182 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
of course, is what traditional hedging is about, where one designs a hedge whose
cash flows exactly offset those from the contract being hedged. Thus, if one could
match every contractual foreign currency inflow with a corresponding outflow of
the same maturity and amount, then the net contractual exposure would be zero.
However, perfect matching of commercial contracts (sales and purchases, as reflected
inA/RandA/Pand the long-term contracts) is difficult. For example, exporters
often have foreign sales that vastly exceed their imports. An alternative method for
avoiding contractual exposure would be to denominate all contracts in one’s domestic
currency. However, factors such as the counterparty’s preferences, their market
power, and their company policy may limit a firm’s ability to denominate foreign
sales and purchases in its own home currency or in a desirable third currency. Given
that a firm faces contractual exposure, one needs to find out how this exposure can
be hedged. Fortunately, one can use financial contracts to hedge the net contractual
exposure. This is the topic of the next section.
5.3.2 Hedging Contractual Exposure from Transactions on a Par-
ticular Date
One-to-one Perfect Hedging
A company may very well dislike being exposed to exchange risk arising from con-
tractual exposure. (Sound economic reasons for this are discussed in Chapter 12).
If so, the firm could easily eliminate this exposure using the financial instruments
analyzed thus far: forward contracts, loans and deposits, and spot deals. Perfect
hedging means that one takes on a position that exactly offsets the existing exposure,
and with contractual exposure this is easily done.
Example 5.7
We have seen, in Example 5.5, that holding ajpyT-bill with a time-T face value of
jpy1,000,000 creates an exposure of +jpy1,000,000. Thus, to hedge this exposure,
one can sell forward the amountjpy1,000,000 for maturity T.
In the above, the purpose is just to hedge. If the firm also needs cash (inhc), it
could then borrow against the futurehcincome from the hedge. Alternatively, the
familiar spot-forward diagram tells us, one could short spot foreign exchange, that
is, borrow the present value ofjpy1,000,000, and convert the proceeds intousd,
the home currency. At maturity, one would then use the cash flows from thejpy
T-bill to service the loan; as a result, there is no more uncommittedjpycash left,
so that no spot sale will be needed anymore, meaning that exposure is now zero.
Example 5.8
To hedge its net exposure as computed in Example 17.4, Whyran Cabels could
hedge the one-month exposure with a 30-day forward sale ofaud800,000, and the
two-month exposure by a 60-day forward purchase ofaud1,100,000.