Hedging with Derivatives and Money Market Hedge

1
Hedging with Derivatives and Money Market Hedge

• Now that were familiar with options, lets
  look at using forward rates, futures rates and
  call and put options to hedge a long (Account
  Receivable or Note Receivable) or short (Account
  Payable or Note Payable) position in a currency.
  First, lets assume that we sold merchandise to a
  British firm for 1 million pounds payable in 6
  months.

2
Hedging with a Forward Contract with a Bank

• One alternative is to go to our bank who,
  deals in foreign exchange, and simply lock-in the
  value of the 1 million pounds sterling that we
  will receive in six months with a forward
  contract with the bank. Assume that the forward
  rate that the bank offers to us is USD 1.5179 per
  pound. Then, we are guaranteed that the amount
  we will receive will be the following

3
Hedging with a Forward Contract with a Bank

• Value of 1 million pound receivable
• 1,000,000 pounds USD 1.5179 per
• pound
• USD 1,517,900
• What should be apparent, however, is that
  whether the pound appreciates or depreciates,
  weve locked-in the amount that we will receive
  USD 1,517,900

4
Hedging with a Futures Contract

• An alternative to contracting privately with a
  bank is to contract for 1,000,000 pounds with
  futures contracts. Assuming that the futures
  rate of exchange is USD 1.5204 per pound, but
  will include transactions costs (commissions) of
  0.2, we will net the following amount when we
  receive the one million pounds in six months

5
Hedging with a Futures Contract

• 1,000,000 pounds USD 1.5204 per
• pound
• USD 1,520,400 pounds
• - USD 3,041 pounds
• (1,520,400.002)
• USD 1,517,359

6
Hedging with a Futures Contract

• Given the difference between the banks
  forward contract and the futures contract, it
  would be slightly more advantageous to use the
  forward contract (USD 1,517,900 USD 1,517,359
  USD 541). The market effect is that there will
  be a slight increase in supply of pounds in the
  forward market (driving the rate down, with less
  demand in the futures market (driving the rate
  up). They should be the same.

7
Money Market Hedge

• Another alternative is to utilize the money
  markets to hedge the 1 million pound receivable.
  This relies upon borrowing and investing funds
  via the money markets and using the spot rate to
  lock-in the amount we will receive from the
  receivable.

8
Money Market Hedge

• Assume the following
• We can invest in British t-bills at a rate of
  8 and we can borrow in Britain at a rate of 11.
• Also, assume that we can invest in US t-bills
  at a rate of 5 or borrow in the US at an 8 rate
  of interest.

9
Money Market Hedge

• Now, think about what we are trying to do. We
  will receive one million pounds in six months, so
  we want to move the pounds to the United States.
  The following slide shows how we can accomplish
  this through the money markets

10
Money Market Hedge
11
Money Market Hedge

• Since we are going to receive one million
  pounds in six months, we want to move the funds
  using the money markets as the following arrows
  indicate

12
Money Market Hedge
13
Money Market Hedge

• As the arrows indicate, we want to borrow
  against the 1 million pounds in Britain, convert
  to US dollars at the spot rate of exchange, and
  invest in U.S. t-bills. The reason we want to
  invest in t-bills is so we can compare the amount
  of dollars we will receive today by borrowing
  against the receivable with the amount of dollars
  we will receive in six months using a forward
  contract or a futures contract.

14
Money Market Hedge

• Borrowing against the 1 million pound
  receivable
• 1,000,000 pounds/(1.055)
• 947,867 pounds
• Converting to US dollars at the spot exchange
  rate of USD 1.5385 per pound
• 947,867 pounds USE 1.5385 / pound
• USD 1,458,294

15
Money Market Hedge

• Investing the dollars at 5 in US t-bills for
  six months
• USD 1,458,294 1.025
• USD 1,494,751
• As is obvious, in this case the forward or
  futures contract approaches will yield more funds
  for the receivable than using a money market
  hedge. This is due to the fact that our
  borrowing rate in Britain is higher than British
  t-bill rates (a transactions cost).

16
Using a Put Hedge

• One way of perfectly hedging our long position
  in pounds by using options is to sell a call
  option on the pounds and buy a put option. By
  selling a call, weve locked-in what we will
  receive (the buyer will force us to sell at the
  strike price) if the pound goes up in value. By
  buying a put option, weve locked-in what we will
  receive if the pound depreciates (we can force
  the seller of the option to buy pounds from us at
  the strike price).

17
Using a Put Hedge

• Assume that we can buy a put option with a
  strike price of USD 1.53 per pound by paying USD
  0.015 per pound (one and one-half cents per pound
  is the cost of the put option). Also, assume
  that at maturity in six months that the exchange
  rate is USD 1.5243 per pound. Since the market
  rate of exchange is less than the strike price,
  we will want to exercise our put option and sell
  at the strike price of USD 1.53 per pound.

18
Using a Put Hedge

• 1,000,000 pounds USD 1.53 / pound
• USD 1,530,000
• Subtracting the cost of the put option of USD
  15,000 (1,000,000 pounds USD 0.015 per pound
  USD 15,000), we will net USD 1,515,000.

19
Using a Put Hedge

• USD 1,530,000
• - USD 15,000
• USD 1,515,000
• Why might we be willing to buy a put option
  that only nets us USD 1,515,000 when a forward
  hedge or a futures hedge will net us between USD
  1,517,359 and USD 1,517,900? Because with the
  put option, we still have the potential for
  realizing the upside potential of an appreciation
  of the pound.