Management of Transaction Exposure
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1 Management of Transaction Exposure 8 Chapter Eight Chapter Objective: This chapter discusses various methods available for the management of transaction exposure facing multinational firms. This chapter ties together chapters 5, 6, and Chapter Outline Differentiate between Transaction, Operating, and Translation Exposure Forward Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts 8-1 1
2 Chapter Outline (continued) Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use? Forward Market Hedge If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract
3 Forward Market Hedge of Payable: Example You are a U.S. importer of Italian shoes and have just ordered next year s inventory. A payment of 100M is due in one year. You will need 100M in one year. You don t know what the price of euro will be in the spot market, one year later (S 1 ). You do not know how many dollars you will need to cover your 100M payment You have foreign exchange risk exposure. How do you eliminate this risk? 8-4 Forward Market Hedge of Payable: Example Suppose, this is the market condition right now: The current price of euro in the spot rate (S) = $1.43 One year, forward rate for euros (F) = $1.50 US Interest Rate (i H )=8% Interest rate in Euro zone (i F )= 3% If you buy a one year forward contract for 100 million, you will have to pay $150 million for it in one year. 8-5 If one year later, the price of euros in the spot market (S 1 ) turns out to be $1.80, then you saved (gained) $30 million. If S 1 is $1.20, then you lost $30 million. 3
4 Gains & Losses from Forward Market Hedge of Payable: Example $30m If you agree to buy 100 million at a price of $1.50/, you will make $30 million if the price of the euro reaches $1.80. Long forward $0 $30m $1.20/ $1.50/ $1.80/ S 1 If you agree to buy 100 million at a price of $1.50 per pound, you will lose $30 million if the price of the euro falls 6 to $1.20/. 8-6 Gains & Losses from Forward Market Hedge of Payable: Example S Cash Flow: Cash Flow: Gain / Losses relative to 1 Unhedged Forward Hedge Unhedged position Position $120,000,000 - $150,000,000 - $30,000, $135,000,000 - $150,000,000 - $15,000, $150,000,000 - $150,000, $165,000,000 - $150,000, $15,000, $180,000,000 - $150,000,000 $30,000,
5 Forward Market Hedge of Receivable: Example You are a U.S. exporter of chemicals expecting a payment of 75M from a German pharmaceutical firm in one year. You will need to convert 75M into $ in the spot market in one year. You don t know what the price of euro will be in the spot market, one year later (S 1 ). You do not know how many dollars you will receive in exchangefor 75M payment py You have foreign exchange risk exposure. How do you eliminate this risk? 8-8 Forward Market Hedge of Receivable: Example Suppose, this is the market condition right now: The current price of euro in the spot market (S) = $1.43 One year forward rate for euros (F) = $1.50 US Interest Rate (i F )=8% Interest rate in Euro zone (i H )= 3% If you sell a one year forward contract for 75 million, you will receive $112.5 million for it in one year. 8-9 If one year later, the price of euros in the spot market (S 1 ) turns out to be $1.80, then you lost $22.5 million. If S 1 is $1.20, then you gained $22.5 million. 5
6 Gains & Losses from Forward Market Hedge of Receivable: Example $22.5m Short forward If you agree to sell 75 million at a price of $1.50 you will make $22.5 million if the price of the euro falls to $1.20 $0 $22.5m $1.20 $1.50 $1.80 If you agree to sell 75 million at a price of $1.50 you will lose $22.5 million if the price of the euro rises to $1.80 S Gains & Losses from Forward Market Hedge of Receivable: Example S 1 Cash Flow: Unhedged Position Cash Flow: Forward Hedge Gain / Losses relative to Unhedged position $ 90,000,000 + $112,500,000 $22,500, $101,250,000 + $112,500,000 $11,250, $112,500, $112,500, $123,750,000 + $112,500,000 - $11,250, $135,000,000 + $112,500,000 - $22,500,
7 Forward Market Hedge: Summary E(S 1 ) = Expected spot rate one year later Management Expectations on FX Market Management Risk Preference Payable Exposure Cautious Hedge Hedge Receivable Exposure E(S 1 ) = F Neutral Hedge Hedge Aggressive Will not hedge Will not hedge Cautious Hedge Hedge E(S 1 ) < F Neutral Will not hedge Hedge Aggressive Will not hedge Hedge Cautious Hedge Hedge E(S 1 ) > F Neutral Hedge Will not hedge Aggressive Hedge Will not hedge 8-12 Money Market Hedge of Payable This is the same idea as covered interest arbitrage. To hedge a foreign currency payable (A), borrow in a US bank, and use proceeds to buy the foreign currency today and put it in the foreign bank: Determine the amount of the foreign currency required to be deposited in the foreign bank: A /(1+ i F ) Borrow the USD equivalent of that amount from a US bank: S * [A /(1+ i F )] Pay off the US bank loan at maturity: (1+ i H ) * S * [A /(1+ i F )]
8 8-14 Money Market Hedge of Payable: Example Same example as before: A U.S. importer of Italian shoes needs to pay the Italian supplier 100M in one year. The current price of euro in the spot market kt(s) is $1.43. One year forward rate for euro (F) is $1.50. US Interest Rate (i H ) is 8%. Interest rate in Euro zone (i F )is 3% 1. The US firm will need to invest: (100,000,000 / 1.03) = 97,087, in the Italian bank, so that it has exactly 100,000,000 to pay off the supplier in one year. 2. Borrow the USD equivalent of that amount: 97,087, x 1.43 = $138,834, from US bank 3. Pay off the US bank loan in one year with: $138,834,951.5 x 1.08 = $149,941,748 Effectively, the US firm will need $149,941,748 to cover a 100,000,000 payable one year later. Money Market Hedge & Forward Hedge of Payables In this case, based on the one-year euro forward contract price (F) of $1.50, the forward hedge amount for 100,000,000 is $150,000, Since this is higher than the MM Hedge amount of $149,941,748, MMH will be preferred. For payable hedge (choose the hedge with the lower amount): If MMH > FH: Choose FH If MMH < FH: Choose MMH Under IRP: MMH = FH
9 Money Market Hedge of Receivables This is the same idea as covered interest arbitrage. To hedge a foreign currency receivable (A), borrow foreign currency against that receivable from a foreign bank, and convert the proceeds to USD, and put it in the US bank: Determine the amount of the FX that can be borrowed against the receivables from a foreign bank: A /(1+ i F ) Convert the borrowed FX into USD: S * [A /(1+ i F )] Deposit that amount into US bank to get this at maturity: (1+ i H ) * S * [A /(1+ i F )] Money Market Hedge of Receivable: Example Same example as before: AU.S.exporterofchemicalsisexpectinga payment of 75M from a German pharmaceutical customer in one year. The current price of euro in the spot market (S) is $1.43. One year, forward rate for euro (F) is $1.50. US Interest Rate (i H )is8%. Interest rate in Euro zone (i F )is3% 1. The US firm should borrow: (75,000,000 / 1.03) = 72,815, the German bank against the 75,000,000 it is going to receive in one year from its customer. 2. Convert the borrowed euros into USD: 72,815, x 1.43 = $104,126, and deposit the USD in US bank 3. Withdraw the following from the US bank in one year: $104,126, x 1.08 = $112,456,311 Effectively, the US firm will have $112,456,311 in exchange for 75,000,000 receivable one year later. 9
10 Money Market Hedge & Forward Hedge of Receivable In this case, based on the one-year euro forward contract price (F) of $1.50, the forward hedge amount for 75,000,000 is $112,500, Since this is higher than the MM Hedge amount of $112,456,311, FH will be preferred. For receivable hedge (choose the hedge with the higher amount): If MMH > FH: Choose MMH If MMH < FH: Choose FH Under IRP: MMH = FH 8-18 Options Market Hedge While both FH and MMH completely eliminate FX exposure, options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency. If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. If the currency does not appreciate (or depreciates), you can let the call option expire and buy the FX in the spot market. To hedge a foreign currency receivable buy puts on the currency. If the currency depreciates, your put option lets you sell the currency for the exercise price. If the currency does not depreciate (or appreciates), you can let the put option expire and sell the FX in the spot market
11 Option Hedge of Payable: Example Same example as before: A U.S. importer of Italian shoes needs to pay the Italian supplier 100M in one year. The current price of euro in the spot market (S) is $1.43. Forward rate for euro (F) is $1.50. Exercise price of acall option with one year to expire is $1.50. The call premium is $0.02/. US Interest Rate (i H ) is 8%. Interest rate in Euro zone (i F )is3% The total cost of the option as of the maturity date (considering time value of money): $0.02 * 100,000,000 * 1.08 = $2,160,000. If S 1 > $1.50: The option will be exercised. The net cost of securing 100M = 1.50 * 100,000, ,160, = $152,160,000. If S 1 < $1.50: The option will not be exercised. The firm will purchase in the spot market at S 1. The net cost of securing 100M = S 1 * 100,000, ,160, Dollar Cost of Options Hedge of Payable: Example 8-21 S 1 Exercise? Gross Dollar Cost Option Cost Net Dollar Cost 1.20 No $120,000,000 $2,160,000 $122,160, No $135,000,000 $2,160,000 $137,160, Neutral $150,000,000 $2,160,000 $152,160, Yes $150,000,000 $2,160,000 $152,160, Yes $150,000,000 $2,160,000 $152,160,000 Using forward hedge, the dollar cost of securing 100,000,000 will always be $150,000,000 The break even spot rate one year later (S* 1 ) where there will be a preference switch between forward and options hedge: 1.50 * 100,000,000 = S 1 * 100,000, ,160,000 = $
12 Options Hedge v/s Forward Hedge for Payable: Example $ Cost of securing 100M $ m $150 m Options hedge $1.50= E Forward Hedge $ = S * Option Hedge of Receivable: Example Same example as before: A U.S. exporter of chemicals is expecting a payment of 75M from a German pharmaceutical customer in one year. The current price of euro in the spot market (S) is $1.43. One year forward rate for euro (F) is $1.50. Exercise price of a put option with one year to expire is $1.50. The put premium is $0.015/. US Interest Rate (i H ) is 8%. Interest rate in Euro zone (i F )is3% The total cost of the option as of the maturity date (considering time value of money): $0.015 * 75,000,000 * 1.08 = $1,215,000. If S 1 < $1.50: The option will be exercised. Proceeds from selling 100M = 1.50 * 75,000,000 - $1,215,000 = $111,285,000 If S 1 > $1.50: The option will not be exercised. The firm will sell in the spot market at S 1. Proceeds from selling 75 M = S 1 * 75,000,000-1,215,
13 Dollar Proceeds from Options Hedge of Receivable: Example 8-24 S 1 Exercise? Gross Dollar Proceeds Option Cost Net Dollar Proceeds 1.20 Yes $112,500,000 $1,215,000 $111,285, Yes $112,500,000 $1,215,000 $111,285, Neutral $112,500,000 $1,215,000 $111,285, No $123,750,000 $1,215,000 $122,535, No $135,000,000 $1,215,000 $133,785,000 Using forward hedge, the dollar proceeds from selling 75,000,000 will always be $112,500,000 The break even spot rate one year later (S* 1 ) where there will be a preference switch between forward and options hedge: 1.50 * 75,000,000 = S 1 * 75,000,000-1,215,000 = $ Options Hedge v/s Forward Hedge for Payable: Example $ Proceeds from 100M Options hedge $112.5 m $ m $1.50= E Forward Hedge $ = S *
14 Options Markets Hedge With an exercise price denominated in local currency 8-26 IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS. If the price of the currency ygoes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price. EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS. If the price of the currency yg goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price. Options A motivated financial engineer can create almost any risk-return profile that a company might wish to consider. Straddles and butterfly spreads are quite common. Notice that the butterfly spread costs our importer quite a bit less than a naïve strategy of buying call options
15 Cross-Hedging Minor Currency Exposure The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Thai bhat. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies Cross-Hedging Minor Currency Exposure Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated. An example would be a U.S. importer with liabilities in Swedish Sweds krona hedging gwt with long gor short otforward owad contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way
16 Hedging Contingent Exposure If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options Hedging Recurrent Exposure with Swaps Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards
17 Hedging through Invoice Currency The firm can shift, share, or diversify: shift exchange rate risk by invoicing foreign sales in home currency share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies diversify exchange rate risk by using a market basket index 8-32 Hedging via Lead and Lag If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow
18 Exposure Netting A multinational firm should not consider deals in isolation, i but should ldfocus on hedging the firm as a portfolio of currency positions. As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if it s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately Exposure Netting Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging
19 Should the Firm Hedge? Not everyone agrees that a firm should hedge: Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges Should the Firm Hedge? In the presence of market imperfections, the firm should ldhedge. Information Asymmetry The managers may have better information than the shareholders. Differential Transactions Costs The firm may be able to hedge at better prices than the shareholders. Default Costs Hedging may reduce the firms cost of capital if it reduces the probability of default
20 Should the Firm Hedge? Taxes can be a large market imperfection. Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have boom and bust cycles in their earnings stream What Risk Management Products do Firms Use? Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts. The greater the degree of international involvement, the greater the firm s use of foreign exchange risk management
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