MANAGING TRANSACTION EXPOSURE

MGT 589

Transaction Exposure

“When the future cash transactions of a firm are affected by exchange rate fluctuations”

identify the degree of transaction exposure decide whether to hedge the exposure choose technique for hedging

IDENTIFYING THE NET TRANSACTION EXPOSURE Netting: consolidation of all exposed inflows and outflows

for a particular time and currency. Goal: reducing overall exposure to the MNC; maximize

the overall value of the MNC. Subsidiary's Role:

reporting current and projected data; assessing economic environment and trends. Local financial markets may evaluate sub's individual financial

position and un-hedged positions may be considered more risky. If one sub. hedges it may increase overall exposure of MNC. If both subs hedge additional transaction costs will incur.

Examples Eastman Kodak implements an centralized

currency management approach - instead of billing subs in US $ it accepts local currencies.

Borg-Warner Corp. has centralized clearing house system.

Fiat has a comprehensive monitoring and reporting system. {421 subs in 55 countries}.

Is Hedging Worthwhile ?

Consider hedging payables with forward contracts: If future spot rate > forward rate then gains If future spot rate < forward rate then loses

If forward rate is an unbiased predictor of the future spot rate then MNC will lose/gain with equal frequency.

Yet MNC may prefer knowing its cash flows with certainty to enhance corporate planning.

Adjusting Invoice Policy

Modifying invoicing policy to reduce transaction exposure; e.g., invoicing in the same currency that will be needed to pay for imports.

Difficulties: precise matching of the amounts and timing of cash flows.

Summary of techniques for hedging transaction exposure

Hedging Technique To Hedge Payables To hedge Receivables

1. Futures contract Purchase futures contract on the FC

Sell futuresContract on the FC.

2. Forward contract Purchase forwardcontract on the FC

Sell forward contract on the FC.

3. Money Market Hedge

* Borrow LC ($);* convert to FC;* invest abroad;* payback LC loan;* pay off supplier.

* Borrow the FC;* convert to LC ($);* invest at home;* pay loan from A/R* receive $ invested

4. Currency Option hedge

Purchase FC call options;

Purchase a currencyPut option.

Real cost of hedging payables RCHp = NCHp - NCp NCHp = nominal cost of hedging payables NCp = nominal cost of payables without hedging Example: Need to pay SF100,000 in 90 days. The

90-day forward SF rate is $0.62 and the spot rate is $0.65. The firm estimates the following possible spot rates in 90 days and assigns a subjective probability with each possibility.

Real Cost of Hedging-example

PossibleSpot rate

Prob-ability

Nominal costs Real cost

NCHp NCp RCHp

$0.58 .10 $62,000 $58,000 $ 4,000

0.60 .20 62,000 60,000 2,000

0.62 .60 62,000 62,000 0

0.64 .10 62,000 64,000 (2,000)

Hedging cost

Expected Cost of Hedging = .1(4000)+.2(2000)+.6(0)+.1(2000)=$600

Expected spot rate = .1(.58)+.2(.60)+.6(.62)+.1(.64) = 0.614

Real cost of hedging receivables RCHr = NRr - NRHr NRr = nominal home currency revenues

without hedging NRHr = nominal home currency revenues

with hedging. Note: NCH can be expressed in percentages

to facilitate comparison with hedging positions in different currencies.

ILLUSTRATION OF HEDGING TECHNIQUES Spot rate of Swiss franc as of today = $0.71 Forward rate of Swiss franc as of today = $0.70 (180 days) Current interest rates: Borrowing Deposit Switzerland 10% 8% U.S. 6% 4% A call option on SF that expires in 180-days, has an

exercise price of $0.70 and an premium of $0.02 A put option on SF that expires in 180-days, has an

exercise price of $0.70 and a premium of $0.03.

Probability distribution

SF spot rates in 180 days:

Possible spot rate $/Sf 0.66 0.68 0.70 0.72

Probability: 0.10 0.30 0.40 0.20

Hedging Payables: ABC Corp. will need SF 400,000 in 180 days. Forward Hedge:

Purchase SF 400,000, 180-day forward:

dollars needed in 180 days

= SF payables * forward SF rate

400,000 x 0.70 = $280,000

Money Market Hedge Borrow $, convert to SF, invest SF, repay

$ loan in 180 days Amount of SF to be invested =

SF 400,000/(1.04) = 384,615 Amount to be borrowed ($) =

384,615 x 0.71 = $273,077 Amount repaid in 180 days =

273,077 x 1.03 = $ 281,269

Call Option

PossibleSpot rate

Prob-ability

ExerciseOption ?

Total cost/SF

Total cost(SF 400,000)

0.66 .10 No .66+.02 = 0.68 $272,000

0.68 .30 No .68 + .02 = 0.70 $280,000

0.70 .40 No .70 + .02 = 0.72 $288,000

0.72 .20 Yes .70 + .02 = .72 $288,000

Expected nominal cost of SF 400,000? $284,000

Purchase call option on SF 400,000; exercise price = 0.70, premium = 0.02

Call Option – with interest on premium

PossibleSpot rate

Prob-ability

ExerciseOption ?

Total cost/SF

Total cost(SF 400,000)

0.66 .10 No .66+.021 = 0.681 $272,400

0.68 .30 No .68 + .021 = 0.701 $280,400

0.70 .40 No .70 + .021 = 0.721 $288,400

0.72 .20 Yes .70 + .021 = .721 $288,400

Expected nominal cost of SF 400,000? $284,400

Purchase call option on SF 400,000; exercise price = 0.70, premium = 0.02, Ks = 10%

Future value of premium = .02 + 5%(.02) = .021

Remain un-hedged

PossibleSpot rate

probability Total cost of SF 400,000

0.66 .10 $264,000

0.68 .30 $272,000

0.70 .40 $280,000

0.72 .20 $288,000

Expected nominal cost of SF 400,000 ? = $277,000

Hedging Receivables

ABC will receive SF 200,000 in 180 days. Forward Hedge:

Sell SF 180-days forward:

$ to be received in 180 days

= Receivables SF * forward rate

200,000 x 0.70 = $140,000

Money Market Hedge Borrow SF, convert to $, invest $, use receivables

to pay off loan in 180 days. Amount of SF to be borrowed =

200,000/1.05 = SF 190,076 Amount of $ received from converting=

SF 190,076 x 0.71 = $135,238 $ accumulated in 180 days =

$135,238 x 1.02 = $137,943

Put Option Hedge: purchase put option; exercise price =0.70; premium = $0.03

Possible Spot Rate

Probab-ility

Exercise option?

$/Sf received

Total receipt SF200,000

0.66 .10 Yes .70 -.03 =0.67 $134,000

0.68 .30 Yes .70 -.03 =0.67 $134,000

0.70 .40 No .70 -.03 =0.67 $134,000

0.72 .20 No .72 -.03 =0.69 $138,000

Expected nominal $ receipt from SF 200,000? = 138,800

Including Interest on premium

Suppose cost of capital = 10%

Considering the future value of the option will add $ 300 to the cost of hedging with put option:

$ 0.03/SF x 5% x SF 200,000 = $300

Remain un-hedged

Possible Spot Rate

Probability Total receipt (SF200,000)

0.66 .10 $132,000

0.68 .30 $136,000

0.70 .40 $140,000

0.72 .20 $144,000

Expected nominal $ receipt from SF 400,000? = $138,800

Some Observations Hedge/no-hedge decision depends on managements risk

aversion. If the forward rate is an unbiased predictor of the future

spot rate then real cost of hedging approaches zero over time.

Actual real cost of hedging can be determined only after the hedge is closed.

The forward market hedge and the money market hedge can be compared directly.

If the interest rate parity exists the forward rate hedge will yield the same results as the money market hedge.

Currency options will be more flexible when the amounts to be hedged are not certain

HEDGING LONG-TERM TRANSACTION EXPOSURE

Limitations of Repeated Short-term Hedging Over Time Forward rates will exhibit a (stable) premium over time

over a strong FC period. Use of forward contracts during a strong FC period

may be preferable to a no-hedge strategy, but will still result in subsequent increases in future prices.

Amount of FC to be hedged further into the future is more uncertain.

Long-term Forward Contracts

Until recently long-term contracts were seldom used.

Long-forwards now quoted for up to 5 years; can be tailor-made.

Attractive to firms with longer term fixed-price contracts.

Currency Swaps:two firms with different long-term needs

€ ReceiptsFrom German Sub's

operations

$ Payments on $ denominated loans

US PARENT

$ ReceiptsFrom US Sub's

operations

€ Payments on € denominated loans

GERMAN

PARENT

Parallel Loans (Back-to-back)

Simultaneous loans provided by two parties with an agreement to repay at a specified point in future.

British parent desires to expand in the U.S. US parent desires to expand in the U.K.

TECHNIQUES TO REDUCE TRANSACTION EXPOSURE

Limitations of Hedging: amounts to be hedged may not be known with

certainty cost of hedging may be too high hedging instruments in the FC may not be

available barriers to foreign investing/borrowing may

exist.

Reducing Transaction Exposure Leading and Lagging: adjustments in the timing of

payments or disbursements to reflect expectations about future currency movements. Leading: accelerating payments in FC expected to

appreciate. Lagging: stalling payments in FC expected to

depreciate. Countries limit the length of time involved in

collection and receipt of payments.

Cross-Hedging

If financial contracts are not available in one FC hedge against another currency which is highly

correlated with the first. Netting highly correlated currencies.

Currency Diversification

Denominate in a basket (cock-tail) of currencies

If the FCs are not highly positively correlated dollar value of inflows in FC will be more stable