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How SMEs Use Forward Exchange Transactions and Forex Options as Hedging Tools

How SMEs Use Forward Exchange Transactions and Forex Options as Hedging Tools. Simon H. Yen Professor of Finance National Chengchi University August 16, 2011. How SMEs Use Forward Exchange Transactions and Forex Options as Hedging Tools. Summary

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How SMEs Use Forward Exchange Transactions and Forex Options as Hedging Tools

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  1. How SMEs Use Forward Exchange Transactions and Forex Options as Hedging Tools Simon H. Yen Professor of Finance National Chengchi University August 16, 2011

  2. How SMEs Use Forward Exchange Transactions and Forex Options as Hedging Tools Summary Facing volatile exchange rates, Taiwan’s SMEs have to hedge the currency risk to protect the firm’s revenue. Most of the firms utilize the following currency derivatives to hedge: forward exchange contracts, forex option contracts, range forward contracts, and currency cylinder contracts. Each type of these derivatives has its characteristics: forward exchange contracts could provide perfect hedge by fixing the hedged position values constant, while forex option contracts could limit the downside risk but retain the upside potential by charging some costs or premium. Compared to forex option contracts, range forward contracts provide limited upside potential in exchange for no hedging costs. However, because of regulatory restrictions, range forward contracts are not available in Taiwan and practitioners, in response, have tried to use maturity-mismatched currency cylinder contracts as instead. Since this will lead SMEs to expose to another risk, we suggest relaxing the restrictions on the maturities of currency cylinder contracts.

  3. 1. Using Forward Exchange Transactions as Hedging Tools revenue (NT$m) +S • Suppose a Taiwan’s SME will receive $1million from an American company on Dec.16,2011 and want to hedge the NT$/$ exchange rate risk. 28.85 (unhedged) e(NT$/$) 28.85 profit (NT$m) 0.4 28.85 e(NT$/$) 0.2 -0.2 -0.4 -Forward revenue (NT$m) 28.85 +S-Forward (hedged) e(NT$/$) 28.85

  4. 2. Using Forex options as Hedging Tools revenue (NT$m) +S 28.85 (unhedged) e(NT$/$) 28.85 28.50 29.20 profit (NT$m) 0.4 e(NT$/$) 28.85 0.2 28.50 +P revenue (NT$m) +S+P (hedged) 28.85 28.50 e(NT$/$) 28.85 28.50 29.20

  5. 3. Using Range Forward Exchange Transactions (Currency Collars) as Hedging Tools revenue (NT$m) +S 28.85 (unhedged) e(NT$/$) 28.85 profit (NT$m) 0.4 0.2 e(NT$/$) 28.85 28.50 29.20 – RF If e1<NT$28.50, then RF=NT$28.50 If NT$28.50<e1≦ NT$29.20, then RF=e1 If e1>NT$29.20, then RF=NT$29.20 revenue (NT$m) +S – RF 29.20 28.85 (hedged) 28.50 e(NT$/$) 28.50 29.20

  6. 4. Using Currency Cylinders as Hedging Tools revenue (NT$m) +S (unhedged) 28.85 e(NT$/$) 28.85 Buy American Put 12/16/2011 EP=NT$28.50 Sell European Call 01/16/2012 Ec=NT$29.20 Currency Cylinder = +P-C Profit (NT$m) Short Call 0.4 – C(5 month contract) EP EC 0.2 e(NT$/$) 28.85 28.50 29.20 – Currency Cylinder +P(4 month contract) Long Put revenue (NT$m) +S – Currency Cylinder 29.20 (hedged) 28.85 28.50 e(NT$/$) 28.85 28.50 29.20

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