Week 8
Chapter 8 Management of Transaction Exposure
Overview Introduction to Transaction Exposure Forward Market Hedge Money Market Hedge Option Market Hedge Swap Market Hedge Cross Hedge: Minor Currency Exposure Operational Techniques Should the Firm Hedge? Mini Case: Airbus Case Study: Metallgesellschaft AG
Introduction Three types of foreign currency exposure: Economic Exposure Translation Exposure Transaction Exposure
Economic Exposure The extent to which the value of the firm would be affected by unanticipated changes in exchange rates Profound effects on the firm s competitive position, cash flows and market value
Translation Exposure The potential that the firm s consolidated financial statement can be affected by changes in exchange rates Consolidation involves translation of subsidiaries financial statements from local currencies to the home currency.
Consolidation Subsidiary in UK financial statement Subsidiary in Japan financial statement $ Subsidiary in China financial statement
Transaction Exposure The sensitivity of realized domestic currency values of the firm s contractual cash flows dominated in the foreign currencies to unexpected exchange rate changes Short-term economic exposure Fixed-price contracting in a world where exchange rates are changing randomly
Transaction Exposure When & where to hedge? International business Foreign-currency-denominated receivables or payables Commercial and financial contracts dominated in foreign currencies The magnitude of exposure is the same as the amount of foreign currency that is in receivables or payables.
Transaction Exposure How to Hedge? Financial contracts Forward market hedge Money market hedge Option market hedge Swap market hedge Operational Techniques Choice of the invoice currency Lead/lag strategy Exposure retting
Forward Market Hedge
Forward Market Hedge The most direct and popular way of hedging transaction exposure Firms sell(buy) their foreign currency receivables(payables) forward to eliminate exchange risk exposures.
Forward Market Hedge Boeing Example (sell receivables) Suppose that Boeing Corp. exported a Boeing 747 to British Airways, and billed 10 million payable in one year. The U.S. interest rate: The U.K. interest rate: The spot exchange rate: $1.50/ The forward exchange rate: 6.10% per annum 9.00% per annum $1.46/ (1-year maturity)
Forward Market Hedge Step 1: Boeing sells forward its pounds receivable( 10 million) for delivery in one year. Step 2: On the maturity date of the contract, Boeing delivers this 10 million to the bank and in return, takes delivery of $14.6 million($1.46*10 million).
Forward Market Hedge Step 3: Boeing uses the 10 million that it is going to receive from British Airways to fulfill the forward contract. Result: Boeing s receivable is exactly offset by the pound payable(created by the forward contract), the company s net pound exposure becomes zero.
Forward Market Hedge Proceeds($) Unhedged position $14,600,000 Forward hedge 0 F=$1.46 ST
Forward Market Hedge Suppose: On the maturity date of the forward contract The spot rate= $1.40/ < The forward rate= $1.46/ Boeing would have received $14.0 million(rather than $14.6 million) if it did not enter into the forward contract. Boeing GAINED $0.6 million from forward hedging.
Forward Market Hedge Suppose: On the maturity date of the forward contract The spot rate= $1.40/ > The forward rate= $1.46/ Boeing would have received $15.0 million(rather than $14.6 million) if it did not enter into the forward contract. Boeing LOST $0.4 million from forward hedging.
Forward Market Hedge Receipts from the British Sale ST Unhedged Position Forward Hedge Gains/Lisses from Hedge $1.3 $13 M $14.6 M $1.6 M $1.4 $14 M $14.6 M $0.6 M $1.46 $14.6 M $14.6 M $0 $1.5 $15 M $14.6 M -$0.4 M $1.6 $16 M $14.6 M -$1.4 M Gain = (F ST)* 10 million
Forward Market Hedge Firms must decide whether to hedge or not to hedge ex ante: ST F ST < F ST > F
Forward Market Hedge ST F The expected gains/losses are approximately zero. Firms would be inclined to hedge as long as it is averse to risk. Valid when the forward exchange rate is an unbiased predictor of the future spot rate.
Forward Market Hedge ST < F Firms expect a positive gain from forward hedging. Since firms expect to increase the dollar proceeds while eliminating exchange exposure, it would be even more inclined to hedge under this scenario than under the first scenario.
Forward Market Hedge ST > F Firms can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds from the foreign sale. Other things being equal, firms would be less inclined to hedge under this scenario. Whether firms actually hedge or not depend on the degree of risk aversion.
Forward Market Hedge Why forward contracts, not currency futures contracts? Forward contracts are tailor-made to the firm s specific needs, futures contracts are standardized instruments. Due to the marking-to-market property, there are interim CF prior to the maturity date of the futures contract that may have to be invested at uncertain interest rates.
Money Market Hedge
Money Market Hedge What is money market? Money Markets are markets where debt securities with original maturities of one year or less are traded. Major securities includes T-bills, federal funds, repurchase agreements, commercial paper, and negotiable certificates of deposits.
Money Market Hedge Characteristics: Transactions occur via telephone or computer (OTC) Money market securities are liquid and have low credit risk, but, are usually sold in large denomination(e.g. in unit of $1 million to $10 millions)
Money Market Hedge What is money market hedge? The use of borrowing and lending transactions in foreign currencies to lock in the home currency value of a foreign currency transaction. Borrow To hedge foreign currency receivables Lend To hedge foreign currency payables
Money Market Hedge Advantage: Synthetic forward positions can be built in currencies for which there are no forward currency markets. Disadvantage: Might not be feasible if there are constraints on borrowing or lending
Money Market Hedge Boeing Example(currency outflow-payable) Step 1: Boeing borrows pounds in the U.K. at t=0 Borrowing amount = the discounted PV of the pound receivable = 10million/(1.09)= 9,174,312 Step 2: Boeing converts into $ using spot exchange rate $1.5/. Dollar amount= ( 9,174,312)($1.5/ )=$13,761,468
Money Market Hedge Step 3: Boeing invests $ using the U.S. interest rate 6.10% for 1 year. Step 4: Boeing collects 10 million receivables to repay the pound loan in step 1 Step 5: Boeing receives the maturity value of dollar investment in step 3 ($13,761,468)(1+6.10%)=$14,600,918
Money Market Hedge Transaction Current Cash Flow Cash Flow at Maturity 1. Borrow Pounds 9,174,312-10,000,000 2. Buy dollar spot with pounds $13,761,468-9,174,312 3. Invest in US -$13,761,468 $14,600,918 4. Collect pound receivable 10,000,000 Net cash flow 0 $14,600,918
Money Market Hedge Interest rate parity(irp) conditions Forward market hedge Money market hedge IRP holds $14,600,000 14,600,918 Nearly Identical IRP is not holding The dollar proceeds will be different. One will dominate the other! In a competitive and efficient world financial market, any deviations from IPR are not likely to persist.
Outflows/Payable Inflows/Receivable STEP 1 STEP 2 STEP 3 STEP 4 Borrow home currency Amount is the PV of payable in domestic currency Covert into foreign currency at current spot exchange rate Invest money at foreign interest rate Amount grows to the payable amount at the time the payable is made Repay the borrowed domestic loan Amount is same as in the forward contract if IRP is hold Borrow the foreign currency Amount is the PV of the receivable Convert into domestic currency at current spot exchange rate Invest money at domestic interest rate Amount is same as in the forward contract if IRP is hold Repay the borrowed foreign currency loan with the receivable
Option Market Hedge
Option Market Hedge Forward & Money Market Hedge - completely eliminate exchange exposure Option Market Hedge: Call Hedge foreign currency payables Put Hedge foreign currency receivables
Option Market Hedge Boeing example(put Receivables) In OTC market, Boeing purchased a put option on 10million British pounds with an exercise price of $1.46 and a one-year expiration. Premium: $0.02/ Risk free interest rate: 6.10%
Option Market Hedge Spot exchange rate=$1.30/ < $1.46/ Exercise the put option + $1.46/ * 10,000,000=$14,600,000 Premium cost (considering time value) - (1+6.1%)($0.02/ )( 10,000,000)=$212,200 Net dollar proceeds = $14,387,800 Without put option? $1.30/ * 10,000,000=$13,000,000 Net dollar proceeds = $13,000,000
Option Market Hedge Spot exchange rate=$1.60/ > $1.46/ Do not exercise the put option + ($1.60/ )( 10,000,000)=$16,000,000 Premium cost - $212,200 Net dollar proceeds = $15,787,800
Option Market Hedge The option hedge allows the firm to limit the downside risk while preserving the upside potential. Premium cost There rarely exist free lunches in Finance!!
Option Market Hedge Option vs Forward When ST<$1.46/ (exercise price of put option) Because of the premium cost of option hedge Forward hedge > Option hedge When ST>$1.46/ Do not exercise the option Break-even point $(10,000,000) ST-$212,200 =($1.46/ )( 10,000,000) ST=$1.48/
Option Market Hedge Proceeds($) Option Hedge PUT $14,600,000 $14,387,800 Break-even Forward Hedge 0 E=$1.46 ST*=$1.48 ST
Option Market Hedge Forward & Money Market Hedge Obligation Completely eliminate exchange exposure One forward rate for a given maturity More risky (over-thecounter market) Option Market Hedge Right Limit the downside risk while preserving the upside potential Multiple exercise exchange rates for the options contract. (higher exercise price, higher option premium)
Hedging Contingent Exposure Contingent Exposure: a situation in which the firm may or may not be subject to exchange exposure.
Example General Electric is bidding on a hydroelectric project in Quebec. If the bid is accepted, which will be know in 3 months, GE is going to receive C$100 million to initiate the project.
Alternative #1 Use forward contracts to hedge GE sell C$100m to hedge Bid is accepted Use C$100m to fulfill Bid is rejected Unhedged short position in C$ Do nothing: No guarantee the outcome Bid can be accepted
Alternative #2 Use Three-month Put Option Three-month put option on C$100 million Bid is accepted ST<exercise rate ST>exercise rate Exercise put No exercise put & convert C$100m at ST Bid is rejected ST<exercise rate ST>exercise rate Exercise put Let the put expire Each outcome can be covered Option premium upfront need to be paid
How to trade the option Step 1: Decide how much money you want to trade Step 2: Find a broker that trades options Step 3: Open a demo account with the broker Step 4: Open a live account and start trading
Summary
Swap Market Hedge
Swap Market Hedge Fact: firms often have to deal a sequence of accounts payable or receivable of a foreign currency How to hedge such recurrent cash flows?
Swap Market Hedge Currency swap contract: an agreement to exchange one currency for another at a predetermined exchange rate on a sequence of future dates Swap rate: predetermined exchange rate
Swap Market Hedge Currency Swap Contract: Behave like a portfolio of forward contracts with different maturities Flexible in terms of amount and maturity Maturity: a few months 20 years
Swap Market Hedge Boeing British Airways January 1 st December 1 st 1996 Deliver an aircraft Pay 10,000,000 1997 Deliver an aircraft Pay 10,000,000 1998 Deliver an aircraft Pay 10,000,000 1999 Deliver an aircraft Pay 10,000,000 2000 Deliver an aircraft Pay 10,000,000 Recurrent cash flows Boeing faces a sequence of exchange risk exposures!
Swap Market Hedge Boeing British Airways Boeing entering forward contract Date January 1 st December 1 st December 1 st 1996 Deliver an aircraft Pay 10,000,000 Deliver 10,000,000 to 1997 Deliver an aircraft Pay 10,000,000 the counterparty Receive a 1998 Deliver an aircraft Pay 10,000,000 predetermined dollar 1999 Deliver an aircraft Pay 10,000,000 amount each year 2000 Deliver an aircraft Pay 10,000,000 $15,000,000 Suppose the agreed swap exchange rate is $1.5/, what is the amount Boeing will receive each year?
Swap Market Hedge When a company using a swap contract hedge, it will receive the predetermined amount of money regardless of the future spot and forward rates. A set of swap contracts would not be priced at a uniform rate Different forward rates for different maturities Long-term forward contracts are not readily available
Cross-Hedge: Minor Currency Exposure
Financial Instrument: Cross-Hedge Commonly used for minor currency exposures Minor Currency: Currencies that can be high of value but are not as stable as the major currencies Examples: Mexican Peso, Korean Won, etc The need for cross-hedge arises due to the lack of a market for the minor currencies. This inhibits a firm s ability to reduce its transaction exposure.
Cross-Hedge: How it works Type 1: hedge the minor currency with a currency that is more stable Requirement: need to find a highly correlated replacement Type 2: hedge with commodity futures
Cross-Hedge: Type 1 Example A US company has an A/R in Korean Won and wants to hedge its position. Since Won/Dollar Exchange rate is highly correlated to Yen/Dollar, Yen will be a good replacement. The US company would sell a Yen amount = Won amount. Forward against the Dollar Limitations: effectiveness limited to the stability and strength of Won/Yen correlation
Cross-Hedge: Type 2 Example A US company has a A/R in Mexican Pesos. Assume that Dollar/Peso is highly correlated to Oil Prices. Then the company would utilize Oil futures in order to hedge its position.
Operational Techniques
Operational Techniques Choice of the invoice currency Lead/Lag strategy Exposure netting
Choice of Invoice Currency A firm can simply diverse its exchange risk by instilling an appropriate currency for its transactions For example, a US company will only do business with another company in another country if it was paid based on the Dollar. Can also use a tool called SDR -A basket of currencies including: Yen, Dollar, Euro, Pound Limitations: highly dependent on the bargaining power of your company
Lead/Lag Strategy A firm can lead or lag its foreign currency receipts and payments. To Lead : to pay or collect early To Lag : to pay or collect late The firm would wait until the exchange rate is at a good rate before executing its transactions. Typically used in intra-firm payments/receivables
Exposure Netting Typically used when a firm as both payments and receivables in a particular currency Instead of hedging one side of the transactions, a firm should consider hedging only the net exposure. Companies today use a financial subsidiary (reinvoice center) as a way to centralize exposure management functions. This subsidiary decides which method of hedging is best for the firm and would net the exposure
Trends of FX Hedging FX is the world's largest financial asset class with $2 trillion changing hands on the markets ever day. Hedging foreign exchange helps companies to remove the uncertainty from their financial forecasts. Companies today seek to reduce potential risk, and the most favorable method to reduce transaction exposure is to hedge in order to reduce all risks related to future fluctuations in the foreign exchange.
Trends of FX Hedging FX hedging is best when it is simple. For many companies buying simple forward contracts that will deliver the foreign currency in three to six months can be the most effective way to hedge FX exposure. Chris Towner, senior economist at HiFX, says: "It's often when FX moves start to impact the bottom line, that executives start to be interested in hedging, but it should be something that is constantly managed.
Should the Firm Hedge?
Should the Firm Hedge? Arguments against corporate risk management: The exchange exposure management at the corporate level is redundant when stockholders can manage the exposure themselves. Only systematic risk matters in the firm valuation, corporate risk management may only reduce the total risk. May be valid in a perfect capital market
Should the Firm Hedge? Market Imperfections: Information asymmetry Differential transaction cost Default costs Progressive corporate taxes
Expected corporate taxes ($) Should the Firm Hedge? Taxes can be a large market imperfection. 2.5m A 2m B 5m 10m 15m Earnings before taxes ($)
Should the Firm Hedge? Firms are engaged in different hedging activities. Corporate risk management is relevant to maximizing the firm s value. Stockholders themselves cannot properly manage exchange risk, the firm s managers can do it for them, contributing to the firm s value.
Risk Management Products 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.
Mini Case: Airbus
Airbus Dollar Exposure(p213) Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company for $30 million payable in sixmonth. The Euro zone interest rate: The U.S. interest rate: The spot exchange rate: $1.05/ The forward exchange rate: 2.5%(six-month) 3.0%(six month) $1.10/ (six-month maturity)
Hedge Using a Forward Contract Airbus only needs to buy $30 million forward in exchange for the following amount: ($30,000,000) ($1.10/ ) = 27272727.27 Unit here is $/, we use division!
Hedge Using Money Market Instruments Airbus first compute the PV of its foreign currency payable $: ($30,000,000) (1+3%) Then sell the $ proceeds spot for : ($29126213.59) ($1.05/ ) =$29126213.59 = 27739251.04
Hedge Using Money Market Instruments Invests exactly the same amount at the U.S. interest rate of 3.0% Use the maturity of this investment to payoff its dollars payable Outlay a certain euro amount today in order to spot the dollar amount that needs to be invested
Hedge Using Put Option Strike price: 0.95/$ Premium: 0.02/$ We know the six-month forward exchange rate is $1.10/, change the unit to /$ first: 1 $1.10/ = 0.9091/$ < 0.95/$ ST< F
Hedge Using Put Option ST<F Airbus expects to exercise the option and receive($30,000,000)( 0.95/$)= 28,500,000 Premium=($30,000,000)( 0.02/$)= 600,000 FV( 600,000)= ( 600,000)(1+2.5%)= 615,000 Net proceeds from the American sale = 28,500,000-615,000= 27,885,000
Break-Even Point Indifferent rate Compare the option and money market hedge Money market hedge Solving for ST: ( 27739251.04)(1+2.5%) = ($30,000,000)ST - 615,000 Option market hedge ST= 0.968/$ or $1.033/ The time value of money is always considered!
Case Study: Metallgesellschaft AG
Background Metallgesellschaft AG A $15 billion sales commodity and engineering conglomerate based in Frankfurt am Main, Germany 251 domestic and foreign subsidiaries Trade and Financial Services, engineering Services
Facts In 1992, MG Energy, a subsidiary of MG in New York, began to sell long-term and fixedprice contracts by offering oil products to both wholesale and retail customers. At the same time, MG purchasing entirely short-term oil futures to manage its price risk They are playing as both speculators and hedgers.
Facts However, buyers of those contracts was granted an option to terminate the contracts at any time. MG can earn profit only if the future market remained in backwardation. Customers can gain the possible profit from the difference between a risen spot future price and the strike price.
Statistics Volume of Firm Fixed and Firm Flexible Contracts in Million barrels December 1992 July 1993 September 1993 December 1993 43 84 154 150 Source: Special Auditors Report Loss from hedge Contracts in Million U.S dollar December 1993 Early 1994 1030 857 Source: Special Auditors Report
A Big Reversal Why? Reason 1: The OPEC s decision: not to restrict oil production Reason 2: The risk management strategy itself was full of controversy Result: spot prices plummeted & MG Energy incurred losses
What s the Reality? The Market Flips: The market conditions shifted gears into contango (i.e. spot prices lower than futures prices) Accounting for MG Energy: MG Energy s accounting did not do a good job of portraying the economic reality of the effectiveness of the Company s speculating strategies.
Accounting Solution IFRS standard IAS 39: Hedge Accounting Lays out rules for assessing the effectiveness of hedge positions Allows for derivatives to be displayed at fair value A related rule, IFRS 7, requires for extensive disclosure for hedge accounting
Recommendation Do not give customers the buy-out option Use hedge instead of speculate
Question
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