8 management of transaction exposure

8/2/2019 8 Management of Transaction Exposure

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INTERNATIONAL

FINANCIAL

MANAGEMENT

EUN / RESNICK

Fifth Edition

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


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Chapter Objective:

This chapter discusses various methods available

for the management of transaction exposure facing

multinational firms.This chapter ties together chapters 5, 6, and 7.

8Chapter EightManagement of

Transaction Exposure

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Chapter Outline

Forward Market Hedge

Money Market Hedge

Options Market Hedge Cross-Hedging Minor Currency Exposure

Hedging Contingent Exposure

Hedging Recurrent Exposure with SwapContracts

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3

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?

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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.

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Forward Market Hedge: an Example

You are a U.S. importer of Italian shoes and have

just ordered next years 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 positionthat delivers100M in one yeara longforward contract on the euro.

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6


$1.50/

Value of1 in $

in one year

Suppose the

forward exchange

rate is $1.50/.

If he does not

hedge the100m

payable, in one

year his gain

(loss) on the

unhedged position

is shown in green.

$0

$1.20/ $1.80/

$30m

$30m

Unhedged

payable

The importer will be better off ifthe euro depreciates: he still

buys100m but at an exchange

rate of only $1.20/ he saves$30 million relative to $1.50/

But he will be worse off if

the pound appreciates.

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7


$1.50/

Value of1 in $

in one year$1.80/

If he agrees

to buy100m

in one year at

$1.50/ hisgain (loss) on

the forward

are shown in

blue.

$0

$30m

$1.20/

$30m

Long

forward

If you agree to buy100 million at a

price of $1.50 per pound, you will lose

$30 million if the price of the euro falls

to $1.20/.

If you agree to buy100

million at a price of$1.50/, you will make

$30 million if the price of

the euro reaches $1.80.

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$1.50/

Value of1 in $

in one year$1.80/

The red line

shows the

payoff of the

hedgedpayable. Note

that gains on

one position are

offset by losseson the other

position.

$0

$30 m

$1.20/

$30 m

Long

forward

Unhedged

payable

Hedged payable

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Futures Market Cross-Currency Hedge

Your firm is a U.K.-based exporter of

bicycles. You have sold

750,000 worth of

bicycles to an Italianretailer. Payment (in

euro) is due in six

months. Your firm

wants to hedge thereceivable intopounds.

Sizes of forward

contracts are shown.

Country

U.S. $

equiv.

Currency

per U.S. $

Britain (62,500) $2.0000 0.5000

1 Month Forward $1.9900 0.5025

3 Months Forward $1.9800 0.5051

6 Months Forward $2.0000 0.500012 Months Forward $2.1000 0.4762

Euro (125,000) $1.4700 0.6803

1 Month Forward $1.4800 0.6757




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Futures Market Cross-Currency Hedge:

Step One

You have to convert the750,000 receivable first

into dollars and then into pounds.

If we sell the750,000 receivable forward at the

six-month forward rate of $1.50/ we can do this

with a SHORT position in 6 six-month euro

futures contracts.

6 contracts = 750,000125,000/contract

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Futures Market Cross-Currency Hedge:

Step Two

Selling the750,000 forward at the six-monthforward rate of $1.50/ generates $1,125,000:

9 contracts =562,500

62,500/contract

$1,125,000 =750,000 1

$1.50

At the six-month forward exchange rate of $2/,

$1,125,000 will buy 562,500.

We can secure this trade with a LONG position in

9 six-month pound futures contracts:

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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.

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 tocover your foreign currency payable.

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Money Market Hedge

A U.S.based importer of Italian bicycles

In one year owes100,000 to an Italian supplier.

The spot exchange rate is $1.50 =1.00

The one-year interest rate in Italy is i = 4%

$1.501.00

Dollar cost today = $144,230.77 =96,153.85

100,000

1.0496,153.85 =Can hedge this payable by buying

today and investing96,153.85 at 4% in Italy for one year.

At maturity, he will have100,000 =96,153.85 (1.04)

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Money Market Hedge

$148,557.69 = $144,230.77 (1.03)

With this money market hedge, we have

redenominated a one-year100,000 payable into

a $144,230.77 payable due today.

If the U.S. interest rate is i$ = 3% we could borrowthe $144,230.77 today and owe in one year

$148,557.69 =100,000

(1+ i)T (1+ i$)

TS($/)

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Money Market Hedge: Step One

Suppose you want to hedge a payable in the amount

of y with a maturity ofT:

i. Borrow $x at t= 0 on a loan at a rate ofi$ per year.

$x = S($/) y(1+ i)T

0 T

$x $x(1 + i$)T

Repay the loan in Tyears

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Money Market Hedge: Step Two

at the prevailing spot rate.

y

(1+ i)T

ii. Exchange the borrowed $x for

Invest at ifor the maturity of the payable.y(1+ i)T

At maturity, you will owe a $x(1 + i$)T.

Your British investments will have grown to y. Thisamount will service your payable and you will have no

exposure to the pound.

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Money Market Hedge

1. Calculate the present value of y at iy

(1+ i)T

2. Borrow the U.S. dollar value of receivable at the spot rate.

$x = S($/) y(1+ i)

T3. Exchange for y

(1+ i)T

4. Invest at ifor Tyears.y

(1+ i)T

5. At maturity your pound sterling investment pays your

receivable.

6. Repay your dollar-denominated loan with $x(1 + i$)T.

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Money Market Cross-Currency Hedge

Your firm is a U.K.-based importer of bicycles.

You have bought750,000 worth of bicycles froman Italian firm. Payment (in euro) is due in one year.

Your firm wants to hedge the payable intopounds. Spot exchange rates are $2/ and $1.55/

The interest rates are 3% in, 6% in $ and 4% in ,all quoted as an APR.

What should you do to redenominate this 1-year-denominated payable into a -denominatedpayable with a 1-year maturity?

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Sell pounds for dollars at spot exchange rate, buy euro at spotexchange rate with the dollars, invest in the euro zone for oneyear at i = 3%, all such that the future value of the investmentequals750,000.

Using the numbers we have:Step 1: Borrow 564,320.39 at i = 4%,

Step 2: Sell pounds for dollars, receive $1,128,640.78

Step 3: Buy euro with the dollars, receive728,155.34

Step 4: Invest in the euro zone for 12 months at 3% APR

(the future value of the investment equals750,000.)

Step 5: Repay your borrowing with 586,893.20

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Where do the numbers come from?

586,893.20 = 564,320.39 (1.04)

728,155.34 =750,000

(1.03)

$1,128,640.77 =728,155.34 1

$1.55

564,320.39 = $1,128,640.77 $21

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Options Market Hedge

Options provide a flexible hedge against thedownside, while preserving the upside potential.

To hedge a foreign currency payable buy calls on

the currency. 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.

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Options Market Hedge

$1.50/

Value of1 in $

in one year

Suppose the

forward exchangerate is $1.50/.

If an importer who

owes100m does

not hedge the

payable, in one

year his gain (loss)

on the unhedgedposition is shown

in green.

$0

$1.20/ $1.80/

$30m

$30m

Unhedged

payable

The importer will be better off if

the euro depreciates: he still buys

100m but at an exchange rate of

only $1.20/ he saves $30 million

relative to $1.50/

But he will be worse off if

the euro appreciates.

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Options Markets Hedge

Profit

loss

$5m$1.55/

Long call on

100mSuppose our

importer buys a

call option on

100m with anexercise price

of $1.50 per

pound.

He pays $.05

per euro for the

call.

$1.50/

Value of1 in $

in one year

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Value of1 in $

in one year


Profit

loss

$5m

$1.45 /

Long call on

100mThe payoff of theportfolio of a call

and a payable is

shown in red.

He can still profit

from decreases in

the exchange rate

below $1.45/ but

has a hedge againstunfavorable

increases in the

exchange rate.

$1.50/ Unhedged

payable

$1.20/

$25m

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$30 m

$1.80/Value of1 in $

in one year


Profit

loss

$5 m

$1.45/

Long call on

100m

If the exchange

rate increases to$1.80/ the

importer makes

$25 m on the callbut loses $30 m onthe payable for a

maximum loss of

$5 million.

This can be

thought of as an

insurance

premium.

$1.50/ Unhedged

payable

$25 m

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IMPORTERS who OWE

foreign currency in thefuture should BUY CALL

OPTIONS. If the price of the currency goes

up, his call will lock in an upper

limit on the dollar cost of hisimports.

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 inforeign currency should BUY

PUT OPTIONS. 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.

With an exercise price denominated in local currency

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Hedging Exports with Put Options

Show the portfolio payoff of an exporter whois owed 1 million in one year.

The current one-year forward rate is 1 = $2.

Instead of entering into a short forwardcontract, he buys a put option written on 1million with a maturity of one year and astrike price of 1 = $2. The cost of this option is $0.05 per pound.

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Options Market Hedge:


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28

S($/)360

$2m

$2

Long put

$1,950,000

$50k

Options Market Hedge:Exporter buys a put option to protect the dollar

value of his receivable.

$50k

$2.05

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Th h b i


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29

S($/)360

$2

The exporter who buys a put option to protect

the dollar value of his receivable

$50k

$2.05

has essentially purchased a call.

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Hedging Imports with Call Options

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 long 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.

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Forward Market Hedge:


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31LOSS

(TOTAL)

GAIN

(TOTAL)

S($/)360

Long

currencyforward

Accounts Payable = Short

Currency position

Forward Market Hedge:Importer buys 1m forward.

This forward hedgefixes the dollar value

of the payable at

$1.80m.$1.80

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Options Market Hedge:


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32

$1.8m

S($/)360

$1.80

Call

$80k

$1.88

$1,720,000

$1.72

Call option limits

thepotential cost of

servicing the payable.

Options Market Hedge:Importer buys call option on 1m.

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O i t h b ll t t t hi lf


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S($/)360

$1.80

$1,720,000

$1.72

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.

$80k

The cost of this insurance policy is $80,000

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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. Large dollar depreciations increase the cost of his

imports

Large dollar appreciations increase the foreign currency

cost of his competitors exports, costing him customersas his competitors renew their focus on the domestic

market.

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Our Importer Buys a Second Call Option


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35

p y p

S($/)360

$1.80

$1,720,000

$1.72

$80k

This position is called a straddle

$1.64 $1.96

$1,640,000

$160k

2ndCall

$1.88

Importers synthetic put

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Suppose instead that our importer is willing to


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S($/)360

$1.80

$1,720,000

$1.72

risk large exchange rate changes but wants to

profit from small changes in the exchange rate,

he could lay on a butterfly spread.

$80k

A butterfly spread is analogous to an interest rate collar; indeed its

sometimes called a zero-cost collar. Selling the 2 puts comes close

to offsetting the cost of buying the other 2 puts.

$2

buy a put $2 strike

butterfly spread

Sell 2 puts $1.90 strike.

$1.90

Importers synthetic put

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37

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.

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Cross-Hedging


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C oss edg g

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 Thaibhat.

It is difficult, expensive, or impossible to use

financial contracts to hedge exposure to minorcurrencies.

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Cross-Hedging


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g g

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 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 theeuro is expensive it can be a good hedge. But they need

to co-vary in a predictable way.

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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 willneed 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.

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Hedging Recurrent Exposure


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g g p

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 withswaps than with a program of hedging each

exposure as it comes along.

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

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Hedging through


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g g g

Invoice Currency

The firm can shift, share, or diversify:

shift exchange rate risk

by invoicing foreign sales in home currency

share exchange rate risk by pro-rating the currency of the invoice between foreign and

home currencies

diversify exchange rate risk

by using a market basket index

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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.

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Exposure Netting

A multinational firm should not consider deals inisolation, but should focus on hedging the firm asaportfolio of currency positions. As an example, consider a U.S.-based multinational

with Korean won receivables and Japanese yenpayables. Since the won and the yen tend to move insimilar directions against the U.S. dollar, the firm canjust 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.

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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 thefirm implements hedging.

In the following slides, a firm faces the following

exchange rates: 1.00 = $2.00

1.00 = $1.50

SFr 1.00 = $0.908-45

Exposure Netting


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150

150

150

150

$150

$150

SFr150

SFr150

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SFr150 SFr1$0.90 = $135150 1

$2.00 = $300 150 1$1.50 = $225

Exposure Netting


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150

150

150

150

$150

$150

SFr150

SFr150

$135

$135

$300

$

300

$2

25

$225$225

$225

$300

$

300

$150

$150

$135

$135

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Exposure Netting


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$225

$225

$300

$

300

$150

$150

$135

$135

$15

$75

$75

$165

$75

$165

$75

$15

8-48

Exposure Netting


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$75

$165

$75

$15$15

$

180

=$

165

+$

15

$180

$180

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50

Exposure Netting: an Example

Consider a U.S. MNC with three subsidiaries andthe following foreign exchange transactions:

$10 $35 $40$30

$20

$25 $60

$40

$10

$30

$20$30

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51

Exposure Netting: an Example

Bilateral Netting would reduce the number offoreign exchange transactions by half:

$10 $35 $40$30

$20

$40

$30

$20$30

$20$30$10

$40$30$10

$30$20

$60

$10 $35$25

$60

$40$20

$25

$10

$25

$10$15

$10

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Multilateral Netting: an Example

Consider simplifying the bilateral netting with multilateralnetting:

$25 $10$20

$10

$10$10

$15 $10

$10

$30 $15$10

$10

$40$15

$15$40$40

$15

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S i ?


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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 ofthe firm. Therefore shareholders who hold a diversified

portfolio are not helped when management hedges.

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Sh ld h Fi H d ?


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In the presence ofmarket imperfections, the firmshould hedge. Information Asymmetry

The managers may have better information than the

shareholders.

Differential Transactions Costs The firm may be able to hedge at better prices than the

shareholders.

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

probability of default.

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Sh ld th Fi H d ?


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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.

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What Risk Management Products do

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Firms Use?

Most U.S. firms meet their exchange riskmanagement needs with forward, swap, and

options contracts.

The greater the degree of internationalinvolvement, the greater the firms use of foreign

exchange risk management.

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8 management of transaction exposure

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