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ABSTRACT:
This study compares the effectiveness of money market hedges and options hedges for both payables and receivables denominated in British pounds, German marks, Japanese yen and the Swiss franc. Data on interest rates, exchange rates, and options contracts were obtained from public sources for two recent time periods. This information was used to determine, for each currency: 1) the lowest rate of exchange for payables, and 2) the highest rate of exchange for receivables for each hedging technique. Unique "money market hedge exchange rate factors" and "options hedge exchange rate factors" were developed to facilitate comparisons between the two hedging techniques.
BACKGROUND
The decisions that multinational corporations (MNCs) must make regarding whether to hedge, or leave open, transactions denominated in foreign currencies can have a critical impact on both their expected returns and the riskiness of their cash flows. Even if MNCs believe they will profit from an unhedged position, they may decide, nonetheless, to hedge their positions to lock in the home-currency values of their future payables and receivables. If MNCs make a judgement to hedge these transactions, they must then determine which type of hedge to utilize.
A variety of hedging techniques are available, including the money market hedge and the option hedge. The money market hedge for payables requires the MNC to borrow home currency, convert this to foreign currency, and invest this foreign currency in a money market instrument denominated in that currency. For receivables, the MNC would borrow foreign currency from the (foreign) money market, convert this to the home currency, and invest this in the (home) money market.
Utilizing call or put options to hedge transactions, alternatively, is somewhat less complicated. To hedge payables using options, the MNC can obtain an option to buy a specific currency at a specific time at a specific price. To hedge receivables, MNCs can obtain an option to sell a specific currency at a specific time at a specific price. Notwithstanding the premium paid, hedging transaction exposure using options (as opposed to the money market) provides MNCs increased flexibility because the corporation can either exercise, or not exercise, an option contract.
The globalization of the world economy and increasingly volatile exchange rates have magnified the foreign exchange exposure of multinational...