1 (of 26) IBUS 302: International Finance Topic 12–Transaction Exposure I Lawrence Schrenk, Instructor

2 (of 26) Learning Objectives 1. Explain the three forms of exposure to FX risk.▪ 2. Discuss the benefits and disadvantage to hedging 3. Construct and compare no hedging with forward and option market hedges.▪

3 (of 26) Exposure Transaction Risk to cash flows due to changes in FX rates. Economic Risk to firm value, i.e., market value, due to changes in FX rates. Translation Risk to accounting statements, i.e., book value, due to changes in FX rates.

4 (of 26) Example Your company, based in the U.S., supplies machine tools to manufacturers in Germany and Brazil. Prices are quoted in each country’s currency, so fluctuations in the €/$ and R$/$ exchange rate have a big impact on the firm’s revenues. How can the firm hedge these risks? Should it?

5 (of 26) Why Hedge? Con Hedging is Irrelevant or Wasteful Purely financial transaction Diversified shareholders don’t care about firm- specific risks Since markets are efficient, risk management does not add to firm value Active risk management wastes resources Agency cost

6 (of 26) Why Hedge? Pro Hedging creates Value Helps ensure that cash is available for positive NPV investments Reduces dependence on (expensive) external finance Reduces probability of financial distress Improves performance evaluation and compensation Reduces tax obligation

7 (of 26) Do Firms Hedge? Overall, Firms’ Behavior Diverse 50% of surveyed firms do use derivatives for risk management–especially large firms (83%), and especially for FX risk. Mainly hedging, but some speculation Wharton/CIBC World Markets Survey of Financial Risk Management by US Non- Financial Firms 1998 Wharton/CIBC World Markets Survey of Financial Risk Management by US Non- Financial Firms

8 (of 26) Hedging Instruments Forwards and futures A contract to exchange an asset in the future at a specified price Obligation for both Options Gives the holder the right to buy (call option) or sell (put option) an asset at a specified price and time. Preserve the upside potential Buyer has the choice

9 (of 26) 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.

10 (of 26) Options Market Hedge Options provide a flexible hedge against the downside, 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.

11 (of 26) FX Hedging Example Your company, headquartered in the U.S., supplies auto parts to Jaguar PLC in Britain. You have just signed a contract worth ₤18.2 million to deliver parts next year. Payment is certain and occurs at the end of the year. The $/₤ exchange rate is currently S($/₤) = How do fluctuations in exchange rates affect dollar ($) revenues? How can you hedge this risk?

12 (of 26) Timeline NowOne Year 01 S($/₤) = F 1 ($/₤) = CF = ₤18.2 million $ ???

13 (of 26) Possibility 1: Do Not Hedge Expected Cash Flow E[S 1 ($/₤)] = F 1 ($/₤) = Expected Cash Flow = x ₤18.2 million = $26.41 million Risk Upside FX Exposure:Yes Downside FX Exposure:Yes Cost of Hedge Position: $0

14 (of 26) Possibility 1: Payoff $26.41 S 1 ($/₤) Cash Flow ($) $25.48 $24.57 $27.30 $28.21

15 (of 26) Possibility 2: Forward Market Hedge Known Cash Flow E[S 1 ($/₤)] = F 1 ($/₤) = Lock in Revenues x ₤18.2 million = $26.41 million Risk Upside FX Exposure:No Downside FX Exposure:No Cost of Hedge Position: Minimal

16 (of 26) Possibility 2: Payoff $26.41 S 1 ($/₤) Cash Flow ($) $25.48 $24.57 $27.30 $28.21

17 (of 26) Possibility 3: Option Market Hedge The relevant option has three possible strike prices: Put Options Strike Min. Rev. Premium Cost (×18.2 M) 1.35 $24.6 M $0.012 $221, $25.5 M $0.026 $470, $26.4 M $0.047 $862,771 NOTE: Premium from Black-Scholes Formula

18 (of 26) Possibility 3: Option Market Hedge Minimum Cash Flow E[S 1 ($/₤)] = F 1 ($/₤) = Lock in Minimum Revenue x ₤18.2 million = $26.41 million Risk Upside FX Exposure:Yes Downside FX Exposure:No Cost of Hedge Position: $862,771

19 (of 26) Possibility 3: Payoff $26.41 S 1 ($/₤) Cash Flow ($) $25.48 $24.57 $27.30 $28.21 Value ▪ Profit ▪ -$862,771

20 (of 26) Payoff Comparisons $26.41 S 1 ($/₤) Cash Flow ($) $25.48 $24.57 $27.30 $28.21 Option Market Hedge Forward Market Hedge No Hedge