This content explains how to manage foreign exchange (FX) risk by comparing two external hedging methods: forward contracts and money market hedges, demonstrating that a money market hedge can be more cost-effective.
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Remember,
we're still looking at how to manage FX
risk and we've said there are several
methods to use both internal and
external method. Internal method you can
issue in local currency. You can do
matching and netting.
You can as well do lead payment.
external method. We said you can use
forward transactions, you can use
futures, you can use money market edge
swaps, both forex swaps and currency
swaps, you can use options as well. Now
I'm looking at a question to practice
some of those methods and this question
if you pause the video take one minute
to go through the question. This
question requires you to apply three
methods. The first one is the netting.
The second one requires the knowledge of
forward contracts and the third one is
the knowledge of money market edge. So
but the requirement want us to decide
whether the company should use a forward
or should use a money market edge.
Remember both forward and money market
edge edges are actually external
methods. But if you see this question
and you realize that you have to do
matching first because there's an
application of internal method that you
can use and this is due to the fact that
there is
an account payable of 240,000
due in 3 months and there's account
receivable of the same currency of about $69,000
$69,000
due at in this at the same time. Yeah.
So in that case you can do the initial
internal method which is matching or
netting in this case because the
external part is involved. So you can
call it matching. Yeah. So you have
171,000 net. So this is the net account
payable that you need to look for
And for us to decide whether the company
should use forward contract or money
market edge,
this will be based on our attempt to
edge $171,000
and not $240.
So this is the amount that we need to
edge because this is what we need to pay
net in 3 months that we don't have.
How do we go about this? Let's check how
much this will equivalent to in our
local currency. If we use forward contract
contract
remember contract about you fixing the
feature rate at which we do a contract.
We need to know our exposure first of
all and we know that our exposure is
that we need to buy $171,000
That is what we want to achieve. So if
we want to use forward it means that we
need to buy forward for 3 months. So and
we've been given the quote for 3 months
forward here as you can see it for
dollar and euro as to this. But the
question is which rate are we using? Is
it a buy rate or is it a sell rate? And
remember the clue that I always tell
you, you must always interpret your
quotes in bank perspective and second
currency perspective. Which means you're
asking yourself what is the bank going
to do to the second currency. What is
the second currency here is the base
currency which is the currency at the
back that's one in one unit and here is
euro. Yeah, because what the quote is
saying is that bank will buy 0.9520
for 10 and will sell one for sorry let
me start again bank will buy 10 for 0.9520
0.9520
if the company needs to buy $171,000.
What does that mean for the bank in
terms of euro? Let's go through the
thought process. If the company wants to
buy $171,
it means that the company will have to
sell pounds to be able to buy that
dollar. So now, sorry, we have to sell
euro and good enough euro is our second
currency. So we get that understanding,
right? So the company is selling euro
and if company is selling euro, they
must be selling to the bank. then that
means the bank is buying the euro and in
that case we able to interpret from the
bank perspective and from euro
perspective. So if bank is buying euro
definitely the applicable rate that will
be used will be 0 9520
which is the buying rate so which means
this US dollar is equivalent to 1.
US to hedge and that will mean we need
to buy we need to sell the company. We
have to sell this amount of euro to be
able to buy this amount of dollars from
the bank. So which means the amount that
we need in local currency is 171 179
179
6 to1
in order for us to use forward. But
let's see what money market edge has for us.
us.
Remember the few steps I always tell you
to use for money market edge so that you
don't get confused and feel like it is
complicated. It is not complicated. The
first one is always to understand the
company's situation which is the
exposure. Yeah. And this come around the
That is the problem that we have.
Then we need to create a money market
objective to manage that problem. So
since we know that this is a liability
that we have
remember the money market objective is
always the opposite.
What does it mean? It means that we need
to create an asset that will be exactly $171
$171
in 3 months. So we're saying we need to
create an asset
now that will have value equal
equal to
to 171k
171k
So that is the opposite thing that we
need to do. We need to create that asset.
That is that is our objective. That is
what we want to achieve this objective.
This is the money market objective.
Okay. Now since we know the money market objective,
objective, [Music]
[Music]
we need to calculate what is that amount
now of asset that will give us $171,000
US in 3 months.
The only difference is the fact that
we're going to be investing an asset now
to be able to get that figure. So we
need to know what is our investment rate
in US dollar. And if we check that our
investment rate in US dollar will be
in this line not in Australia not in
euro. This is what we need to be looking
at and you know definitely investment is
always at a lower rate because the bank
will always want to make money. So the
quotes are always from the bank. So bank
will allow you to invest with them at
10% but if you want to borrow money from
them they will give you at 12%. That's
what it is saying in US dollars. So
which means
But 10% is anom 1 year but we are saying
3 months. So which means the appropriate
interest rate will be 3 months rate and
that is 10% divided by 12 * 3 months and
that is the percentage that we are going
to be using.
And please remember what I always tell
you rates are always in annual form
except the com the question
categorically tell you to say this is in
quarterly rate or monthly rate but once
they acquired it means the rates are in
annual. So you must break them down into
your respective period that you are
interested in. Okay. So if that is the
interest rate that is applicable for 3
months and we need to invest now the
that will yield 171
in 3 months definitely will now be
equals to that 171,000 that we are
and that will give us the amount that we
need to invest now. So, which means if
today
at 10% perom
in 3 months time it will be $171.
So, we have this information. Now
Now
we are not US company.
We are European company based in France.
So we don't have US dollars. What does
that mean? It means that we need to find
euro to sell to be able to buy this
amount of dollars. So the question is
how much euro do we need to sell
in order to have this amount?
We want to sell euro to be able to buy
it. Then we need to ask ourself what
quotes that we do we need. So
We know that
if we are selling euro then definitely
bank must be buying euro. So which means
this is a buying rate. However, we're
talking about now today. So we're going
to be looking at the spot.
Remember your money market edge actually
closes foreign exchange on the spot. It
doesn't wait to the future is current is
now. What happens while you are waiting
for the period time is either investment
or borrowing. The exchange itself
happens on the spot. So that means our
spot trade buying is 0 9830. That's what
we're going to use. And that's
But we are looking for
this $166.
So which means the amount of euro that
we will need to
sell to be able to have that amount
is equals to this divided by can be
multiplied. So
yeah because normally if you cross
multiply what you're saying is
166 * 1 divided by 983.
So which means
we need to sell 169714.41
to be able to buy the amount of US
dollar that we need. But remember
you don't use excess money for this. In
fact most times question will even tell
you. So even if they don't tell you need
to understand that in money market edge
you always borrowing and investing you
don't have excess fund. So because you
don't have excess fund it means that you
we have to borrow that 169. So amount to
is equals to 169
169 714.41
714.41 41.
So that is the amount that we have to
borrow now. So we borrow that money now. However,
However,
this contract is a 3-month contract. So
which means to close the money market
edge that we're doing, we are going to
be borrowing for about 3 months. So
there will be interest expense. Nobody's
going to borrow us money free. So on
that money, there will be interest
expense. So we need to check
in euro how what is the borrowing rate
and it's 13% as you can see the bank
will borrow money will give you money at
13%. So if they're going to give you
money at 13%, the interest is cross to
13%, this is annual rate. Don't forget
divide by 12 * 3 to convert it into what
it should be. Then multiply by the
principle. The principal is 169 that
we're borrowing. And you see that we
have additional interest of 515. So the total
total
euro needed to do this money market edge
is equals to the amount that we borrow
principle plus the interest that we paid
and that is the total that we need for
money market h. Now if you compare the
situation with what you need for forward
definitely you have to conclude that
money market edge is a choice edge
method for this transaction because it
requires lower amount of
cash outflow in the local currency. Fat,
you'll be saving about, let's see,
you'll be saving about this minus
this guy. Yeah, that's about 4,000
savings if you use money market edge.
And that is it. A quick revision for you
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