Question

Which financial product can be used to hedge foreign exchange risk by multinational enterprises? How does that work? Please give an example.

Answer 1

Answer-

The following financial products can be used to hedge foreing exchange risk by multinational companies-

1) FORWARD CONTRACT

a) A forward transaction is a transaction requiring delivary at a future date of a specified amount of one currancy for a specified amount of another currancy. The exchange rate is determined at the time of entering into the contract, but the payment and delivary taken on maturity

b) Depending upon whether the forward rate is greater than the spot rate, given the currancy in consideration, the forward may be either at par or 'discount' or at a 'premium'.

Exapmle-

An Indian firms buys electronics from British firm with payment of 10,00,000 pounds(GBP) in 90 days. Suppose, the present price of pound(GBP) is Rs.68. Over the next 90 days, the pound(GBP) may rise or decline against Indian Rupee. The importer can undertake an agreement to buy 10,00,000 pounds(GBP) at a rate say Rs.68.10, after 90 days.

According to forward contract, the seller will give 10,00,000 pounds(GBP) to the Indian importer, who in turn will pay Rs.68.10*10,00,000= Rs.6,80,00,000. In this way, the importer has made certain his payment obligation in terms of Rupee.

Thus importer has covered his risk by buying pound in the forward market.

2) MONEY MARKET HEDGE

Money market hedge is a market for short term instruments. In this market you can borrow or lend for a short period of time .

Example-

a) A British company, that expects to receive in threee months time a given amount in Euro, from a debtors located in a Italy. The British company borrows Euro for three months and thereby creates a matching Euro liability with an identical maturity-tenor.

The Euro loan is repaid, when the customer in Italy settles the transaction on maturity. The amount of borrowing would be net of interest, such that the princial borrowed and interest thereon, equates the Euro-asset.

b) An Indian company that has to pay in 3 months to a Japanese crditor. The Indian company has therefore a Yen(JPY) liability . It should now create a JPY asset. It could use its Rupees or borrow Rupees, buy JPY and invest the JPY proceeds. On due date, it will use the JPY proceeds to pay the JPY liability.

Money market hedges involves

• Borrowing in foreign currancy (say$) in the case of export
• Investing in foreign currancy (sayJPY) in the case of imports.

Note- JPY means Japanese Yen

3 CURRANCY OPTION

a) Currancy options are right not oligations given to the buyer of foreign currancy to buy or sell specific amount of foreign currancy at a specific exchange rate (the strike price) till a specific date when the contract expires. If not exercised, the option expires. For this protection buyer has to pay a premium.

b) Curancy option may be entered either for a put or a call option. A put option gives the right to sell a foreign currancy whereas a call option gives a right to buy foreign exchange. This depends upon the position that is required under a specific, situation by the party entering into an option market.

lets see example

1. Example of Exporter

An Indian Exporter is expecting to receive $1,00,000 after 3 months. He expects that the exchange rate may vary during this period. He can buy a put option to be able to sell $1,00,000 in 3 months time at the strike exchange rate. If the exchange rate falls below the strike price in the market, he can exercise the put option, otherwise he would let the put option lapse.

2. Example of Importer

An Indian Importer is expecting to pay $1,00,000 after 3 months. He expect that the exchange rate may vary during this period. He can buy a call option to be able to buy $1,000,00 in a 3 months time at a strike exchange rate. If the exchange rate increases above the strike price in the market , he can exercise the call option, otherwise he would let the call option lapse.

4. SPOT CONTRACT

Spot contract allows you to exchange currancy at the market rate in effect. Spot contract trades settle within two business days. These transaction can be carried out online vai internet Banking Solutions