Foreign Exchange Hedging, James Tompkins

hi everybody this is James Tompkins and welcome to lecture 11 of the international finance series where today I'm going to discuss foreign exchange hedging but as you know if you've been watching this series I hope you're not too tired of us I always like you to know why we're doing what we're doing as opposed to hey this is in chapter 6 and chapter 6 follows chapter 5 so in any case the overall theme of this class was what international financial principles as it affects firm value and values a function of risk and return and what element of risk have we been looking at that one might relate internationally exchange rate risk right so know it's my goal has get you to not memorize but understand why the dollar goes up and down value and we've used that as a benchmark or a platform from which to also under other look at other or understand other reasons why currencies go up and down value you know why does the Hong Kong dollar not change and and why did the Zimbabwe dollar basically go bankrupt etc etc so in any case the second half this class is going to look at managing us risk and managing it not only in the short term but also the long term and in lecture 10 we looked at foreign exchange markets and we're going to use some of the knowledge of what we learned in that in other words some of those markets in this lecture to manage exchange rate risk in the short term and that comes under the heading of foreign exchange hedging so that's why we're doing what we're doing so agenda not complicated basically I'm going to start off a little bit of an introduction and then we're gonna go through a hedging example and what I'm going to do is I want to pick a really simple example and the goal will be just to go through a whole host of alternatives as we're faced with potential exchange rate risk in this example so that way we'll see the pros and cons of the different alternatives that we highlight so first of all what is the goal of hedging obviously this is definitional right so you know that you are the nobody you don't but any any thoughts well basically it's to eliminate or reduce risk and in the context of what we're talking about is going to be risk associated with foreign exchange transactions now when you think of risk is risk about the expected or the unexpected well pretty much the unexpected right I mean so for example in your lifetime has has the Sun ever not risen for you in the morning now I don't mean whether you see it or not I mean you know even if it's cloudy has the Sun ever not risen for you in the morning it hasn't right so in other words you know what what you expected to happen has always happened and so in other words nothing unexpected has ever happened when it comes to the Sun rising right so when you think of this at least based on historic experience when you think of this notion of the risk associated with whether or not the Sun will unexpectedly not arise you would say that risk is what probably zero right and so basically risk is about the unexpected so we set the goal of hedging was to eliminate or reduce risk associated in this example with foreign exchange transactions so when we think about hedging foreign exchange transactions are they providing you protection if you will you know this is you know managing or eliminating or reducing this risk are they providing you protect against expected exchange rate changes or unexpected exchange rate changes unexpected right I mean first of all does does the market have an expectation of what the exchange rate will be for say the yen in three months it does right I mean we saw that in the last lecture we saw that with the forward market with a futures market you know them in the same way that the market says hey Apple stock is worth you know five hundred and fifty dollars a share today which is based on its expectations of both cash flows and or risk inherent in those cash flows okay the market also has expectations of what an exchange rate is going to be say three months down the road and so when it comes to hedging I mean I'll give you an example okay suppose I would make this up let's say right now the the exchange rate for the euro is say you know a dollar thirty five per euro okay so let's say the exchange rate today is a dollar thirty five euro and let's say today that the market expects the exchange rate say in in three months and again I'm making this up okay is a dollar forty clear so in other words imagine that the futures price today you go to Wall Street Journal what Evans and look up the the futures price or the forward rate and and the markets basically saying all right well today we expect the exchange rate in three months to be a dollar forty forty per euro so in other words does the market expect a change in this exchange rate they do right that they're actually expecting the dollar to work weaken or strengthen we could write they're expecting it to take more dollars three months down the road to buy euro and therefore they're expecting the dollar to weaken so when it comes to hedging is hedging gonna eliminate this difference the difference between the dollar 40 and the dollar 35 it's not right because that's what's expected but suppose the at the actual exchange rate would it would it be a huge coincidence if the actual exchange rate was the same as the expected exchange rate three months down the road you would be right would that be that'd be like you investing in Apple stock and and maybe apples trading at five hundred and fifty is Sharon and you expected to be trading at six hundred dollars a share in one year well one year from now would it be a huge coincidence if Apple was trading at exactly six hundred dollars per year it would right so same thing here I want to make something up so so suppose that the actual exchange rate in three months is a dollar forty two pierrot okay so here we have today's exchange rate again all these numbers are made up here we have the markers saying today hey in three months we expect the exchange rate to be a dollar forty Bureau and imagine I have a crystal ball and and three months down the road the actual exchange rate is a dollar 42 Piro so if you are going to completely eliminate exchange rate risk associated with hedging then what what what what difference would you be protecting yourself against well how much of this guy the dollar forty two is unexpected the difference between this dollar forty two and the dollar forty right because dollar forty was what was expected a dollar forty two were imagining is what actually happened so hedging would protect you against the unexpected or in other words the point O to the the unexpected additional amount that the dollar what weakened or strengthened weakened so so bottom line is that hedging does not provide protection against expected exchange rate changes but rather unexpected so let me bring up one key principle behind hedging it and look I'm probably being way simplistic here but I like to keep things simple all right if it's if it's if it's not simple it's over my head all right so and I'll set this up with a situation an example in fact this is gonna be our example when we get to it imagine a US businessman or woman or whatever owes a japanese supplier a hundred million yen in 90 days okay so because you know the Japanese is is supplying with something okay now would you've created if you're the US business person would you've created an accounts payable or accounts receivable if you're gonna owe 100 million yen in 90 days that accounts payable right I mean you know that there you have the accounts payable and you are 100 million yen in 90 days now next question the amount that you owe in dollars would it depend upon the actual exchange rate and therefore be subject to risk you would write and so I mean to the extent that ya the market has an expectation today of what the exchange rate will be in 90 days and so therefore you have an expectation today of how much you'll owe in dollars and 90 days but if you just waited and you saw it the actual exchange rate was would you be subject to paying unexpectedly or likely be subject to paying unexpectedly more dollars or fewer dollars you would right so here's my question what imprints of all could you do to avoid any unexpected exchange rate payments okay so so in the context of this balance sheet what could you create such that in the end you would not pay anything unexpected well basically what you could do is create something equal and opposite on the other side of the balance sheet so in other words with your transaction if you Oh 100 million yen if somehow and we'll get and this was this is where we'll get into various alternatives with our example later on but if somehow you could create something equal and opposite on the other side we'll call that our hedge then is it going to matter what the exchange rate is it isn't right because you could take the hundred million yen that is owed to you in 90 days and could you then use it to pay off what you owe in 90 days you could right and and so so basically that's if you will the one key principle in hedging you know create something equal and opposite on the other side so a couple more questions in principle does hedging apply just the short term say a year or less or could it also apply to long term well in reality it could apply to both the short and long term okay now what we're going to be talking about today is short term and the reason we will be discussing short term is because we're gonna be using these markets that we learned last time and you remember what those markets were well we had the well first of all what happens at a market you buy and sell stuff right so what kind of MA I'm talking about foreign exchange markets so what's being bought and sold currency right and so we'd like we talked last time about the spot market and they remember forward market the futures market the options market and and all of those are short term I mean that there's some exceptions like options they have what's called leaps which goes beyond a year but they're generally pretty thinly traded and in any case we're gonna be talking about using these instruments for a year or less and we're gonna associate it with a specific transaction I'll tell you what I mean by that in a minute but hedging can also imprensa Pillai in the long term maybe you've heard of something called a natural hedge does anyone know what a natural hedges well it might be that you have operations let's say the ski a ski resort maybe you have a ski resort in vailed but you also have a ski resort in Switzerland and and and owning a ski resort is that short term a long term that's long term right so we'll be looking at managing this risk and actually taking advantage of risk opportunities that exist in the long term but not today today we're going to talk about the short term management of exchange rate risk and in particular as I mentioned we'll be talking about something called transaction exposure and what is transaction exposure well it's not complicated basically we engage in a transaction that of course in our case involves paying or needing to pay with foreign currency and so what risk is associated with the fact for this transaction that might make you pay more so from the US perspective more dollars than expected well less dollars than expected because of unexpected movements in the exchange rate risk I mean in the exchange rate so here's a question can you be subject to transaction exposure when there is not a credit transaction you know it's a payment is immediate you can't write because because if if payment is immediate by using today's exchange rate you are right and so is there any risk or uncertainty about what today's exchange rate is when you say all right hey you know give me my widgets now and I'll pay you now is there any uncertainty about how much you'd be paying whether it's in yen or dollars or whatever there isn't right so when it comes to creating risk your time has to pass for there to be a situation where unexpected stuff happens so let's get into a hedging example okay imagine an American fun wants to buy widgets now you guys like the real world right uh-huh I thought so and so guess what you know widgets are real all right I took the trouble of looking it up and if you look up right here widget and if you look up what at least one of the meanings of a widget is I'll give you a couple any small mechanism or device the name of which is unknown or temporarily forgotten well where somebody who's not buying something unknown we're buying widgets something that is known right a small device in a beer can which when the can is opened releases nitrogen gas into the beer giving it a head all right so that's what we're buying okay so we're talking real world stuff here okay a couple other things I need to make up all right so we're buying widgets Japanese supplier cost us a hundred million yen and it's due in 90 days okay so we want the widgets today but we want the credit and and by the way not an unusual way to do business so in other words hey you know give me my stuff now my widgets now I'll then add value to it somehow and then I'll sell it and then I'll get my money and I'll use that money to pay you okay so we want the credit now imagine here's some interest rates will be working with these as as we go through the various alternatives imagine the u.s. 90 day t-bill rate is 3% the Japanese 90 day t-bill rate two-and-a-half percent the US prime rate 6% Japanese primary 4.75% by the way what's what's the difference between a tea rate or Treasury rate and a prime rate well who's doing the borrowing when for example you invest in a UST bill the American government right they're borrowing money okay what about a when the prime rate who who's doing the borrowing they're the the banks most creditworthy customers okay so the prime rate is the rate of which banks will lend to the most creditworthy customers all right a couple other things imagine the spot rate today is point zero zero nine nine eight eight dollars P n imagine the 90 day for two futures rate is 0.01 dollars P n so in other words what does that mean that means that today the market is saying hey we have an expectation that in 90 days the exchange rate will be what 0.01 dollars P n now now this and this in a Spartan forward in futures is that data that is available in the real world on a second-by-second basis it is right all you have to do is just get on your computer and you'll see what the current exchange rate is right now and you'll see what the current futures of Floyd Raiders right now etc etc but to create risk the only part that's imaginary in this example is I'm gonna have to make up what the actual exchange rate is in 90 days so obviously I don't have a crystal ball I don't know what that is for real so I have to make that up right so imagine that in 90 days either the yen is gonna go to 0.01 two dollars so 0.01 $2 PN or point zero zero $8 PN with equal probability okay so so in other words that that's the crystal ball part of it that that's that's the unexpected part okay the market is expecting 0.01 dollars PN but maybe the end unexpectedly what with this number here's the end unexpectedly appreciating or depreciating if the yen is expected to buy you 0.01 dollars but in the end it actually buys you 0.01 two dollars because the yen unexpectedly appreciate or depreciated appreciate right okay so there's the example and like I said what we'll do is we'll go through a number of different alternatives okay so alternative number one yeah we let's say we buy the hundred million yen today so at today's exchange rate of all the various exchange rates I listed you I gave to the spot rate I gave you the forward or futures rate I gave you the actual exchange rates with 50/50 probability in 90 days what what what exchange rate would I need to determine how many dollars I'd need to buy a hundred million yen today well the spot rate right today is exchange rate I'm changing the money today all right so so there I have you know that would mean I'd need $998,000 and so my question is well alright if I now own the hundred million yen today can I use that to pay what L owe in 90 days I can write but but let me ask you this would i if i got the hundred million yen today well what would I do with it would I put it under my mattress my corporate mattress I wouldn't write I mean that wouldn't be very smart right so the question is do I really need the hundred million yen today don't really need the whole hundred million yen today no I don't right I mean what I could do is I could get a little bit less than that today and invest it right such that by the time the investment grows it will grow into a hundred million today yen now that at least that's better than putting out of my mattress right so so what would I do what I would I look for a high-risk investment or low-risk investment well hopefully something is close to zero risk right as possible because the whole point of hedging is to do what with risk eliminate or reduce risk so so what is the most risk-free thing that you can think of of what I could do with yen well lend it to Japanese government right you know it's by a yen t-bill so in other words what I could do is I could buy enough yen and lend it to the Japanese government at two and a half percent such that in ninety days it would grow to a hundred million yen so that way in ninety days I'll be owed 100 million yen and if that's the case can I use that to pay what I owe I can right and by the way by doing that will we have created an accounts receivable we will write because just to remind you with our widgets okay we Oh 100 million yen in 90 days is that our hedge or is that our transaction that's our transaction right and have we created an accounts receivable or an accounts payable with our transaction well we've created an accounts payable right so here we owe 100 million yen in 90 days well if we go through this alternative number one okay will be owed 100 million yen in 90 days is that an accounts receivable if somebody's gonna owe it to us in this case the Japanese government or is that an Accounts Payable well it's an accounts receivable right so in other words what we've done is that we've created our hedge on this side we've created an accounts receivable so let's get into the numbers okay so we don't want a hundred million yen today we want a little bit yet less such that we'll use it to buy a Japanese yen tea bell and a tune hub set we want that to grow into 100 million yen so if we look at how much we need today let's say X is what we need today at two and a half percent ninety days later we want to grow into 100 million yen so if I go through the time value money stuff this is basically a future value formula right and by the way if that's not clear to you you can always go to I think it's lecture 2 of the not International Finance but my corporate finance series and and get a thorough not memorization but really thorough understanding of time value money so in any case what this shows us is that we would need about ninety-nine point four million yen today such that a two and a half percent it would grow in a hundred million yen and so therefore this is the amount of yen I need today can I calculate how many dollars I need today I can write what exchange rate what I use when I use the future of forward rate when I use the spot rate today for an exchange today hint hint that's what I'd use right so basically using the spot rate I'd need you know almost a million dollars today I'd need nine hundred and ninety three thousand dollars today roughly so if we look at what's going on we would need nine hundred ninety thousand dollars today we convert it in today's exchange rate to about ninety nine point four million yen and then what would we do with it next we'd lend it to the Japanese government right who's t-bill rate at the time is two-and-a-half percent and then then what would happen well in ninety days it's pay day for us right they would owe us one hundred million yen so that's that's basically the transaction involved in alternative number one now can you think of any advantages with this first alternative well are we perfectly hedged we are right I mean because again here's our transaction this is the widget and here's our hatch right we'vewe've create an account receivable so do we care whether the exchange rate goes to 0.01 $2 PN or point zero zero $8 p.m. in the end will we have paid a known quantity for the widgets in dollars we will write certain advantages is we're perfectly hedged now can you think of any disadvantages now you know what one thing that you might say as well yeah we we gave up the opportunity to maybe unexpectedly pay fewer dollars than expected and that's true but then at the same time have we also given up the opportunity to pay more dollar than expected we have right so let's just assume throughout all these alternatives when we're talking about advantage and disadvantage that those two offset each other you know it's when we're talking about risk is risk unexpected dollars both in the happy face direction and the sad face direction it is right so so so what we'll assume there's always offset each other but what's another disadvantage well how many dollars did we have to come up with today to engage in this hedge well we had to come up with practically a million bucks right and and but did we want credit yeah we didn't want to have to mess with coming up with any money especially not a million dollars for another 90 days and so an advantage of this first alternative is yes we're perfectly hedged but a disadvantage is what well we gave up our credit advantage so that's alternative number one let's look at alternative number two okay number two says you can just accept the risk and purchase the currency on the due date okay so let's let's see what happens okay imagine the yen unexpectedly appreciates right because how much we'll be expecting the exchange rate to be okay if I draw this out we were we're expecting the exchange rate to be point O $1 p.m. okay this is this is what we were expecting the point o $1 p.m. but either the yen would unexpectedly do what here appreciate or depreciate appreciate right by you more dollars than expected or the end would unexpectedly depreciate okay so so let's look what happens if we just take on the risk okay so if the yen appreciates to 0.01 $2 BN then how much will we owe in the end well we are we are a hundred million and I mean how much we own dollars we are one hundred million yen right but if the actual exchange rate in 90 days is 0.01 - and we just wait 90 days we don't do anything well then we're gonna we're gonna pay 1.2 million dollars now is that happy face or sad face well we've gone yay glad we took on this risk or where we go man huh I wish we hadn't taken this risk that's sad face right and and how would I know that sad face what calculation would I have to do well I'd have to compare it to what we were expected to pay in dollars now I know how much I have to pay in yen 100 million yen what exchange rate would I use at time zero today to figure out how much I'd be expected to pay in dollars you're a multiple choice when I use today's spot rate would I use the expected exchange rate are the for two futures right well I'd use the expected exchange rate right and so basically I was expected to pay a million dollars but if I take on the risk in the end I would pay 1.2 million so if the yen unexpectedly appreciated would I have lost or made money by accepting the risk lost right and how much would I have unexpectedly lost while we expected pay million in the end we would actually have to pay 1.2 million so how much of that is unexpected 200,000 right let's look at what happens when the yen unexpectedly depreciates well how much would we owe in dollars well in 90 days if the exchange rate is point zero zero eight per yen and we are 100 million yen then we would pay $800,000 so would that be happy face or sad face that'd be happy face right because how much will be expected to oh in dollars again a million dollars right so so therefore would we pay paying more than expected or less than expected if we took on the risk and the yen depreciated less right because we were expecting to pay million but in this example we would only pay eight hundred thousand so so we would have made two hundred thousand so happy face or sad face that'd be happy face right so what I want to do now is get across some language and this this concept of long and short and the reason that I want to do that is because it'll probably be easier to figure this stuff out as we go forward okay so so here's our transaction okay and and when we owe something and when you owe something as opposed to when you earn something are you long or short you're short okay so for example if I buy you know ten shares of Apple stock I own it so would I be long Apple stock or short Apple stock I'd be long Apple stock right but in this example with our transaction with our widgets okay we owe 100 million yen so are we long or short yen was short right so what I want to do is look at when you're long and your short and things go up and down in value whether you make or lose money okay so when you're long something and that something goes up in value have you made or lost money you've made money right so for example if you buy a hundred shares of IBM at say $80 are you long a short IBM stock you long IBM stock that's what we're used to and and and so suppose the price now goes up to $90 it's a gonna be happy face or sad face happy face right so so when you long something and that something goes up in value you've made money so in this example we buy hundred shares at 80 so it basically we have something that's valued at $8,000 when we buy it and then it goes up to $90 now it's valued at 9000 so so we've made it a thousand dollars okay and and what if IBM had gone down in value suppose we've gone from 80 down to 70 what you've made money lost money lost right so that this is what we're used to when you long something or when you own something and it goes up in price you make money and when it goes down in price you lose money so that's that's the easy thing that that's what you're used to okay now what about the other thing what does it mean when you're short a hundred shares of IBM stock well now now short is the opposite along right so when so if you're long you earn the stock but if you're short do you owe the stock oh oh w EU you owe it right now it's you borrowed it so so when you're short a hundred shares of IBM stock basically you've borrowed a hundred shares of IBM stock so let's say you short a hundred shows that stock at eighty dollars okay so what what that means is that you know your account literally it's like go in the bank and and borrowing $8,000 okay now if if if it's time if it now goes up to 90 and it's time to repay that hundred shares then how many dollars will you have to come up with to get those hundred shares well you'd have to come up with nine thousand dollars right and so it's like go to the bank in this example and you borrow $8,000 so you put that $8,000 in your pocket and and and then you keep it but when it's time to pay back you have to come up with 9,000 to repay what you borrowed so when you short something and that's something goes up in value have you made a lost money you've lost money so again re-emphasize you know you borrowed 100 shares and 80 you account went up by eight by eight thousand dollars then it came time to return the shares but now you're returning them at 90 so your account goes down by nine thousand and so you've lost money and so similarly so when you short something and that something goes up in value view made or lost money you've lost money but when you're short something and that something goes down in value have you made or lost money you've made money right so for example in this case imagine that IBM stock had gone down to say 70 well then you would have only need instead of 90 you'd only needed $7000 to come up with these hundred shares and so you will have made money so that's the concept of short and long so short is the opposite of long long as what you and I used to how you know you buy Apple stock it goes up in value it's happy face goes down in value of sad face short the rules are completely reversed so now let's apply this to our transaction are we long N or short yet well we're short y n right with our transaction so we were short yen and when the yen unexpectedly appreciated okay so when you short something and that something goes up in value then where do we make or lose money we lose money right do you remember how much we lost we lost two hundred thousand right why because again if we took the risk we were expected to pay how much okay we're expected to pay a million dollars with this expected exchange rate but if we took the risk we would actually pay how much 1.2 million and so therefore we will have paid two hundred thousand more than expected or less than expected more than expected right and so so that's consistent with what we learned about long and short when when when you're short something and that something goes up in price or values that yen unexpectedly appreciated then did we make or lose money we lost money right and what about the other way around okay so so we're short yen in our transaction if the yen unexpectedly depreciated okay so went down and valued it did we make or lose money we made money right why again because we're expected at this exchange rate to pay million but if we took the risk when the yen unexpectedly depreciated then we would have ended up paying 800 thousand which is 200 thousand more than expected or less than expected less than expected right and so we're assured something that something went down in value and so therefore we made 200 thousand dollars so let's put it all together okay we'll turn number two yeah take on the risk and buy the currency on the due date okay and so what are the advantages relative to alternative number one what are the advantages well basically did we have to come up with any money today if we did this we didn't write you know taking on the risk which by the way in the context of International Finance is called standing naked okay just take the risk chances are that's what you do when you go on vacation right if you plan a vacation to Europe say in three months probably you just accept whatever exchange rate exists in three months okay so but in any case an advantage of this relative to alternative number one is did we have to come up with any money today we didn't right and so we have we now regained the credit advantage we have right and and a relative to alternative number one what's a disadvantage well we hedged we're not right we're taking on the risk so if we put this all together we could argue that so far hey you know neither one of these choices look that great right I either we buy the yen today we're perfectly hedged but we have to forego the credit advantage or we take the risk and we regain the credit advantage but we're not hedged so let's move on to alternative number three so the next alternative we're going to look at is a Ford contract okay so do we need T long or short a Ford yen contract for our hedge well let's look at our transaction right on our transaction side or our widget side are we long a short yet we're short yen right and so therefore for a hedge do we need to be long or short yen we need to be long right we need to be on the opposite side of the transaction so do you remember what a Ford contract is this would have been in the previous lecture okay now now if you don't and if you're watching this without having seen the previous lecture I strongly encourage you especially from this point forward I strongly encourage you to go back and watch that lecture because it'll make a lot more sense what I proceed with today but in any case with a Ford contract basically you know say I'm a US businessman and I go to a bank and I say hey I want to make a deal today about an exchange in the future so in other words if I if I if I were the the business person I'd go to a bank and say hey I want to make a deal today such that in 90 days I'll agree to pay you a certain number of dollars and you'll owe me a hundred million yen okay so that's that's the forward contract and and specifically what exchange rate would I use I'd use the forward rate right which was 0.01 dollars PN so the way it looks like is is this is this is me I'm the guys say that's buying that the widgets from Japan and at night I go to the bank today and I say hey let's agree today that I'll give you a million dollars in 90 days and you give me a hundred million yen in 90 days by the way you'll notice that exchange means that the exchange rate is what 0.01 dollars PN which is by the way what we what the forward or futures rate is so with that in mind let's look at ellora let's look at our alternatives say the spot goes to point zero zero eight dollars PN okay so the yen depreciates okay now on the forward side have we made or lost money all right let's think about this on the forward side okay are we long or short yet we're long right you know now our hedge is on that side with with we're here's our forward contract is our widgets that's our transaction so we're long yet right so when you long something and that something goes down in value in this case the yen has depreciated have we made or lost money we've lost money right just like buying Apple stock at five hundred and fifty dollars a share and Apple stock goes down to five hundred it's a happy face or sad face that's sad face right and and and why is that the case well with the food contract well we have locked in an exchange rate of 0.01 dollars PN we were we would write that's what the forward contract is we would have locked in the fact that hey you know we'll give you a million dollars and you give us a hundred million yet but if we had not locked in this Ford contract and we could have got in the open market then how much would it have cost us to in dollars to buy the N eight hundred thousand right and so by having the Ford contract we lost two hundred thousand dollars okay consistent with what we said earlier when you long something and that something goes down in value have you made a lost money well you've lost money okay so that let that explains you know this site when the yen depreciate on this side we lost money what about on this side what about on the transaction side on the transaction side are we short or long yen we're short right and when you short something and that something goes down in price have you made um lost money you've made money right how much did we make two hundred thousand right because on this side with what we owe were expecting to pay million but if we actually only had to pay 800 thousand that would be happy face or sad face that be happy face right so if we put it together all together on the hedge side with a Ford contract we lost two hundred thousand but on the transaction side or the widget side we made two hundred thousand and so by having that forward hedged when the yen depreciated would there be any unexpected dollar payments they wouldn't write so let's look at the the other situation imagine at the end appreciates unexpectedly appreciates on the Ford side are we long a short yen well on the fourth side we're on the side we long yen and it again appreciated you know that went up in value when you long something and that something goes up in value have you made money or lost money you've made money right and so let's see how this works but basically with the hedge what exchange rate or with a Ford contract what exchange rate have we locked in 0.01 dollars PN right which means that to buy the hundred million yen we're gonna have to come up with how many dollars a million dollars right but if we didn't have that forward contract and we just went to the open market to see how much you know yeah well how much money would we need if we just went to the open market and we hadn't locked in this exchange rate well we would have needed 1.2 million dollars right so we'll have been happy face or sad face the fact that we had the forward contract happy face right basically it saved us two hundred thousand dollars so again you long something that something goes down up in value so we long yen with our forward contract the the yen appreciates and so we made money on the Ford side but what about on the transaction side okay so here we are the out with our transaction are we short or long yen on this side we're short right and when you short something and that something goes up in value have you made money or lost money you've lost money right why because again you know you're expected to a million dollars right here but if you just left it for the open market you would have owed you I mean if you left there at mark you widow 1.2 million dollars right so it's a $200,000 more than expected so if we put it all together when the yen unexpectedly appreciated okay we made money on the forward side two hundred thousand we're going yay boy sure I'm glad we locked in early paying a million bucks for that hundred million yen because if we had to go to the open market we would have had to come up with how many dollars 1.2 million right but then on the transaction side we lost 200,000 so again when the yen unexpectedly appreciated were there any unexpected dollar payments they weren't right and so whether the yen appreciated or depreciate unexpectedly in both scenarios did we pay anything unexpected with dollars we didn't right so if we put this all together okay relative to alternative number one and number two what are some advantages at the Ford contract of using the forward contract well then we have to come up with any money today we didn't right so if we have we regained the credit advantage unlike in alternative number one we have right and we also perfectly hedged we are right I mean as we just went through the whole example you know no matter whether the yen unexpectedly appreciates or depreciates will we pay any unexpected amount of dollars we weren't right and so so now we've we've we both we've got the best of both worlds we can have our cake we can eat it - right in this example you know not only have we regained the credit Vantage but we're also perfectly hedged well we didn't have both those advantages in both of the first two alternatives right so great but but what's a disadvantage of a Ford contract to remember this would rely on your understanding of the previous lecture well to engage in a Ford contract typically what's that what's the minimum amount for an entire contract or I should say for a single contract a million dollars right it could be one point one three nine eight million it could be you know two point seven million it could be it could be any amount but typically the minimum mountain's million dollars which suggests that if you're going to being engaged in using a Ford contract are you likely going to be large or small probably large right and what about your credit worthiness is is the bank taking a risk by making a deal with you today for an exchange in the future they are all right what kind of risk are they taking credit risk right I mean you you may go under in the next 90 days and so therefore are they more likely to engage in that transaction with their more creditworthy customers they are right so one of the disadvantages of the forward market is that you have to be relatively large and credit worthy as far as accessibility is concerned so if we summarize it all with perfectly hedged we're using our credit we've regained our credit advantage but typically we have to be large and credit worthy all right so let's look at alternative number four a futures contract so question number one okay for a hedge do you have to be long or short a futures yen contract well on what side is our transaction on the long side or the short side the short side right this is the widgetts we owe a hundred million yen so the hedge then do we have to be long or short yen futures we have to be long yen futures you know we have to make a deal today such that in 90 days we will be owed yet we will be expecting to receive yet without futures contract okay now if you recall with the futures you it's not like afford where it's convenient as long as you do at least a million bucks worth it's convenient what the quality is with the futures contract if you recall you could only do it in what units in the case of yen we saw one contract was twelve and a half million yen now also if you recall for the privilege of engaging in a futures contract then what did you have to put up you had to put up margin right so what that means is you have to put up certain amount of money and we'll go through an example but when you did put up that money - that money belong to you it did right now and we'll see why we'll see why in a minute I'll illustrate what we talked about last time okay but in any case if it takes 12 and a half million yen to have one contract so twelve point five million yen but we want to hedge how many yen in total 100 million yen right okay so so one contract has 12.5 million yen but we need to hedge a hundred million yen and guess what I can do this because this classroom right I made it convenient okay we're lucky it's exactly divisible we would need 16 contracts okay so times I mean sorry eight contracts right okay so twelve and a half million times says eight contracts comes to 100 million yen so so we need eight futures contracts and by the way this how many yen contrast do we need to buy that buy that's a little bit of a misnomer okay do you really buy a uterus contract or do you engage in a futures contract you engage in it right it's not his fight bus give me my broccoli the second that you enter into your futures contract does it have any built-in value it doesn't right because the active the expected the exchange rate the Lockean is the expected exchange rate there's no built-in advantage or disadvantage the second you engage in it in any case as we discussed last time you do have to put up if you will collateral yeah it's called margin so so how much margin would we have to put up if it was 4% i I made up that number four percent well let's take a look here we have the eight contracts twelve and a half million yen for each contract so that's a hundred million yen the futures rate is 0.01 dollars p.m. so all this multiplied comes to a million dollars and if you have to put out fourth and four percent then that means you have to come up with $40,000 today now if that $40,000 is that yours does that belong to you it is right that belongs to you because what we talked about last time was this daily mark-to-market system so for example suppose the very next day the futures price not the spot price but the futures price goes from 0.01 dollars p.m. to point zero zero nine nine dollars p.m. okay so in other words has the the yen the futures price you know how has it appreciate it or depreciated the yen's depreciated right and and and for your for your hedge for the futures are you long or short yet you long right so when you're long something and that something goes down in value you made money or lost money you've lost money right so will you have received a margin call you would right but is what we said was that this daily mark-to-market what they do is they on a daily basis they see how much money you make or lose and and if you lose money they basically say alright well you need to to give us enough money to bring this back up to forty thousand dollars and and that's not completely true I'm missing a wrinkle they have something called an initial margin and a maintenance margin okay so but let's just assume they're both one the same to keep it simple okay so in any case you will receive a margin call for the amount that you lost will calculate how much you lost in just a minute and let's say how much you lost comes to you know I'll make it I'll make it up for now say $5,000 if you've if you sent them the $5,000 then fine you get to maintain your futures contract but if you don't then what happens well because it's tradable that's why the future stuff has to be standardized because it's liquidy they would trade you out and then they would give you how much money they give you $35,000 so in any case let's let's look at list let's be specific okay let's let's look at what's going on here okay so the futures price only changes by one percent okay and and we've already gone through the logic of why you would receive a margin call again because you're long on the futures yen side when you're long something that something goes down in value have you made or lost money you've lost money right so you'd receive a margin call so how much you know have you lost right how much would you have to add to your margin well I mean basically it's really no more complicated than figuring how much you lost a few own shares of stuff right so suppose you had you know ten shares of IBM say at $100 a share and then IBM goes over time to say $80 a share okay so let's say you have 10 shares of IBM and $100 to share and then it goes down and value goes to $80 a share can I calculate how much I lost sure right I mean I could take this difference 100 minus 80 is 20 so $20 per share and I would apply that to how many shares well I would apply it to ten shares right so I will have lost $200 so could I use the same logic here could I could I see how much the to my disadvantage the futures price has gone down look at the difference and then apply it to the number of yen or futures contracts I've lost that into I could write so for example here was the futures price that I locked in the very next day the futures price not the spot the futures price went to my disadvantage because the yen the futures price of the yen had unexpectedly appreciated or depreciated depreciated right so this difference here in my IBM example is like the hundred bucks in the 80 bucks so the amount I've lost is applied to this money yet a hundred million yen okay so what that means is it in one day I lost ten thousand dollars so what would happen well as I mentioned before all right send us send us ten thousand dollars to bring your margin back up to 40 thousand and then you can keep this futures contract or if you don't do that then sorry but we're gonna have to trade you out of this futures contract and you'll receive how much thirty thousand but let me ask you something when you look at these numbers suppose that we're using the futures just for spective reason so let's say we weren't hedging okay so forget this whole widget example for a minute would that suggest that if as an investor you decided well I think I'll play the the futures markets you know in in specifically the currency markets currency futures markets would that suggest that engaging in this type of trading activity what it's just high risk low risk medium risk what what what's your sense well actually unbelievably unbelievably high risk and I'll tell you why okay how much did you have to put up to engage in this contract forty thousand dollars right that's the amount that you put up and when the futures price changed only by one percent how much money did you have to put up in one day ten thousand right so if you're forty thousand that you put up originally how much did you lose in one day twenty-five percent right the futures price changed only by one percent and in one day you lost 25 percent what that means is that if you engage in futures prices trading or you know futures trading for speculative purposes here you're not using for hedging purposes then this is unbelievably high-risk stuff and by the way this is this is true of derivative securities in general what's a derivative security do you know a derivative security is one whose values derived by something else so in other words the value of this futures is is derived from the yen you know the underlying value of the yen or you could have options on yet that's a derivative security also so so trading in droves the Curie's is is very very risky now again as I mentioned if we did not mark-to-market in this example what would they do they'd say alright well you originally gave us 40,000 that was your margin in one day you lost 25 percent or 10,000 so now that's down to 30,000 you know if you're not going to bring it back up to 40 remember I'm assuming which is not true but just for simplicity I'm assuming the initial margin and the maintenance margin are the same but if you don't bring it back up to 40 well we're just going to trade you out and by the way here's the rest of what belongs to you that's the 30 thousand so that's basically you know using some some numbers for the futures contract let's let's go through and and check some other issues okay so first of all are we are we perfectly hatched or are we hedged we are right because you know whatever money I make on this side I'll loose on this side and vice versa okay however even though we are hedged would we have a preference for whether or not the yen appreciated or depreciated in the end to 0.01 $2 PN or point zero zero $8 PN would we have a preference well let's think about that right under what circumstance if you've got futures contract here under what circumstance would you be receiving margin calls if the end appreciated or if the yen depreciated if the end appreciated right and so if 90 days later the you know the yen goes to point zero zero eight dollars per yen eventually that the futures price you know one day today 89 you know the the futures price would be very close to point zero zero eight and obviously on the day of its it's no longer a futures price it's a spot okay so if that if the yen depreciated then you will received margin calls to the tune of how many dollars overtime $200,000 right why because the rate you locked in was 0.01 dollars PN okay and in the in the end what you have a value is is 800,000 so you see you'd have locked in basically paying a million dollars for a hundred million yen but if you hadn't on the long side you could have only paid $800,000 for a hundred million yen right and so so basically the difference is two hundred thousand and it's only on day 90 that you make it up right it's only on day 90 when you owe the yen that you're glad that you don't have to come up with 1.2 million dollars to buy the hundred million yen why because you've locked in a million dollars to buy a hundred million yen and so the question is well would you rather have would you rather have a bunch of margin calls over time and then make it up on day 90 or would you rather not have those marching course you'd rather not have those margin calls right let me draw you a quick diagram to to show you what I'm talking about okay so so let's say this is day 90 and that stays zero and so basically over time okay you would have received here minus two hundred thousand dollars okay so it's kind of looks like this okay so if this is if this is day zero this is day 90 by the yen depreciating on the future side you'll have received a sum total of two hundred thousand dollars over the 90 days in margin calls and only on day nine is that $200,000 made up with the fact that the widgets you've locked in a favorable exchange rate so so in any case that's that's that's futures right so in the end you're perfectly hedged right but you you prefer obviously that you not received as those margin calls so if we put it all together okay advantages and disadvantages well we could say we're we're perfectly hedged maybe maybe you want to say more or less because it's possible that you know you have to wait you know 90 days until the the hedge is complete if you will do we have to come up with any money today but we have to come up with our margin right so but relative to alternative number one where we had to come up with actually a million bucks if we pretty much regained our great advantage we have right so it perfectly heads more or less we've we've regained our credit advantage to it you know to you know a reasonable degree what else what about relative to forwards okay because the forward had both those advantage right the forward perfectly hedged and completely regained the credit advantage are there any benefits to the futures relative the forward well what about size do you do now is a million bucks pretty much the minimum or is it a lot less it's a lot less right I mean we're talking about you know maybe somewhere in the yen case somewhere between say 10 and 20 thousand dollars worth so you don't have to be nearly as big and what about creditworthiness do you even need to go through a credit check well I don't know this for a fact but I assume you don't because you have to put up the margin right presumably the margin is large enough to to cover any daily loss that you might have and they have that mark-to-market system if we summarize everything we're perfectly hedged moreless we still have our credit Vantage more or less and now relative to Ford's we can be relatively small and we don't have to be credit worthy well what I want to do now is is take a little bit of a break we've got more alternatives to go through but I want to talk about hedging in the real world okay and and I want to ask you the question that basically in in theory and in practice you know hedging creates value and yet some really sophisticated well known companies that you and I will have heard of choose deliberately not to hedge and the question is why but before I get to that question first I want to make sure everybody understands why it is that hedging this avoiding paying more than expected or less than expected what why that creates value in theory what why does it create value in theory I mean after all you're used to hey with greater risk we require higher returns right well what if I could tell you okay you know what you're gonna have the same required returns and we're gonna reduce your risk would that be happy face or sad face that be happy face right I'd be great hey you know same returns expected returns required returns now I'm being a little bit loose here but lower risk yeah that's great right and so so let's let's think about this okay in the context of our example so the business man and buying widgets from from Japan what what what is our risk okay what business are we in well we're in the widget business right I don't know what we do with these things right but we are in the widget business surface if we looked at our company our assets would basically be you know or the risk of what we're engaged if you will would be widget risk right and so is there a does the market have a perception of risk inherent in the widget industry they do right and so so so given the risk inherent in this industry to investors require a specific return they do right so here's my question okay does the market necessarily know I guess the even even if they know does is it true that maybe some companies will choose to hedge their exchange rate risk and others won't but but they're still both subject to which at risk that's true right and and whether or not you're a company that happens to hedge your foreign exchange transactions does that change the risk inherent in the widget business it doesn't right I mean widget business risk is widget business risk okay exchange rate risk is exchange rate risk you that those are two yet what one is not necessarily part of the other why is one not necessarily part of the other well because you can choose to hedge out thee or manage the exchange rate risk right and so basically you know the theory of why hedging and the practice the theory and the practice of why hedging creates value is because to the extent that you can costlessly hedge exchange rate risk away okay but you're not giving up any required returns within the business that you're engaged in the widget business then ceteris paribus would that be similar to what i open this up with hey you know given required or expected return and i get rid of some risk with that be happy face or sad face I'd be happy face right and so that's the theory of hedging and yet okay in theory and practice while hedging has these benefits yet many large and sophisticated companies they say you know what we're not going to hedge and by the way in this hatching you can be a really big deal okay I all right we haven't had a sea story for a while okay here's a sea story and yeah I don't know this for a fact but one of the companies that I would I mean some what I'm about to say I don't know for a fact but one of the companies that I worked with okay they had a a big fleet of breakbulk ships and they basically bought them in in the early 60s the Coast Guard lets you keep them for about 25 years and then maybe they'll give a five-year extension here and there etc but but by the mid 80s this company needed to change you get rid of a lot of their break box ships and then instead what they did was they ordered three container ships and these ships were about three football fields in length okay and as I recall I could be wrong here but they either had them built in Japan or Korea I forget which one let's say they had them built in in South Korea okay so so basically when you order a ship this would have been mid 1985 okay so in 1985 when you order a ship then I don't know how long it takes to build but but let's say it took a couple years to build okay and so let's say in 1987 is delivery of these ships all right so when when they bid on these ships the exchange rate was it was just unlucky right they bid obviously in Korean Won right and in mid 85 is when the dollar peaked by 87 it had weakened quite a bit which means if they had negotiated say you know X Korean Won I know what the exchange rate is X millions of Korean won and they didn't do any hedging then with a oh more dollars and expected or fewer dollars expected they would owe more right and and here's where I'm completely speculating I could be completely wrong okay but in my opinion or at least my opinion there's a possibility that for this company this was the beginning of the end for them okay that this used to be you know the largest merchant marine company in the United States where they had more ships than any other company United States and about I don't know maybe a decade later or five years later again I forget but this company went bankrupt and and the reason and there were other things that went on but the reason I think this was the beginning of the end is Big Biz Buzz yeah I've done other work or other cases or whatever and so for example I wrote a case it was with Northwest where they had the biggest purchase of aircraft ever at the time and doing sensitivity analysis with weather was positive net present value or zero negative or whatever what do you think was the biggest factor that made it positive or negative NPV and I'll give you some multiple choice maybe unexpectedly higher fuel prices maybe unexpectedly higher labor costs the the negotiations and how much you paid for the plane what's that last one yeah that that was a huge deal whether it was overpaid or underpaid and so in any case the other shipping company I was talking about they they had a policy of not hedging at least that's my understanding I could be wrong about that they had a policy of not hedging and so some in my opinion there's the possibility that this was the beginning of the end for them so the bottom line is at hatching this is a big deal and yet some come Ponies deliberately choose not to hatch and I mean they they they have the resources they have to know how they the big enough etc such a they they they're exposed to foreign exchange risk they understand the theory behind it they understand the practice behind it and yet they choose not to hedge can you think of why well I'll tell you another story to answer the question okay have any of you ever heard of bearings Bank okay well bearings Bank used to be one of the oldest merchant banks in the whole world and I think it was the oldest in England and in a case in in 1995 this guy by the name of Nick Leeson okay I'm looking at an old article here this guy by the name of Nick Leeson you probably heard of rogue traders on an unauthorised basis he decided to engage in in trades in the name of baring banks using guess what derivative securities okay remember some of that speculation I was talking about and in the process of just a few months he ended up losing the equivalent of 1.3 1.4 billion dollars so he had the oldest bank in England and after this whole episode of just a few months of engaging in this speculative kind of activity and we've already seen how risky this stuff is guess guess how much you know the bank went on to guess how much it was sold for in the end one pound okay was sold for one pound and so it basically just got crippled to its knees now one of the one of the duties of the Board of Directors is to ensure that there are controls in place to try to identify measure and control risk okay and the kind of risk that is that I'm talking about in this example is something that is called internal control risk okay in other words there need to be mechanisms in place such that the Board of Directors can be assured that row trading is not going to happen now it's really tempting when when a rogue trader is making money as it is attempting for management and and maybe even the board to sort of okay great great at least relative to losing a ton of money is attempting to not really pride deeply into it probably is right but in reality is that just as much of a red flag it is right and so many companies have these internal control control risk mechanisms in place but some companies say you know what yeah even with these controls that we could put in place and do have in place and so forth we we still don't trust it okay and so we're just gonna not hedge why because if we had you that means that our employees or someone on our behalf has access to these kind of securities and it's just not worth the risk and so therefore you know many sophisticated firms that you and I will have heard of choose to hatch they trust their internal risk control systems but other companies say no it's just too much of a risk so that's a little bit on hedging in the real world so let's get to alternative number five and that is to use a options contract okay now do you remember what an option is well this is from the previous lecture and an option basically a call option say gives you the right but not the obligation to buy if it was a yen call option a certain number of young at a pre agreed exchange rate Auto before an agreed-upon date and a put option gives you the right but not the obligation to sell certainly not a yen etc etc so here's my question okay remember our transaction we're on this side we're short yen those are our widgets so would we want a call or a put option would we want the right but not the obligation to buy yen and if we bought yen would be own yen or a yen we'd own it right so would we want that or would we want the right but not the obligation to sell yen we'd want a call option right because we want to earn the end we want to be on that side right so so we need to be long yen therefore we want a call option okay so on the Philadelphia exchange yen options are traded in in units of six point two five million yen okay I don't know why but it's half of of what the futures contract size is so we would need how many of these contracts we'd need sixteen right so that's what would come to a hundred million yen so let's say you buy a call option and and and here are you buying your alright here it is like his five bucks give me my broccoli now I have something of value the broccoli something of value right so here's in the example I've made up you know here's twenty four hundred dollars give me a piece of paper that says I have two right but not the obligation to buy with 16 contracts a hundred million yen for a million dollars on or before a specific date so let's imagine this cost you twenty four hundred dollars so that twenty four hundred dollars does that belong to you anymore is that gone that's gone right that no longer belongs to you it's not like the futures were you putting up margin now suppose a few days later the yen in this example has unexpectedly appreciated or depreciated it's it's appreciated right at least relative to the 0.01 okay and so the intrinsic value the option that is well if I exercise it right now today how much money would I have saved by the fact that I've lost him it will have the right but not the obligation for a specific exchange rate so in other words in this example okay on the open market I could buy yen for 0.01 $1 but my option says I had the right but not the obligation to only spend point o $1 so while I've been happy or sad that I had the option happy right because well on the open you know with with what I've locked in I met an advantage relative to the market so how many dollars will this have saved me well similar to what we said before you know look at the difference and apply it to the number of yen that you can do this for so if I look at this difference it will have saved me a hundred thousand dollars so we would say that the intrinsic value of the option in that example is a hundred thousand dollars now what if the yen what if the spot a few days later goes down so so it goes to point zero zero nine nine dollars p.m. would you remember the right but not the obligation to buy the end for 0.01 dollars but on the open market you would only have to spend point zero zero nine nine dollars P n so which of those rates would you use well presumably the one was cheaper to you right and which one's cheaper to you well this one here on the open market therefore would you be using the option you wouldn't right so what would the intrinsic value of the option be would it be negative no there's no such thing as a negative intrinsic value for an option why because you're not locked it and you have the right but not the obligation and so the intrinsic value would be zero so let's go through these alternatives or you know when the spot when the yen appreciates and depreciates okay so imagine the yen depreciates okay so remember on the option side or we love a short yet we're long right and when you log something that something goes down in value if you made money or lost money you've lost money right but what's the most we can lose with the option apart from its cost zero right there's there's no negative intrinsic value so so when the yen depreciates well there's the cost the option and I've made that up the intrinsic value is zero okay so serve vomit on the call side we lost 2,400 bucks but on the transaction side okay so on this side your short yen the yen depreciates when you short something and that something goes down in value have you made a lot of money or lost money you've lost money right nope and you've gained money right when you're short something that something goes down and all you've met you've gained money how much did you gain well you've gained two hundred thousand right because why well you expected to pay a hundred million yen but if you only had to pay eight hundred thousand then you'd gain money so on the transaction side we gain two hundred thousand so put that together and you've gained one ninety seven six so let's look at the other the end appreciating now okay so the spot goes to 0.01 to did you make money or lose money with a call option well of course you had to pay twenty four hundred bucks right but is there any intrinsic value so the option is saying you have the right but not the obligation to only spend 0.01 dollars to buy a hundred million yen or you could go the open market and spend point o 1/2 net now does the option have intrinsic value it does right as we calculated before it would have two hundred thousand dollars in intrinsic value so on the call option side we made 197 six but what about on the transaction side you assured something that something goes up in value you mate or you lost money you've lost money right and as we saw earlier we lost two hundred thousand so if we put all that together the net effect is minus twenty four hundred so if we put it all together okay if the yen appreciates we lose twenty four hundred if the yen depreciates we gain 197 six hundred so first of all is this a perfect hedge well what would these two numbers have to be that this guy right here at 2400 loss and this 190 7600 game what would those have to be just say it was a perfect hedge have to be zero and zero right you know they'd have to be nothing that you pay more than expected or less than expected no matter what happened to the unexpected movements of the yet so it's not a perfect catch and so my question say relative to a Ford contract hey let's say you're large enough and your credit worthy enough so you have access to the Ford market okay what would you do would you would you would you hedge with this option or would you hedge with a with a Ford contract now there is a I love net hoping you are spotted there is a floor that's FL aw a floor and in the numbers I made up and specifically the 2400 I'll tell you what floor is in a minute but but basically let me put it this way okay what business are you n well you're in the widget business right now the shareholders want you to engage in risk well some of you might say no no they want us to you know well well if if shareholders do not want you to engage in risk then if I invest in an apple what's the safest thing Apple could do with the money that I did when I invested in Apple they could invest it all in us t-bills say right well some might argue how safe that is but that's another subject so so in any case do eyes a shareholder do I want Apple to use the money that I give them as a shareholder to invest in t-bills no so do I want Apple to engage in risk well yeah of course do I want them to engage in any risk or does it matter what kind of risk we don't want Apple to engage in getting into the fishpond business no in fact if they announce tomorrow hey we're gonna get into the fish farm business what do you think would have happened to that announcement with apples stock price wealth pipe plummet right why well because that's not that area of expertise so does shareholders want companies to engage in risk yes does it matter which risk yes they wanted to engage in risks in their area of expertise okay so so you know to the extent that the area that they're in is an unlevel playing field but they're on top there is an expectation not a guarantee but an expectation that they can do better with your money then you can on a risk-adjusted basis so here's my question if this was a Ford contract this number here the 2400 loss and that number there the 197 600 gain those would be zero zero but with the option we've got a minus 2400 plus 197 600 night I intentionally made the numbers look tempting is the option relatively risky compared to the Ford it is right the Ford is no risk so if you're in the widget business and you're not in the you know exchange rate business does shareholders want you to engage in exchange rate risk they don't right and so so therefore if you had a choice what would be better the Ford of the options the option right I mean yeah the forward right okay the one without the risk if you have a choice so we'll ask in a minute you know what's the real advantage of hedging with options but but I'll I'll admit to my floor now and that is that at the very beginning I said that the yen unexpectly appreciates or depreciates with what probability 50/50 right so the fact that I get these numbers here you know my expected cash flows point 5 times minus 2400 plus 0.5 x plus 197 600 so in other words this price of $2,400 for the option was way way under price for the numbers I made up if if it had been efficiently priced then it wouldn't have looked nearly this tempting okay but in any case the the big picture concept is that with shareholders they do they do not want you to engage in risk they do but does it matter what that risk is yeah areas of your expertise so if taking on exchange rate risk is outside of your area of expertise and you have the choice to relatively cautiously avoid that risk is that what they would want they would right and so if that's the case then then under what circumstances might even notes not a perfect hat under what circumstance might you use options as a hedge any thoughts well what about this okay here's another example suppose suppose you're a u.s. construction company okay and you're building on a contract in in Japan so let's say Tokyo okay so Tokyo says to you all right hey come come build a building we'll take bids okay and we'll announce the bed the winner of the bed in three months okay so first of all with that example with your transaction have you set up an accounts receivable or an accounts payable well an accounts receivable right because will Tokyo pay you to build a building if you win the bid they will right so so so let's say I'll keep the numbers the same okay let's say your transaction okay you build a hundred million yen okay for the building so so you're saying all right well if you pick us you you'll owe us a hundred billion yen and we'll build a building okay but three months later as far as dollars is concerned would you be getting and you win the bid would you be getting an unexpected more dollars a few dollars you would right so if you're gonna hedge what side would you hedge on the same side or the opposite side the opposite side right so somehow you would have to set up your hedge you know 100 million yen in accounts payable okay okay on the on the other side okay but here's the problem okay three months let's say you hedge with the Ford contract and three months later you lose the bed okay so all of this goes away are you now completely exposed on your Ford side you right because you have what's called a contingent situation here maybe win the bid maybe you don't win the bid if you if you hedged with a fourth contract you'd be completely exposed but you'd have nothing here and everything here which means you'd either make or lose a lot of money you'd be taking a lot of risk okay but instead if you engaged if you engaged in an in a although not a perfect hedge with an options contract on this side then then you put much more of a flaw in the most you could lose you do right I mean basically the most you could lose would be the cost of the option and you might get lucky and you might make make some money too right with the exchange rate risk and so the real advantage of hedging with options would be under contingent situations where maybe you're going to be involved in this transaction and maybe you're not so if we put it all together okay well we've got the advantage the options edge is it's good for what kind of situations it's good for contingent situations disadvantages or is it a perfect hedge it's not right and by the way this is true of futures also with futures and options do you think they're available for all currencies in the world or more primarily the less risky ones primarily and less risky ones right that they're not available for all currencies in the world I could be wrong but I doubt there's a a futures market for the I don't know the I don't know what country to pick I was going to say the Russian ruble but maybe there is one for that because there's such a large economy but in any case they don't exist for all currencies so if we summarize everything so far well forwards and futures they provide perfect echizen-ya more or less I know there's a little bit of a more or less with the future stuff ford market how are the journal eminent to what large and creditworthy customers right can you be smaller with the future if you're a futures you can write you know have to have at least a million bucks okay so futures market is now more accessible if we look at the options side okay big advantages for contingent situations all right so you're not left standing naked or totally exposed with that forward contract example I gave but the options market is or is not a perfect hedge it's not right the options market is not a perfect edge and futures and options available for all currencies or less risky currencies less risky currencies right and so that brings us to our next alternative alternative number six something called a money market hedge okay now does anyone know what a money market hedges well that's a definition right this is not understanding either you know you don't know it so hey tell you what I'll tell you what it is okay a money market hedge is basically borrowing and lending in different currencies so let's put this in the context of our example and to do this I'm gonna go all the way back to alternative number one okay if you recall alternative number one what we had to do was come up with 99-year almost a million bucks today convert it today's rate to get ninety nine point four million yen and then what do we do with those yet we lent it to the Japanese government by investing in a what a yen t-bill right such that at two and a half percent in ninety days they would is what a hundred million yen right so see here's our transaction here's the widgets an alternative number one is we create an account receivable by having the Japanese OS 100 million yen in 90 days but what was the disadvantage to all of that well we were perfectly hedged but we lost the crowd advantage okay and so what would be a solution how you know we had to come up with practically a million bucks today you know nine hundred ninety three thousand dollars roughly well what could we do if we want to regain the credit advantage well what do you do when you need credit do you borrow money you do right so so what we could do is we could borrow this money right now that's consistent with the definition of money market hedge right we could borrow dollars and lend yen so the question is well what rate would we be borrowing at well if we look at the various interest rates that I gave you earlier on you know these were the interest rates we made up three percent ninety day rate two-and-a-half percent I mean T build us Japanese Japanese Prime I mean us prime Japanese prime etcetera okay so so we're an American we're borrowing dollars so so first of all would with the either of Japanese rates be relevant or irrelevant irrelevant right because we're buying dollars so we have the choice of this u.s. 90 day tea rate or u.s. prime rate what would apply to us the prime rate right of those two the only choice has to be the prime rate why because are we the government we're not right we're the widget business people okay so this is Miss 980 rate is that is the government so six percent so if we borrow this much today six percent ninety days later how much would we oh well time value money stuff again if this is not crystal clear then you can go to the time value money lecture from the corporate finance series but basically the future value just real quick why don't we why do we take this six percent divided by four well because by convention that's how to communicate the exchange rate by convention this is an annualized number and to turn into an effective 90 day rate the only first step you can do with that six percent is divided by four because they're about 40 90 days in a one year period at least that's what we're assuming so in any case you know borrow this much today at 6% paid now we're looking at a little bit over a million about 7500 bucks over a million now how much will we expect him to pay for the widgets if you recall the expected exchange rate was 0.01 dollars P n so this exchange rate applied to 100 million yen that came to what a million dollars right so we were expecting to pay a million dollars but if we engage in this money market hedge in the end how much we having to come up with well all about seventy five hundred bucks over a million right and so we would say that the cost of a hedge is about seventy five hundred dollars so here's my question for you what is driving this cost what is driving this cost well remember okay now what rate are we lending the yen okay that was a two and a half percent right and at what rate are we borrowing dollars that was six percent right so we're lending yen at two and a half percent and we're borrowing dollars at six percent so the fact that six percent is greater than two and a half percent okay so the fact that we're borrowing at this number and lending at this number is what is driving that cost it would appear so right however that's not completely correct really in fact is there's really another layer of thinking because if we had somehow been able to borrow at 3% and learned it two and half percent okay so if we didn't if we hadn't been able to get this rate instead of the sex and guess what the cost of the hedge would have been would have been zero why is that well does this 3% look familiar well the three percent was the 90 day us t-bill rate right and the two-and-a-half percent was the 90 day Japanese tipo rent right and if interest rate parity had held that would the expected exchange rate be such that you were indifferent between the two it would have right so so if interest rate parity had held that wouldn't have been a cost so what drives the cost is not in a direct sense the fact that one number is bigger than the another number what drives the cost is that is is the relative risk okay if you is the borrower a higher risk than who you're lending it to then you're gonna have a higher cost or a lower cost for your hedge a higher cost right so so let me give you another example just to maybe really drive this point home okay whenever you lend money to a government is that necessarily at all close to zero risk it's not right I mean yes opposed you lent sorry to pick on some barware but suppose you lent you the choice when I can either lend money to Zimbabwe or I can lend money to IBM okay so IBM they don't have the right to print money etc and and well a notice in Bob we now but but in any case who would you perceive of as to being there higher risk the Zimbabwean government or IBM doesn't Bob Wian government right so yeah you can engage in a money market hedge with any currency I mean to the extent that a government is willing to borrow money from you okay however suppose that you the business person you the widget person will lower risk than the government that you are learning to then instead of us say a 7,500 cost of hedge that 7,500 would that now be a negative number it would right because because now you're changing this sign if you're if you as the borrower a lower rest and who you're lending to then the cost of the hedge is going to be negative but is that like a free lunch no no it's not a free lunch because now you're taking on what kind of risk you're taking on credit risk right you're taking on the fact that hey here this government that I let money to they may not pay me back right and so so it matters who you create or which entity you create this money market hedge with so if we put put this all together okay as far as pros and cons of money market hedge well an advantage is well are you hatch does it work if we engage in a money market hatch will we have created something equal and opposite on this side we will have right and with the money market hedge have you regained the credit advantage you have right and with a money market hedge can you create that with any currency you can write it was that true of futures and options it futures an option exist for in all currencies they don't write that they exist for the for the relatively less risky currencies and so but but but a disadvantage of what you have to be careful about is that you're not exchanging one risk for another that you're not exchanging exchange rate risk for credit risk yeah it matters which entity you're lending the money to to create the money market hedge okay well another alternative alternative number seven is called risk shifting now what do you think we're shifting is well basically you know in with the hundred million yen for the widget example is that you're telling the Japanese supply I know do not bill Mannion tell me what I owe you in dollars so basically you refuse to deal in any currency other than your own now if the Japanese supplier cannot you know hedge that risk for whatever reason if they're taking on risk that they cannot get rid of then ceteris paribus or what else being equal what might they do to the prices they might raise them right and so so essentially you know yeah you can refuse to deal any currency other than your own but you might pay for that privilege another one you know risk sharing okay what do you think we're sharing us well basically we're sharing is you say all right well you know this is the expected exchange rate okay so imagine you know whatever this is let's say this is the expected exchange rate and let's say you create this band on each side okay maybe it's plus 1% and minus 1% or whatever okay and andrush sharing is saying well you know if it if it if the actual exchange rate ends up here or it ends up there so in other words it ends up within the band then all right fine we've got a small winner and a small loose but if it comes outside of this band do we now have a big winner and a big loser we do right and if it goes outside of this band basically all right well the winner agrees to give up his or her winnings such that there's neither a winner or loser so that's we're sharing and I can I can tell you a story about that so I see story but it's a story and it's not with exchange rates but I remember when my my parents they retired to North Carolina that they've had this property and and and they were finally gonna build on it and this was in 91 92 time period at the time the price of lumber was just really fluctuating it was very volatile and so typically you would go to a contractor and he or she would would build your house but they would have to presumably build into the price of the house there the risk of what lumber cost and my dad basically made a deal with the contractor that was similar to this he said look you know if you here's the lumber near the price of lumber and and and why don't we say that if it if it's unexpectedly high then you know if it goes outside of this this band then you know I'll kick in some more we'll bring it down before it's not especially low you kick in some more we'll bring it back up to this level and so basically we'll just share the risk and the contract wow that's great yeah because I don't want to take on this risk it it's win for me and it's win for you and so that's basically what risk sharing is you know if the exchange rate stays within a certain range fine you've got a small winner and a small loser but if it goes outside of a particular range then yeah let's let's bring it back down to having either a winner or a loser at least with respect to what was expected all right so this one last thing I want to bring up and that's exposure netting and let me let me bring it up with an ex okay imagine I have operations on an American firm I have operations in Germany where I have an accounts receivable of a million euros and I have operations in France where I've an Accounts Payable of eight hundred thousand euros now if I wanted to could I create a million euro hedge here and a 800 thousand euro hedge right there I could write sure I could do that why not but could I also sort of net these out where where you know this offsets that and I'm left with a net of two hundred thousand euros and then just have a hedge on this side for two hundred thousand I could write and that would be something called exposure netting and what's an advantage of exposure netting well an advantage of exposure netting is basically well which one is going to have fewer transaction costs if I if I had eight hundred thousand here and I had eight a million here or hedging just two hundred thousand there and of course you know just this one hedge for two hundred thousand euros is going to have a who's going to have lower transaction costs and so that's basically what exposure netting is so this essentially you know concludes this lecture the goal was to manage exchange rate risk in the short term so like I said we started off this class understanding why the dollar goes up and down in value or why other currencies go up and down in value so get a really good understanding that risk in the second half this course we're looking at managing this risk managing not only the short term which is what we did today but moving forward managing it in the long term and by the way not just managing it but looking for risk opportunities if you will that exists out there so in any case I as always I hope this was a really good learning experience and I hope to see you at the next lecture take care bye-bye

Channel: Understanding Finance

Views: 28,177

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Keywords: Exchange-rate Regime (Taxonomy Subject), Finance (Industry), Understanding Finance, Net Exposure, Hedge, Exchange Rates, Options, Business, Finance Education, Forward Contract, International Finance (Field Of Study), Futures, Foreign Exchange Market (Taxonomy Subject), Money Market Hedge, Exchange Rate Risk, International Finance Lecture, Forex, Forwards, Hedging, Trading, James Tompkins, Finance Lecture, currency hedging, currency, Exchange-rate Regime (Literature Subject)

Id: GCPRCt8qFkA

Length: 120min 36sec (7236 seconds)

Published: Tue Mar 25 2014