Management of Transaction Exposure

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• Management of Transaction Exposure
• (chapter 13)

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Transaction Exposure

• Arises from changes in the value of past
  contractual obligations in FC (e.g. payables and
  receivables, loans and deposits)
• Example Suppose that on January 1, 2005 Ford is
  awarded a contract to supply trucks to Dutch army
  forces. On December 31, 2005, Ford will receive a
  payment of Euro 25 million for these trucks.You
  have the following capital markets information as
  of January 1, 2005
• Spot US dollar /Euro 1 /Euro
• 1 year US interest rate 2 percent
• 1 year Euro interest rate 4 percent
• 1 year forward rate US dollar/ Euro 0.98
  /Euro

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Hedging
Hedging a particular currency exposure means
establishing an offsetting currency
position Whatever is lost or gained on the
original currency exposure is exactly offset by a
corresponding foreign exchange gain or loss on
the currency hedge Hedgings basic objective
reduce/eliminate volatility of accounting
earnings and future cash flows as a result of
exchange rate changes.
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Without hedging
The value of the cash flow in dollars (domestic
currency) depends on the XR on December 31,
2005 If the Euro (FC) depreciates against dollar
(DC), the dollar (DC) value of the Euro (FC)
position decreases Ex for 0.93 USD/Euro the
value of the expected cash flow becomes 0.93 x
25m USD 23.25m Hedging costs can be seen as
insurance premium the firm has to pay to avoid
steep currency losses
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Hedging strategies

• Using financial derivatives
• Hedging in the forward/futures market
• Hedging in the options market
• Using operational techniques
• Hedging through invoice currency
• Hedging via lead and lag
• Exposure netting

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Forward market hedge
A company that is going to receive (has
receivables) foreign currency in the future will
sell the foreign currency forward A company that
is going to owe (has payables) foreign currency
in the future will buy the foreign currency
forward The forward contract is entered into at
the time the exposure is created Our example
Ford is expected to receive Euro 25m. in one
year, thus it will sell forward Euro 25 m.
Forward rate 0.98 USD/Euro A forward sale of
Euro 25 million for delivery in one year will
yield Ford 0.98x25m USD 24.5m
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Forward Market Hedge
Why futures are not so popular for hedging? -
standardized contracts lack of flexibility -
marking-to-market Example You are the CFO of a
U.S. importer of British woolens and have just
ordered next years inventory. Payment of 100m.
is due in one year. Spot rate is 1.25/. Forward
rate is 1.20/. Question How can you hedge
this currency exposure? What are the dollar
payments with hedging?
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Options Market Hedge

• Options provide a flexible hedge against the
  downside, while preserving the upside potential
• Options are more suitable for hedging when
• - the company wants to benefit from favorable
  currency movements and limit the extent of
  currency loses
• - the future FC cash flow is uncertain (ex.
  Competitive bidding for a construction project
  abroad that might not be awarded)
• No free-lunch here hedging with options
  involve upfront premium costs

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Options Market Hedge

• To hedge an expected FC cash outflow (payable)
  buy calls on the FC
• If the currency appreciates, your call option
  lets you buy the currency at the exercise price
  of the call.
• To hedge an expected FC cash inflow (receivable)
  currency receivable buy puts on the currency.
• If the currency depreciates, your put option lets
  you sell the currency for the exercise price.

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Hedging certain future cash flows Ford example

• On January 1, 2005 S 1/Euro and F 0.98/Euro
• Suppose that Ford purchased a put option on 25m.
  Euro with an exercise price 0.99 /Euro and a
  one-year expiration. The option premium was
  0.02/Euro. Ford thus paid 500,000(0.02xEuro25mx
  1/Euro)
• The transaction provides Ford with right, but not
  the obligation, to sell 25. Euro for 0.99/Euro,
  regardless of the future spot rate.
• If at the expiration
• S1/Euro put is out-of-the-money. Ford does not
  exercise the option and change/sell the Euros at
  S1/Euro.
• Proceeds Euro 25m X 1/Euro 25m.
• Costs option premium 0.5m (without the time
  value of money)
• Costs 0.5x1.02 0.51m (with the time value of
  money)
• Net proceeds Proceeds-costs 25-0.524.5 m.

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(2) S0.95/Euro put is in-of-the-money. Ford
exercise the option and change/sell the Euros at
S0.99/Euro. Proceeds Euro 25m X 0.99/Euro
24.75m. Costs option premium 0.5m Net
proceeds Proceeds-costs 24.75-0.524.25 m.
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Options Hedging importer of British woolens
The importer can hedge his 100 million payable
by buying a call option. Consider that the strike
price X1.3/ premium0.02 Calculate the net
proceeds if at the maturity (1) S1.4/, and
(2) S1.2 /. Disregard the time-value-of-money
of the premium.
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Hedging through Invoice Currency

• Operational technique
• The firm can shift, share, or diversify
• shift exchange rate risk
• by invoicing foreign sales in home currency
• Ex Ford can invoice 25m than Euro 25m.
• 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

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Hedging via Lead and Lag

• Operational technique
• 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.
• Caveats
• - can hamper the relations with your
  customers/suppliers
• - involves forecasting the XRs
• Useful for intrafirm payables and receivables

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Exposure Netting

• A multinational firm should not consider deals in
  isolation, but should focus 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 its not a perfect hedge, it may be too
  expensive or impractical to hedge each currency
  separately.
• MNCs centralize their FX exposure

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Observations
It is virtually (if not actually) impossible to
forecast future changes in foreign exchange
rates. Attempting to profit from foreign
exchange forecasting is speculating, not
hedging FC transactions and hedging choices
should be evaluated upon forward rate and not
current spot rate If financial markets are
efficient, firms cannot hedge against expected
rate changes
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Should the Firm Hedge?
Not everyone agrees that a firm should hedge -
Exposure is hard to measure and hedging hard to
understand - Management often speculates instead
of hedge - Hedging by the firm may not add to
shareholder wealth if the shareholders can
manage exposure themselves
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Should the Firm Hedge?

• In the presence of market imperfections, the firm
  should hedge.
• 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.

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Learning outcomes

• What is transaction exposure and how is it
  different from economic and translation exposure?
• Know how to implement a hedging transaction with
  forwards (numerical application)
• Know how to implement a hedging transaction with
  options (numerical application)
• Discuss the following operational hedging
  techniques invoicelead and lag exposure
  netting
• Discuss the arguments against hedging.
• Discuss three arguments for hedging.
• Recommended end-of-chapter questions1, 3, 4, 5,
  6, 7
• Recommended end-of-chapter problems3a,b,c