Hedging Risk and Exposure

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Hedging Risk and Exposure

• International Corporate Finance
• P.V. Viswanath

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Learning Objectives

• Should firms hedge forex risk?
• How do firms hedge transactions exposure using
  forwards, futures and options?
• How can firms hedge operating exposure?

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Why firms should hedge

• Reasons why a firm should hedge, rather than its
  shareholders
• Progressive corporate income tax
• Scale economies in hedging transactions
• Marketing and employment benefits
• Lower expected bankruptcy costs
• Better internal information

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Hedging with forwards

• An importer or exporter faces exposure and risk
  because of delay between agreeing on a
  foreign-currency price and settling the
  transaction.
• Suppose WalMart has placed an order with a
  European manufacturer for 1m worth of fabric
  delivery in 3 months.
• This exposes WMT to fluctuations in the / rate.
• WMT could buy the euros forward.
• The 3-mth forward rate on euros (6/21/06) is
  1.27347 bid/ 1.27513 ask. Hence WMT could lock
  in its obligations at 1.27513m.
• The expected cost of hedging would be
  1m.x1.2753-E(e)
• If speculators do not need a risk premium, then
  this zero.

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Hedging using forwards

• If there is a risk premium, then the expected
  cost of hedging provides the benefit of not
  having to bear the risk.
• Hence the existence of a risk premium does not
  affect the decision to hedge or not, unless
  shareholders are of less than average risk.
• If there are transactions costs, the forward ask
  will be greater than the expected future spot
  ask, while the forward bid will be lower than the
  expected future spot bid.
• fask-eask gt 0 and fbid-ebid lt 0
• Assume fask-eask -(fbid-ebid)
• Then fask-eask ½fask-eask-(fbid-ebid)
  ½fask-fask-(eask-ebid)

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Hedging using forwards

• This can be interpreted as follows
• Suppose we buy and sell forward, the transaction
  cost is fask-fbid
• the transaction cost from buying and selling spot
  is eask-ebid.
• The difference is fask-fbid-(eask-ebid).
• This gt 0 because the spread is generally larger
  in forward markets.
• Hence the cost of hedging is half the difference
  between the forward bid-ask spread and the spot
  bid-ask spread.
• The spot bid-ask spread for the euro is 0.0005
  the 3-mth forward bid-ask spread is 0.00147
  hence the estimated cost of hedging is 0.000485/
  or 485 for 1m.

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Futures Market Hedging

• Futures-market hedging achieves essentially the
  same result as forward hedging.
• However, with futures the foreign exchange is
  bought or sold at the spot rate matmaturity, and
  the balance of receipts from selling a foreign
  currency or cost of buying a foreign currency is
  reflected in the margin account.
• Because interest rates vary, the exact receipt or
  payment with currency futures is uncertain.

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Hedging using options

• Foreign currency accounts payable can be hedged
  by buying a call option on the foreign currency,
  and account receivable can be hedged by buying a
  put option on the foreign currency.
• Options set a limit on the worst that can happen
  from unfavorable exchange rate movements without
  preventing enjoyment of gains from favorable
  exchange rate movements.

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Hedging Using Swaps

• An importer can hedge with a swap by borrowing in
  the home currency, buying the foreign currency
  spot, and investing in the foreign currency.
• Exporters can hedge with a swap by borrowing in
  the foreign currency, buying the home currency
  spot, and investing in the home currency the
  loan is repaid from the export proceeds.
• Lets us compute the cost of this strategy for an
  importer.
• Consider the case of WMT, which had to pay 1m.
  in 3 months.

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Cost of using swaps

• Assume 3-mth interest rates in euros are
  (2.88/2.92), and in dollars (4.45/4.52). The spot
  rate today is 1.2616/1.2621 the 3-mth forward
  rate 1.268590/1.270240.
• Now, WMT needs 1m in 3 mths it can invest in
  riskfree euro securities at the rate of 2.88 so
  it will need 1/(10.0288/4) 992,851 today
  this can be obtained by buying spot with
  992,851(1.2621) 1,253,078.
• Alternatively, WMT can buy the euros forward by
  committing to pay 1,270,240, which can be
  acquired by putting 1,270,240/(10.045/4)
  1,256,109 in riskfree dollar securities.
• The cost of hedging using swaps over forward is
  1,256,109 - 1,253,078 or 3031 in todays dollars.

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Hedging through currency of invoicing

• Forex exposure can be eliminated by invoicing in
  domestic currency.
• Exposure can also be reduced by invoicing in a
  mixture of currencies or by buying inputs in the
  currency of exports.

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Risk Sharing

• Risk-Sharing is a contractual arrangement in
  which the buyer and seller agree to share or
  split currency movement impacts on payments that
  pass between them.
• This is worthwhile if the relationship between
  the two firms is long-term.
• For example, Ford and Mazda may agree that all
  purchases by Ford will be made in Japanese yen at
  the current rate, as long as it is between 115
  and 125 yen/.
• If the rate falls outside this range, they may
  agree to share the difference equally.
• Of course, if the equilibrium rate level changes
  drastically, the agreement will have to be
  changed.

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Reinvoicing Centers

• A reinvoicing center is a separate corporate
  subsidiary that manages in one location all
  transaction exposure from intracompany trade.
• Effectively, the reinvoicing center centralizes
  transaction exposure risk, and diversifies the
  exposure of the parent company to transaction
  exposure. It need only hedge residual exposure
  risk.
• This method releases individual company
  subsidiaries from having to worry about
  transaction exposure for intracompany trades.
• The reinvoicing center can manage intra-affiliate
  cash flows, including leads and lags of payments.

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Reinvoicing Centers
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Managing Operating Exposure Strategically
Diversifying Operations

• The key to operating exposure management is to
  anticipate and influence the effect of unexpected
  changes in exchange rates on a firms future cash
  flows.
• Management can diversify the firms operating and
  financing base.
• Diversifying operations means diversifying sales,
  location of production facilities and raw
  material sources.
• Diversifying financing means raising funds in
  more than one capital market and in more than one
  currency.
• It can change the firms operating and financing
  policies.

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Strategic Diversification of Operations

• There might be a change in comparative costs in
  the firms own plants located in different
  countries.
• Management can make marginal shifts in sourcing
  raw materials, components, or finished products.
  If spare capacity exists, production runs can be
  lengthened in one country and reduced in another.
• There might be a change in profit margins or
  sales volume in one area compared to another,
  depending on price and income elasticities of
  demand and competitors reactions.
• Marketing efforts can be strengthened in export
  markets where the firms products have become
  more price-competitive.

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Managing Operating Exposure Diversifying
Financing

• Interest rates differentials might not adjust
  fully to expected changes in interest rates.
• In this case, provided the firm is established
  and known in different markets, it can change the
  source of its short and long-term financing.
• Diversifying financing per se can also help
  diversify risks of restrictive capital market
  policies or government borrowing competition in
  the capital market
• It can help diversify political risks
  expropriation, war, blocked funds, or unfavorable
  changes in laws.

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Modifying Financing Policies Natural Hedges

• Suppose we have a US firm selling to a Canadian
  client. One way to offset an anticipate
  continuous long exposure to a particular currency
  is to acquire debt denominated in that currency
  in this case, the Canadian dollar.
• If stable (in foreign currency) and continuing
  receipts from sales are expected, debt in the
  foreign currency could be issued the sales
  receipts would be used to make interest payments
  on the debt. This is a form of matching.
• The firm could also seek raw material suppliers
  in Canada, so that sales receipts could be used
  to pay for purchases.
• The firm could arrange to pay raw material
  suppliers from a third country using the foreign
  currency of the sales receipts.

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Natural Hedges An Example
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Currency Swaps
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Currency Risk Sharing

• Suppose GE expects to receive 10m. from
  Lufthansa from the sale of turbines in 1 year.
• Suppose the current spot price is 1.00/ and the
  forward price is 0.957/.
• GE can avoid the transaction exposure to euros if
  Lufthansa, its customer would allow it to bill in
  dollars.
• However, since Lufthansa is aware of the forward
  rate and the alternative available to GE, it
  would be willing to accept such billing only if
  it receives a discount of 0.43m, for a total
  bill of 9.57m as before.
• If Lufthansa uses the spot rate of 1/ and
  accepted a quote of 10m, it would be forgoing
  0.43m.

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Currency Risk Sharing

• Lufthansa and GE can agree to share the currency
  risks associated with their turbine contract.
  This can be done by developing a customized hedge
  contract embedded in the underlying trade
  transaction.
• Possible agreement
• A neutral zone (0.98-1.02/) within which there
  will be no price adjustment. In this zone,
  Lufthansa will pay GE, the dollar equivalent of
  10m at the base rate of 1/.
• If the euro depreciates from 1 to, say, 0.90,
  the actual rate wil have moved 0.08 beyond the
  lower boundary of the neutral zone (0.98/).
  This amount is shared equally. The actual rate
  used, here is 0.96 (1.00-0.08/2)
• If the euro appreciates to, say, 1.1, the actual
  rate will have moved 0.08 beyond the upper
  boundary (1.02/)/ The actual rate used will be
  1.04/. GE collects 10.4m and Lufthansa pays
  9.45 (10.4/1.1)

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Protection with Currency Risk Sharing
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Currency Collars/ Range Forwards

• A currency collar is a contract that provides
  protection against currency moves outside an
  agreed-upon price range.
• Suppose GE is willing to accept variations in the
  value of its euro receivable associated with
  fluctuations in the euro in the range of 0.95 to
  1.05, but not more.
• With a currency collar purchased from a bank, GE
  can obtain the following forward euro rate
• If e1 lt 0.95, then RF 0.95
• If 0.95 lt e1 lt 1.05, then RF e1
• If e1 gt 1.05, then RF 1.05
• If e1 lt 0.95, GE will be shielded from losses on
  its receivable.
• If e1 gt 1.05, the bank will make a profit.
• By forgoing the profit, the cost, for GE, of the
  downside protection will be lower.

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Protection with Currency Collars
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Cross Hedging

• Hedging with futures is similar to hedging with
  forwards.
• However, it is very difficult to find a futures
  contract that matches the needs of the hedger in
  currency, maturity and amount simultaneously.
• As long as the futures price on the futures
  contract that is available is positively
  correlated with the exposure being hedged, the
  company can obtain some protection. Such use of
  futures contracts is called cross-hedging.
• Suppose a US firm has a Danish Krone receivable,
  but it wants to use euro futures to hedge. Then,
  the slope coefficient from the regression of
  changes in the DK/ rate against changes in the
  / rate is the number of euros it should sell
  forward per DK.

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Foreign Currency Options

• Using forwards/futures or currency collars makes
  sense if the extent of the exposure is known.
  However, at times, a firm might want to hedge
  against a future exposure that might or might not
  materialize.
• In this case, using forwards might not be a good
  idea. If the exposure does materialize, well and
  good. However, if the exposure does not
  materialize, then the firm would end up with an
  unwanted exposure, once again.
• One way around this would be to buy an option.
  This is more like insurance.

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Foreign Currency Options

• Suppose GE bids on a contract worth 10m. to be
  paid in 3 months. However, GE will only know in
  2 months if the bid has been accepted.
• If GE sells a forward contract maturing in 3
  months at a price of 0.98/, it will receive
  9.8b. if the bid is accepted, no matter what the
  euro rate in 3 months.
• If the bid is not accepted, then GE will be
  contractually obligated to sell euros at 0.98/
  in 3 months time, no matter what the euro rate.
• If GE buys an option allowing it to sell 10m.
  for dollars in 3 months at a rate of 0.98/, it
  can use the option if its bid is accepted. If
  not, it can let the option lapse unless the
  euro depreciates by then to less than 0.98/.
  The cost to GE will be the cost of the option.

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Options versus Forwards

• Options are more useful than forwards when the
  amount of the exposure is uncertain.
• However, if there is some part of the exposure
  that is known for sure, such as that the exposure
  will be at least 5b., the firm can hedge the
  5b. in the forward market and the rest of the
  potential exposure in the options market.
• This assumes that the objective of the manager is
  to reduce risk, and that both forwards and
  options are priced fairly. Obviously, if these
  conditions do not hold, then the optimal policy
  might be different.

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Contractual Hedging and Long-term Exposure

• Normally, firms take contractual positions like
  forward contracts and options in order to hedge
  positions that do not have quantity risk (but
  only exchange rate risk), such as hedging
  transaction exposure.
• However, firms that have relatively predictable
  cash flows might use contractual strategies to
  hedge operating exposure as well. This is
  usually difficult because it is necessary for the
  firm to be able to predict competitor response as
  well.
• Another question with contractual hedging to
  protect against changes in strategic position is
  that it is purely a short-term hedge. A change
  in strategic posture would be a longer-term
  response.
• Hence contractual hedging would be effective only
  if the strategic impacts are temporary.