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APPLICATION IN CURRENCY RISK MANAGEMENT

Thus far, I have presented examples relating to specifically valuing options. In this section I will discuss the use of these techniques to make strategic risk-management decisions.

Assume that a U.S. manufacturing company sells its products in Germany. As a consequence, its operating costs are in U.S. dollars (USD) and its revenue is in Eurodollars (EUR). Using the data in Table 3.13, assume that the manufacturer wants to convert EUR50,000,000 into USD in a month.

Given the backdrop, it is clear that the company is exposed to risks associated with weakening of the EUR (and benefits from the strengthening of the EUR). While it is easy for the company to buy a 1-month put option on EUR to hedge itself right off the bat, before implementing anything it is important for the company to understand the value of implementing such a strategy – which only can be understood by asking the right questions. Here are some questions that the company would need to be able to answer before implementing any kind of hedging strategy.

TABLE 3.13 Currency Hedging Data

Spot (USD/EUR)

1.3100

1 month continuously compounded USD rate

1.0000%

1 month continuously compounded EUR rate

1.2000%

Annualized volatility

13%

Notional to be exchanged in 1 month (millions EUR)

50

Market Based

■ What risks is the company exposed to (as in how good or bad can things get as they relate to currency movements)?

Can the risks be mathematically quantified?

■ What short-term and long-term views does the company have on the currency market (or more precisely the impact on USD/EUR)?

What are the different strategies available to manage the risks (including the pros, cons, and costs associated with the strategies)?

■ What are the costs and minimum trade size associated with each strategy?

Operational Based

■ How frequently does the EUR need to be converted to USD (e.g., once a month)?

■ What flexibility is there on delaying the EUR conversion?

■ What is the range of the amount the company expects to be converted every month (e.g., EUR 50 million in the first month, EUR 100 – 130 million in the second month, and so on)?

■ What constraints are there on counterparties and instruments used for the transactions?

■ What constraints are there on the trading/risk limits?

■ What infrastructure does the company have for active versus passive risk management (including the right collection of professionals, systems, etc.)?

■ What systems does the company have in place to monitor and mark-to- market their trade positions daily?

Given the above backdrop, I will now address a few of these points.

 
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