Fina 470 – International Finance

FINA 470 – INTERNATIONAL FINANCE

ASSIGNMENT 3

Monday, June 30th 2014

Presented to:

Professor Derek Hirsch

Presented by:

1. We have examined how derivatives can be used to help a firm hedge against (relatively) short term exchange rate movements. Provide one example each of how forwards, options, and swap contracts can be used to hedge against exchange rate risk.

a) A currency swap transaction represents an agreement to exchange one currency for another at an agreed upon exchange rate. Essentially in a swap, the holder of an unwanted currency exchanges that currency for an equivalent amount of another currency. Swaps can be used to hedge risk if for example, company A wants to buy a bond in a certain currency, but the market is oversaturated so you can’t get one. Like this, you can get another bond and swap the interest payments with company B. Thus, company A exchanges its interest and currency rate exposures from one currency to another. In this case, we observe two simultaneous transactions; because the swap market is a zero sum game, there is one of buying and one of selling at exchange rates that are previously agreed upon.

b) Forwards can be used to hedge if company A is expecting an exact payment in a foreign currency from company B but is afraid that the foreign dollar will fall in value. Company A can use forward contracts to sell the foreign currency amount expected at a future time and at a given exchange rate. The settlement will take place at the chosen time and the exchange rate mentioned in the contract. This will occur no matter the fluctuations of the exchange rate on the foreign exchange market.

c) One of the most common uses of derivatives is to hedge against foreign exchange rate risk. Options can be used to hedge long and short positions in foreign currency, they give their holder a right but not an obligation to sell or buy a specific amount at an agreed upon exchange rate. In order to obtain this right the holder...