Firms, which have access to international money markets for short-term borrowing as well as investment, can use the money market for hedging Forex transactions exposure.
Important money market hedging tools used for managing Forex risk are :
1. Discounting Foreign Currency Denominated Bills Receivable:
Discounting is used in cases where the export receivables are settled through bills of exchange. The system enables the recipient to receive cash prior to the settlement date itself. The discount represents the cost for the facility extended by the bank discounting the bill. It enables the exporter to guard himself from -losses arising out of an adverse change in-the foreign exchange rate. There are two options before the exporter while considering bill discounting. The first, is to get the bill discounted through a bank in the importer’s country. The foreign currency so obtained can be repatriated at the spot rate prevailing then. The second option is to discount it at the home country of the exporter itself, in which case the settlement is received in the home currency itself.
2. Factoring Export Receivables:
Factoring is done when export receivables are settled on open account. The- receivables are used as collateral bank financing. Such an arrangement generally gives protection against foreign exchange rate risks. Undue variations are taken care of through appropriate adjustments in the factoring agreement. The exporter sells his export receivables to a factor (usually a commercial bank, or a specialized factoring institution) in exchange for home currency. Factoring costs are generally high as the credit risks, cost of financing, and exchange rate risk cover have all to be incorporated in it. But benefits accrue in the form of easier access to export finance, and reduction of credit collection costs.
3. Currency Overdrafts:
Overdrafts in Euro-currencies are available from major banks. By far the currencies most sought after are the US dollar and the Euro. The technique is especially useful when a company has numerous transactions involving small amounts denominated in foreign currency, each having no certain date of payment. The use of the technique is restricted because of exchange control. The exchange control prevents residents from maintaining bank accounts in foreign currencies.
The company interested in overdraft arrangement has to maintain an amount equal to the overdraft in foreign currency receivables. The foreign currency receivables maintained are in the same currency as the overdraft. As and when the receivables are liquidated that portion of the overdraft may be reduced. In such cases the sales made in that currency should be reduced. The burden of making numerous adjustments in the overdraft amount outstanding as payments are received, makes this method less attractive.
4. Borrow, convert and invest:
Sometimes the company may prefer to sell the foreign currency receipts received against foreign receivables in the spot market. This reduces the burden of making numerous adjustments in the overdraft amount outstanding as payments are received.
Suppose that on January 1, General Electric is awarded a contract to supply turbine blades to British airways. On December 31 of that year, GE will receive payment of £ 25 million for these blades. It can use a money market hedge, which would involve borrowing £ 25 million for one year, converting it into dollars and investing the proceeds in a security that matured on December 31. Suppose Pound sterling and US dollar interest rates are 7.5% and 5% respectively. After one year GE will receive £ 25 mn. Let it borrow now a certain amount of £, which together with interest will amount to £ 25 mn in one year. This is using a money market hedge. General Electric will borrow £ 23.2558 million for one year, (i.e., £ 25 mn/1.075). GE converts it into $ 41.2256 million in the open market (at the spot rate of $1.7727/ £), and invests the $41.2256 million for one year. On December 31, GE will receive 1.05 X $ 41.2256 million = $ 43.28688 million from its dollar investment. £ 25 million it receives from British Airways is passed to the lender to meet principal and interest. Thus the exposure is hedged.