1. Transaction Exposure Risk due to lags in payments Hedging strategies October 27, 20151Transaction Exposure

2. Exposure  Transaction exposure changes in the value of outstanding contracts  Operating exposure (economic exposure) change in the PV of the firm (real exchange rates)  Translation exposure (accounting exposure) change in value of owner equity  Tax exposure October 27, 20152Transaction Exposure

3. Transaction exposure sources  lending or receivables denominated in foreign currency  borrowing or payables denominated in foreign currency  holding a defaulted forward contract October 27, 20153Transaction Exposure

4. Lags and transaction exposure  t 0 - order placed Forward contract agreed to  t 1 - order shipped (10 days)  t 2 - order delivered (24 days)  t 3 - order settled (90 days) October 27, 2015Transaction Exposure4

5. Balance sheet perspective  Contract: price, quantity, due date (today)  Forward contract purchased (today)  Input inventories purchased (today) Inventories increase (Payables increase)  May also be funded by LT debt  Output inventories created (8days) Input inventories decrease Output inventories increase (Accruals increase)  May also be funded by LT debt  Goods shipped (no change) (10 days) October 27, 20155Transaction Exposure

6. Balance sheet perspective (cont)  Goods received (24 days) Inventories decrease Receivables increase  Contract paid (90 days) Receivables decrease Take delivery on forward contract Cash increases  During this process Payables paid Accruals paid October 27, 20156Transaction Exposure

7. To Hedge  Reduce the volatility of future cash flows Eliminate one source of risk  Exchange rate volatility  Cost of the hedge Does not change default risk  Management either hedges or speculates ?? Does not have expertise in exchange rate risk October 27, 20157Transaction Exposure

8. To not Hedge  Shareholders better able to diversify risk than firm  If parity holds NPV of hedging negative Costs of hedging  Efficient markets have already impounded the risk into share price  Agency problem Management is risk averse relative to their jobs not to stockholder value October 27, 20158Transaction Exposure

9. Accounting practices non-hedged position  Balance sheet Input inventories at cost Output inventories at COGS Receivable denominated in cd  Spot in effect at time of delivery  Income statement At payment  Gain or loss realized  Counted on income statement October 27, 20159Transaction Exposure

10. Types of hedges  contractual hedges forwards, futures, option, money market hedges  operating & financial hedges risk-sharing leads & lags swaps October 27, 201510Transaction Exposure

11. Forward hedge - 90 day  short goods (delivered) selling goods for 154,000 usd  long bill of exchange (bankers accept) payment 154,000 usd promised forward  long a forward contract forward contract set for delivery of 229,460 cd  delivery of 154,000 usd  delivery of 229,460 cd discounted value 225,796.28 October 27, 201511Transaction Exposure

12. Forward hedge - Sources of risk  delivery on bill bank backing the bill could default  delivery on forward contract bank delivering cd forward could defaulat  risk of default is low  the hedge reduces transaction exposure October 27, 201512Transaction Exposure

13. Accounting practices Hedged position  Contract values 231,000 receivable @ spot = 1.50 229,460 payable @ forward = 1.49  Balance sheet Input inventories at cost Output inventories at COGS Receivable denominated  Denominated at spot in effect at time of delivery Forward contract as payable  Denominated at forward rate October 27, 201513Transaction Exposure

14. Money market hedge - 90 day  short goods (delivered) 154,000 usd  long bill for 154,000 usd  short loan 154,000/(1.0765).25 = 151,188  exchange for 225,270 cd  delivery of 154,000 usd  pay off loan of 154,000 October 27, 201514Transaction Exposure

15. Money market hedge - Sources of risk  delivery on bill bank backing the bill could default  no forward contract  risk of default is lower  the hedge reduces transaction exposure October 27, 201515Transaction Exposure

16. One can also discount the bill - 90 day  short goods 154,000 usd  long bill of exchange  sell bill at discount to bank @ 8.65% 150,839 usd  exchange for 224,750 cd October 27, 201516Transaction Exposure

17. Discounting bill of exchange - Sources of risk  no risk delivery on bill bill sold at discount to another party  no forward contract  risk of default is eliminated  the hedge eliminates transaction exposure October 27, 201517Transaction Exposure

18. OTC option contract - 90 day  short goods 154,000 usd  long bill of exchange  long call option to buy 229,508 cd @0.0025 usd/cd cost = 573.77 usd exercise price = 6710  delivery of 154,000  if e > x, exercise option get 229,508 cd net of cost of hedge October 27, 201518Transaction Exposure

19. Option contract - Sources of risk  risk of bank default on delivery on bill  risk of default by bank on option contract  the hedge reduces transaction exposure October 27, 201519Transaction Exposure

20. Present value of the hedges  forward hedge = 225,796 cd  money market hedge = 225,270  discounting = 224,750  option contract = 229,508 cd / (1.0667).25 - (573.77 usd * 1.49cd/usd) = 224,989 cd October 27, 201520Transaction Exposure

21. Accounting for unhedged positions  Payables and receivables are booked at current spot income statements balance sheets  at settlement - changes to book value must be counted losses gains October 27, 201521Transaction Exposure

22. Accounting hedged positions  Payables and receivables are booked at current spot  Use your forward rate as best estimator of future expected spot foreign exchange gain/loss = forward - spot forward contract loss = 0  Gains/losses will be the difference between contract evaluated at forward and contract evaluated at spot October 27, 201522Transaction Exposure

23. Risk management  Hedging costs money  Hedging exposure As contracts are anticipated  Contracts may not be signed  If contracts signed unanticipated exchange rate changes As contracts are signed  Risk that contract may be refused  Risk that goods may not clear customs As contracts are delivered  Default by the importer Out goods Must deliver on forward contract October 27, 201523Transaction Exposure

24. Other hedge practices  Proportional hedges Forward contracts hedge percentage of exposure  Percentage cover directly related to term to maturity  Forward points (using Interest Rate Parity) The usd sells forward at discount May not hedge this transaction because they may get a better exchange rate in the future October 27, 201524Transaction Exposure