9 - 10 Transaction Exposure 2h2zw

Management of Transaction Exposure Chapter Objective: This chapter discusses various methods available for the management of transaction exposure facing multinational firms.

Chapter Outline       

Forward Market Hedge Futures Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts

Chapter Outline (continued)     

Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use?

Forward Market Hedge 

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If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.

Forward Market Hedge: an Example You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year. Question: How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers £100M in one year—a long forward contract on the pound.

Forward Market Hedge Suppose the forward exchange rate is $1.50/£.

$30m

If he does not hedge the £100m $0 payable, in one year his gain (loss) on the –$30m unhedged position is shown in green.

The importer will be better off if the pound depreciates: he still buys £100m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/£ Value of £1 in $ $1.20/£ $1.50/£ $1.80/£ in one year But he will be worse off if the pound appreciates.

Unhedged payable

Forward Market Hedge If he agrees to buy £100m in one year at $30m $1.50/£ his gain (loss) on the forward $0 are shown in blue. –$30m

If you agree to buy £100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80.

Long forward

Value of £1 in $ $1.20/£ $1.50/£ $1.80/£ in one year If you agree to buy £100 million at a price of $1.50 per pound, you will lose $30 million if the price of a pound is only $1.20.

Forward Market Hedge The red line shows the payoff of the $30 m hedged payable. Note that gains on $0 one position are offset by losses –$30 m on the other position.

Long forward

Hedged payable Value of £1 in $ $1.20/£ $1.50/£ $1.80/£ in one year Unhedged payable

Futures Market Hedge 

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As an exporter you expect to receive 3 months from now US $ 20,000. The spot price of US $ is Rs 50.00 while 3-m futures at NSE is trading at Rs 49.30 indicating depreciation of US dollar. Under what circumstances would you like to hedge? What would be the hedging strategy?

Futures Market Hedge 

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If as exporter one believe that in 3 months' time US dollar would depreciate below the futures price of Rs 49.30 one must hedge else not. For hedging with futures market the exporter being long on the underlying asset would go short on futures. Close to expiry of futures when exporter receives the funds he would buy back the futures contract hoping to nullify the gains/losses and realise close to target rate of Rs 49.30

Futures Market Hedge 

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Assume that the exporter hedges with the futures contract. One futures contract at NSE is for US $ 1,000 and it is cash settled. Find out the exchange rate realised by the exporter when prior to maturity 

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a) spot rate is Rs 50.50 and futures is selling for Rs 50.42 b) spot rate is Rs 48.40 and futures is selling for Rs 48.48.

Futures Market Hedge The exporter has receivable of US $ 20,000. With contract size of US $ 1,000 the exposure shorts 20 futures contract at Rs 49.30 now and buys back later. He sells the foreign currency in the spot market.  The effective exchange rate realized by the exporter under two different scenarios is worked out as below: Scenario “a” Scenario “b” Futures contract sold at 49.30 49.30 Futures contract bought at 50.42 48.48 Profit/loss in cash from futures position (1.12) 0.82 Spot rate realized 50.50 48.40 Effective exchange rate realized 49.38 49.22 Effective price can also be found by adding basis at the end to the futures price. Futures price at inception 49.30 49.30 Basis at end 0.08 (0.08) Effective exchange rate realized 49.38 49.22 

Futures Market Hedge Impex Limited has to make a payment of US $ 25,000 after 3 months. The spot exchange rate is Rs 46 and it has been increasing in the recent past. The appreciation of dollar is expected to continue as reflected in the 3-m futures quotation of Rs 47.50. The management of Impex Limited believes that US dollar is expected to go beyond Rs 47.50 in 3 months' time. 1. How can Impex Limited hedge its foreign currency exposure? 2. Assume that Impex Limited takes position in futures and at the time of making payment after 3 months it unwinds the position in futures. Find out the effective exchange rate paid by them if a) spot rate is Rs 49.10 and futures price is Rs 49.20, and b) spot price is Rs 46.75 and futures price is Rs 46.80. 

Futures Market Hedge Impex limited has payable of US $ 25,000. With contract size of US $ 1,000 they buy 25 futures contract at Rs 47.50 now and sell the futures later. Impex Limited fulfils the foreign exchange requirement from the spot market. The effective exchange rate paid by Impex Limited under two different scenarios is worked out as below: Scenario "a" Scenario "b" Futures contract bought at 47.50 47.50 Futures contract sold at 49.20 46.80 Profit/loss in cash from futures position 1.70 (0.70) Spot rate paid 49.10 46.75 Effective exchange rate paid 47.40 47.45 Effective price can also be found by adding basis at the end to the futures price. Futures price at inception 47.50 47.50 Basis at end (0.10) (0.05) Effective exchange rate paid 47.40 47.45

Money Market Hedge  

This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. 

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Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable.

Money Market Hedge A U.S.–based importer of Italian bicycles   

In one year owes €100,000 to an Italian supplier. The spot exchange rate is $1.25 = €1.00 The one-year interest rate in Italy is i€ = 4%

€100,000 Can hedge this payable by buying €96,153.85 = 1.04 today and investing €96,153.85 at 4% in Italy for one year. At maturity, he will have €100,000 = €96,153.85 × (1.04) Dollar cost today = $120,192.31 = €96,153.85 × $1.25 €1.00

Money Market Hedge 

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With this money market hedge, we have redenominated a one-year €100,000 payable into a $120,192.31 payable due today. If the U.S. interest rate is i$ = 3% we could borrow the $120,192.31 today and owe in one year $123,798.08 = $120,192.31 ×(1.03) €100,000 T $123,798.08 = S($/€)× T × (1+ i$) (1+ i€)

Options Market Hedge 

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Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency. 

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If the currency appreciates, your call option lets you buy the currency at the exercise price of the call.

To hedge a foreign currency receivable buy puts on the currency. 

If the currency depreciates, your put option lets you sell the currency for the exercise price.

Options Market Hedge Suppose the forward exchange rate is $1.50/£. If an importer who $30m owes £100m does not hedge the $0 payable, in one year his gain (loss) on the unhedged position is shown –$30m in green.

The importer will be better off if the pound depreciates: he still buys £100m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/£ Value of £1 in $ $1.20/£ $1.50/£ $1.80/£ in one year But he will be worse off if the pound appreciates.

Unhedged payable

Options Markets Hedge Profit

Suppose our importer buys a call option on £100m with an exercise price of $1.50 per –$5m pound. He pays $.05 per pound for the call.

loss

Long call on £100m

$1.55/£ $1.50/£

Value of £1 in $ in one year

Options Markets Hedge Profit

The payoff of the portfolio of a call and a payable is shown in red. $25m He can still profit from decreases in the exchange rate –$5m below $1.45/£ but has a hedge against unfavorable increases in the loss exchange rate.

Long call on £100m

$1.20/£ $1.45 /£ $1.50/£

Value of £1 in $ in one year Unhedged payable

Options Markets Hedge Profit If the exchange rate increases to $1.80/£ the importer makes $25 m $25 m on the call but loses $30 m on the payable for a maximum loss of –$5 m $5 million. –$30 m This can be thought of as an insurance .

loss

Long call on £100m

$1.45/£ $1.50/£

Value of £1 in $ $1.80/£ in one year Unhedged payable

Options Markets Hedge IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS. 

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If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.

EXPORTERS with s receivable denominated in foreign currency should BUY PUT OPTIONS. 

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If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.

Hedging Exports with Put Options 

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Show the portfolio payoff of an exporter who is owed £1 million in one year. The current one-year forward rate is £1 = $2. Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2. 

The cost of this option is $0.05 per pound.

Options Market Hedge:

Exporter buys a put option to protect the dollar value of his receivable.

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$1,950,000

–$50k

–$2m

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Long put $2 $2.05

S($/£)360

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The exporter who buys a put option to protect the dollar value of his receivable has essentially purchased a call.

S($/£)360

–$50k $2 $2.05

Hedging Imports with Call Options 

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Show the portfolio payoff of an importer who owes £1 million in one year. The current one-year forward rate is £1 = $1.80; but instead of entering into a short forward contract, He buys a call option written on £1 million with an expiry of one year and a strike of £1 = $1.80 The cost of this option is $0.08 per pound.

GAIN (TOTAL)

Forward Market Hedge: Importer buys £1m forward. Long currency forward

$1.80

LOSS (TOTAL)

This forward hedge fixes the dollar value of the payable at $1.80m.

S($/£)360

s Payable = Short Currency position

$1.8m $1,720,000

Options Market Hedge: Importer buys call option on £1m. Call Call option limits the potential cost of servicing the payable. S($/£)360

–$80k nh U

$1.80 $1.72 $1.88

ed ge d l ig ob at io n

$1,720,000

Our importer who buys a call to protect himself from increases in the value of the pound creates a synthetic put option on the pound. He makes money if the pound falls in value.

S($/£)360

–$80k $1.80 $1.72 The cost of this “insurance policy” is $80,000

Taking it to the Next Level 

Suppose our importer can absorb “small” amounts of exchange rate risk, but his competitive position will suffer with big movements in the exchange rate. 

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Large dollar depreciations increase the cost of his imports Large dollar appreciations increase the foreign currency cost of his competitors exports, costing him customers as his competitors renew their focus on the domestic market.

Our Importer Buys a Second Call Option $1,720,000

This position is called a straddle 2nd Call

$1,640,000

–$80k –$160k

S($/£)360 $1.64 $1.80 $1.96 $1.72 $1.88

Importers synthetic put

$1,720,000

Suppose instead that our importer is willing to risk large exchange rate changes but wants to profit from small changes in the exchange rate, he could lay on a butterfly spread. Sell 2 puts $1.90 strike.

butterfly spread S($/£)360

–$80k $1.80 $1.90 $1.72

Importers synthetic put

$2 buy a put $2 strike

A butterfly spread is analogous to an interest rate collar; indeed it’s sometimes called a zero-cost collar. Selling the 2 puts comes close to offsetting the cost of buying the other 2 puts.

Options 

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A motivated financial engineer can create almost any risk-return profile that a company might wish to consider. Straddles and butterfly spreads are quite common. Notice that the butterfly spread costs our importer quite a bit less than a naïve strategy of buying call options.

Cross-Hedging Minor Currency Exposure 

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The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Thai bhat. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.

Cross-Hedging Minor Currency Exposure 

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Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated. 

An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way.

Cross Hedging: Example 

Apex Company, a computer chip manufacturer, has sold computer chips to customers in Thailand on March 1 and will receive Thai baht (THB) 5 million on April 28. The exchange rates on March 1 are THB 1 = INR 1.4092 and USD 1 = INR 45.3462. The correlation between the Thai baht and the U.S. dollar is estimated as 0.97. The standard deviation of THB–INR exchange rate is 0.53 and that of USD–INR futures is 2.35. Explain how you would hedge the Thai baht exchange rate risk? The USD–INR futures with expiry on April 28 are priced at INR 45.5387

Solution

Apex should sell 1,094 USD-INR futures with expiry on April 28 at 45.5387

Hedging Contingent Exposure 

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If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options.

Hedging Recurrent Exposure with Swaps 

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Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer- than futures and forwards.

Hedging through Invoice Currency 

The firm can shift, share, or diversify: 

shift exchange rate risk  by

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invoicing foreign sales in home currency

share exchange rate risk  by

pro-rating the currency of the invoice between foreign and home currencies

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diversify exchange rate risk  by

using a market basket index

Hedging via Lead and Lag 

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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.

Exposure Netting 

A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. 

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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 s come due and just buy yen with won. Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.

Exposure Netting 

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Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging.

Exposure Netting: an Example Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions: $20 $30 $40 $10 $35

$10 $25 $20 $30

$60

$30 $40

Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $20 $10 $30 $10$25$35

$40 $20

$15 $10

$25 $20 $10 $30

$60

$30$10$40

Multilateral Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $10

$15$25 $15 $10

$20 $30 $40 $40

$15 $15 $10

$10

$10

Should the Firm Hedge? 

Not everyone agrees that a firm should hedge: 

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Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.

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.

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Differential Transactions Costs  The

firm may be able to hedge at better prices than the shareholders.

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Default Costs  Hedging

may reduce the firms cost of capital if it reduces the probability of default.

What Risk Management Products do Firms Use? 

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Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts. The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.

Quiz Time 

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How would you define transaction exposure? How is it different from economic exposure? Discuss and compare the costs of hedging via the forward contract and the options contract. What are the advantages of a currency options contract as a hedging tool compared with the forward contract? What is exposure netting? What is cross hedging? Discuss the factors determining its effectiveness. Should a firm hedge? Why or why not?

Quiz Time: Practical Problem You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland. (a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF. (b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract. (c) At what future spot exchange rate will you be indifferent between the forward and option market hedges? (d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.

Solution 

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(a) Total option = (.05)(5000) = $250. In three months, $250 is worth $253.75 = $250(1.015). At the expected future spot rate of $0.63/SF, which is less than the exercise price, you don’t expect to exercise options. Rather, you expect to buy Swiss franc at $0.63/SF. Since you are going to buy SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of buying SF5,000 will be the sum of $3,150 and $253.75, i.e., $3,403.75. (b) $3,150 = (.63)(5,000). (c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x, we obtain x = $0.57925/SF. Note that at the break-even future spot rate, options will not be exercised. (d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option, you will exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3,453.75 = $3,200 + $253.75. This is the maximum you will pay.

Case Study: Airbus Exposure

a.

b.

c.

d.

Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned with the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.05/euro and six-month forward exchange rate is $1.10/euro at the moment. Airbus can buy a six-month put option on U.S. dollars with a strike price of euro 0.95/$ for a of euro0.02 per U.S. dollar. Currently, six-month interest rate is 2.5% in the euro zone and 3.0% in the U.S. Compute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using a forward contract. If Airbus decides to hedge using money market instruments, what action does Airbus need to take? What would be the guaranteed euro proceeds from the American sale in this case? If Airbus decides to hedge using put options on U.S. dollars, what would be the ‘expected’ euro proceeds from the American sale? Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate. At what future spot exchange rate do you think Airbus will be indifferent between the option and money market hedge?

Solution a. Airbus will sell $30 million forward for EURO 27,272,727 = ($30,000,000) / ($1.10/EURO). b. Airbus will borrow the present value of the dollar receivable, i.e., $29,126,214 = $30,000,000/1.03, and then sell the dollar proceeds spot for euros: EURO 27,739,251. This is the euro amount that Airbus is going to keep.

Solution c. Since the expected future spot rate is less than the strike price of the put option, i.e., EURO 0.9091< EURO 0.95, Airbus expects to exercise the option and receive EURO 28,500,000 = ($30,000,000)(EURO 0.95/$). This is gross proceeds. Airbus spent EURO 600,000 (=0.02x30,000,000) upfront for the option and its future cost is equal to EURO 615,000 = EURO 600,000 x 1.025. Thus the net euro proceeds from the American sale is EURO 27,885,000, which is the difference between the gross proceeds and the option costs.

Solution d. At the indifferent future spot rate, the following will hold: EURO 28,432,732 = ST (30,000,000) – EURO 615,000. Solving for ST, we obtain the indifference future spot exchange rate, i.e., EURO 0.9683/$, or $1.0327/EURO. Note that EURO 28,432,732 is the future value of the proceeds under money market hedging: EURO 28,432,732 = (EURO 27,739,251) (1.025).