FX Risk Management Transaction Exposure

1
FX Risk ManagementTransaction Exposure

• Overview
• The three major foreign exchange exposures
• Foreign exchange transaction exposure
• Pros and cons of hedging foreign exchange
  transaction exposure
• Alternatives of managing significant transaction
  exposure
• Practices and concerns of foreign exchange risk
  management

2
Foreign Exchange Exposure

• Types of foreign exchange exposure
• Transaction Exposure measures changes in the
  value of outstanding financial obligations due to
  exchange rate changes
• Operating Exposure also called economic
  exposure, measures the change in the present
  value of the firm resulting from any change in
  expected future operating cash flows caused by an
  unexpected change in exchange rates
• Translation Exposure also called accounting
  exposure, is the changes in owners equity
  because of the need to translate financial
  statements of foreign subsidiaries into a single
  reporting currency for consolidated financial
  statements
• Tax Exposure as a general rule only realized
  foreign losses are deductible for purposes of
  calculating income taxes

3
Foreign Exchange Exposure
4
Why Hedge - the Pros Cons

• Opponents of hedging give the following reasons
• Shareholders are more capable of diversifying
  risk than the management of a firm
• Currency risk management does not increase the
  expected cash flows of a firm
• Management often conducts hedging activities that
  benefit management at the expense of shareholders
• Managers cannot outguess the market
• Managements motivation to reduce variability is
  sometimes driven by accounting reasons
• Efficient market theorists believe that investors
  can see through the accounting veil and
  therefore have already factored the foreign
  exchange effect into a firms market valuation

5
Why Hedge - the Pros Cons

• Proponents of hedging give the following reasons
• Reduction in the risk of future cash flows
  improves the planning capability of the firm
• Reduction of risk in future cash flows reduces
  the likelihood that the firms cash flows will
  fall below a necessary minimum avoiding
  bankruptcy costs
• Management has a comparative advantage over the
  individual investor in knowing the actual
  currency risk of the firm
• Markets are usually in disequilibirum because of
  structural and institutional imperfections
• Reduction in variability of income reduces a
  firms overall tax burden

6
Why Hedge - the Pros Cons
Net Cash Flow (NCF)
NCF
Expected Value, E(V)
Hedging reduces the variability of expected cash
flows about the mean of the distribution. This
reduction of distribution variance is a reduction
of risk, but who benefits from it.
7
Measurement of Transaction Exposure

• Transaction exposure measures gains or losses
  that arise from the settlement of existing
  financial obligations, namely
• Purchasing or selling on credit goods or services
  when prices are stated in foreign currencies
• Borrowing or lending funds when repayment is to
  be made in a foreign currency
• Being a party to an unperformed forward contract
  and
• Otherwise acquiring assets or incurring
  liabilities denominated in foreign currencies

8
Purchasing or Selling on Open Account

• Suppose Trident Corporation sells merchandise on
  open account to a Belgian buyer for 1,800,000
  payable in 60 days
• Further assume that the spot rate is 0.9000/
  and Trident expects to exchange the euros for
  1,800,000 x 0.9000/ 1,620,000 when payment
  is received (assuming no change in exchange rate)
• Transaction exposure arises because of the risk
  that Trident will receive something other than
  1,620,000 expected
• If the euro weakens to 0.8500/, then Trident
  will receive 1,530,000
• If the euro strengthens to 0.9600/, then
  Trident will receive 1,728,000

9
Purchasing or Selling on Open Account

• Trident might have avoided transaction exposure
  by invoicing the Belgian buyer in US dollars, but
  this might have caused Trident not being able to
  book the sale
• Even if the Belgian buyer agrees to pay in
  dollars, however, Trident has not eliminated
  transaction exposure, instead it has transferred
  it to the Belgian buyer whose dollar account
  payable has an unknown euro value in 60 days

10
Purchasing or Selling on Open Account
Life Span of a Transaction Exposure
11
Borrowing and Lending

• A second example of transaction exposure arises
  when funds are loaned or borrowed
• Example PepsiCos largest bottler outside the US
  is located in Mexico, Grupo Embotellador de
  Mexico (Gemex)
• On 12/94, Gemex had US dollar denominated debt of
  264 million
• The Mexican peso (Ps) was pegged at Ps3.45/
• On 12/22/94, the government allowed the peso to
  float due to internal pressures and it sank to
  Ps4.65/

12
Borrowing and Lending

• Gemexs peso obligation now looked like this
• Dollar debt mid-December, 1994
• 264,000,000 ? Ps3.45/ Ps910,800,000
• Dollar debt in mid-January, 1995
• 264,000,000 ? Ps5.50/ Ps1,452,000,000
• Dollar debt increase measured in Ps
• Ps541,200,000
• Gemexs dollar obligation increased by 59 due to
  transaction exposure

13
Other Causes of Transaction Exposure

• When a firm buys a forward exchange contract, it
  deliberately creates transaction exposure this
  risk is incurred to hedge an existing exposure
• Example US firm wants to offset transaction
  exposure of 100 million to pay for an import
  from Japan in 90 days
• Firm can purchase 100 million in forward market
  to cover payment in 90 days

14
Hedging Alternatives

• Transaction exposure can be managed by
  contractual, operating, or financial hedges
• Contractual hedges forward, money market,
  futures, and options
• Operating and financial hedges use risk-sharing
  agreements, leads and lags in payment terms,
  swaps, and other strategies
• A natural hedge refers to an offsetting operating
  cash flow
• A financial hedge refers to either an offsetting
  debt obligation or some type of financial
  derivative such as a swap

15
Foreign Currency Derivatives

• Derivatives drive their values from the
  underlying asset
• They might be used for two distinct management
  objectives
• Speculation the financial manager takes a
  position in the expectation of profit
• Hedging the financial manager uses the
  instruments to reduce the risks of the
  corporations cash flow
• In the wrong hands, derivatives can cause a
  corporation to collapse (Barings, Allied Irish
  Bank), but used wisely they allow a financial
  manager the ability to plan cash flows
• The derivatives we will consider are
• Foreign Currency Futures
• Foreign Currency Options

16
Foreign Currency Futures

• A foreign currency futures contract is an
  alternative to a forward contract
• It calls for future delivery of a standard amount
  of currency at a fixed time and price
• These contracts are traded on exchanges with the
  largest being the Chicago Mercantile Exchange
  (CME)
• Contract Specifications
• Size of contract called the notional principal,
  trading in each currency must be done in an even
  multiple
• Method of stating exchange rates American
  terms are used quotes are in US dollar cost per
  unit of foreign currency, also known as direct
  quotes

17
Foreign Currency Futures

• Contract Specifications
• Maturity date contracts mature on the 3rd
  Wednesday of January, March, April, June, July,
  September, October or December
• Last trading day contracts may be traded
  through the second business day prior to maturity
  date
• Collateral maintenance margins the purchaser
  or trader must deposit an initial margin or
  collateral
• At the end of each trading day, the account is
  marked to market and the balance in the account
  is either credited if value of contracts is
  greater or debited if value of contracts is less
  than account balance

18
Foreign Currency Futures

• Contract Specifications
• Settlement only 5 of futures contracts are
  settled by physical delivery, most often buyers
  and sellers offset their position prior to
  delivery date by taking offsetting positions
• The complete buy/sell or sell/buy is termed a
  round turn
• Commissions customers pay a single commission
  to their broker to execute a round turn
• Use of a clearing house as a counterparty All
  contracts are agreements between the client and
  the exchange clearing house. Therefore, there is
  no counter-party risk

19
Using Foreign Currency Futures

• If an investor wishes to speculate on the
  movement of a currency can pursue one of the
  following strategies
• Short position selling a futures contract based
  on view that currency will fall in value
• Long position purchase a futures contract based
  on view that currency will rise in value

20
Using Foreign Currency Futures

• Example (cont.) Amy believes that the value of
  the peso will fall, so she sells a March futures
  contract
• By taking a short position on the Mexican peso,
  Amy locks-in the right to sell 500,000 Mexican
  pesos at maturity at a set price above their
  current spot price
• Amy sells one March contract for 500,000 pesos at
  the settle price 0.10958/Ps

Value at maturity (Short position) Notional
principal ? (Spot Futures)
21
Using Foreign Currency Futures

• To calculate the value of Amys position we use
  the following formula
• Using the settle price from the table and
  assuming a spot rate of 0.09450/Ps at maturity,
  Amys profit is
• If Amy believed that the Mexican peso would rise
  in value, she would take a long position on the
  peso
• Using the settle price from the table and
  assuming a spot rate of 0.11500/Ps at maturity,
  Amys profit is

Value at maturity (Short position) Notional
principal ? (Spot Futures)
Value Ps500,000 ? (0.09450/Ps 0.10958/Ps)
7,540
Value at maturity (Long position) Notional
principal ? (Spot Futures)
Value Ps500,000 ? (0.11500/Ps 0.10958/Ps)
2,710
22
Foreign Currency Futures Versus Forward Contracts
23
Foreign Currency Options

• A foreign currency option is a contract giving
  the purchaser of the option the right to buy or
  sell a given amount of currency at a fixed price
  per unit for a specified time period
• The most important part of clause is the right,
  but not the obligation to take an action
• Two basic types of options, calls and puts
• Call buyer has right to purchase currency
• Put buyer has right to sell currency
• The buyer of the option is the holder and the
  seller of the option is termed the writer

24
Foreign Currency Options

• Every option has three different price elements
• The strike or exercise price is the exchange rate
  at which the foreign currency can be purchased or
  sold
• The premium, the cost, price or value of the
  option itself paid at time option is purchased
• Spot exchange rate in the market
• There are two types of option maturities
• American options may be exercised at any time
  during the life of the option
• European options may not be exercised until the
  specified maturity date

25
Foreign Currency Options

• Options may also be classified as per their
  payouts
• At-the-money (ATM) options have an exercise
  price equal to the spot rate of the underlying
  currency
• In-the-money (ITM) options may be profitable,
  excluding premium costs, if exercised immediately
• Out-of-the-money (OTM) options would not be
  profitable, excluding the premium costs, if
  exercised

26
Foreign Currency Options Markets

• Over-the-Counter (OTC) Market OTC options are
  most frequently written by banks for US dollars
  against British pounds, Swiss francs, Japanese
  yen, Canadian dollars and the euro
• Main advantage is that they are tailored to
  purchaser
• Counterparty risk exists
• Mostly used by individuals and banks
• Organized Exchanges similar to the futures
  market, currency options are traded on an
  organized exchange floor
• The Chicago Mercantile and the Philadelphia Stock
  Exchange serve options markets
• Clearinghouse services are provided by the
  Options Clearinghouse Corporation (OCC)

27
Tridents Transaction Exposure

• CFO of Trident, has just concluded a sale to
  Regency, a British firm, for 1,000,000
• The sale is made in March for settlement due in
  June (3 months)
• Assumptions
• Spot rate is 1.7640/
• 3-month forward rate is 1.7540/ (a 2.27
  discount)
• Tridents cost of capital is 12.0
• UK 3 month borrowing rate is 10.0 p.a.
• UK 3 month investing rate is 8.0 p.a.
• US 3 month borrowing rate is 8.0 p.a.
• US 3 month investing rate is 6.0 p.a.
• June put option in OTC market for 1,000,000
  strike price 1.75/ priced at 0.0265/
• Tridents foreign exchange advisory service
  forecasts future spot rate in 3 months to be
  1.7600/
• The budget rate (lowest acceptable amount) is
  based on an exchange rate of 1.7000/

28
Tridents Transaction Exposure

• Trident faces four possibilities
• Remain unhedged
• Hedge in the forward market
• Hedge in the money market
• Hedge in the futures market
• Hedge in the options market

29
Tridents Transaction Exposure

• Unhedged position
• If the future spot rate is 1.76/, then Trident
  will receive 1,000,000 x 1.76/ 1,760,000 in
  3 months
• However, if the future spot rate is 1.65/,
  Trident will receive only 1,650,000 well below
  the budget rate

30
Tridents Transaction Exposure

• Forward Market hedge
• A forward hedge involves a forward contract
• The forward contract is entered at the time the
  A/R is created, in this case in March
• When this sale is booked, it is recorded at the
  spot rate.
• In this case the A/R is recorded at a spot rate
  of 1.7640/, thus 1,764,000 is recorded as a
  sale for Trident
• If the firm wants to cover this exposure with a
  forward contract, then the firm will sell
  1,000,000 forward today at the 1.7540/
• In 3 months, Trident will received 1,000,000 and
  exchange those pounds at 1.7540/ receiving
  1,754,000
• This sum is 6,000 less than the uncertain
  1,760,000 expected from the unhedged position
• This would be recorded in Tridents books as a
  foreign exchange loss of 10,000 (1,764,000 as
  booked, 1,754,000 as settled)

31
Tridents Transaction Exposure

• Money Market hedge
• To hedge in the money market, Trident will borrow
  pounds in London, convert the pounds to dollars
  and repay the pound loan with the proceeds from
  the sale
• To calculate how much to borrow, Trident needs to
  discount the PV of the 1,000,000 to today
• 1,000,000/1.025 975,610
• Trident should borrow 975,610 today and in 3
  months repay this amount plus 24,390 in interest
  (1,000,000) from the proceeds of the sale
• Trident would exchange the 975,610 at the spot
  rate of 1.7640/ and receive 1,720,976 at once
  (today)
• This hedge creates a pound denominated liability
  that is offset with a pound denominated asset
  thus creating a balance sheet hedge

32
Tridents Transaction Exposure

• In order to compare the forward hedge with the
  money market hedge, we must analyze the use of
  the loan proceeds
• Remember that the loan proceeds may be used
  today, but the funds for the forward contract may
  not
• Because the funds are relatively certain,
  comparison is possible in order to make a
  decision (the comparison is made on future
  values)
• Three logical choices exist for an assumed
  investment rate for the next 3 months
• First, if Trident is cash rich the loan proceeds
  might be invested at the US rate of 6.0 p.a.
• Second, the loan proceeds can be substituted for
  an equal dollar loan that Trident would have
  otherwise taken for working capital needs at a
  rate of 8.0 p.a.
• Third, the loan proceeds can be invested in the
  firm itself in which case the cost of capital is
  12.0 p.a.

33
Tridents Transaction Exposure

• Because the proceeds in 3 months from the forward
  hedge will be 1,754,000, the money market hedge
  is superior to the forward hedge if the proceeds
  are used to replace a dollar loan (8) or conduct
  general business operations (12)
• The forward hedge would be preferable if the loan
  proceeds are invested at (6)
• We will assume the cost of capital as the
  reinvestment rate

1,720,976 Treasury bill 6 p.a. or
1.5/quarter 1,746,791
1,720,976 Debt cost 8 p.a. or
2.0/quarter 1,755,396
1,720,976 Cost of capital 12 p.a. or
3.0/quarter 1,772,605
34
Tridents Transaction Exposure

• A breakeven investment rate can be calculated
  between forward and money market hedge

• To convert this 3 month rate to an annual rate,

• In other words, if Trident can invest the loan
  proceeds at a rate equal to or greater than 7.68
  p.a. then the money market hedge will be superior
  to the forward hedge

35
Tridents Transaction Exposure
36
Tridents Transaction Exposure

• Futures market hedge
• Trident could also cover the 1,000,000 exposure
  by selling futures contracts now at say 1.7540/
  - most futures contracts are not delivered
  therefore instead of spot rate you would have
  purchase price of the futures contract below
• If spot rate is 1.7600/ then the result of
  futures position is
• Value at maturity (Short position) Notional
  principal ? (Spot Futures)
• Value at maturity (Short position) 1,000,000
  ? (1.7600/ 1.7540/ )
• Value at maturity (Short position) 6,000
• The loss on futures would reduce the value of
  receivable
• Value of receivable 1,000,000 ? 1.7600/
  1,760,000
• The net value of receivable is
• 1,760,000 6,000 1,754,000
• Implied exchange rate of conversion is
• 1,754,000 / 1,000,000 1.7540/ (Rate at
  which we sold futures contracts.

37
Tridents Transaction Exposure

• Option market hedge
• Trident could also cover the 1,000,000 exposure
  by purchasing a put option. This provides the
  upside potential for appreciation of the pound
  while limiting the downside risk
• Given the quote earlier, a 3-month put option can
  be purchased with a strike price of 1.75/ and a
  premium of 0.0265/
• The cost of this option would be

38
Tridents Transaction Exposure

• Because we are using future value to compare the
  various hedging alternatives, we need future
  value of the option cost in 3 months
• Using a cost of capital of 12 p.a. or 3.0 per
  quarter, the premium cost of the option as of
  June would be
• 26,460 ? 1.03 27,254 or 27,254 / 1,000,000
  0.0273/
• Since the upside potential is unlimited, Trident
  would not exercise its option at any rate above
  1.75/ and would convert pounds to dollars at
  the spot market
• If the spot rate is 1.76/, Trident would
  exchange pounds on the spot market to receive
  1,000,000 ? 1.76/ 1,760,000 less the
  premium of the option (27,254) netting
  1,732,746
• If the pound depreciates below 1.75/, Trident
  would exercise the put option and exchange
  1,000,000 at 1.75/ receiving 1,750,000 less
  the premium of the option netting 1,722,746

39
Tridents Transaction Exposure

• As with the forward and money market hedges, a
  breakeven price on the option can be calculated
• The upper bound of the range is determined by
  comparison of the forward rate
• The pound must appreciate above 1.754/ forward
  rate plus the cost of the option, 0.0273/, to
  1.7813/
• The lower bound of the range is determined by
  comparison to the strike price
• If the pound depreciates below 1.75/, the net
  proceeds would be 1.75/ less the cost of
  0.0273/ or 1.722/
• Note that the following graph shows the net
  proceeds of the option contract under varying
  exchange rates. Net proceeds are not same of a
  put option payoff diagram because we have
  exposure to the underlying asset ()

40
Tridents Transaction Exposure
Option cost (future cost) 27,254
Proceeds if exercised
1,750,000
Minimum net proceeds
1,722,746
Maximum net proceeds
unlimited
Breakeven spot rate (upside)
1.7813/
Breakeven spot rate (downside)
1.7221/
41
Net Proceeds of Alternatives
Cell E5 Entry is IF(A5ltC2,(C2-C3)C1,(A5-
C3)C1)
42
Net Proceeds of Alternatives
43
Strategy Choice and Outcome

• Trident, like all firms, must decide on a
  strategy to undertake before the exchange rate
  changes but how a choice can be made among the
  strategies?
• Two criteria can be utilized
• Risk tolerance - of the firm,as expressed in its
  stated policies and
• Viewpoint managers view on the expected
  direction and distance of the exchange rate
• Trident now needs to compare the alternatives and
  their outcomes in order to choose a strategy
• There were four alternatives available to manage
  this account receivable

44
Strategy Choice and Outcome
Remain uncovered Unknown
Forward Contract hedge _at_ 1.754/ 1,754,000
Money market hedge _at_ 8 p.a. 1,755,396
Money market hedge _at_ 12 p.a. 1,772,605
Put option hedge _at_ strike 1.75/
Minimum if exercised 1,722,746
Maximum if not exercised Unlimited
45
Managing an Account Payable

• The choices are the same for managing a payable
• Assume that the 1,000,000 was an account payable
  in 90 days
• Remain unhedged Trident could wait the 90 days
  and at that time exchange dollars for pounds to
  pay the obligation
• If the spot rate is 1.7600/ then Trident would
  pay 1,760,000 but this amount is not certain

46
Managing an Account Payable

• Use a forward market hedge Trident could
  purchase a forward contract locking in the
  1.754/ rate ensuring that their obligation will
  not be more than 1,754,000
• Use a money market hedge this hedge is
  distinctly different for a payable than a
  receivable
• Here Trident would exchange US dollars at the
  spot rate and invest them for 90 days in pounds
• The pound obligation for Trident is now offset by
  a pound asset for Trident with matching maturity

47
Managing an Account Payable

• Using a money market hedge
• To ensure that exactly 1,000,000 will be
  received in 3 months, discount the principal by
  8 p.a.

• This 980,392.16 would require 1,729,411.77 at
  the current spot rate

48
Managing an Account Payable

• Using a money market hedge
• Finally, carry the cost forward 90 days using the
  cost of capital in order to compare the payout
  from the money market hedge

• This is higher than the forward hedge of
  1,754,000 thus unattractive

49
Managing an Account Payable

• Futures market hedge
• Trident could also cover the 1,000,000 exposure
  by buying futures contracts now at say 1.7540/
• If spot rate is 1.7600/ then the result of
  futures position is
• Value at maturity (Long position) Notional
  principal ? (Spot Futures)
• Value at maturity (Long position) 1,000,000 ?
  (1.7600/ 1.7540/)
• Value at maturity (Long position) 6,000
• The gain on futures would reduce the value of
  payable
• Value of payable 1,000,000 ? 1.7600/
  1,760,000
• The net value of payable is
• 1,760,000 6,000 1,754,000
• Implied exchange rate of conversion is
• 1,754,000 / 1,000,000 1.7540/ (Rate at
  which we bought futures contracts.

50
Managing an Account Payable

• Using an option hedge instead of purchasing a
  put as with a receivable, you want to purchase a
  call option on the payable
• The total cost of an ATM call option with strike
  price of 1.75/ and a premium of 0.0265/

• Carried forward 90 days the premium amount is
  26,460 ? 1.03 27,254 or 27,254 / 1,000,000
  0.0273/

51
Managing an Account Payable

• Using a call option hedge
• If the spot rate is less than 1.75/ then the
  option would be allowed to expire and the
  1,000,000 would be purchased on the spot market
• If the spot rate rises above 1.75/ then the
  option would be exercised and Trident would
  exchange the 1,000,000 at 1.75/ less the
  option premium for the payable

Exercise call option (1,000,000 ?
1.75/) 1,750,000 Call option premium (carried
forward 90 days) 27,254 Total maximum
expense of call option hedge 1,777,254
52
Net Proceeds of Alternatives
Cell E5 Entry is IF(A5gtC2,(C2C3)C1,(A5
C3)C1)
53
Net Proceeds of Alternatives
54
Risk Management in Practice

• Which Goals?
• The treasury function of most firms is usual
  considered a cost center it is not expected to
  add to the bottom line
• However, in practice some firms treasuries have
  become aggressive in currency management and act
  as profit centers
• Which Exposures?
• Transaction exposures exist before they are
  actually booked yet some firms do not hedge this
  backlog exposure
• However, some firms are selectively hedging these
  backlog exposures and anticipated exposures
• Which Contractual Hedges?
• Transaction exposure management programs are
  generally divided along an option-line those
  which use options and those that do not
• Also the amount of risk covered may vary. Tare
  are proportional hedging policies that state
  which proportion and type of exposure is to be
  hedged by the treasury

55
Example

• Dragon Inc, of Moorhead purchased a Korean
  company that produces plastic nuts and bolts for
  auto manufacturers. The purchase price was
  Won7,030 million. Won1,000 million has already
  been paid and the remaining Won6,030 million is
  due in six months. The current spot rate is
  Won1,200/, and the 6-month forward rate is
  Won1,260/
• Additional data
• Six-month Korean interest rate 16.00 p.a.
• Six-month US interest rate 4.00 p.a.
• Six-month call option on Korean Won at 1,260 with
  a premium of Won33.33/
• Six-month put option on Korean Won at 1200 with a
  premium of Won41.67/
• Dragon can invest at the rates given above or
  borrow at 2 p.a. above those rates. Dragons
  cost of capital is 25.
• Compare hedging alternatives and make a
  recommendation.