one of the group companies can be matched with the expenditure of another company. In order to reduce the transaction exposure to maximum level, it is of immense importance that forecast of amount and timings of foreign currencies are reliable.

External Hedging Methods: Forward Rate Agreements:

Under this method, hedging refers to making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

Using this method, we can fix the exchange rate now for a future transaction of the needed currency. Because spot rates are changing every day and fixing the exchange rate for future date ‘now’ reduces the risk to significant extent.

A forward contract is binding upon both the parties – currency dealer and a company/client. This means that both parties must honor their commitment to sell or buy the foreign currency on the specified date and amount. By hedging against the risk of an adverse exchange rate movement with a forward contract, the company also closes an opportunity to benefit from a favorable change in the spot rate.

Hedging is based on the assumption or estimate that it will be expensive to pay US $ in three months time because of the fact the PKR will be weakening against US $. Therefore, a company enters into a contract to buy x dollars after 3 months at an exchange rate of Rs 60/ US $ decided now. At the maturity date both parties have to honor their respective commitments of buying and selling of US $ at agreed rates. Now if on the maturity date, the spot ex rate is Rs 61/US $, (PKR weakened against US $), then the company has actually eliminated the loss and benefited financially.

However, if the spot rate on maturity date is Rs. 59/US $, (contrary to its estimation of weak local currency, local currency strengthened) then the company has missed the opportunity to benefit from this favourable sport rate.

For best results, one must possess the knowledge of Forex market with a vision of future to estimate that which currency will weaken against which other one.

Timing of cash flow is of crucial importance in hedging contract. Money Market Hedging:

Money markets are wholesale (large-scale) markets for lending and borrowing of money for short term. Bank are major player of money markets and companies seek their services to hedge against the ex rate fluctuations in short term.

As forward ex rate (which is agreed now) is derived from sport rates using interest rates, a money market hedge can produce the same results as of forward contract.

There will be two situations:

- A company is to receive money in foreign currency (FCY) at a future date and will exchange it into local currency, and

- A company needs to pay foreign currency (FCY) at some future date and will use local currency to buy the FCY to make payment

Scenario: Future Income in FCY

What is needed at this point is to fix the exchange value of the future currency income. A hedge will be created by fixing the value of income now in local currency.

We can do it:

Borrow now in foreign currency (the same that the company will receive in future). The maturity of both – loan and receipt should be the same.

The loan + interest on FCY loan should equal the amount of FCY future receipt. When the FCY receipt hit the account, loan will be paid off.

The FCY loan can be converted to local currency immediately and may be put to a short-term deposit to earn interest.

Corporate Finance –FIN 622 VU

We shall take care of following topics in this hand out:

¾ Future payment situation – hedging

¾ Currency futures – features

¾ CF – future payment in FCY Money Market Hedge – future FCY payment scenario

A similar approach will be taken to create the hedge when a firm is expecting to pay in FCY in future. In this scenario, a hedge can be created by exchanging local currency for FCY now using spot rates and putting the currency on deposit until the future payment is to be made. The amount borrowed and the interest earned on the deposit should be equal to the FCY. If it is not the case then it will not be a clean hedge. The cash flows are fixed because the cost in local currency is the cost of buying FCY on spot rates that was put under a deposit.

Mechanism:

Step 1: determine the FCY (assume US $) amount to be put to a deposit that will grow exactly to equalize the future payment in dollars. You need to calculate this using the available spot rates and interest rate on dollar deposit.

Step 2: in order to deposit dollars in interest bearing account, the company will buy dollars at spot rates. Step 3: the company will borrow local currency for the period of hedge.

These steps will ensure that the hedge created a definite cash flow regardless of exchange rate or interest rate fluctuations. The exchange rate has been fixed.

Currency Futures:

A currency future is a standard contract between buyer and seller in which the buyer has a binding obligation to buy a fixed amount, at a fixed price and on a fixed date of some underlying security.

Fixed amount = contract size Fixed date = delivery date Fixed price = future price

Futures are forward contracts traded on future and option exchanges. There are several such exchanges around the world and although some trade in similar forward contracts, as a general rule each exchange specializes in its own future contracts. This means that if a company wants of trade in future contracts it has to go to exchange where those contracts are traded.

Futures are only traded on exchanges using standardized contracts. Each future contract is in particular item having identical specification. For example, every sterling contract has same specification.

Settlement of future contracts is made at predetermined times during a year. These are usually in March, June, September and December each year. This means, for example, that sterling future contracts are traded on the exchange for settlement in these months.

Futures are traded at a price agreed between the buyer and the seller. This price reflects the price of the item traded by the contract.

Most of the futures do not run to their final settlement date. These contracts may be cash settled or physical delivery settled. With cash settlement, there is payment in cash from one party to the other. With physical delivery, the underlying item is delivered by one party to other.

When a trader buys future, this represents taking a long position in futures. Such a trader having a long position can close his position at any time before the settlement date by selling the same number of contracts.

On the other side, when a trader is selling futures then it represent his or her short position. It is possible to sell future even you don’t have them. A trader who is in short position can close her position by buying the same number of future before the final settlement date.

Ticks:

A tick is the minimum price movement of a contract. For example, the movement in US$ / PKR rate from 60.1501 to 60.1505, means the rate has risen four ticks. Every tick movement in price has same money value. For example, sterling/us$ contract standard size is sterling 62,500/-. The price is in us$ and tick size is $ 0.0001, which means each tick value is $ 6.25. If a trader is holding a long position and price of future increases, then there’s profit and fall in value represents loss. If trader is holding is short position, rise in future value represent a loss, fall in price profit.

Like forward contracts, currency futures have also two-scenario: receipt of FCY and payment involving FCY.

Corporate Finance –FIN 622 VU