Difficult to manage contingent exposure using traditional hedging tools like forward contracts, but an alternative is for GE to buy a put option on C$100m
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Hedging Recurrent Exposure with Swap Contracts
Firms often must deal with a “sequence” of accounts payable or receivable in terms of a foreign currency, and these recurrent cash flows can be best hedged using a currency swap contract
Currency swap contracts are agreements to exchange one currency for another at a predetermined exchange rate, that is, the swap rate, on a sequence of future dates
Similar to a portfolio of forward contracts with different maturities
Very flexible in terms of amount and maturity, with maturity ranging from a few months to 20 years
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Hedging through Invoice Currency
Hedging through invoice currency is an operational technique that allows the firm to shift, share, or diversify exchange risk by appropriately choosing the currency of invoice
Example: If Boeing invoices $150m rather than £100m for the sale of aircraft, it does not face exchange exposure anymore. Though the exchange exposure has not disappeared, it has been shifted to the British importer.
Another option would be for Boeing to invoice half of the bill in U.S. dollars and the remaining half in British pounds, thereby sharing the exchange exposure
Finally, the firm can diversify exchange exposure to some extent by using currency basket units, such as the SDR, as the invoice currency
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Hedging via Lead and Lag
The lead/lag strategy reduces transaction exposure by paying or collecting foreign financial obligations early (lead) or late (lag) depending on whether the currency is hard or soft
Challenges associated with this strategy:
If we assume Boeing would like BA to prepay £100m, we can also assume BA would have no incentive to do so unless they received a substantial discount to compensate for prepayment
Pushing BA to prepay may hurt future sales efforts by Boeing
To the extent the original invoice price incorporated the expected depreciation of the pound, Boeing is already partially protected against depreciation of the pound
Strategy can be employed more effectively to deal with intrafirm payables and receivables among subsidiaries
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Exposure Netting: Lufthansa
“In 1984, Lufthansa, a German airline, signed a contract to buy $3 billion worth of aircraft from Boeing and entered into a forward contract to purchase $1.5 billion forward for the purpose of hedging against the expected appreciation of the dollar against the German mark. This decision, however, suffered from a major flaw: A significant portion of Lufthansa’s cash flows was also dollar-denominated.”
Lufthansa had a so-called “natural hedge”
The following year, the dollar depreciated substantially against the mark and Lufthansa experienced a major foreign exchange loss from settling the forward contract
The lesson here is that, when a firm has both receivables and payables in a given foreign currency, it should consider hedging only its net exposure
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Exposure Netting
Realistically, typical multinational corporations are likely to have a portfolio of currency positions
In this case, firms should hedge residual exposure rather than hedge each currency position separately
Exposure netting is hedging only the net exposure by firms that have both payable and receivables in foreign currencies
For firms that would like to apply this approach aggressively, it helps to centralize the firm’s exchange exposure management function in one location
Many MNCs are using a reinvoice center, a financial subsidiary, as a mechanism for centralizing exposure management functions
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What Risk Management Products Do Firms Use?
Among U.S. corporations, based on a survey of Fortune 500 firms, the most popular product was the traditional forward contract
Jesswein, Kwok, and Folks (1995) found 93% of respondents reported using forward contracts
Kim and Chance (2018) study:
Examined actual currency risk management practices of 101 largest nonfinancial corporations in South Korea
Authors document a great discrepancy between what firms say they do versus what they actually do, attributing the discord to attempts by companies to time their hedges
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