Managing Transaction Exposure

1
Managing Transaction Exposure
2
Why to hedge?

• Against
• Its expensive
• Global investor can easily diversify (say, invest
  in both exporters and importers)
• As many as 40 of derivatives users (1/3 of US
  firms) speculate (75 of users hedge their
  commitments)
• For
• Information asymmetry (managers know more than
  shareholders)
• Differential transaction costs (firms can hedge
  cheaper)
• Lowering of default (expected bankruptcy) costs
• Easier access to new capital
• Lowering of firms cost of capital (WACC)
• Lowering of tax bill (in case of progressive
  taxes)

3
Lets help Remington Arms Company

• The oldest U.S. gun and ammo maker
• Annual worldwide sales 446 million (2006)
• Production almost exclusively in the U.S.
• Sales all over the world
• Lets assume the company has a receivable of
  10,000,000 in 6 months
• How can we get the most out of it?

4
Currency market data (as of 11/12/2007)

• Spot rate 2.0550 (/ )
• 6-month forward rate 2.0413
• 6-month U.S. Treasury rate 3.64
• 6-month U.K. Government rate 5.41
• 6-month call option prices (strike/price in
  dollars)
• 2.0450/0.0540
• 2.0550/0.0500
• 2.0650/0.0460
• 6-month put option prices (strike/price in
  dollars)
• 2.0450/0.0460
• 2.0550/0.0510
• 2.0650/0.0570

5
Should Remington be concerned?

• The company is to receive 10,000,000 in 6 months
• Should the managers be afraid of appreciation of
  the Pound?
• Should the managers be afraid of depreciation of
  the Pound?
• Is the Pound likely to appreciate or depreciate?
• What is the forward rate implies by Interest Rate
  Parity?
• (1ius) F/S(1iUK)
• F S(1iUS)/(1iUK) 2.0550(10.0364/2)/(10.0
  541/2) 2.05500.99138 2.0373
• Actually, BMO Capital Markets has an expert
  6-month forecast of 2.0000

6
Different scenarios for Remington

• If exchange rate does not change in 6 months
  (2.0550)
• The company will receive 10,000,0002.0550
  20,550,000
• If the exchange rate falls to 2.0000
• The company will receive 10,000,0002.0000
  20,000,000
• Would be quite a big difference for the company
  that just had Net Income of 300,000 (on EBIT
  29.6 mil)
• If the company sells a forward contract (the
  buyer will pay Remington 2.0413 per each Pound)
• The company will receive 10,000,0002.0413
  20,413,000
• Forward contracts are the most common hedging
  mechanisms (93 of Fortune 500 firms use them)

7
Forwards vs. options

• What if Dollar further depreciates to 2.1000?
• Unhedged profits would be 10,000,0002.1000
  21,000,000
• But with forward hedge we have 10,000,0002.0413
  20,413,000
• Buy PUT options instead (right to SELL my Pounds
  for a pre-determined price)
• Leaves upward potential
• Protects against downward risk

8
Option pay-off alternatives
9
What about money market hedge?

• Remington will receive 10,000,000 in 6 months
  it would be able to REPAY a loan in Pounds
• How much can they borrow now?
• 10,000,000/(10.05410.5) 10,000,000 /
  (1.02705) 9,736,624
• Lets convert the Pound loan into dollars at a
  spot rate
• 9,736,6242.0550 20,008,763
• And lets invest those dollars in the US. After 6
  months
• We repay the 10,000,000 loan with the
  receivables from the U.K.
• We are left with 20,008,763(10.03640.5)
  20,008,763(1.0182) 20,372,922
• WHICH HEDGE (IF ANY) IS THE BEST?

10
Hedging in emerging markets

• Options and/or forward contracts may not be
  available
• How to decrease exposure to foreign currencies?
• Hedging through invoice currency
• Preferably use home currency
• Or at least try to move away from the most
  volatile currencies
• Exposure netting
• Match costs and revenues
• For example, if 30 of my revenues are in s and
  70 of my revenues are in s, then attempt to
  structure you input, labor, etc. costs in the
  same relative ratio

11
Sellier and Bellot (SB) whats so special?
12
Characteristics of SB

• Czech sport ammunition producer, primarily
  exports (5th largest seller of sport ammo in the
  U.S.)
• Sales CZK 1 billion (55 mil)
• 55 in Euros
• 28 in US Dollars
• 17 in Czech Korunas
• Labor costs, financing primarily in CZK
• Input costs (brass and lead) in ???? (flexible)
• Between 2000 and present
• US dollar fell from 38.1 CZK/ to 18.2 CZK/
  (-52)
• Euro fell from 35.6 CZK/ to 26.6 CZK/ (-25)
• Do you think SB performance improved or worsened
  over last several years?

13
Provide an advice to SBs CEO!

• Assume that SB has 5,000,000 receivable to be
  collected in 6 months. You know (as of
  11/12/2007)
• Spot rate 18.279 CZK/
• 6-month forward rate 18.196 CZK/
• 6-month Czech Government rate 3.49
• 6-month U.S. Treasury rate 3.64
• Question 1 Is the expected movement in exchange
  rates favorable/detrimental for SB?
• Question 2 If the company decides to hedge,
  should it use forward contract or money market
  hedge?