Chapter 11 Managing Transaction Exposure

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Chapter 11
Managing Transaction Exposure
LE
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Transaction Exposure
exists when future cash transactions of a firm
are affected by exchange rate fluctuations
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Is hedging worthwhile?
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Should the firms hedging strategy be to use
forward contracts for all of its future foreign
exchange transactions?
Sometimes it is higher and other times it is
lower but it balances out over the long run
? Firm does not bear the cost of hedging
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YES
By hedging, MNC knows with certainty what
its future cash outflows and inflows will be.
This makes planning much easier for the MNC.
Should the firm hedge a future foreign exchange
transaction if it feels the exchange rate will
move in an unfavorable direction?
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The MNCs level of risk aversion, and its ability
(and desire) to forecast exchange rates
determine
Conclusions

• If it will hedge
• How much it will hedge
• How it will hedge

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The Company uses foreign currency debt and
derivatives to hedge the foreign currency risk
associated with certain royalties, intercompany
financings and long-term investments in foreign
subsidiaries and affiliates. In 2005, the Company
used foreign currency debt to hedge the foreign
currency risk associated with foreign currency
denominated cash and equivalents related to HIA.
This reduces the impact of fluctuating foreign
currencies on cash flows and shareholders
equity. Total foreign currency denominated debt,
including the effects of foreign currency
exchange agreements, was 8.1 billion and 6.6
billion for the years ended 2005 and 2004,
respectively. In addition, where practical, the
Companys restaurants purchase goods and services
in local currencies resulting in natural hedges.
2005 Financial Report, McDonalds Corporation, p
18 http//www.mcdonalds.com/corp/invest/pub/2005_F
inancial_Report.RowPar.0002.ContentPar.0001.Column
Par.0003.DownloadFiles.0001.File.tmp/Financial_Rep
ort_2005.pdf
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Identifying Net Transaction Exposure
Do this on a currency-by-currency basis
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U.S. Based MNC
(millions of )
Subsidiary London 100 Munich
- 110 Toronto 30 Consolidated
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How could the MNC use forward contracts to hedge
against its transaction exposure to s?
London and Toronto subsidiaries could sell s
forward and Munich subsidiary could buy s
forward
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(millions of )
What could the MNC do about its transaction
exposure to the ?
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Should net exposure be viewed from the
subsidiary level or be centralized (from the
view of the entire MNC)?
Favoring Centralized Control
Goal of financial decision maker is to maximize
the value of the overall MNC, not the value of
individual subsidiaries
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Implications
If exposure of subsidiaries nets out ? no hedge
is necessary
If a single subsidiary hedges, then the MNC
overall becomes exposed
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Favoring Decentralized (Subsidiary) Control
1. Local creditors may look unfavorably toward
subsidiarys exposure if it doesnt handle its
own exposure
2. Subsidiarys management may feel more
comfortable handling their own exposure so they
will not be hurt by adverse movements in
exchange rates which make them look bad on their
job record
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Real World
In the past Kodak would bill its subsidiaries in
s for supplies it provided so each subsidiary
had to deal with its own transaction exposure
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Fiat (Italian auto maker) has a centralized
system for 421 subsidiaries in 55 countries, uses
a comprehensive reporting system to keep track of
cash flows in each currency, and its main
headquarters does any necessary hedging
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Techniques for Managing Transaction Exposure

• Invoicing Strategy
• Pricing Strategy
• Futures (Forward) Contracts
• Money Market Hedge
• Options Hedge
• Go Uncovered

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Today G.E. is awarded a contract to supply
turbine blades to Lufthansa (German company).
The blades will be delivered to Lufthansa one
year from today and G.E. will receive 25,000,000
for the blades. Currently the spot rate is
0.55/ and the 1-year futures rate is 0.54/.
The size of a futures contract is 125,000.
German annual interest rates are 6 on deposits
and 8 on borrowed funds and U.S. annual interest
rates are 5 on deposits and 7 on borrowed
funds. 1-year call options with a strike price
of 0.51/ have a premium of 6 / and put
options with a strike price of 0.58/ have a
premium of 5 /.
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Is G.E. long or short in s?
LONG
- 25,000,000 0
If G.E. decides it wants to offset this long
position, it will set up a situation which will
require it to pay 25,000,000 one year from today
HEDGING
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Invoicing Strategy
If G.E. is buying parts from a German firm for
delivery in one year, it could agree to pay for
them in s (i.e. Invoice price is in
s)
Pricing Strategy When negotiating the contract
with Lufthansa, G.E. could have insisted on being
paid in U.S. s rather than s
Could this cause problems for G.E.?
Lufthansa may award the contract to a company
that prices their blades in s
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Futures Contract Hedge
Should G.E. buy or sell a futures contract?
Since it will receive s in the future and wants
to convert them to s, it should sell Futures
Contracts
Today
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One Year from Today
1. G.E. receives 25,000,000 from Lufthansa
2. G.E. delivers s on Futures Contract
G.E. receives (25,000,000)(0.54) 13,500,000
Should G.E. hedge with a Futures Contract or
maintain its long position in s?
That depends on what G.E. thinks the future spot
rate will be
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Develop a probability distribution for what the
spot rate will be one year from today
Possible Future Spot Rates 0.53/
0.54/ 0.55/
Probability 15 40 45
Calculate the expected spot rate
Espot (15)(0.53) (40)(0.54)
(45)(0.55) 0.542/
Since Espot gt Future Rate, do not hedge
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If GE doesnt hedge, what is the probability it
made the correct choice?
40 45 85
What is GEs expected revenue without hedging?
(25,000,000)(0.542) 13,550,000
Compare this to GEs revenue if it
hedges (25,000,000)(0.54) 13,500,000
GE will have to decide if the extra expected
revenue of 50,000 is worth the risk of going
unhedged
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Money Market Hedge
Take a money market position to offset a future
foreign currency payables or receivables position
GE can borrow s today instead of s with the
idea of using the 25,000,000 it receives from
Lufthansa to repay this loan
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Should GE borrow 25,000,000?
NO
It should borrow less than 25,000,000
Borrowed(1 iGer) 25,000,000 ?
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Today
1. GE borrows 23,148,148 from German bank at
8 for 1 year
3. Use the s to help build the new plant in the
U.S.
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One Year from Today
1. GE receives 25,000,000 from Lufthansa
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EXAMPLE 2
GE does not need to borrow s to help finance
construction of a new plant
Today
1. GE borrows 23,148,148 from German bank at
8 for 1 year
2. Convert s to s at spot rate
(23,148,148)(0.55) 12,731,481
3. Deposit s in U.S. bank for 1 year at 5
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One Year from Today
1. GE receives 25,000,000 from Lufthansa
3. GE receives s from U.S. bank
(12,731,481)(1 5) 13,368,055
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Which is better for GE, the Money Market hedge or
the Futures hedge?
GE gets 13,500,000 with the Futures hedge
compared to 13,368,055 with this Money Market
hedge
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Suppose GE must pay 203,000 to a German company
three months from today. The 90-day interest
rate on borrowed funds in the U.S. is 1.75 and
on deposits in Germany is 1.5. Use a Money
market hedge.
How many s should GE deposit in a German bank?
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Today
1. GE converts appropriate amount of s to s
200,000(0.55) 110,000
2. GE deposits 200,000 in a German bank at 1.5
for 90 days
2. GE uses these s to pay German company
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EXAMPLE 2
GE does not have excess cash (or has excess but
doesnt want to use it for this purpose)
Today
2. Convert 110,000 to 200,000
3. GE deposits s in German bank for 90 days at
1.5
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2. GE uses these s to pay German company
Compare the amount repaid to the U.S. bank to the
cost of getting the needed s with a Futures
Contract to determine which is best
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Consider the s GE will receive from Lufthansa.
What bad could happen which would cause GE to
be interested in buying a Futures Contract?
A Futures Contract and a Money Market Hedge will
protect GE from the bad effects of this occurring
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What would GE like to see happen to the spot rate
over the next 12 months if it did not hedge?
Would a Futures Contract or a Money Market Hedge
allow GE to benefit from this situation occurring?
NO
What would allow GE to benefit from this
situation occurring?
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Currency Option Hedge
Should GE use a Put or a Call?
Put Option
Should GE buy or sell a Put?
BUY
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Today
1. GE buys 200 Put Options to sell 25,000,000
with a strike price of 0.58/ and a premium of
5/
Cost (25,000,000)(5) 1,250,000
GE is now guaranteed that the minimum they will
receive for the turbine blades is (25,000,000)(0.
58 - 5) 13,250,000
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One Year from Today
1. GE receives 25,000,000 from Lufthansa
How does GE decide if it should exercise the Put?
Compare the spot rate to the strike price
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gt
If spot 0.58
GE should not exercise the Put ? GE sells the s
in the spot market ? GE receives 25,000,000(spot
rate) ? clears 25,000,000(spot rate) - 1,250,000
If 0.63 lt spot ? GE recoups all of the 5
premium plus more
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Which would have been better for GE?
Sell Futures Contract 0.54/
Buy Put Option strike 0.58/ 5 cent premium
Futures Contract
If spot rate is 0.58/?
Futures Contract
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If spot rate is 0.65/?
Put Option
If spot rate is 0.595/?
Put Option
Conclusions
Put Option is better if spot gt 0.59
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NOTE
If the spot rate is greater than 0.54 one year
from today, the best course of action for GE to
take today would be not to hedge at all
GE will not know this until after it had to make
a decision
RISK
Not hedging would leave GE unprotected if
depreciated below 0.54/
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GEs Future (Forward) hedge, Money Market hedge,
Put Option hedge, and going uncovered can be
compared visually.
Possible Future Spot Rates 0.50/
0.53/ 0.60/
Probability 10 30 60
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Future's Contract Hedge
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Put Option Hedge Strike price 0.58 and premium 5
100 80 60 40 20
13,750,000 spot is 60 dont exercise put
13,250,000 spot is 50 or 53 exercise put
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Uncovered Position
100 80 60 40 20
12,500,000 spot is 50
13,250,000 spot is 53
15,000,000 spot is 60
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Hedging Long-term Transaction Exposure
Some MNCs know they will be exposed for many
years into the future (Disney with theme parks in
France Japan)
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Long-term Forward Contracts
Many large international banks offer terms up to
five years on British pounds, Canadian dollars,
Japanese yen, and Swiss francs.
Because forward contracts are tailored to the
needs of the customer, maturities up to 10 years
or more are sometimes available for the major
currencies.
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Currency Swaps
There are many forms of Currency Swaps
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They agree to exchange their foreign currency
cash flows at a specific rate
Brokers employed by large banks will act as
middlemen and will charge a fee for their services
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Alternative Hedging Techniques
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EXAMPLE
French firm ships supplies to its subsidiary in
Switzerland and will be paid in SFs
What should the French firm do if it thinks the
SF will depreciate against the ?
What should the French firm do if it thinks the
SF will appreciate against the ?
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Cross-Hedging
Suppose a firm has transaction exposure against a
currency where a hedge does not exist
Identify another foreign currency which is
highly positively correlated with the currency
needed (relative to movements against the home
currency) and for which a hedge does exist
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Building Blocks for FINC 445
Skills Communication Problem Solving
Hedging Invoicing strategy, pricing strategy,
futures contract hedge, money market hedge,
currency option hedge, uncovered position,
leading lagging hedging technique,
cross-hedging
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Image created by Ralph A. Clevenger