11/30/2010

Management of
Transaction Exposure

Chapter Eight

Chapter Objective:
This chapter discusses various methods available
for the management
g
of transaction exposure
p
facingg
multinational firms.
This chapter ties together chapters 5, 6, and 7.

8-0

Chapter Outline

Differentiate between Transaction, Operating, and

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

8-1

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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?

8-2

Forward Market Hedge

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.
contract

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Forward Market Hedge of Payable:

Example
You are a U.S. importer of Italian shoes and have just
ordered next year
yearss inventory.
inventory A payment of 100M is
due in one year. You will need 100M in one year. You
dont know what the price of euro will be in the spot
market, one year later (S1). You do not know how many
dollars you will need to cover your 100M payment
You have foreign exchange risk exposure.
How do you eliminate this risk?
8-4

Forward Market Hedge of Payable:

Example
Suppose, this is the market condition right now:
The current pprice of euro in the spot
p rate ((S)) = $1.43
One year, forward rate for euros (F) = $1.50
US Interest Rate (iH) = 8%
Interest rate in Euro zone (iF)= 3%
If you buy a one year forward contract for 100 million,
you will have to pay $150 million for it in one year.
year
If one year later, the price of euros in the spot market (S1) turns out to
be $1.80, then you saved (gained) $30 million.
If S1 is $1.20, then you lost $30 million.
8-5

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Gains & Losses from Forward

Market Hedge of Payable: Example

$30m

If you agree to buy 100

million at a price of
$1.50/, you will make
$30 million if the price of
the euro reaches $1.80.

Long
forward

$0

S1
$1 20/ $1.50/
$1.20/
$1 50/ $1.80/
$1 80/

$30m

If you agree to buy 100 million at a

price of $1.50 per pound, you will lose
$30 million if the price of the euro falls
6
to $1.20/.

8-6

Gains & Losses from Forward

Market Hedge of Payable: Example
Cas Flow:
Cash
ow:
Forward Hedge

Ga / Losses
Gain
osses relative
e at ve to
Unhedged position

1.20 - $120,000,000

- $150,000,000

- $30,000,000

1.35 - $135,000,000

- $150,000,000

- $15,000,000

1.50 - $150,000,000

- $150,000,000

1 65 - $165,000,000
1.65
$165 000 000

- $150,000,000
$150 000 000

$15 000 000

$15,000,000

1.80 - $180,000,000

- $150,000,000

$30,000,000

S1

Cas Flow:
Cash
ow:
Unhedged
Position

8-7

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Forward Market Hedge of Receivable:

Example
You are a U.S. exporter of chemicals expecting a payment
of 75M from a German pharmaceutical firm in one
year. You will need to convert 75M into $ in the spot
market in one year. You dont know what the price of
euro will be in the spot market, one year later (S1). You
do not know how many dollars you will receive in
exchange
g for 75M ppayment
y
You have foreign exchange risk exposure.
How do you eliminate this risk?
8-8

Forward Market Hedge of Receivable:

Example
Suppose, this is the market condition right now:
The current pprice of euro in the spot
p market ((S)) = $1.43
One year forward rate for euros (F) = $1.50
US Interest Rate (iF) = 8%
Interest rate in Euro zone (iH)= 3%
If you sell a one year forward contract for 75 million, you
will receive $112.5
$112 5 million for it in one year.
year
If one year later, the price of euros in the spot market (S1) turns out to
be $1.80, then you lost $22.5 million.
If S1 is $1.20, then you gained $22.5 million.
8-9

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Gains & Losses from Forward Market

Hedge of Receivable: Example
If you agree to sell 75
Short
forward million at a price of $1.50
ill make
k $22.5
$22 5
you will
million if the price of the
$22.5m
euro falls to $1.20
S1
If you agree to sell 75
million at a price of $1.50
you will lose $22.5 million
if the price of the euro rises
to $1.80

$0
$1.20 $1.50

$1.80

$22.5m

10

8-10

Gains & Losses from Forward Market

Hedge of Receivable: Example

S1

Cash Flow:
Unhedged
Position

Cash Flow:
Forward Hedge

Gain / Losses relative to

Unhedged position

1.20

+ $ 90,000,000

+ $112,500,000

$22,500,000

1.35

+ $101,250,000

+ $112,500,000

$11,250,000

1 50
1.50

+ $112,500,000
$112 500 000

+ $112,500,000
$112 500 000

1.65

+ $123,750,000

+ $112,500,000

- $11,250,000

1.80

+ $135,000,000

+ $112,500,000

- $22,500,000

8-11

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Forward Market Hedge: Summary

E(S1) = Expected spot rate one year later
Management Expectations
on FX Market

E(S1) = F

E(S1) < F

E(S1) > F

Management
Risk Preference

Payable Exposure

Receivable Exposure

Cautious

Hedge

Hedge

Neutral

Hedge

Hedge

Aggressive

Will not hedge

Will not hedge

Cautious

Hedge

Hedge

Neutral

Will not hedge

Hedge

Aggressive

Will not hedge

Hedge

Cautious

Hedge

Hedge

Neutral

Hedge

Will not hedge

Aggressive

Hedge

Will not hedge

8-12

Money Market Hedge of Payable

This is the same idea as covered interest arbitrage.

To hedge a foreign currency payable (A), borrow in
a US bank, and use proceeds to buy the foreign
currency today and put it in the foreign bank:

Determine the amount of the foreign currency required to

be deposited in the foreign bank: A /(1+ iF)
Borrow the USD equivalent of that amount from a US
bank: S * [A /(1+ iF)]
Pay off the US bank loan at maturity:
(1+ iH) * S * [A /(1+ iF)]

8-13

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Money Market Hedge of Payable:

Example
Same example as before: A U.S. importer of Italian shoes needs to pay
the Italian supplier 100M in one year. The current price of euro in
th spott market
the
k t (S) is
i $1.43.
$1 43 One
O year forward
f
d rate
t for
f euro (F) is
i
$1.50. US Interest Rate (iH) is 8%. Interest rate in Euro zone (iF) is
3%
1. The US firm will need to invest: (100,000,000 / 1.03) =
97,087,378.64 in the Italian bank, so that it has exactly
100,000,000 to pay off the supplier in one year.
2 Borrow the USD equivalent of that amount: 97,087,378.64
2.
97 087 378 64 x
1.43 = $138,834,951.50 from US bank
3. Pay off the US bank loan in one year with: $138,834,951.5 x 1.08
= $149,941,748
Effectively, the US firm will need $149,941,748 to cover a
100,000,000 payable one year later.

8-14

Money Market Hedge & Forward

Hedge of Payables
In this case, based on the one-year euro forward contract price (F)
of $1.50, the forward hedge amount for 100,000,000 is
$150 000 000
$150,000,000.
Since this is higher than the MM Hedge amount of $149,941,748,
MMH will be preferred.
For payable hedge (choose the hedge with the lower amount):
If MMH > FH: Choose FH
If MMH < FH: Choose MMH
Under IRP: MMH = FH

8-15

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Money Market Hedge of Receivables

This is the same idea as covered interest arbitrage.
To hedge a foreign currency receivable (A), borrow
foreign currency against that receivable from a
foreign bank, and convert the proceeds to USD, and
put it in the US bank:

Determine the amount of the FX that can be borrowed

against the receivables from a foreign bank: A /(1+ iF)
Convert the borrowed FX into USD: S * [A /(1+ iF)]
Deposit that amount into US bank to get this at maturity:
(1+ iH) * S * [A /(1+ iF)]

8-16

Money Market Hedge of Receivable:

Example
Same example as before: A U.S. exporter of chemicals is expecting a
payment of 75M from a German pharmaceutical customer in one
year The current price of euro in the spot market (S) is $1.43.
year.
$1 43 One
year, forward rate for euro (F) is $1.50. US Interest Rate (iH) is 8%.
Interest rate in Euro zone (iF) is 3%
1. The US firm should borrow: (75,000,000 / 1.03) =
72,815,533.98 the German bank against the 75,000,000 it is
going to receive in one year from its customer.
2 Convert the borrowed euros into USD: 72,815,533.98
2.
72 815 533 98 x 1.43
1 43 =
$104,126,213.60 and deposit the USD in US bank
3. Withdraw the following from the US bank in one year:
$104,126,213.60 x 1.08 = $112,456,311
Effectively, the US firm will have $112,456,311 in exchange for
75,000,000 receivable one year later.
8-17

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Money Market Hedge & Forward

Hedge of Receivable
In this case, based on the one-year euro forward contract price (F)
of $1.50, the forward hedge amount for 75,000,000 is
$112 500 000
$112,500,000.
Since this is higher than the MM Hedge amount of $112,456,311,
FH will be preferred.
For receivable hedge (choose the hedge with the higher amount):
If MMH > FH: Choose MMH
If MMH < FH: Choose FH
Under IRP: MMH = FH

8-18

Options Market Hedge

While both FH and MMH completely eliminate FX

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

T hedge
To
h d a foreign
f i currency receivable
i bl buy
b puts on the
h
currency.

8-19

If the currency appreciates, your call option lets you buy the
currency at the exercise price of the call.
If the currency does not appreciate (or depreciates), you can let
the call option expire and buy the FX in the spot market.

If the currency depreciates, your put option lets you sell the
currency for the exercise price.
If the currency does not depreciate (or appreciates), you can let
the put option expire and sell the FX in the spot market

10

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Option Hedge of Payable: Example

Same example as before: A U.S. importer of Italian shoes needs to pay
the Italian supplier 100M in one year. The current price of euro in
the spot market (S) is $1.43. Forward rate for euro (F) is $1.50.
E
Exercise
i price
i off a call
ll option
ti with
ith one year to
t expire
i is
i $1.50.
$1 50 The
Th
call premium is $0.02/. US Interest Rate (iH) is 8%. Interest rate in
Euro zone (iF) is 3%
The total cost of the option as of the maturity date (considering time
value of money): $0.02 * 100,000,000 * 1.08 = $2,160,000.
If S1 > $1.50: The option will be exercised. The net cost of
securing 100M = 11.50
50 * 100
100,000,000
000 000 + 22,160,000
160 000 =
$152,160,000.
If S1 < $1.50: The option will not be exercised. The firm will
purchase in the spot market at S1. The net cost of securing
100M = S1 * 100,000,000 + 2,160,000
8-20

Dollar Cost of Options Hedge of

Payable: Example
S1

Exercise?

Gross Dollar
Cost

Option Cost

Net Dollar Cost

1.20

No

$120,000,000

$2,160,000

$122,160,000

1.35

No

$135,000,000

$2,160,000

$137,160,000

1.50

Neutral

$150,000,000

$2,160,000

$152,160,000

1.65

Yes

$150,000,000

$2,160,000

$152,160,000

1.80

Yes

$150,000,000

$2,160,000

$152,160,000

Using forward hedge, the dollar cost of securing 100,000,000

will always be $150,000,000
The break even spot rate one year later (S*1) where there will
be a preference switch between forward and options hedge:
1.50 * 100,000,000 = S1* 100,000,000 + 2,160,000 = $1.4784
8-21

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Options Hedge v/s Forward Hedge

for Payable: Example
$ Cost of securing 100M

Options hedge

$152.16 m
$150 m
$1.50= E

Forward Hedge

$1.4784 = S*1

8-22

Option Hedge of Receivable: Example

Same example as before: A U.S. exporter of chemicals is expecting a
payment of 75M from a German pharmaceutical customer in one
year. The current price of euro in the spot market (S) is $1.43. One
year forward
f
d rate
t for
f euro (F) is
i $1.50.
$1 50 Exercise
E
i price
i off a putt option
ti
with one year to expire is $1.50. The put premium is $0.015/. US
Interest Rate (iH) is 8%. Interest rate in Euro zone (iF) is 3%
The total cost of the option as of the maturity date (considering time
value of money): $0.015 * 75,000,000 * 1.08 = $1,215,000.
If S1 < $1.50: The option will be exercised. Proceeds from selling
100M = 11.50
50 * 75
75,000,000
000 000 - $1,215,000
$1 215 000 = $111,285,000
$111 285 000
If S1 > $1.50: The option will not be exercised. The firm will sell
in the spot market at S1. Proceeds from selling 75 M = S1 *
75,000,000 - 1,215,000.

8-23

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Dollar Proceeds from Options Hedge of

Receivable: Example
S1

Exercise?

Gross Dollar
Proceeds

Option Cost

Net Dollar Proceeds

1.20

Yes

$112,500,000

$1,215,000

$111,285,000

1.35

Yes

$112,500,000

$1,215,000

$111,285,000

1.50

Neutral

$112,500,000

$1,215,000

$111,285,000

1.65

No

$123,750,000

$1,215,000

$122,535,000

1.80

No

$135,000,000

$1,215,000

$133,785,000

Using forward hedge, the dollar proceeds from selling

75,000,000 will always be $112,500,000
The break even spot rate one year later (S*1) where there will
be a preference switch between forward and options hedge:
1.50 * 75,000,000 = S1* 75,000,000 - 1,215,000 = $1.5162
8-24

Options Hedge v/s Forward Hedge

for Payable: Example

Options hedge

$ Proceeds from 100M

$1.50= E
$112.5 m

Forward Hedge

$111.285 m
$1.5162 = S*1

8-25

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Options Markets Hedge

With an exercise price denominated in local currency
IMPORTERS who OWE
foreign currency in the
future should BUY CALL
OPTIONS.

8-26

If the pprice of the currencyy goes

g
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 accounts

receivable denominated in
foreign currency should BUY
PUT OPTIONS.

If the pprice of the currencyy goes

g
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.

Options

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 nave strategy of buying call
options.

27

8-27

14

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Cross-Hedging
Minor Currency Exposure

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,
difficult expensive,
expensive or impossible to use
financial contracts to hedge exposure to minor
currencies.

8-28

Cross-Hedging
Minor Currency Exposure

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
Swed
s krona
o a hedging
edg g with
w t long
o g oor sshort
o t forward
o wa d
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.

8-29

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Hedging Contingent Exposure

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
contract. Your firm
can hedge this contingent risk with options.

8-30

Hedging Recurrent Exposure

with Swaps

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.
along
It is also the case that swaps are available in
longer-terms than futures and forwards.

8-31

16

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Hedging through
Invoice Currency

The firm can shift, share, or diversify:

shift exchange rate risk

share exchange rate risk

by invoicing foreign sales in home currency

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

diversify exchange rate risk

by using a market basket index

8-32

Hedging via Lead and Lag

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.

8-33

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Exposure Netting

A multinational firm should not consider deals in

i l i but
isolation,
b should
h ld focus
f
on hedging
h d i the
h firm
fi 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
g
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.

8-34

Exposure Netting

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.

8-35

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Should the Firm Hedge?

Not everyone agrees that a firm should hedge:

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.

8-36

Should the Firm Hedge?

In the presence of market imperfections, the firm

should
h ld hedge.
h d

Information Asymmetry

Differential Transactions Costs

The managers may have better information than the

shareholders.
The firm mayy be able to hedge
g at better pprices than the
shareholders.

Default Costs

Hedging may reduce the firms cost of capital if it reduces the

probability of default.

8-37

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Should the Firm Hedge?

Taxes can be a large market imperfection.

Corporations that face progressive tax rates may find

that they pay less in taxes if they can manage earnings
by hedging than if they have boom and bust cycles in
their earnings stream.

8-38

What Risk Management Products do

Firms Use?

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 firms use of foreign
exchange risk management.
management

8-39

20