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Hedging Strategies: Forwards, Options, and Money Market Hedges, Slides of Management Fundamentals

Mizoram University Management Fundamentals

The findings of a 1995 study on hedging practices among fortune 500 companies, focusing on the use of forwards, bank options, and fx futures. The text also explains the concept of money market hedges and provides examples of hedging a long and short position.

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2012/2013

Uploaded on 07/26/2013

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What Hedges are Used?

1995 study by Kwok and Folks of Fortune 500

companies revealed:

Type of Product Heard of Used

Forwards 100.0% 93.1%

Bank (O-T-C) Options 93.5% 48.4%

FX Futures 98.8% 20.1%

Exchange Traded Options 96.4% 17.3%

Why do you think the forwards were preferred over

the others?

Why do you think bank options were preferred over

exchange traded options?

Do you think you would see these same results

today?

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What Hedges are Used? 

1995 study by Kwok and Folks of Fortune 500companies revealed:



Type of Product

Heard of

Used



Forwards



Bank (O-T-C) Options



FX Futures



Exchange Traded Options



Why do you think the forwards were preferred overthe others?



Why do you think bank options were preferred overexchange traded options?



Do you think you would see these same resultstoday?

Explaining The Findings 

(1) Why was there a use preference for forwardcontracts over others? 

Perhaps because they are simple to understand andsimple to use.



Forward contract can be tailored to specific needs ofhedging firms.



There is no upfront cost.



(2) Why was there a use preference for bankoptions over exchange options? 

Again, tailored to specific needs of hedging firms.



Exchange traded options are “standardized” withregard to currency, the amount, and the maturity datesof the contract.

Hedging Through Borrowing orInvesting in Foreign Markets 

The third strategy used by global firms to hedgeopen foreign exchange exposure is through theuse of borrowing or investing in foreign financialmarkets (i.e., in foreign currencies). 

This strategy is commonly referred to as a moneymarket hedge since it involves short term financialassets and liabilities.



Offsetting an open long position: Borrowing (i.e.,taking on a liability) in a foreign currency.



The borrowing produces an offsetting short position.



Offsetting an open short position: Investing (i.e.,acquiring an asset) in a foreign currency.



The investing produces an offsetting long position.

Hedging a Long Position 

Assume a U.S. firm expects to receive £1,000,000 in1 year as a result of a sale to a British company.



The U.S. firm could: 

Sell the pounds (in 1 year) at the 1 year forward bid rate, or



Purchase a put option on the pounds to sell pounds at astrike price in 1 year, or,



Or, use a Money Market Hedge: 

(1) Borrow pounds now.



(2) Swap out of pounds into dollars at the current spot rate.



(3) In 1 year, when the firm receives payment from theBritish company, use those pounds to pay off the bankloan.



Note: The loan (from the borrowing) produces ashort FX position which offsets the original long FXposition.

Outcome of Money Market Strategy fora Long Position 

What has the firm accomplished with this moneymarket strategy? 

The firm has effectively offset its initial foreigncurrency long position with the foreign currencydenominated loan (which is a short position).



The firm as also converted its initial foreign currencylong position into its home currency and has receivedits home currency now (before receiving payment).



The firm has hedged against a weakening of theforeign currency.



However, the firm cannot benefit from a favorablechange in the exchange rate (i.e., if the poundstrengthens).

Hedging a Short Position 

Assume a U.S. firm needs to pay £1,000,000 in 1 year asa result of a purchase from a British company.



The U.S. firm could: 

Buy the pounds (in 1 year) at the 1 year forward ask rate, or



Purchase a call option on the pounds to buy pounds at a strikeprice in 1 year, or,



Use a Money Market Hedge: 

(1) Borrow U.S. dollars now



(2) Swap out of dollars into pounds at the current spot rate.



(3) Invest in a 1 year pound denominated financial asset.



(4) In 1 year, when the pound denominated financial assetmatures, use the proceeds to pay off the £1,000,000 accountpayable.



Note: The financial asset (i.e., from the investment)produced a long FX position which offsets the original shortFX position.

Outcome of Money Market Strategy fora Short Position 

What has the firm accomplished with thisstrategy? 

The firm has effectively offset its foreign currencyshort exposure with the foreign currencydenominate asset which is a long position



The firm has converted its foreign currency liabilityinto a home currency liability.



The firm has hedged against a strengthening ofthe foreign currency.



Hedging Strategies: Forwards, Options, and Money Market Hedges, Slides of Management Fundamentals

Related documents

Partial preview of the text

Download Hedging Strategies: Forwards, Options, and Money Market Hedges and more Slides Management Fundamentals in PDF only on Docsity!

What Hedges are Used? 

1995 study by Kwok and Folks of Fortune 500companies revealed:

Type of Product

Heard of

Used

Why do you think the forwards were preferred overthe others?

Why do you think bank options were preferred overexchange traded options?

Do you think you would see these same resultstoday?

Perhaps because they are simple to understand andsimple to use.

Forward contract can be tailored to specific needs ofhedging firms.

There is no upfront cost.

Again, tailored to specific needs of hedging firms.

Exchange traded options are “standardized” withregard to currency, the amount, and the maturity datesof the contract.

This strategy is commonly referred to as a moneymarket hedge since it involves short term financialassets and liabilities.

The borrowing produces an offsetting short position.

The investing produces an offsetting long position.

Assume a U.S. firm expects to receive £1,000,000 in1 year as a result of a sale to a British company.

The U.S. firm could: 

Or, use a Money Market Hedge: 

Note: The loan (from the borrowing) produces ashort FX position which offsets the original long FXposition.

The firm has effectively offset its initial foreigncurrency long position with the foreign currencydenominated loan (which is a short position).

The firm as also converted its initial foreign currencylong position into its home currency and has receivedits home currency now (before receiving payment).

The firm has hedged against a weakening of theforeign currency.

However, the firm cannot benefit from a favorablechange in the exchange rate (i.e., if the poundstrengthens).

Assume a U.S. firm needs to pay £1,000,000 in 1 year asa result of a purchase from a British company.

The U.S. firm could: 

Use a Money Market Hedge: 

Note: The financial asset (i.e., from the investment)produced a long FX position which offsets the original shortFX position.

The firm has effectively offset its foreign currencyshort exposure with the foreign currencydenominate asset which is a long position

The firm has converted its foreign currency liabilityinto a home currency liability.

The firm has hedged against a strengthening ofthe foreign currency.

However, the firm will cannot benefit from afavorable change in the exchange rate (i.e., if thepound weakens).