FINM8007 Chap.8 Managing Foreign Exchange Risk
Managing Foreign Exchange Risk
Choosing among hedges
Once an exposure is measured, a firm can hedge it with financial contracts or with operating decisions.
This chapter compares forward, money market and option hedges on the same receivable in home currency, shows that forward and money market hedges coincide when interest rate parity holds, and covers cross hedges and currency swaps.
Hedges without contracts, and whether to hedge
It then turns to natural hedges, invoice currency, leading and lagging and exposure netting, the strategic responses to economic exposure, options for contingent exposure, and the arguments for and against hedging in perfect and imperfect markets.
Where marks are won and lost
The hedging solutions follow one pattern: convert every alternative into home currency at the same future date, show the calculation for each, state the criterion and then choose.
In the Week 9 comparison practice the put is chosen on expected dollars, with each scenario computed separately.
The Week 9 tutorial solutions add a deeper point for written answers: when a firm carries risky debt, hedging can shift value between bondholders and shareholders, so shareholders may oppose a hedge that makes the firm safer overall.
How it connects
This chapter draws together quotes from Chapter 1, parity from Chapter 5 and the exposure types from Chapter 7, and it hands on to Chapter 9, where the location of production becomes a long-run hedge and political risk joins currency risk in the decision to invest abroad.
What this chapter covers
- 01
Financial versus natural hedges
- 02
Forward hedge
- 03
Money market hedge
- 04
Option hedge
- 05
Comparing hedges in home currency
- 06
Forward and money market equivalence
- 07
Invoice currency, lead and lag, netting
- 08
Should the firm hedge
Worked example · free
Read the break-even points between a forward, a put and no hedge
- 1Forward proceeds: 400,000 × 1.5300 = A$612,000 at every spot rate.
- 1Put worst case: below the strike it pays 400,000 × (1.5500 − 0.0300) = A$608,000.
- 2Put matches the forward where 400,000 × (S − 0.0300) = 612,000, so S = 1.5600 AUD per USD.
- 1Unhedged matches the forward where 400,000 × S = 612,000, so S = 1.5300.
Key terms
- Forward Hedge
- Selling a foreign receivable, or buying a payable, forward to fix its home-currency value.
- Option Hedge
- Buying a put on a receivable or a call on a payable to set a floor or a ceiling for a premium.
- Cross Hedge
- Hedging a minor currency with a contract on a closely correlated major currency.
- Exposure Netting
- Offsetting receivables and payables in related currencies and hedging only the residual.
- Lead and Lag
- Collecting or paying early or late to shift timing towards a favourable currency move.
- Currency Swap
- An agreement to exchange currencies at a set rate on a sequence of future dates.
Managing Foreign Exchange Risk FAQ
When do forward and money market hedges give the same result?
Exactly when interest rate parity holds. Equating the forward proceeds with the money market proceeds reproduces the parity formula, so any difference between the two hedges measures how far the quoted forward sits from its parity value.
Which option hedges a foreign-currency payable?
A call on the foreign currency. It caps the home-currency cost at the strike plus the premium if the currency rises, and lets the firm buy at the lower spot rate if the currency falls.
Why might a firm not hedge at all?
In a perfect capital market shareholders can hedge or diversify for themselves, and managers may hedge to protect their own pay. Hedging adds value only through imperfections such as information gaps, lower transaction costs, taxes and the costs of financial distress.
How is contingent exposure best hedged?
With options, because the firm does not know whether the foreign cash flow will happen. If the deal falls through, the firm lets the option lapse and loses only the premium, whereas a forward would leave it with an obligation and nothing to deliver.
Why might shareholders oppose a hedge?
When a firm has risky debt, an unhedged position gives equity a chance of a large payoff in good states while bondholders bear the bad ones. Hedging makes the debt safer and transfers that value to bondholders, so shareholders can prefer the riskier, unhedged position.
Exam move
Take one receivable and one payable and price every hedge in home currency at the same date; then write which criterion picks which hedge, and one natural hedge that would shrink the exposure first. Finish by writing the argument for and against hedging for one real firm, naming the market imperfection that tips the balance.
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