Financial management of foreign exchange: an operational technique to reduce risk
Foreign exchange risk is a major problem for most large international corporations. This book describes one of the first applications of management science to the field of international finance: the development of an operational technique to determine international financing and hedging strategies. A computerized model determines such strategies with explicit trade-off between costs and risks. The financial manager then chooses the specific strategy that best fits his own risk preferences. Different types of international financial transactions are handled: loans, forward exchange contracts, swaps, bond investments, and repatriations of profits. The types of foreign exchange risks that can be handled by the model include devaluations and revaluations of foreign currencies under the present monetary system. The model has also been adapted to other potential monetary systems such as floating exchanges, crawling pegs, and wider bands. In his introduction the author says: "The effectiveness of the method has been tested under actual conditions. Over a recent 16-month period, financing and hedging against devaluation of Brazilian cruzeiros cost one major U.S. corporation $1.6 million. It was subsequently shown that had the treasurer been guided by optimal solutions arrived at by the computerized technique he could have reduced the costs to $275,000, a saving of 83%. Improvements on current practices can thus be measured precisely with this technique." The book provides all the preliminary facts and concepts necessary to understand the problem and the theoretical model before presenting the model itself. A case study of a hypothetical Ace International Company shows how "real-life" financial transactions and operation constraints can be handled by the model, and how it may be extended by refining some assumptions and eliminating some simplifications. Information requirements for the technique are expressed in financial terms, and the data are available in most information systems of large international corporations. The mathematics employed is simple algebra, basic probability, and statistical decision theory.
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The Unitemporal Model
The Multitemporal Model
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Ace International asset or liability assumption bank loans basic cash requirements bond transactions Brazil Brazilian business risks cash equation Chapter computed constraints cost equations covariance currency decision variables devaluation amount devaluation losses devaluation probability devaluation-hedging model effective efficient frontier example exchange contracts expected cost expected return expected value export swaps exposed assets exposed liabilities Figure financial swap financing and hedging forward-exchange contracts German mark hedging bond horizon input interest cost investment low-risk maximum million cruzeiros monetary system month multitemporal model normal distribution objective function operations optimal solution optimal strategy option output portfolio positive correlation present private loan probability distribution purchase QPS code quadratic quadratic programming quarter random variable represents Section simulation soft currency straight dollar loan subroutine technique tion treasury bonds uncertainty unitemporal model variance zero