Explain how you could use foreign financing for your business in a manner that would reduce your exposure to exchange rate risk. Be specific. Given that you receive periodic payments in foreign currency for your exports, explain how you could effectively use cash management. That is, explain how you would use the funds as they are received. If you had some existing short-term debt, would you prefer to invest the cash in short-term securities or would you pay off the debt? Solution Borrowing and Lending in a Foreign Currency Transaction exposure emerges when borrowing or lending is done in a foreign currency. If the foreign currency appreciates, the burden of borrowing will be greater in terms of domestic currency, while if the foreign currency depreciates, the burden will be lower. Similarly, the receipt of the lender in case of the appreciation of the foreign currency will be larger in terms of the domestic currency. If foreign currency depreciates, there will be loss to the lenders in terms of domestic currency. It is not only the principal but also the amount of interest that changes owing to changes in the exchange rate. Foreign exchange risk/exposure management is the process through which finance managers try to eliminate/reduce the adverse impact of unfavourable changes in the foreign exchange rates to a tolerable level. We already know that changes in exchange rate lead to foreign exchange exposure. If such an exposure results in loss to a firm, it needs to be hedged; that is, it needs to be eliminated or reduced. The process of hedging is known as the management of exchage rate exposure. Hedging refers to managing risk to an extent that makes it bearable. In international trade and dealings foreign exchange play an important role. Fluctuations in the foreign exchange rate can have significant impact on business decisions and outcomes. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. The contractual techniques for hedging foreign exchange exposure are external techniques involving contractual relationship with the parties outside the firm for insuring against potential foreign exchange loss. The major contractual hedging techniques include: 1. Hedging through Forward Contracts. 2. Hedging through Currency Futures. 3. Hedging through Currency Options. 4. Hedging through Swaps. 5. Hedging through Money Market Operations. I. Hedging through Forward Contracts Historically, the foremost instrument used for exchange rate risk management is the forward contract. Forward contracts are customized agreements between two parties to fix the exchange rate for a future transaction. This simple arrangement would easily eliminate exchange rate risk, but it has some shortcomings, particularly getting a counter party who would agree to fix the future rate for the amount and time period in question may not be easy. By entering into a forward rate agreement with a bank, .

1. Explain how you could use foreign financing for your business in a manner that would reduce
your exposure to exchange rate risk. Be specific.
Given that you receive periodic payments in foreign currency for your exports, explain how you
could effectively use cash management. That is, explain how you would use the funds as they are
received.
If you had some existing short-term debt, would you prefer to invest the cash in short-term
securities or would you pay off the debt?
Solution
Borrowing and Lending in a Foreign Currency
Transaction exposure emerges when borrowing or lending is done in a foreign currency. If the
foreign currency appreciates, the burden of borrowing will be greater in terms of domestic
currency, while if the foreign currency depreciates, the burden will be lower. Similarly, the
receipt of the lender in case of the appreciation of the foreign currency will be larger in terms of
the domestic currency. If foreign currency depreciates, there will be loss to the lenders in terms
of domestic currency. It is not only the principal but also the amount of interest that changes
owing to changes in the exchange rate.
Foreign exchange risk/exposure management is the process through which finance managers try
to eliminate/reduce the adverse impact of unfavourable changes in the foreign exchange rates to
a tolerable level.
We already know that changes in exchange rate lead to foreign exchange exposure. If such an
exposure results in loss to a firm, it needs to be hedged; that is, it needs to be eliminated or
reduced. The process of hedging is known as the management of exchage rate exposure. Hedging
refers to managing risk to an extent that makes it bearable. In international trade and dealings
foreign exchange play an important role. Fluctuations in the foreign exchange rate can have
significant impact on business decisions and outcomes. Many international trade and business
dealings are shelved or become unworthy due to significant exchange rate risk embedded in
them.
The contractual techniques for hedging foreign exchange exposure are external techniques
involving contractual relationship with the parties outside the firm for insuring against potential
foreign exchange loss. The major contractual hedging techniques include:
1. Hedging through Forward Contracts.
2. Hedging through Currency Futures.

2. 3. Hedging through Currency Options.
4. Hedging through Swaps.
5. Hedging through Money Market Operations.
I. Hedging through Forward Contracts
Historically, the foremost instrument used for exchange rate risk management is the forward
contract. Forward contracts are customized agreements between two parties to fix the exchange
rate for a future transaction. This simple arrangement would easily eliminate exchange rate risk,
but it has some shortcomings, particularly getting a counter party who would agree to fix the
future rate for the amount and time period in question may not be easy. By entering into a
forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which
will now have to bear this risk. Of course the bank in turn may have to do some kind of
arrangement to manage this risk. Forward contracts are somewhat less familiar, probably because
there exists no formal trading facilities, building or even regulating body.
Under the process of hedging, currencies are bought and sold forward. Forward buying and
selling depends upon whether the hedger finds himself in a long, or a short, position. An export
billed in foreign currency creates a long position for the exporter. On the contrary, an import
billed in foreign currency leads to a short position for the importer.
Let us first take the long position. An Indian exporter enters into a contract for mica export to the
USA for US $ 1,000. The export proceeds are to be received within three months. The exporter
fears a drop in the value of the US dollar that may diminish the export earnings in terms of rupee.
To avoid this diminution, the exporter opts for a three-month forward contract and sells forward
one thousand US dollars. Suppose the spot as well as the forward rate is Rs.40/US $. If the dollar
depreciates to Rs.39 after three months, the export earnings will diminish to Rs.39 thousand, but
since the exporter has already sold forward similar amount in dollars, the loss due to depreciation
of the dollar will be met through the forward contract. By selling dollars, it would fetch Rs.40
thousand that will be equal to the original export value.
However, the forward deal has disadvantages too. The advantage is that if the value of the dollar
falls, the exporter will not have to suffer any loss of income while the disadvantage is that if the
value of the dollar appreciates, the exporter will not benefit from the appreciation. Moreover, in
case a part of the merchandise is not accepted by the importer, the exporter will have to arrange
for the dollars to honour the forward contract. In the event of a short position where the Indian
importer buys goods from the USA for US $ 1,000, and where the importer fears an appreciation
in the value of the US dollar, the forward deal will involve the buying of dollars. If the dollar
appreciates to Rs.41 after the three-month period, the importer will have to pay Rs.1,000 more
but if he has opted for a forward deal to buy a similar amount in dollars, he will purchase US $
1,000 with Rs.40,000 and pay US $ 1,000 to the exporter and so save himself from the Rs.1,000

3. loss. Here again, if the dollar appreciates, the importer eliminates the loss, but if it depreciates,
the importer does not benefit from the depreciation.
In these two examples of forward deals, we have assumed that the spot rate and the forward rate
are equal but this is not always true. There may be either a forward premium or a forward
discount. Suppose the spot rate is Rs.40/US $ and the three-month forward rate is Rs.39.50/US $.
In this case, if the spot rate after the expiry of three months turns out to be Rs.39/US $, and if the
Indian exporter has a forward contract for selling the same amount in dollars, he will be able to
diminish the loss by Rs.500 because he will get Rs.39,500 from the forward deal. Had there been
no forward contract, the exporter would have received only Rs. 39,000 following the
depreciation of the US dollar. If however, the US dollar depreciates only to Rs.39.80, the
forward deal will cause a loss for Rs.300 because it would fetch only Rs.39,500 instead of Rs.
39,800 that would have been received in the absence of a forward deal.
The advantage or disadvantage of the forward deal is reaped not only by the exporter but also by
the importer. In case of a short position, a forward discount is favourable to the hedger because it
enables the hedger to obtain foreign exchange at a rate lower than the current spot rate. On the
contrary, a forward premium is unfavourable because it makes the forward foreign currency
costlier. However, the exact magnitude of loss or gain to the importer depends upon the
difference between the forward rate and the future spot rate that we have just discussed. If the
forward rate is Rs. 39.50/US $ and if the future spot rate is Rs. 39.80/US $, the Indian importer
will be able to save Rs. 300 because he will get US $ 1,000 only for Rs. 39,500 under the
forward contract; whereas he would have had to pay Rs. 39,800 for one thousand dollars, had
there been no forward contract. But if the future spot rate comes down to Rs. 39/US $, the
importer will have to face a loss of Rs. 500 under the forward contract. Thus hedging in a
forward market, whether it concerns a long position or a short position, is a double-edged sword
and if the trend in the exchange rate movement is not according to expectations, it can result in a
loss.
Limitations to forward and futures hedges
In view of the above discussion, a hedger's decision to go for a forward/futures hedge depends
on two factors. They are:
(a) Difference between future spot rate and the forward rate
(b) Expected transaction costs
Hedging in a forward market will be beneficial for an importer only when the future spot rate of

4. the currency in which he/she has to make the payments is higher than the forward rate.
Alternatively, it will be beneficial for an exporter when the future spot rate of the currency in
which it has to receive the export proceeds is lower than the forward rate. If these conditions are
not met, the hedging in the forward market will not be helpful.
The above discussion of the forward market hedging is based on the assumption that there is no
transaction cost. But in the real world, the transaction cost exists. Thus, the forward market
hedge is lucrative only till the transaction cost is lower than the total gains from hedging.
II. Hedging through Currency Futures
Noting the shortcomings of the forward market, particularly the need and the difficulty in finding
a counter party, the futures market came into existence. The futures market basically solves some
of the shortcomings of the forward market. A currency futures contract is an agreement between
two parties – a buyer and a seller – to buy or sell a particular currency at a future date, at a
particular exchange rate that is fixed or agreed upon today. This sounds a lot like the forward
contract. In fact the futures contract is similar to the forward contract but is much more liquid. It
is liquid because it is traded in an organized exchange– the futures market (just like the stock
market). Futures contracts are standardized contracts and thus are bought and sold just like
shares in the stock market. The futures contract is also a legal contract just like the forward, but
the obligation can be ‘removed’ before the expiry of the contract by making an opposite
transaction. As for hedging with futures, if the risk is an appreciation of value one needs to buy
futures and if the risk is depreciation then one needs to sell futures.
When a client has to make a futures deal, it contacts the commission brokers through its own
agent. After the deal is transacted, the client deposits the margin money with the clearing house.
Daily settlement begins and continue till final settlement on maturity. In the majority of
contracts, delivery of currencies is not made but is offset by a reversing deal. The client gets only
the difference between the two deals.
Traders make use of the market for currency futures in order to hedge their foreign exchange
risk. For instance, suppose a French importer importing goods from USA for $ 1.0 million needs
this amount for making payments to the exporter. It will purchase US dollar futures contract
which would lock in the price to be paid to the exporter in terms of US dollar at a future
settlement date. By holding a futures contract, the importer does not have to worry about any
change in the spot rate of the US dollar over time. On the other hand, if the French exporter
exports goods to a US firm and has to receive US dollar for the exports, the exporter would sell a
dollar futures contract. This way the exporter will be locking in the price of the export to be
received in terms of US dollar. It will protect itself from the loss that may occur in case of

5. depreciation of the US dollar over time.
However, the question is whether futures hedge can be a perfect hedge. It is particularly in view
of the fact that while forward deal can be tailored to any size of the currency transaction and to
any maturity, the futures cannot be, insofar both the size of the contract and the maturity of the
futures deal are fixed. Suppose, a German importer decides to import on 1st of September from
Canada for which C$ 62,500 has to be paid on December 1. If the maturity in the futures market
falls on December 26, the maturity does not match with that of the actual cash transaction Again,
since the size of the Canadian dollar futures is C$ 1,00,000, it does not match with the size of
cash transaction. On this ground, futures hedge cannot normally be a perfect hedge.
If the maturity of futures contract mismatches, futures hedging is known as a delta hedge. If
maturity matches but the size of the futures contract does not match, one can go for a cross
hedge. If both the size and maturity do not match, the hedger can go for a delta cross hedge.
Delta hedge exists when the maturity does not coincide with the hedger’s need for the currency.
Suppose for a moment that the value of import made on September 1 is C$ 1,00,000. The amount
is to be paid on December 1. If the German importer goes for a forward contract, he will buy
Canadian dollar three-month forward. In case of forward contract, forward rate on the date of
maturity can easily be calculated on the basis of the interest rate parity theory. But in a futures
hedge, where maturity falls on December 26, 25 days are still left for the maturity during which
the interest rate differential may change. So a futures hedge cannot be a perfect hedge and there
will be some variations in the hedged pay-offs. It can however, be very nearly a perfect hedge if
there is no change in the interest rate differential. It is because there is virtually no basis risk if
interest rate differential does not change. It may he noted here that basis risk arises on account of
unexpected change in the relationship between spot rate and futures rate.
Cross hedge exists when the amount of the futures contract does not tally with the actual amount
to be hedged.
Let us take another example where the value of import is C$ 62,500 and the payment has to be
made on December 26. Here the maturity matches, but the size of the contract does not. In this
case, the size of payment matches with that of the British pound futures. Importer can go for
buying pound in the futures market if there is a high degree of correlation between British pound
and the Canadian dollar. The futures hedge can be made a perfect hedge this way.
It is a case when there is both maturity and size mismatch. In such cases, it is difficult to
eliminate the basis risk. As a result, the futures hedge is normally not a perfect hedge. The
hedger can, however, go simultaneously for a cross hedge and a delta hedge in order to make the
hedge a perfect one as far as possible.
To enter into a futures contract a trader needs to pay a deposit (called an initial margin) first.

6. Then his position will be tracked on a daily basis (called marking to the market) so much so that
whenever his account makes a loss for the day, the trader would receive a margin call (also
known as variation margin), i.e. requiring him to pay up the losses.
· Standardized Features of the Futures Contract and Liquidity
Contrary to the forward contract, the futures contract has a number of features
that has been standardized. These standard features are necessary in order to increase the
liquidity in the market, i.e. the number of matching transactions. In the practical world traders
are faced with diverse conditions that need diverse actions (like the need to hedge different
amounts of currency at different points of time in the future) such that matching transactions may
be difficult to find. By standardizing the contract size (i.e. the amount) and the futures maturity,
these different needs can be matched to some degree even though perhaps not perfectly. Some of
the standardized features include expiry date, contract month, contract size, position limits (i.e.
the number of contracts a party can buy or sell) and price limit (i.e. the maximum daily price
movements). These standardized features introduce some hedging imperfections though. For
example, if Rs. 10,000,000 needs to ne hedged and the size of each Rupee futures contract is
2,000,000 then 5 contracts need to be sold. However, if the size of each contract is 3,000,000 for
instance, then only 3 contracts can be sold, leaving 1,000,000 Rupees unhedged. Therefore, with
standardization, some part of the spot position can go unhedged.
below:
Some advantages and disadvantages of hedging using futures are summarized
· Advantages
a) Liquid and central market. Since futures contracts are traded on a central market, this
increases the liquidity. There are many market participants and one may easily buy or sell
futures. The problem of double coincidence of wants that could exist in the forward market is
easily solved. A trader who has taken a position in the futures market can easily make an
opposite transaction and close his or her position. Such easy exit is not a feature of the forward
market though.
b) Leverage. This feature is brought about by the margin system, where a trader takes on a large
position with only a small initial deposit. If the futures contract with a value of Rs.1,000,000 has
an initial margin of Rs.100,000 then a one percent change in the futures price (i.e. Rs.10,000)
would bring about a 10 percent change relative to the trader’s initial outlay. This amplification of
profit (or losses) is called leverage. Leverage allows the trader to hedge big amounts with much
smaller outlays.
c) Position can be easily closed out. As mentioned earlier, any position taken in the futures
market can be easily closed-out by making an opposite transaction. If a trader had sold 5 Rupee
futures contracts expiring in December, then the trader could close that position by buying 5

7. December Rupee futures. In hedging, such closing-out of position is done close to the expected
physical spot transaction. Profits or losses from futures would offset losses or profits from the
spot transaction. Such offsetting may not be perfect though due to the imperfections brought
about by the standardized features of the futures contract.
d) Convergence. As the futures contract approach expiration, the futures price and spot price
would tend to converge. On the day of expiration both prices must be equal. Convergence is
brought about by the activities of arbitrageurs who would move in to profit if they observe price
disparity between the futures and the spot; buying in the cheaper market and selling the higher
priced one.
· Disadvantages
a) Legal obligation. The futures contract, just like the forward contract, is a legal obligation.
Being a legal obligation it can sometimes be a problem to the business community. For example,
if hedging is done through futures for a project that is still in the bidding process, the futures
position can turn into a speculative position in the event the bidding turns out not successful.
b) Standardized features. As mentioned earlier, since futures contracts have standardized features
with respect to some characteristics like contract size, expiry date etc., perfect hedging may be
impossible. Since overhedging is
also generally not advisable, some part of the spot transactions will have to go unhedged.
c) Initial and daily variation margins. This is a unique feature of the futures contract. A trader
who wishes to take a position in the futures market must first pay an initial margin or deposit.
This deposit will be returned when the trader closes his or her position. As mentioned earlier,
futures contracts are marked to market – meaning to say that the futures position is tracked on a
daily basis - and the trader would be required to pay up daily variation margins in the event of
daily losses. The initial and daily variation margins can cause significant cash flow burden on
traders or hedgers.
d) Forego favourable movements. In hedging using futures, any losses or profits in the spot
transaction would be offset by profits or losses from the futures transaction.
The above shortcomings of futures contracts, particularly it being a legal obligation, with margin
requirements and the need to forgo favourable movements prompted the development and
establishment of a more flexible instrument, i.e. the option contracts and option markets.
III. Hedging through Currency Options
A currency option may be defined as a contract between two parties – a buyer and a seller -
whereby the buyer of the option has the right but not the obligation, to buy or sell a specified
currency at a specified exchange rate, at or before a specified date, from the seller of the option.
While the buyer of option enjoys a right but not obligation, the seller of the option nevertheless
has an obligation in the event the buyer exercises the given right. There are two types of options:

8. • Call options – gives the buyer the right to buy a specified currency at a specified exchange rate,
at or before a specified date.
• Put options – gives the buyer the right to sell a specified currency at a specified exchange rate,
at or before a specified date.
Of course the seller of the option needs to be compensated for giving such a right. The
compensation is called the price or the premium of the option. Since the seller of the option is
being compensated with the premium for giving the right, the seller thus has an obligation in the
event the right is exercised by the buyer.
For example assume a trader buys a September RM 0.10/Rupee call option for RM 0.01. This
means that the trader has the right to buy Rupees for RM 0.10 per Rupee anytime till the contract
expires in September. The trader pays a premium of RM 0.01 for this right. The RM 0.10 is
called the strike price or the exercise price. If the Rupee
appreciates over RM 0.10 anytime before expiry, then the trader may exercise his right and buy it
for RM 0.10 per Rupee. If however Rupee were to depreciate below RM 0.10 then the trader
may just let the contract expire without taking any action since he is not obligated to buy it at
RM 0.10. If he needs physical Rupee, then he may just buy it in the spot market at the new lower
rate.
Thus, the options market allows traders to enjoy unlimited favourable movements while limiting
losses. This feature is unique to options, unlike the forward or futures contracts where the trader
has to forego favourable movements and there is also no limit to losses.
The options market is simply an organized insurance market. One pays a premium to protect
oneself from potential losses while allowing one to enjoy potential benefits. For example when
one buys a car insurance, one pays its premium. If the car gets into an accident one gets
compensated by the insurance company for the losses incurred. However if no accident happens,
one loses the premium paid. If no accident happens but the car value appreciates in the second
hand market, then one gets to enjoy the upward trend in price. An options market plays a similar
role. In the case of options however the seller of a option plays the role of the insurance
company.
The gain of the buyer of call option is represented by the excess of the spot rate over the sum of
the strike rate and the premium. In case of the put option, it is represented by how far the spot
rate is lower than the sum of the strike rate and the premium. The loss to the option buyer is
limited to the amount of premium. On the other hand, the loss to the option seller is unlimited
while the gain is limited to the amount of premium.
In hedging using options, calls are used if the risk is an upward trend in price and puts are used if

9. the risk in a downward trend in price. Hedgers in short position buy a call or sell a put or go for
both simultaneously. Hedgers in long position buy put and sell a call or go for both
simultaneously. Tunnel means combining call and put.
In order to hedge their foreign exchange risks, if it is a direct quote, the importers buy a call
option and the exporters buy a put option.
Take first the case of an importer. Suppose an Indian firm is importing goods for £ 62,500 and
the amount is to be paid after two months. If an appreciation in the pound is expected, the
importer will buy a call option on it with maturity coinciding with the date of payment. If the
strike price is Rs. 83.00/£, the premium is Rs. 0.05 per pound and the spot price at maturity is Rs.
83.20, the importer will exercise the option. It will have to pay Rs. 83.00 x 62,500 + 3,125 =
51,90,625. If the importer had not opted for an option, it would have had to pay Rs. 62,500 x
83.20 = 52,00,000. Buying of the call option reduces the importer's obligation by Rs. 52,00,000
— 51,90,625 = 9,375. If, on the other hand, the pound falls to Rs. 82.80, the importer will not
exercise the option since his obligation will be lower even after paying the premium.
However, one question that arises is whether hedging through buying of an option is preferable
to forward market hedging. Buying of currency options is preferred only when strong volatility
in the exchange rate is expected and if volatility is only marginal, forward market hedging is
preferred. Suppose, in the earlier example, the pound appreciates to only Rs.83.04 or depreciates
to only Rs.82.97, the amount of premium paid by the importer will be more than the benefit from
hedging through purchase of options. There will then be net positive cost of hedging through
buying of option.
The exporter buys a put option. Suppose an Indian exporter exports goods for £ 62,500. It fears a
depreciation of pound within two months when payments are to be received. In order to avoid
the risk, it will buy a put option for selling the pound for a two-month maturity. Suppose the
strike rate is Rs. 83.00, the premium is Rs. 0.05 and the spot rate at maturity is Rs.82.80. In case
of the hedge, it will receive Rs. 62,500 x 83.00 — 3,125 = 51,84,375. In the absence of a hedge,
it will receive only Rs. 51,75,000. This means, buying of a put option helps increase the
exporter's earnings, or reduces its exposure, by Rs. 51,84,375 — 51,75,000 = Rs.9,375.
Hedging through selling of options is advised when volatility in exchange rate is expected to be
only marginal. The importer sells a put option and the exporter sells a call option.

10. Let us first take the case of importers. Suppose an Indian importer imports for £ 62,500. It fears
an appreciation in the pound and so it sells a put option on the pound at a strike price of
Rs.83.00/£ and at a premium of Rs.0.15 per pound. If the spot price at maturity goes up to Rs.
83.05, the buyer of the option will not exercise the option. The importer as a seller of the put
option will receive the premium of Rs. 9,375 which it would not have received if it had not sold
the option. If the spot price at maturity falls to Rs. 82.95, the buyer of the option will exercise the
option. But in that case, the importer received premium of Rs. 9,375. The net gain to the importer
will be Rs. 9,375 — 3,125 = Rs. 6,250.
The exporters sell the call option. If an Indian exporter exports for £ 62,500 and fears that the
pound will depreciate and sells a call option on the pound at a strike price of Rs.83.00 at a
premium of Re. 0.15 per pound. If the spot rate at maturity really falls to Rs.82.95, the buyer of
the call option will not exercise the option. The exporter being the seller of the call option will
get Rs.9,375 as the premium.
Foreign exchange exposure can be hedged also through the use of tunnels or, through
simultaneous sale and purchase of options. An importer buys a call and sells a put option. The
exporter buys a put and sells a call option.
The importer buys an out-of-the-money call and sells an out-of-the-money put option. As a
result, neither the call, nor the put option is exercised if the exchange rate moves within a narrow
margin. Here the premium to be received on the sale of the put must be enough to cover the
premium to be paid on the purchase of the call option. The exporter buys a put and sells a
call—both out-of-the-money. If the exchange rate moves within a narrow margin, the premium
received covers the premium paid. But if the currency depreciates sharply, the put option is there
to guarantee a minimum price.
Advantages and Disadvantages of Hedging using Options
The advantages of options over forwards and futures are basically the limited downside risk and
the flexibility and variety of strategies possible. Also in options there is neither initial margin nor
daily variation margin since the position is not marked to market. This could potentially provide
significant cash flow relief to traders.
Because options are much more flexible compared to forwards or futures, they are thus more
expensive. The price is therefore a disadvantage.
IV. Hedging through Swaps
Swaps, as the name implies, are exchange/swap of debt obligations (interest and/or principal

11. payments) between two parties. In general, currency swaps are arranged between two
firms/parties through a bank. While it is true that swaps are not financing instruments (as the
firms, involved in swap contracts already have debt) they comfort the parties involved not only
in terms of desired currency involved in debt financing but also provide logistic convenience in
making specified payments of interest and/or principal. Swaps are of two types, namely interest
swaps and currency swaps.
· Interest Swaps
Interest swaps involve exchange of interest obligations between two parties.
The following example explains the modus operandi of interest swaps:
Suppose, a US based party (company X) has 10-year outstanding US $200 million bonds, with
floating rate of interest. A French party (Company Y) also has 10 year outstanding US $200
million bonds. However, these bonds carry a fixed rate of interest. While both companies are to
make a series of interest payments (annual/semi-annual basis) over the next 10 years, the
interest payment stream is known/fixed In the case of Company Y and it varies in the case of
Company X, as per the movements of interest rate changes.
Suppose further, Company X now has stable cash flows and hence, it desires to have interest,
which is non-varying/fixed. Unlike Company X, let us assume Company Y does not have stable
cash flows; they are fluctuating in nature and move with the economy. Interest rates also move
up or down with the economy. Therefore, its management feels it will be more appropriate to
have a floating rate debt.
Interest rate swaps will obviously be ideal in these circumstances for both the companies. As a
result of the swap, Company X is to make fixed Interest payments (matching with its stable cash
flow) and Company Y is to make fluctuating interest payments (consistent with its fluctuating
earnings/cash flows).
Though both the companits, prima facie, find the interest rate swap catering to their preferences,
yet in practice, one firm may be required to make payments to the other. For instance, payment
may be necessitated if one of the two companies has a higher credit risk than the another, the
weaker company is to make payments to the stronger company in a swap.
· Currency Swaps
A currency swap, as the name indicates, is an exchange, by two foreign borrowers
with opposing needs, of a certain amount of currencies via a financial intermediary (usually a
bank). It involves exchange of debt obligation denominated in different currencies. The main
goal of a currency swap is to decrease the cost of financing for both firms involved. It requires
that: 1) their financial needs are opposed and 2) there exists an
absolute (or a comparative) advantage in borrowing for one (both) of the firms involved in the
transaction.

12. Let us look at an example of a currency swap with absolute advantages in borrowing. The spot
exchange rate is 0.7705 $US/CAD. A Canadian company needs to borrow 616,400 US dollars
for one year for refinancing one of its subsidiaries in the United States. At the same time, for
similar reasons, an American company would like to borrow 800,000 Canadian dollars (the same
amount, after conversion: $US 616,400 /
0.7705 = 800,000 CAD). The following table presents the interest rates both firms will face if
they borrow in their home country or abroad. The Canadian company has an absolute advantage
of 1.50% in borrowing Canadian dollars, while the American firm has an absolute advantage of
1.5% in borrowing US dollars. Because they both have an absolute advantage in borrowing on
the home loan market, a swap will benefit both parties.
Currency Swap Example - Borrowing Interest Rates
Canadian Loan Market
American Loan Market
Canadian Company
6.00 %
5.00 %
American Company
7.50 %
3.50 %
Absolute Advantage
1.50 %
1.50 %
The first step is that both firms borrow at a local bank: the Canadian firm borrows
800,000 CAD at an interest rate of 6% and the American firm borrows 616,400 US dollars at
3.50%. Figure 1 illustrates that transaction. Next, the two firms give their money to a financial
intermediary (a bank, for example) that will make the 616,400 US dollars available to the
Canadian firm at an interest rate of 4% and the 800,000 CAD available to the American firm at
an interest rate of 6.5%. This last step is called the currency swap. Compared to the situation
where both firms would have been borrowing abroad, they both save 1% in interest payments.
The financial intermediary, in the currency swap, also makes a profit of 1%.
At the end of the contract, the transactions just follow the reverse path. The only difference now
is that the money paid back includes a certain amount in interest payments. Also, that transaction
occurs at a forward exchange rate, determined at the beginning of the contract. This currency
swap has allowed both firms to reduce their
borrowing cost by taking advantage of their absolute advantage in borrowing. They also hedge

13. against currency risk by specifying the forward exchange rate in the original contract.
V. Hedging through Money Market Operations
Money market hedge involves a money market position in order to cover a future payables/
receivables position.
This hedge involves a money market position to cover a future payable, or receivables position.
An importer, who has to cover future payables, first borrows local currency; then, converts the
borrowed local currency into the currency of payables; and finally, invests the converted amount
for a period matching the payments to be made for the import. An exporter, on the other hand,
who has to hedge the receivables, first borrows the currency in which the receivables are
denominated, then converts the borrowed currency into local currency; and finally invests the
converted amount for a maturity coinciding with the receipt of export proceeds.
The money market hedge may be covered or it may be uncovered. If the firm has sufficient cash
out of business operations to buy the foreign currency or to repay the foreign currency loan, it is
called a covered hedge but if it purchases foreign currency with borrowed funds or repays the
foreign currency loan by purchasing foreign currency in the spot market, it is known as an
uncovered money market hedge.
Let us first take the case of the money market hedge in case of accounts payable. Suppose the
Indian importer has to make payments for import worth US 1,000 after 90 days. If it is a covered
hedge, it creates 90-day investment in foreign currency in which the import is invoiced. The
amount of initial investment will be such that the principal plus interest after 90 days equals the
payments for import. Thus, if the rate of interest on investment is 12 per cent per annum and if
the amount of import is US $ 1,000, the sum of initial investment will be:
US $ 1,000/1.03 = US $ 970.87
On the day imports are to be paid for, the importer will receive US$ 1,000 from the investment
and there will be no problem even if the exchange rate changes.
In an uncovered hedge, the importer will borrow 970.87 x 40( assuming the spot rate of 40/US $)
= 38,834.80. It will convert the rupee amount into Us dollars to get US $
970.87 and invest it at 12 per cent p.a. interest rate. On the day the imports will be paid for, it
will get US $ 1,000 and there will be no problem in paying for imports. The only cost it would
have had to bear is the interest payment on the borrowing.
In case of 90-day receivables, if the export amounts to US $ 1,000, the exporter will borrow US
$ 970.87, convert this amount into Rs. 38,834.80 and invest this amount at 12 percent p.a.
interest. On the day the export proceeds are received, the investment (principal + interest) will
amount to Rs. 40,000. The exporter will not be exposed to exchange rate changes, if any. The
cost of hedging it would have to bear is the payment of interest on the borrowing.
Let us first consider whether the money market hedge yields the same result as the forward

14. market hedge. If the interest rate parity conditions prevail and if transaction cost does not exist,
the two shall yield similar results but since the transaction cost is always present, the results tend
to differ. A break-even investment rate can be computed at which the hedger will be indifferent
between a money market hedge and the forward market hedge. Assuming r as the 90-day
investment rate that would equate the proceeds from the two streams - money market hedge and
the forward market hedge, we get -
Borrowing amount x (1 + r) = forward proceeds
If the 90-day forward rate is Rs.40.40/US $, the forward proceeds based on the above example
will be Rs.40,400. Basing again on the above example,
38,834.80 x (1 + r) = 40,400
1 + r = 40,400/38,834.80 r = 0.0403
the annualised r = 0.0403 x 360/90 = 0.1612 = 16.12 per cent
Here, r is more than the rate of interest on investments, 12 per cent p.a. under money market
hedge, which means that the money market hedge is not so beneficial as the forward market
hedge and so the importer should go for the forward market hedge. But if the forward rate is
Rs.39.80 per US $, the value of annualised r will be 9.94 per cent which is lower than the interest
rate on investment. The money market hedge will be the preferred option in this case.
-The above mentioned techniques can also be used for cash management of exports receipts in
foreign currency.
Canadian Loan Market
American Loan Market
Canadian Company
6.00 %
5.00 %
American Company
7.50 %
3.50 %
Absolute Advantage
1.50 %
1.50 %