Chapter 08 Transaction Exposure

Transaction Exposure The three major foreign exchange exposures Foreign exchange transaction exposure Pros and cons of hedging foreign exchange transaction exposure Alternatives of managing significant transaction exposure Practices and concerns of foreign exchange risk management

Foreign Exchange Exposure Types of foreign exchange exposure Transaction Exposure – measures changes in the value of outstanding financial obligations due to exchange rate changes Operating Exposure – also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates Translation Exposure – also called accounting exposure, is the changes in owner’s equity because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements Tax Exposure – as a general rule only realized foreign losses are deductible for purposes of calculating income taxes

Why Hedge - the Pros & Cons Opponents of hedging give the following reasons: Shareholders are more capable of diversifying risk than the management of a firm Currency risk management does not increase the expected cash flows of a firm Management often conducts hedging activities that benefit management at the expense of shareholders Managers cannot outguess the market Management’s motivation to reduce variability is sometimes driven by accounting reasons Efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation

Why Hedge - the Pros & Cons Proponents of hedging give the following reasons: Reduction in the risk of future cash flows improves the planning capability of the firm Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum – avoiding bankruptcy costs Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm Markets are usually in disequilibirum because of structural and institutional imperfections Reduction in variability of income reduces a firm’s overall tax burden

Why Hedge - the Pros & Cons Hedged Unhedged NCF Net Cash Flow (NCF) Expected Value, E(V) Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk, but who benefits from it.

Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely Purchasing or selling on credit goods or services when prices are stated in foreign currencies Borrowing or lending funds when repayment is to be made in a foreign currency Being a party to an unperformed forward contract and Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

Purchasing or Selling on Open Account Suppose Dragon Corporation sells merchandise on open account to a Belgian buyer for €1,800,000 payable in 60 days Further assume that the current spot rate is $0.9000/€ and Dragon expects to exchange the euros for €1,800,000 x $0.9000/€ = $1,620,000 when payment is received (assuming no change in exchange rate) Dragon will receive something other than $1,620,000 expected If the euro weakens to $0.8500/€, then Dragon will receive $1,530,000 If the euro strengthens to $0.9600/€, then Dragon will receive $1,728,000

Purchasing or Selling on Open Account Dragon might have avoided transaction exposure by invoicing the Belgian buyer in US dollars, but this might have caused Dragon not being able to book the sale Even if the Belgian buyer agrees to pay in dollars, however, Dragon has not eliminated transaction exposure, instead it has transferred it to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days

Purchasing or Selling on Open Account Life Span of a Transaction Exposure Seller quotes a price to buyer t1 Buyer places firm order with seller at offered price t2 Seller ships product and bills buyer t3 Buyer settles A/R with cash in amount of currency quoted at t1 t4 Quotation Exposure Time between quoting a price and reaching a contractual sale Backlog Exposure Time it takes to fill the order after contract is signed Billing Exposure Time it takes to get paid in cash after A/R is issued

Borrowing and Lending A second example of transaction exposure arises when funds are loaned or borrowed Example: PepsiCo’s largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex) On 12/94, Gemex had US dollar denominated debt of $264 million The Mexican peso (Ps) was pegged at Ps3.45/$ On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps4.65/$

Borrowing and Lending Gemex’s peso obligation now looked like this Dollar debt mid-December, 1994: $264,000,000 × Ps3.45/$ = Ps910,800,000 Dollar debt in mid-January, 1995: $264,000,000 × Ps5.50/$ = Ps1,452,000,000 Dollar debt increase measured in Ps Ps541,200,000 Gemex’s dollar obligation increased by 59% due to transaction exposure

Hedging Alternatives Transaction exposure can be managed by contractual, operating, or financial hedges Contractual hedges: forward, money market, futures, and options Operating and financial hedges use risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies A natural hedge refers to an offsetting operating cash flow A financial hedge refers to either an offsetting debt obligation or some type of financial derivative such as a swap

Dayton’s Transaction Exposure CFO of Dayton, has just concluded a sale to Regency, a British firm, for £1,000,000 The sale is made in March for settlement due in June (3 months) Assumptions Spot rate is $1.7640/£ 3-month forward rate is $1.7540/£ (a 2.27% discount) Dayton’s cost of capital is 12.0% UK 3 month borrowing rate is 10.0% p.a. UK 3 month investing rate is 8.0% p.a. US 3 month borrowing rate is 8.0% p.a. US 3 month investing rate is 6.0% p.a. June put option in OTC market for £1,000,000; strike price $1.7500/£; 1.5% premium June call option in OTC market for £1,000,000; strike price $1.7500/£; 1.5% premium Dayton’s foreign exchange advisory service forecasts future spot rate in 3 months to be $1.7600/£ The budget rate (lowest acceptable amount) is based on an exchange rate of $1.7000/£

Dayton’s Transaction Exposure Dayton faces four possibilities: Remain unhedged Hedge in the forward market Hedge in the money market Hedge in the options market

Dayton’s Transaction Exposure Unhedged position If the future spot rate is $1.7600/£, then Dayton will receive £1,000,000 x $1.7600/£ = $1,760,000 in 3 months However, if the future spot rate is $1.6500/£, Dayton will receive only $1,650,000 well below the budget rate

Dayton’s Transaction Exposure Forward Market hedge A forward hedge involves a forward contract The forward contract is entered at the time the A/R is created, in this case in March When this sale is booked, it is recorded at the spot rate. In this case the A/R is recorded at a spot rate of $1.7640/£, thus $1,764,000 is recorded as a sale for Dayton If the firm wants to cover this exposure with a forward contract, then the firm will sell £1,000,000 forward today at the $1.7540/£ In 3 months, Dayton will received £1,000,000 and exchange those pounds at $1.7540/£ receiving $1,754,000 This sum is $6,000 less than the uncertain $1,760,000 expected from the unhedged position This would be recorded in Dayton’s books as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled)

Dayton’s Transaction Exposure Money Market hedge To hedge in the money market, Dayton will borrow pounds in London, convert the pounds to dollars and repay the pound loan with the proceeds from the sale To calculate how much to borrow, Dayton needs to discount the PV of the £1,000,000 to today £1,000,000/1.025 = £975,610 Dayton should borrow £975,610 today and in 3 months repay this amount plus £24,390 in interest (£1,000,000) from the proceeds of the sale Dayton would exchange the £975,610 at the spot rate of $1.7640/£ and receive $1,720,976 at once (today) This hedge creates a pound denominated liability that is offset with a pound denominated asset thus creating a balance sheet hedge

Dayton’s Transaction Exposure In order to compare the forward hedge with the money market hedge, we must analyze the use of the loan proceeds Remember that the loan proceeds may be used today, but the funds for the forward contract may not Because the funds are relatively certain, comparison is possible in order to make a decision (the comparison is made on future values) Three logical choices exist for an assumed investment rate for the next 3 months First, if Dayton is cash rich the loan proceeds might be invested at the US rate of 6.0% p.a. Second, the loan proceeds can be substituted for an equal dollar loan that Dayton would have otherwise taken for working capital needs at a rate of 8.0% p.a. Third, the loan proceeds can be invested in the firm itself in which case the cost of capital is 12.0% p.a.

Dayton’s Transaction Exposure Because the proceeds in 3 months from the forward hedge will be $1,754,000, the money market hedge is superior to the forward hedge if the proceeds are used to replace a dollar loan (8%) or conduct general business operations (12%) The forward hedge would be preferable if the loan proceeds are invested at (6%) We will assume the cost of capital as the reinvestment rate Received Today Invested In Rate Future Value in 3 Months $1,720,976 Treasury Bill 6% p.a. or 1.5%/quarter $1,746,791 Debt Cost 8% p.a. or 2.0%/quarter $1,755,396 Cost of Capital 12% p.a. or 3.0%/quarter $1,772,605

Dayton’s Transaction Exposure A breakeven investment rate can be calculated between forward and money market hedge To convert this 3 month rate to an annual rate, In other words, if Dayton can invest the loan proceeds at a rate equal to or greater than 7.68% p.a. then the money market hedge will be superior to the forward hedge

Dayton’s Transaction Exposure 1.68 1.70 1.74 1.76 1.72 1.82 1.80 1.78 1.86 1.84 Value in US dollars of Dayton’s £1,000,000 A/R Ending spot exchange rate (US$/£) Uncovered yields whatever the ending spot rate is in 90 days Forward rate is $1.7540/£ Money market hedge yields $1,772,605

Dayton’s Transaction Exposure Option market hedge Dayton could also cover the £1,000,000 exposure by purchasing a put option. This provides the upside potential for appreciation of the pound while limiting the downside risk Given the quote earlier, a 3-month put option can be purchased with a strike price of $1.75/£ and a premium of 1.5% The cost of this option would be

Dayton’s Transaction Exposure Because we are using future value to compare the various hedging alternatives, we need future value of the option cost in 3 months Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium cost of the option as of June would be $26,460 × 1.03 = $27,254 or $27,254 / £1,000,000 = $0.0273/£ Since the upside potential is unlimited, Dayton would not exercise its option at any rate above $1.7500/£ and would convert pounds to dollars at the spot market If the spot rate is $1.7600/£, Dayton would exchange pounds on the spot market to receive £1,000,000 × $1.7600/£ = $1,760,000 less the premium of the option ($27,254) netting $1,732,746 If the pound depreciates below $1.7500/£, Dayton would exercise the put option and exchange £1,000,000 at $1.7500/£ receiving $1,750,000 less the premium of the option netting $1,722,746

Dayton’s Transaction Exposure As with the forward and money market hedges, a breakeven price on the option can be calculated The upper bound of the range is determined by comparison of the forward rate The pound must appreciate above $1.7540/£ forward rate plus the cost of the option, $0.0273/£, to $1.7813/£ The lower bound of the range is determined by comparison to the strike price If the pound depreciates below $1.7500/£, the net proceeds would be $1.7500/£ less the cost of $0.0273/£ or $1.7227/£ Note that the following graph shows the net proceeds of the option contract under varying exchange rates. Net proceeds are not same of a put option payoff diagram because we have exposure to the underlying asset (£)

Dayton’s Transaction Exposure Put Option Strike Price ATM Option $1.75/£ Option cost (future cost) $1,750,000 Proceeds if exercised $1,722,746 Minimum net proceeds Cost of Capital Maximum net proceeds Unlimited Breakeven spot rate (upside) $1.7813/£ Breakeven spot rate (downside) $1.7227/£

Net Proceeds of Alternatives Cell E5 Entry is =IF(A5<$C$2,($C$2-$C$3)*$C$1,(A5-$C$3)*$C$1)

Net Proceeds of Alternatives

Strategy Choice and Outcome Dayton, like all firms, must decide on a strategy to undertake before the exchange rate changes but how a choice can be made among the strategies? Two criteria can be utilized: Risk tolerance - of the firm,as expressed in its stated policies and Viewpoint – managers’ view on the expected direction and distance of the exchange rate Dayton now needs to compare the alternatives and their outcomes in order to choose a strategy There were four alternatives available to manage this account receivable

Strategy Choice and Outcome Hedging Strategy Outcome/Payout Remain uncovered Unknown Forward contract hedge @ $1.754/£ $1,754,000 Money market hedge @ 8% p.a. $1,755,396 Money market hedge @ 12% p.a. $1,772,605 Put option hedge @ strike $1.75/£ Minimum if exercised $1,722,746 Maximum if not exercised Unlimited

Managing an Account Payable The choices are the same for managing a payable Assume that the £1,000,000 was an account payable in 90 days Remain unhedged – Dayton could wait the 90 days and at that time exchange dollars for pounds to pay the obligation If the spot rate is $1.76/£ then Dayton would pay $1,760,000 but this amount is not certain

Managing an Account Payable Use a forward market hedge – Dayton could purchase a forward contract locking in the $1.7540/£ rate ensuring that their obligation will not be more than $1,754,000 Use a money market hedge – this hedge is distinctly different for a payable than a receivable Here Dayton would exchange US dollars at the spot rate and invest them for 90 days in pounds The pound obligation for Dayton is now offset by a pound asset for Dayton with matching maturity

Managing an Account Payable Using a money market hedge To ensure that exactly £1,000,000 will be received in 3 months, discount the principal by 8% p.a. This £980,392.16 would require $1,729,411.77 at the current spot rate

Managing an Account Payable Using a money market hedge Finally, carry the cost forward 90 days using the cost of capital in order to compare the payout This is higher than the forward hedge of $1,754,000 thus unattractive

Managing an Account Payable Using an option hedge – instead of purchasing a put as with a receivable, you want to purchase a call option on the payable The total cost of an ATM call option with strike price of $1.7500/£ and a premium of 1.5%: Carried forward 90 days the premium amount is $26,460 × 1.03 = $27,254 or $27,254 / £1,000,000 = $0.0273/£

Managing an Account Payable Using a call option hedge If the spot rate is less than $1.7500/£ then the option would be allowed to expire and the £1,000,000 would be purchased on the spot market If the spot rate rises above $1.7500/£ then the option would be exercised and Dayton would exchange the £1,000,000 at $1.75/£ less the option premium for the payable Exercise call option (£1,000,000  $1.75/£) = $1,750,000 Add call option premium of $27,254 (carried forward 90 days) Total maximum expense of call option hedge is $1,777,254

Net Cost of Alternatives Cell E5 Entry is =IF(A5>$C$2,($C$2+$C$3)*$C$1,(A5+$C$3)*$C$1)

Net Cost of Alternatives

Risk Management in Practice Which Goals? The treasury function of most firms is usual considered a cost center; it is not expected to add to the bottom line However, in practice some firms’ treasuries have become aggressive in currency management and act as profit centers Which Exposures? Transaction exposures exist before they are actually booked yet some firms do not hedge this backlog exposure However, some firms are selectively hedging these backlog exposures and anticipated exposures Which Contractual Hedges? Transaction exposure management programs are generally divided along an “option-line;” those which use options and those that do not Also the amount of risk covered may vary. Tare are proportional hedging policies that state which proportion and type of exposure is to be hedged by the treasury