INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 9
• Topic Understanding and Managing Foreign
  Exchange Exposure

2
What is Foreign Exchange Exposure?

• Simply put, foreign exchange exposure is the risk
  associated with activities that involve a global
  firm in currencies other than its home currency.
• Important Global firms cannot have foreign
  exchange exposure in their home currencies.
• Essentially, it is the risk that a foreign
  currency may move in a direction which is
  financially detrimental to the global firm.
• Given the observed potential for adverse exchange
  rate movements, it would appear that global firms
  should
• Understand and manage their foreign exchange
  exposures.

3
Does Foreign Exchange Exposure Matter? What do
Global Firms Say

• Nike Our international operations and sources
  of supply are subject to the usual risks of doing
  business abroad, such as possible revaluation of
  currencies (2005).
• Starbucks In fiscal 2004, international company
  revenue in US dollars increased 32, in part
  because of the weakening U.S. dollar against both
  the Canadian dollar and the British pound.
  (2005).
• McDonalds In 2000, the weak euro, British pound
  and Australian dollar had a negative impact upon
  reported US dollar results. (2000).

4
Global Companies and FX Exposure

• What is the specific risk to a global firm from
  foreign exchange exposure?
• Settlement value of foreign currency denominated
  contracts, in home currency equivalents, can be
  adversely affected.
• Cash flows from foreign operations, in home
  currency equivalents, can be adversely affected.
• The global competitive position of the firm can
  be affected by adverse changes in exchange rates.
• All of these can have an adverse affect on the
  financial position of the firm.

5
Types of Foreign Exchange Exposure

• There are three distinct types of foreign
  exchange exposures that global firms may face as
  a result of their international activities.
• These 3 foreign exchange exposures are
• Transaction exposure
• Economic exposure
• Translation exposure (sometimes called accounting
  exposure).
• We will develop each of these in the slides which
  follow.

6
Transaction Exposure

• Transaction Exposure Results from a firm taking
  on fixed cash flow foreign currency denominated
  contractual agreements.
• Examples of transaction exposure
• An Account Receivable denominate in a foreign
  currency.
• A maturing financial asset (e.g., a bond)
  denominated in a foreign currency.
• An Account Payable denominate in a foreign
  currency.
• A maturing financial liability (e.g., a loan)
  denominated in a foreign currency.

7
Economic Exposure

• Economic Exposure Results from the physical
  entry of a global firm into a foreign country.
• This is a long term foreign exchange exposure
  resulting from a previous FDI location decision.
• Over time, the firm will acquire foreign currency
  denominated assets and liabilities in the foreign
  country.
• The firm will also have operating income in the
  currency of the foreign country.

8
Economic Exposure -- Continued

• Economic exposure impacts the firm through
  contracts and transactions which have yet to
  occur, but will, in the future, because of the
  firms long term location.
• These are really future transaction exposures
  which are unknown today.
• Economic exposure can have profound impacts on a
  global firms competitive position and on the
  market value of that firm.

9
Two Channels of Economic Exposure
Impact on the home currency value of assets and
liabilities
Firms Competitiveness and Firm Value
Exchange Rate Fluctuations
Impact on future operating cash flows
10
Translation Exposure

• Translation Exposure Results from the need of a
  global firm to consolidated its financial
  statements to include results from foreign
  operations.
• Consolidation involves translating subsidiary
  financial statements in local currencies (i.e.,
  in the foreign markets where the firm is located)
  to the home currency of the firm (i.e., the
  parent).
• Consolidation can result in either translation
  gains or translation losses.
• These are essentially the accounting systems
  attempt to measure foreign exchange ex post
  exposure.

11
Assessing Foreign Exchange Exposure

• All global firms are faced with the need to
  analyze their foreign exchange exposures.
• In some cases, the analysis of foreign exchange
  exposure is fairly straight forward and known.
• For example Transaction exposure.
• There is a fixed (and thus known) contractual
  obligation (in some foreign currency) .
• While in other cases, the analysis of the foreign
  exchange exposure is complex and less certain.
• For example Economic exposure
• There is great uncertainty as to what the firms
  exposures will look like over the long term.
• Specifically when they will take place and what
  the amounts will be.

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Using a Hedge to Deal with Exposures

• In using a hedge, a firm establishes a situation
  opposite to its initial foreign exchange
  exposure.
• A firm with a long position in a foreign currency
  will
• Offset that position with a short position in the
  same currency.
• A firm with a short position in a foreign
  currency will
• Offset that position with a long position in the
  same currency.
• In essence, the firm is covering (offsetting)
  the original foreign exchange position.
• Since the firm has two opposite foreign
  exchange positions, they will cancel each other
  out.

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To Hedge or Not to Hedge?

• What are some of the factors that would influence
  a global firms decision to hedge its exposures?
• Perhaps the firms assessment of the future
  strength or weakness of the foreign currency it
  is exposed in.
• This involves forecasting and how comfortable the
  firm is with the results of the forecast.
• For example If the firm has a long position in
  what they think will be a strong currency they
  may decide not to hedge, or do a partial hedge.
• On the other hand, firms may decide not have any
  currency exposures and simply focus on their core
  business.
• Does Starbucks want to sell coffee overseas or
  speculate on currency moves?
• Obviously, this is different from a company
  managing a hedge fund, or a currency trading
  floor?

14
Hedging Strategies

• It would appear that most firms (except for those
  involved in currency-trading) would prefer to
  hedge their foreign exchange exposures.
• But, how can firms hedge?
• (1) Financial Contracts
• Forward contracts (also futures contracts)
• See Appendix 1 for a discussion of forward
  contracts.
• Options contracts (puts and calls)
• Borrowing or investing in local markets.
• (2) Operational Techniques
• Geographic diversification (spreading the risk)

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Foreign Exchange Options Contracts

• One type of financial contract used to hedge
  foreign exchange exposure is an options contract.
• Definition An options contract offers a global
  firm the right, but not the obligation, to buy (a
  call option) or sell (a put option) a given
  quantity of some foreign exchange, and to do so
• at a specified price (i.e., exchange rate), and
• at some date in the future.

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Foreign Exchange Options Contracts

• Options contracts are either written by global
  banks (market maker banks) or purchased on
  organized exchanges (e.g., the Chicago Mercantile
  Exchange).
• Options contracts provide the global firm with
• (1) Insurance (floor or ceiling exchange rate)
  against unfavorable changes in the exchange rate,
  and additionally
• (2) the ability to take advantage of a favorable
  change in the exchange rate.
• This latter feature is potentially important as
  it is something a forward contract will not allow
  the firm to do.
• But the global firm must pay for this right.
• This is the option premium (which is a
  non-refundable fee).

17
Statement from Nike Corporation

• Nike We use forward exchange contracts and
  option contracts to hedge certain anticipated
  foreign currency exchange transactions
  including receivable and payable balances.
  (2005).

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A Put Option To Sell Foreign Exchange

• Put Option
• Allows a global firm to sell a (1) specified
  amount of foreign currency at (2) a specified
  future date and at (3) a specified price (i.e.,
  exchange rate) all of which are set today.
• Put option is used to offset a foreign currency
  long position (e.g., an account receivable).
• Provides the firm with an lower limit (floor)
  price for the foreign currency it expects to
  receive in the future.
• If spot rate proves to be advantageous, the
  holder will not exercise the put option, but
  instead sell the foreign currency in the spot
  market.
• Firm will not exercised if the spot rate is
  worth more.

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A Call Option To Buy Foreign Exchange

• Call Option
• Allows a global firm to buy a (1) specified
  amount of foreign currency at (2) a specified
  future date and at a (3) specified a price (i.e.,
  at an exchange rate) all of which are set today.
• Call option is used to offset a foreign currency
  short position (e.g., an account payable).
• Provides the holder with an upper limit
  (ceiling) price for the foreign currency the
  firm needs in the future.
• If spot rate proves to be advantageous, the
  holder will not exercise the call option, but
  instead buy the needed foreign currency in the
  spot market.
• Firm will not exercise if the spot rate is
  cheaper.

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Overview of Options Contracts

• Important advantage
• Options provide the global firm with the
  potential to take advantage of a favorable change
  in the spot exchange rate.
• Recall that this is not possible with a forward
  contract.
• Important disadvantage
• Options can be costly
• Firm must pay an upfront non-refundable option
  premium which it loses if it does not exercise
  the option.
• Recall there are no upfront fees with a forward
  contract.
• This fee must be considered in calculating the
  home currency equivalent of the foreign currency.
• This cost can be especially relevant for smaller
  firms and/or those firms with liquidity issues.
• See Appendix 2 for a further discussion of
  options contracts.

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Hedging Through Borrowing or Investing in Foreign
Markets

• Another strategy used by global firms to hedge
  foreign exchange exposure is through the use of
  borrowing or investing in foreign currencies.
• This strategy is commonly referred to as a money
  market hedge.
• Borrowing in a foreign currency is done to offset
  a long position
• The borrowing produces a short position.
• Investing in a foreign currency is done to offset
  a short position.
• The investing produces a long position.

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Statement from McDonalds

• McDonalds The company uses foreign currency
  denominated debt i.e., borrowing to hedge its
  investments in certain foreign subsidiaries and
  affiliates. (2005)

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Money Market Strategy for a Long Position

• Assume a global firm expects to receive foreign
  currency in the future (i.e., it has a long
  position).
• Money market strategy is as follows
• Firm takes out a loan (i.e., borrow) in the
  foreign currency equal to the amount of the long
  position.
• Firm converts the foreign currency loan amount
  into its home currency at the spot exchange rate.
• And eventually the firm will use the long
  position to pay off the foreign currency
  denominated loan.

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Outcome of Money Market Strategy for a Long
Position

• What has the firm accomplished with this
  strategy?
• The firm has effectively offset its initial
  foreign currency long position with the foreign
  currency loan, which is a short position.
• The firm as also converted its initial foreign
  currency long position into its home currency and
  has done so before receiving payment.
• The firm has hedged against a weakening of the
  foreign currency.

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Money Market Strategy for a Short Position

• Assume a global firm needs to pay out foreign
  currency in the future (i.e., it has a short
  position).
• Money market strategy is as follows
• Firm borrows in its home currency an amount equal
  to its short position at the current spot rate.
• Firm converts the home currency loan into the
  foreign currency at the spot rate.
• Firm invests in a foreign currency denominated
  asset
• And eventually the firm will use the proceeds
  from the maturing foreign currency denominated
  financial asset to pay off the short position.

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Outcome of Money Market Strategy for a Short
Position

• What has the firm accomplished with this
  strategy?
• The firm has effectively offset its foreign
  currency short exposure with the foreign currency
  denominate asset which is a long position
• The firm has converted its foreign currency
  liability into a home currency liability.
• The firm has hedged against a strengthening of
  the foreign currency.
• See Appendix 3 for more discussion of this
  borrowing and lending strategy.

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What About Hedging Unknown Cash Flows

• Up to this point, the hedging techniques we have
  discussed (forwards, options, money market
  hedges) have been most appropriate for covering
  transaction exposure.
• Why?
• Because transaction exposures have known foreign
  currency cash flows and thus they are easy to
  hedge with financial contracts
• However, economic exposures do not provide the
  firm with this known cash flow information.

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Dealing with Economic Exposure

• Recall that economic exposure is long term and
  involves unknown future cash flows.
• What can the firm do to manage this economic
  exposure?
• Firm can employ an operational hedge.
• One such strategy involves global diversification
  of production and/or sales markets to produce
  natural hedges for the firms unknown foreign
  exchange exposures.
• As long as currencies associated with these
  different markets do not move in the same
  direction, the firm can stabilize its overall
  home currency equivalent cash flow.

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Are U.S. Companies Diversifying Globally?

• Roughly 44 of the SP 500's 2006 revenues came
  from international sources. This compares to 32
  in 2001.
• Examples include
• Starbucks 21 of total revenue is earned outside
  the U.S. (2006)
• Nike 63 of net revenues is earned outside the
  U.S. (2005)
• Coca-Cola 77 of operating income is earned
  outside the U.S. (first 9 months of 2007)

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McDonalds Global Diversification
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Nikes Global Diversification of Manufacturing
for Footwear, By Country, 2005

• Country Percent
• China 36
• Vietnam 26
• Indonesia 22
• Thailand 15
• Big Four 99
• Others Argentina, Brazil, India, Mexico, and
  South Africa
• Source Nike, 2005 Annual report

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Nikes Global Diversification of Sales by
International Region (U.S. Dollars in Millions),
2005

• Market Revenue Percent
• United States 5,129.3 37.3
• EMEA 4,281.6 31.2
• Asia Pacific 1,897.3 13.8
• Americas 695.8 5.1
• Other 1,735.7 12.6
• Total 13,739.7
• Note EMEA is Europe, Middle East and Africa

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Translation Exposure

• Translation exposure is commonly referred to as
  accounting exposure because it refers to the
  impact of exchange rate changes on the
  consolidated financial reports of a global firm.
• These include impacts on assets and liabilities
  and profits which have been acquired or occurred
  in the past.
• Why do global firms need to consolidate
  statements?
• To report financial results to their
  shareholders.
• To report income to taxing authorities.
• The accounting approach for consolidating
  financial statements depends upon the accounting
  requirements of the firms headquartered country.
• The U.S. is governed by FASB 52.
• Balance sheet and income statement gains or
  losses associated with the consolidation process
  show up in the shareholders equity account

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Statement from Nike

• Nike Adjustments resulting for translating
  foreign currency financial statements into U.S.
  dollars are included in the foreign currency
  translation adjustment, a component in the
  shareholders equity account. (2005).

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Nikes 2005 Financial Statement Summary

• Consolidated Balance Sheet, Fiscal 2005 (millions
  of U.S. dollars)
• Assets 8,793.6
• Liabilities 3,149.4
• Shareholders Equity 5,644.2
• Of which foreign currency
• translation adjustments were
  70.1
• This is a cumulative amount (e.g., in 2004 it
  was 27.5

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Managing Exposure Opening Statement

• The first step in the management of corporate
  foreign exchange risk is to acknowledge that such
  risk does exist and that managing it is in the
  interest of the firm and its shareholders.
• The next step, however, is much more difficult
  the identification of the nature and magnitude of
  foreign exchange exposure. In other words,
  identifying what is at risk, and in what way.
• The following slides present a comprehensive
  approach to the management of foreign exchange
  exposure and foreign exchange risk.

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A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure

• Step 1 Determining Specific Foreign Exchange
  Exposures
• What type of exposure are you dealing with?
• By currency and net amounts (i.e., long minus
  short positions)
• Are the net amounts worth hedging? If they are
  go to Step 2.
• Step 2 Forecasting Exchange Rates
• Determining the potential for and possible range
  of currency movements.
• Important to select the appropriate forecasting
  model.
• A range of forecasts is appropriate here (i.e.,
  forecasts under various assumptions)
• How comfortable are you with your forecast? If
  comfortable, go to Step 3. If not, HEDGE.

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A Comprehensive Approach for Assessing and
Managing Foreign Exchange Exposure

• Step 3 Assessing the Impact of Forecasted
  Exchange Rates on Companys Home Currency
  Equivalents (What is the Measured Risk?).
• Impact on earnings, cash flow, liabilities
  (positive or negative?)
• Go to Step 4
• Step 4 Deciding Whether to Hedge or Not
• Determine whether the anticipated impact of the
  forecasted exchange rate change merits the need
  to hedge.
• Perhaps the estimated negative impact on home
  currency equivalent is so small as not to be of a
  concern.
• But, if impact is unacceptable, go to Step 5
• Or, perhaps the firm feels it can benefit from
  its exposure.
• If this is the case, go to Step 6

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A Comprehensive Approach or Assessing and
Managing Foreign Exchange Exposure

• Step 5 Selecting the Appropriate Hedging
  Instruments if Risk is Unacceptable.
• Consider
• Which hedge is appropriate for the type of
  exposure?
• Financial and/or operational
• Firms familiarity and comfort level with types
  of hedging strategies.
• Review the cost involved with different financial
  contracts.
• Step 6 Selecting the Appropriate Strategy to
  Position the Firm to Take Advantage of a
  Favorable Exchange Rate Change.
• Consider
• Partial open position versus complete open
  position.
• Which financial contract will achieve your
  objective?

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What Hedges are Used?

• 1995 study by Kwok and Folks of Fortune 500
  companies revealed
• Type of Product Heard of Used
• Forwards 100.0 93.1
• Bank (O-T-C) Options 93.5 48.4
• FX Futures 98.8 20.1
• Exchange traded options 96.4 17.3
• Why do you think the first two are preferred over
  the last two?
• Do you think you would see these same results
  today?

41
Preference for Forward Market Contracts

• Why was there a preference for forward contracts?
• Perhaps because they are simple to understand and
  simple to use.
• Forward contract can be tailored to offset known
  contractual agreements.
• They are written by market maker banks for global
  customers on the basis of the customers
  particular needs
• For a particular foreign currency and amount.
• For a particular cash flow (future date).

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Preference of Bank Options over Exchange Traded
Options and Futures

• As with forwards, bank options can be tailored to
  the specific needs of the global customer.
• And they provide the firm with the flexibility to
  take advantage of a favorable change in exchange
  rates.
• But with a cost, which, in part, explains the
  preference for forwards over options.
• Exchange traded options and foreign exchange
  futures are not over the counter instruments.
• They trade on exchanges
• The contracts are standardized with regard to
  currency itself, the amount, and the maturity
  dates of the product.
• Thus, they may not be appropriate for a global
  firms specific needs.
• Especially with regard to timing and amounts.

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Appendix 1 Hedging Foreign Exchange Exposure
with Forward Contracts
44
Forward Contracts

• These are foreign exchange contracts offered by
  market maker banks.
• They will sell foreign currency forward, and
• They will buy foreign currency forward
• Market maker banks will quote exchange rates
  today at which they will carry out these forward
  agreements.
• These forward contracts allow the global firm to
  lock in a home currency equivalent of some
  fixed contractual foreign currency cash flow.
• These contracts are used to offset the foreign
  exchange exposure resulting from an initial
  commercial or financial transaction.

45
Statement from Financial Reports

• Nike We use forward exchange contracts and
  option contracts to hedge certain anticipated
  foreign currency exchange transactions
  including receivable and payable balances.
  (2005).

46
Example 1 The Need to Hedge

• U.S. firm has sold a manufactured product to a
  German company.
• And as a result of this sale, the U.S. firm
  agrees to accept payment of 100,000 in 30 days.
• What type of exposure does the U.S. firm have?
• Answer Transaction exposure an agreement to
  receive a fixed amount of foreign currency in the
  future.
• What is the potential problem for the U.S. firm
  if it decides not hedge (i.e., not to cover)?
• Problem for the U.S. firm is in assuming the risk
  that the euro might weaken over this period, and
  in 30 days it will be worth less (in terms of
  U.S. dollars) than it is now.
• This would result in a foreign exchange loss for
  the firm.

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Hedging Example 1 with a Forward

• So the U.S. firm decides it wants to hedge
  (cover) this foreign exchange transaction
  exposure.
• It goes to a market maker bank and requests a 30
  day forward quote on the euro.
• The market marker bank quotes the U.S. firm a bid
  and ask price for 30 day euros, as follows
• EUR/USD 1.2300/1.2400.
• What do these quotes mean
• Market maker will buy euros in 30 days for
  1.2300
• Market maker will sell euros in 30 days for
  1.2400

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Example 2 The Need to Hedge

• U.S. firm has purchased a product from a British
  company.
• And as a result of this purchase, the U.S. firm
  agrees to pay the U.K. company 100,000 in 30
  days.
• What type of exposure is this for the U.S. firm?
• Answer Transaction exposure an agreement to pay
  a fixed amount of foreign currency in the future.
• What is the potential problem if the firm does
  not hedge?
• Problem for the U.S. firm is in assuming the risk
  that the pound might strengthen over this period,
  and in 30 days it take more U.S. dollars than now
  to purchase the required pounds.
• This would result in a foreign exchange loss for
  the firm.

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Hedging Example 2 with a Forward

• So the U.S. firm decides it wants to hedge
  (cover) this foreign exchange transaction
  exposure.
• It goes to a market maker bank and requests a 30
  day forward quote on pounds.
• The market maker quotes the U.S. firm a bid and
  ask price for 30 day pounds as follows
• GBP/USD 1.7500/1.7600.
• What do these quotes mean
• Market maker will buy pounds in 30 days for
  1.7500
• Market maker will sell pounds in 30 days for
  1.7600

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So What will the Firm Accomplished with the
Forward Contract?

• Example 1 The firm with the long position in
  euros
• Can lock in the U.S. dollar equivalent of the
  sale to the German company.
• It knows it can receive 123,000
• At the forward bid 1.2300/1.2400
• Example 2 The firm with the short position in
  pounds
• Can lock in the U.S. dollar equivalent of its
  liability to the British firm
• It knows it will cost 176,000
• At the forward ask price 1.7500/1.7600

51
Advantages and Disadvantages of the Forward
Contract

• Contracts written by market maker banks to the
  specifications of the global firm.
• For some exact amount of a foreign currency.
• For some specific date in the future.
• No upfront fees or commissions.
• Bid and Ask spreads produce round transaction
  profits.
• Global firm knows exactly what the home currency
  equivalent of a fixed amount of foreign currency
  will be in the future.
• However, global firm cannot take advantage of a
  favorable change in the foreign exchange spot
  rate.

52
Appendix 2 Examples of Put and Call Options
53
Put Option Example

• Recall the U.S. firm which had the 30 day account
  receivable in euros (slide 16)
• Firm anticipates receiving 100,000 euros in 30
  days.
• Assume the current spot rate is 1.2500/1.2600
• Thus the receivable is worth 125,000 at the spot
  rate.
• Assume the firm negotiates a put contract with a
  strike price of 1.2000.
• Thus, the U.S. firm has established an exchange
  rate lower limit for these euros at 1.20 (or
  120,000
• And it will be charged a non-refundable fee of
  2,000 for this contract to lock in this lower
  limit.

54
Put Option Example Continued

• Assume in 30 days the euro spot rate is quoted
  as
• 1.15/1.17
• What has the euro done from 1.25/1.26
• Weakened, by 0.10 per euro.
• Account receivable is now worth 115,000 at this
  spot rate.
• What will the U.S. firm do?
• U.S. firm will exercise its put option and sell
  the euros at the strike price of 1.20.
• Firm will receive 120,000 less the 2,000 up
  front fee, or 118,000
• What would the firm have done if the up-front fee
  was greater than 5,000?

55
Call Option Example

• Recall the U.S. firm which had the 30 day account
  payable in pounds (slide 18).
• Firm knows that it must pay 100,000 pounds in 30
  days.
• Assume the current spot rate is 1.7200/1.7400
• Thus the payable will cost 174,000 at the
  current rate.
• Assume the firm negotiates a call contract with a
  strike price of 1.8000
• Thus, the U.S. firm has established an exchange
  rate upper limit for these pounds at 1.80 (or
  180,000
• And it will be charged a non-refundable fee of
  3,000 for this contract to lock in this upper
  limit.

56
Put Option Example Continued

• Assume in 30 days the euro spot rate is quoted
  as
• 1.35/1.37
• What has the euro done?
• Strengthened, by 0.10 per euro.
• Account receivable is now worth 135,000 at this
  spot rate.
• What will the U.S. firm do?
• Firm will not exercise its put option and instead
  will sell the euros in the spot market at 1.35
• Firm will end up receiving 135,000 (less the
  2,000 up front fee), or 133,000 for the euros.

57
Review of Put Option Example

• We can see from the previous example, that with
  the use of a put option, the firm was able to
  establish (lock in) a lower limit for a long
  position it has in a foreign currency.
• The firm can also walk away from the put contract
  if the exchange rate moves in its favor.
• Specifically, if the foreign currency
  strengthens.
• This is not a feature of a forward contract.

58
Call Option Example

• Assume in 30 days the pound spot rate is quoted
• 1.84/1.86
• What has the pound done from 1.72/1.74
• Strengthened, by 0.12 per pound
• Account payable will now require 186,000 at this
  spot rate.
• What will the U.S. firm do?
• U.S. firm will exercise its call option and buy
  the pounds at the strike price of 1.80.
• Firm will pay 180,000 plus the 3,000 up front
  fee, or 183,000, for the pounds
• What would the firm have done if the up-front fee
  was greater than 6,000?

59
Call Option Example Continued

• Assume in 30 days the pound spot rate is quoted
• 1.64/1.66
• What has the pound done from 1.72/1.74
• Weakened, by .08 per pound
• Account payable will now require 174,000 at this
  spot rate.
• What will the U.S. firm do?
• U.S. firm will not exercise its call option and
  instead buy the pounds at the current spot rate
  of 1.74.
• Firm will pay 174,000 plus the 3,000 up front
  fee, or 177,000, for the pounds

60
Review of Call Option Example

• We can see from the previous example, that with
  the use of a call option, the firm was able to
  establish (lock in) a upper limit for a short
  position it has in a foreign currency.
• The firm can also walk away from the call
  contract if the exchange rate moves in its favor.
• Specifically, if the foreign currency weakens.
• This is not a feature of a forward contract.

61
Examples of Borrowing or Lending to Offset
Foreign Exchange Exposure
62
Using Local Currency Borrowing to Hedge

• Assume a U.S. firm expects to receive 1,000,000
  in 1 year as a result of a sale to a British
  company.
• The U.S. firm could
• Sell the pounds 1 year forward, or
• Purchase a put option on the pounds.
• However, the firm would like to get its money
  now!
• What can it do to achieve this?
• Go to a local U.K. bank and take out a 1 year
  loan in pounds.
• Borrow an amount equal to 1,000,000 minus the
  interest that the back will charge on the loan.
• Swap out of pounds into dollars at the current
  spot rate.
• In1 year, when the firm receives payment from the
  British company, use those pound proceeds pay off
  the bank loan.
• Where is the long and short positions in the
  above example?

63
Borrowing Example

• Assume
• (1) The current spot rate is 1.85/1.87
• (2) The U.K. loan rate is 5 per annum.
• Then
• Borrow 950,000 (Note 50,000 is the interest)
• Swap out of pounds into dollars
• 1,757,500 (at bid quote of 1.85)
• In I year, use the 1,000,000 account receivable
  to pay off the loan.
• Loan payoff 950,000 50,000 1,000,000
• What did the U.S. firm achieve?
• It got its dollars NOW rather than waiting 1 year.

64
Review of Local Currency Borrowing to Hedge

• Strategy used to cover a long position.
• Firm gets its home currency equivalent now and
  can use it.
• Important if the firm is faced with liquidity
  issues.
• However, the firm will not benefit from a
  favorable change in the exchange rate.
• Also, what if the paying firm defaults.
• How can the firm protect itself against this
  risk?
• Answer Insist on a letter of credit and a
  bankers acceptance from the foreign firm.

65
Using Local Currency Investing to Hedge

• Assume a U.S. firm knows it needs to pay
  1,000,000 to a British firm in 1 year.
• The U.S. firm could
• Buy the pounds 1 year forward, or
• Purchase a call option.
• However, it could also
• Go to a U.S. bank and take out a 1 year loan in
  U.S. dollars.
• Borrow an amount in dollars which will be equal
  to 1,000,000 minus the 1 year U.K. interest
  rate.
• Swap out of the U.S. dollars into pounds.
• Invest the pounds in a 1 year U.K. bond and use
  the pound proceeds from the maturing bond in 1
  year to pay the liability.
• Where is the long and short positions in the
  above example?

66
Investing Example

• Assume
• (1) The current spot rate is 1.85/1.87
• (2) The U.S. borrowing rate is 6 per annum.
• (2) The U.K. investing rate is 8 per annum.
• Then
• The firm needs 920,000 which if invested at 8
  for a year will equal the 1,000,000 it needs in
  1 year.
• At the spot rate, the firm needs to borrow
  1,720,400 from a U.S. bank (920,000 x 1.87).
• Swap out of dollars into pounds
• 920,000 (at ask quote of 1.87)
• Invest in a 1 year U.K. financial asset at 8.
• Use the maturing U.K. asset to meet the account
  payable.
• What did the U.S. firm achieve?
• It converted its 1 year pound liability into a
  known U.S. dollar liability.

67
Review of Local Currency Investing to Hedge

• Strategy used to cover a short position.
• Firm locks in its home currency equivalent now
  with its loan in its home country.
• It has exchanged the foreign currency liability
  with a home currency liability.
• Firm can earn some interest in the foreign
  country to offset the interest it will pay on the
  home country loan.
• However, the firm will not benefit from a
  favorable change in the exchange rate.
• Also, what if the bond issuer defaults.
• How can the firm protect itself against this
  risk?
• Answer Buy a government bond (with no risk of
  default).