Forward Hedge
Spot rate US$ 0.74
Forward rate US$ 0.76
US $ received = 800,000*0.76 = US$ 608,000.
If Novena Ltd. takes the forward contract they will exchange the Singapore dollars at the agreed forward rate of US$ 0.76 per Singapore dollar. Under the forward hedge Novena Ltd. will receive US$ 608,000.
Money market Hedge
Step I Borrow in foreign currency
800,000/ (1.07) = SGD$ 747,663.55
In the first step Novena Ltd. Should borrow in Singapore dollars. The amount of money borrowed should be the present value of the expected receipt discounted at Singapore borrowing rate. The present value of SGD$ 800,000 is equivalent to SGD$ 747,663.55 when discounted at the Singapore borrowing rate of 7% for one year.
Convert at Spot
Once the bank grants a loan of SGD$ 747,663.55 Novena Ltd. should convert it at spot exchange rate into US$.
747,663.55*0.74 = US$ 553,271.03
Deposit in home currency
Once Novena Ltd. Receives US$ 533,271.03 it should deposit the money in the US at 9% per annum. By the end of one year Novena US$ deposit will be US$ 603,065.42 calculated as follows:
553,721.03*(1.09) = US$ $603,065.42
Option hedging
Using one-year put options
Today: Option premium (800,000 * $0.04) ($3,200)
1 year later Exercise the option 800,000 *$0.77 $616,000
Net US$ receipts $612,800
Optimal Hedging strategy
Comparing the three hedging strategies that is, option hedging, money market hedging, and forward hedging the optimal strategy is the option hedge that generates the highest amount of US$ receipt of US $612,800.
No hedge position
In order to evaluate the no-hedge position it is important that Novena Ltd. calculates the expected foreign exchange rate. The expected foreign exchange rate at the end of year one can be calculated as follows:
If the company does not hedge and instead opts to trade in the market, the expected one-year spot rate would be US$ 0.778, in this scenario the expected US$ receipts would be:
800,000 * 0.778 = US$ 622,400
The no hedge position generates a higher expected US$ receipt of US$622,400 as compared to the best hedging strategy that is the option hedging that yields US$ receipt of US$ 612,800.In this case Novena Ltd. can argue that it is better not to hedge. However, an expected rate is not actual rate but shows the weighted probability of various possible exchange rates given the probability of their occurrence. There is a 20% chance that the actual rate will be below the expected exchange rate of 0.778. That is, there is a 20% chance that the exchange rate will be US$ 0.75 which is lower than the expected exchange rate of US$ 0.778.
Over-hedging refers to a hedged position in which the offsetting position is for an amount that exceeds the actual exposure the firm is facing. Essentially, over-hedging means that the firm has over estimated the hedge position required to adequately cover for the price movement in its goods, securities or commodities (Narvaez). A firm that is over-hedged incurs excessive risk-financing costs (Narvaez). Firms end-up over-hedging when they over estimate the expected foreign payments or receipts.
Multi-nationals Corporations (MNCs) like Novena Ltd. are likely to be at risk of over-hedging their foreign exchange risk. In order to effectively hedge risks, MNCs must be able to identify the various types of foreign exchange risks. MNCs face three types of foreign exchange risk:
Translation risk is the risk that foreign exchange rate movements will affect the values of assets and liabilities of MNCs with foreign subsidiaries (Narvaez). If the home currency appreciates relative to the foreign currency, it will result in a translation loss, while if the foreign currency weakens relative to the foreign will result in a translation gain. MNCs need not hedge the translation risk because translation risk does not result in any cash flow.
Economic risk is the risk the exchange rate movements will adversely affect the present value of a firm’s cash flow and thus affect the value of the firm (Narvaez). While economic risk poses a significant risk to the firm, it is difficult for a firm to create an effective hedge against economic risk.
Transaction risk is the risk that the foreign exchange rates will change adversely between the date of the transaction and the date of payment or receipt (Narvaez). Most MNCs hedge against transaction risk by use of internal and external hedging techniques.
MNCs must find an appropriate method of assessing and measuring foreign exchange risk in order to hedge accurately. MNCs may decide to only hedge the payments or receipts they are certain of in order to avoid large mismatches between the hedge and the foreign exchange risk the firm is facing (Narvaez).
One method of measuring economic and transaction risk is the Value –at –risk (VaR) model. VaR model measures the risk facing a firm by considering three key factors:
The holding period over which the foreign exchange position is to be held
The level of confidence, the common levels of confidence are 95% and 99%
The unit of currency that the VaR is denominated (Narvaez).
After identifying and measuring the foreign exchange risks MNCs should decide whether to hedge or not. Some MNCs are adopting efficient frontier models in order to determine the most efficient hedging strategy that is most economical for the risk hedged (Narvaez).With a better understanding of the foreign exchange risks MNCs can reduce the impact foreign exchange risk on their profitability.
Work cited
Narvaez, Kristina. "What CFOs Should Know About Foreign Exchange Risks." CFO. 21
May 2015. Web. 27 Mar. 2016.
