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Hedging will be understood to mean a transaction undertaken specifically to offset some exposure arising out of the firm's usual operations Speculation will refer to deliberate creation of a position for the express purpose of generating a profit from exchange rate fluctuations, accepting the added risk Management of transactions exposure has two significant dimensions The treasurer must decide whether and to what extent an exposure should be explicitly hedged The treasurer must evaluate alternative hedging strategies
Outflow
($ Mill) Forward
S90
Third-Currency Forwards
Suppose an Indian firm has a 6-month payable of JPY 20 million. The market rates are as follows: Mumbai : USD/INR spot : 45.50/52 6-months : 45.80/85 Singapore : USD/JPY spot : 110.25/111.10
6-months : 111.50/112.00
From this the JPY/INR 6-month forward cross rate is : 40.89/41.12 (per 100 JPY) If the firm buys JPY forward against INR it will have to pay : Rs.[20,000,000/100](41.12) = Rs.82,24,000.00
Forward-Forwards
Today is July 30. A firm is expecting an import shipment to arrive on October 1. Payment due on January 1 and the invoice will be for USD 100,000. The market rates are as follows : USD/INR Spot : 45.50/60 Outrights : 45.75/45.90 Outrights : 46.25/46.45 2-months swap : 25/30 5-months swap : 75/85
The firm would like to lock-in the 70 paise swap premium between October 1 and January 1 but feels that the dollar is likely to weaken somewhat between July 30 and October 1. It does the following set of transactions on July 29 : (1) Buy USD spot, sell value October 1.
Forward-Forwards..
It has essentially created a swap position, with an outflow of USD on October 1 and a matching inflow on January. The premium locked in is 46.45-45.75 = 0.70. By September 15 the dollar has weakened and the current spot is 44.80/90. The firm buys spot at 44.90 and delivers on the forward 15 days later at 45.75 gaining 0.85 per USD. On January 1, the firm pays 46.45 per USD. The net price paid is 45.60. It is as if the firm could lock in the 3-month premium over October 1 and "pick any spot rate" between July 29 and October 1 to which the premium would then be added.
To manage these currency exposures, we advised on a series of hedging strategies to mitigate risk. In order to stabilize the USD costs of the GBP exposure and allow the client to avail of cost savings from a favorable market move, the client booked a series of Quarterly Participating Forwards. We also advised on a series of Vanilla Window Forwards to accommodate the flexible delivery dates for the remaining British pound needs. In addition, the company booked Monthly Vanilla Forwards for their 5m euro payroll need to their European workforce.
If rate falls to say 1.13, the two parties share the loss (to US firm) 50-50: French firm pays USD equivalent of EUR 10m using a rate of USD 1.16 per USD. [1.18- 0.5(1.17-1.13)] If rate rises to say 1.27 again the gain to US firm is shared 5050. French firm pays USD equivalent of EUR 10m using a rate of USD 1.22 per EUR [1.18+0.5(1.27-1.19)]
LUFTHANSAs HEDGING DECISION 1) Full forward cover is the most conservative no-risk approach. It would involve a payment of DEM 1.6 billion on delivery of the aircraft. 2) Remaining completely unhedged is the maximumrisk alternative. The DEM outlay would be 500ST million where ST is the spot USD/DEM rate at the time of settling the payment. 3) Cover 50% leave the rest open. The DEM outflow on settlement would be (800+250ST) million.
4) With a put option the cost would be either DEM 1696m if ST exceeds 3.2 or DEM (500ST+96)m otherwise.
NO HEDGE FORWARD
PUT OPTION
50% FORWARD
O
Exhibit 6.2 Lufthansas Hedging Alternatives 3.008 3.2 Spot Rate at Settlement S T
The dollar had fallen to DEM 2.3 by January 1986. The DEM outflow was thus 1.375 billion. With no hedge at all, it would have been 1.150 billion and with a put option, 1.246 billion. Lufthansas board criticized Herr Ruhnau for not trusting his instincts and thus not opting for the no hedge alternative or at least the put option.
Some of them questioned his decision to acquire the planes when the dollar was riding so high while others wanted to know why he had not selected Airbus Industries to supply the aircraft it is a European firm and the payment would probably have been in DEM.
LESSONS FROM THE LUFTHANSA STORY YOU MUST HAVE A CLEARLY ARTICULATED RISK MANAGEMENT POLICY. THIS MEANS, CLEAR GUIDELINES ON ACTIVE/PASSIVE POSTURE AND RISK TOLERANCE EXCHANGE RATE FORECASTING IS VERY DIFFICULT IF NOT IMPOSSIBLE. BUDGET RATE MUST BE CURRENTLY ACCESSIBLE, RELEVANT FORWARD RATE. WITH HINDSIGHT ANYONE CAN BE A GENIUS.
MOST OF THEM HAVE SOME QUALITATIVE UNDERSTANDING - DIRECTION OF IMPACT OF EXCHANGE RATE MOVEMENTS ON THEIR CASH FLOWS, PROFITS ETC.
MOST FIRMS WORRY ONLY ABOUT SHORT-TERM TRANSACTIONS EXPOSURE. MOST FIND IT VERY HARD IF NOT IMPOSSIBLE TO QUANTIFY THEIR OPERATING/STRATEGIC EXPOSURE OPERATING EXPOSURE IS DEALT WITH BY MEANS OF CONTRACTUAL ARRANGEMENTS AND RESTRUCTURING OPERATIONS.