Essay About Types Of Foreign Exchange Exposure And Bid Failsexample

Three Types of Foreign Exchange Exposure
Three Types of Foreign Exchange Exposure:[pic 2][pic 1]Overview:Transaction ExposureRisk to Known Foreign Cash-flowsWhat we have been hedgingEconomic Exposure Two ComponentsAsset Exposure—risk to Assets/Liabilities (we know how to hedge)Operating Exposure—risk to Uncertain cash-flows (Harder to hedge)Translation ExposureRisk to Balance SheetsDue to a Change in Translated Value of a Foreign SubsidiaryImpossible to Fully Hedge or EliminateTransaction ExposureRisk to contractual cash-flows due to adverse currency movementsKnown (or contractual) future cash-flowsFlow is in a currency other than the home currencyMethods of HedgingForwards, Futures, and Swaps—Fix translated valueOptions—Eliminate risk of adverse movements, while permitting gains from favorable movements; also used to hedge Contingent ExposuresCross-Hedging—Used when conventional hedging instruments are unavailableMoney Market Hedging—Extract the translated PV of the Cash-FlowsExposure Netting—Efficient method of hedging, reducing the need for use of financial hedgesContingent Exposure HedgingExposures that might manifest, such as from a successful contract bidOptions eliminate risk from adverse currency movements without ceding gains from favorable movementsForwards/Futures/Swaps may create a liability if the bid failsExample:  You have placed a bid with PEMEX to buy oil for 215P/barrel, but will not know whether the bid will be accepted for a month.Entering into Peso/$ forward, futures, or swap contract, prior to signing the agreement, will create financial exposure if our bid is declined (long the naked forward/futures/swap contracts).If we do nothing, the Peso could appreciate during the next month, increasing the price of forward/futures and swap rates.  The oil will be more costly if the bid is accepted.Alternatively, we could purchase Peso Call Options maturing on or after the decision date, with a strike equal to the spot, for the Present Value of the commitments.  If the Peso appreciates during that month, the option payoff will offset our losses.[pic 4][pic 3]Cross-HedgingUsing positions on one currency to hedge another currency with which it is highly correlatedCurrency derivatives are unavailable for a number of minor currencies.Example: US dollar currency options are unavailable for the Thai Baht; however, the Baht/$ exchange rate is highly correlated to the Yen/$ rate.Step 1: Translate the Baht Cash-flows to Yen (using the appropriate spot and forward rates)Step 2: Hedge the corresponding Yen values against the dollarThis reduces risk to the extent that the Baht moves with the Yen, but does not completely eliminate riskExample: We owe 10,000,000 Baht per year for the next three years, the current Yen/Baht spot, and 1-year, 2-year, 3-year forwards are: 2.8, 2.79, 2.78, 2.77.[pic 5]Step 1: Translate to Yen[pic 6]Step 2: Hedge the obligationE.g. buy Yen forward or entering into swap a Yen/dollar swap to receive YenStep 3: Hedge the Yen against the Baht (optional)If Yen/Baht forwards are available, you can further reduce risk by selling Yen forward against the baht.