5.3. USING FORWARD CONTRACTS (2): HEDGING CONTRACTUAL EXPOSURE 183
Issue #1: Are Imperfect Hedges Worse?
Forward contracts, orfcloans and deposits allow you to hedge the exposure to
exchange rates perfectly. There are alternatives. Futures may be cheaper, but are
less flexible as far as amount and expiry date are concerned, thus introducing noise
into the hedge; also, futures exist for heaviliy traded exchange rates only. Options
are “imperfect” hedges in the sense that they do not entirely eliminate uncertainty
about future cash flows; rather, as explained in Chapter 8, options remove the
downside risk of an unfavorable change in the exchange rate, while leaving open
the possibility of gains from a favorable move in the exchange rates. This may
sound fabulous, until one remembers there will be a price to be paid, too, for that
advantage.
Example 5.9
Whyran Cabels, Inc. could buy a thirty-day put option (an option tosell aud
800,000 at a stated price), and a sixty-day call option (an option tobuy aud
1,100,000 at a stated price). Buying these options provides a lower bound or floor
on the firm’s inflows from theaud800,000 asset, and an upper bound or cap on its
outflows from theaud1,100,000 liability.
If one is willing to accept imperfect hedging with downside risk, then one could
also cross-hedge contractual exposure by offsetting a position in one currency with
a position (in the opposite direction) in another currency that is highly correlated
with the first. For example, a British firm that has anA/Rofcad120,000 and
anA/Pofusd100,000 may consider itself more or less hedged against contractual
exposure given that, from agbpperspective, movements in theusdand thecadare
highly correlated and the long positions roughly balance the short ones. Similarly,
if an Indian firm exports goods to Euroland countries, and imports machinery from
Switzerland and Sweden, there is substantial neutralisation across these currencies
given that the movements in these currencies are highly correlated and the firm’s
positions have opposite signs.
Issue #2: Credit Risk
So far, we have limited our discussion to contractual exposure, and ignored credit
risk. The risk of default, if non-trivial, creates the following dilemma:
- If you leave the foreign currencyA/Runhedged (open) and the debtor does
pay, you will be worse off if the exchange rate turns out to be unexpectedly
low. This is just the familiar exchange risk. - On the other hand, if you do hedge but the debtor defaults, you are still
obliged to deliver foreign exchange to settle the forward contract. As soon as
you hear about the default, you know that this forward contract, originally
meant to be a hedge, has become an open (quasi-speculative) position. So