International Finance Applied Financial Economics

Question: LA Limited is a US firm and expects to receive S$800,000 in one year. The existing spot rate of the Singapore dollar is US$0.74. The one-year forward rate of the Singapore dollar is US$0.76. LA Limited created a probability distribution for the future spot rate in one year as follows: Future Spot Rate Probability US$0.75 20% US$0.77 50 US$0.81 30 Assume that one-year put options on Singapore dollars are available, with an exercise price of US$0.77 and a premium of US$0.04 per unit. One-year call options on Singapore dollars are available with an exercise price of US$0.74 and a premium of U$0.03 per unit. Assume the following money market rates: U.S. Singapore Deposit rate 9% 6% Borrowing rate 10% 7% Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether LA Limited should hedge its receivables position. Required: a. Calculate the forward contract hedge. (5 marks) b. Calculate the money market hedge. (5 marks) c. Calculate the option hedge. (5 marks) d. Briefly discuss the optimal hedge against the no hedge position of the company. e. Discuss whether the multi-national corporation (MNC) like LA Limited will risk be over-hedged its position to the extent affect the companys financial position. Answer: LA Ltd. Has Singapore $8,00,000 receivable in one year. So, under the forward contract hedge, it is afraid of Dollars($) falling. So, in order to hedge against the same, LA Ltd. Should enter into a forward contract by selling the $8,00,000 which it will receive after a year at 1 month forward $/Singapore $ rates. So, under this alternative, LA Ltd. Shall sell $8,00,000, 1 month forward and thereby get $8,00,000* 0.76 = US $ 6,08,000 at the end of 1 month. Under the money market hedge, LA Ltd. Shall follow the following steps: Borrow the Present value of Singapore $8,00,000 @ 7%per annum, implying 0.5833% for 1 month. So, borrow 8,00,000/ 1.005833 = Singapore $ 7,95,360 (approx) Sell Singapore $ 7,95,360 spot @ 0.74, getting 7,95,360* 0.74 = US $ 5,88,567 Invest US $ 5,88,567 @ 9% per annum, i.e., 0.75 % for 1 month. So, US $ inflow after 1 month = 5,88,567 * 1.0075 = US $ 5,92,981.25. LA Ltd. Has Singapore $ 8,00,000 receivable, i.e., it has foreign currency receivable. Hence, it is afraid of foreign currency, i.e. Singapore $ falling. 1 month futures U.S $ rate = (0.75* 0.2) + (0.77* 0.5) + (0.81* .30) = US $ 0.778 Here, the exercise price for the put option is US $ 0.77 with a premium of US $ 0.04, net US $ 0.73. Since the exercise price is less than the 1 month futures rate, therefore the put lapses. Yet, inflow from exercising the put option = 8,00,000* 0.73 = US $5,84,000. From the above calculations in a), (b) and (c), we find that the most optimal hedge shall be that of the forward contract hedge, since the US $ inflow after a month is the highest in this alternative. In case of no hedge position, LA Ltd. Will receive $ 8,00,000 * spot rate after a month, i.e., $ 8,00,000* 0.078 = $ 6,24,000 as compared with $ 6,08,000 under the forward cover. So, the no hedge option is a better alternative than any of the alternatives given. Large Multi- national corporations (MNCs) can manage their risk exposure by operational or financial hedging. Hedging is required because of certain unexpected changes in the foreign exchange rates and the foreign currency demand conditions. If the quantity of foreign currency inflow or outflow is certain, then, it is much easier to hedge the exchange risk exposure associated with it by using a forward contract. This eliminates the associated transaction exposure completely with a relatively simple financial hedge. However, fluctuating foreign currency cash flow represents an additional source of uncertainty for many multinationals. For certain products, demand conditions can swing dramatically from year to year, inducing large changes in foreign currency revenues. However, if the foreign currency flow is uncertain, hedging is not possible. Mello, Parsons, and Triantis (1995) consider the design of an optimal financial hedging policy for a multinational with production flexibility. Financial hedging helps alleviate the agency problem associated with the firms outstanding debt and moves equity owners to closer to the first best operating policy. Firms that utilize financial hedges must indeed determine the correct instruments and implementation that are most effective for their environment. In other words, just because a straddle strategy with foreign exchange options is successful for other firms, it does not necessarily mean that that type of hedge will be successful for all firms. Industry type, exposure, business structure, etc. must be taken into account when choosing a hedging strategy. To mitigate the impact of exchange-rate fluctuations, it has been claimed that multinational corporations can employ risk-management strategies not only through financial derivatives, but also through operational hedges. MNCs operate in a large number of foreign countries; the currencies of these countries generally do not move in the same direction at the same time. Most international companies have a financial strategy that works as a guideline and regulates the mandate regarding risk management. One major financial risk for multinational companies is the foreign exchange rate risk, which occurs when performing international transactions. The risk of currency fluctuations can be reduced and stabilized by hedging (Allayannis Weston 2001). Financial derivatives such as options, forward and swap contracts are the most financial instruments used for hedging (Black et al. 2008). Derivatives are not only used for hedging purposes; they can also be used in a speculative purpose in form o f proprietary trading. This is a way for companies to earn additional return outside their core business (Hagelin 2003). It is very crucial to determine how MNCs use financial hedge strategies, and their overall effects on firm value. It should further be noted that all of the MNCs studied do utilize some type of hedge strategies, but may not necessarily utilizing financial hedging. MNCs who utilize various financial hedges must indeed determine the correct instruments and implementation that are most effective for their environment. In other words, just because a straddle strategy with foreign exchange options is successful for an IT firm, it does not necessarily mean that that type of hedge will be successful for all IT firms. Industry type, exposure, business structure, etc. must be taken into account when choosing a hedging strategy. Although there has been no prescriptive hedge strategy for MNCs, research conducted by Yin Han (2011) suggests that the use of forward contracts i n hedge strategies will outperform the use of currency options. However, there is obviously no preferred method of hedge strategy among MNCs. The supporting evidence shows that different instruments are preferential in different economic environments. In summary, each and every MNC that engages in hedge strategies to mitigate risk must identify what the exposures are, what potential costs that exposure could inflict, and how to implement a hedge strategy that most effectively deals with that exposure. List of References Hagelin N. (2003). Why firms hedge with currency derivatives: an examination of transaction and translation exposure, Applied Financial Economics, 13(1):55-58. Allayannis, G. Ofek, E. (2001). Exchange rate exposure, hedging, and the use of foreign currency derivatives, Journal of International Money and Finance, 20 (2): 273296 Allayannis, G. Weston, J. (2001). The use of foreign Currency Derivatives and firm market value, Review of Financial Studies, 4(3):243-256. Yin, L., Han, L. (2011). Forward or Options? Currency Risk Hedging for International Portfolios via Stochastic Programming. International Research Journal of Finance and Economics, (72), 84-99 Hagelin, N., Pramborg, B. (2004). Hedging Foreign Exchange Exposure: Risk Reduction from Transaction and Translation Hedging. Journal of Financial Management and Accounting, 15(1), 1-20. Dufey, Gunter and Srinivasulu, S. N. (1983) The case for corporate management of foreign exchange risk, Financial Management 5462. Mello, Antonio S., Parsons, John E., and Triantis, Alexander (1995) An integrated model of multinational flexibility and financial hedging, International Economic Review 39, 2751. Aliber, Robert Z. (1978) Exchange Risk and Corporate International Finance, Halsted Press, New York.