FIN 40500: International Finance Hedging Foreign Exchange Risk

To hedge or not to hedge….that is the question” Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate: $ Day Forward: $1.85 (-1.6%) If you were to “lock in” your price with the forward/futures contract, you would pay $185,000 for the goods (with certainty)

Suppose you have the following forecast for the percentage change in the British pound over the upcoming 90 days % Change in e ($/GBP) Mean: -1.6% Std. Dev: 2% -1.6% [ -3.6%, 0.4%] [ -5.6%,2.4%] [ -7.6%, 4.4%]

Given a standard deviation, we can approximate a distribution for the exchange rate in 90 days. Standard Deviations Percentage Change Exchange RateProbability %$1.741% %$1.774% -3.6%$1.8125% 0-1.6%$1.8540% 1.4%$1.8925% 22.4%$1.934% 34.4%$1.961% Current Spot Rate: $1.88

Given the distribution of exchange rates, we can estimate the expected cost of the hedge Exchange Rate ProbabilityCost w/out hedge Cost w/hedge Value of Hedge $1.741%$174,000$185,000-$11,000 $1.774%$177,000$185,000-$8,000 $1.8125%$181,000$185,000$-4,000 $1.8540%$185,000 $0 $1.8925%$189,000$185,000$4,000 $1.934%$193,000$185,000$8,000 $1.961%$196,000$185,000$11,000 Current Spot Rate: $1.88 Expected Value: $0

From the previous table, we can show the distribution of gains from the hedge If forward rates are unbiased, most of the weight will be at zero!

Money Market Hedges Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate = $1.88 British 90 Day Interest Rate = 2.6% US 90 Day interest rate = 1%

Money Market Hedges Spot Rate = $1.88 British 90 Day Interest Rate = 2.6% US 90 Day interest rate = 1% Today90 Days GBP 100, Present Value of 100,000 in 90 days $1.88= $183,236 (1.01) = $185,000  Borrow 1% for 90 Days  Convert to $1.88  Invest in 90 Day British 2.6%  Collect GBP 100,000 to pay for imports  Pay of loan + interest = $185,000

Money Market Hedges VS. Forward/Futures Hedge Recall Covered Interest Parity If covered interest parity holds (and it does!), then the forward rate reflects the interest differential and the money market hedge is identical to the forward/future hedge!

Currency Options With options, you have the right to buy/sell currency, but not the requirement  Call: The right to buy at a specific “strike price”  Put: The right to sell at a specific “strike price” The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option. The buyer must pay an up front price for the contract

Payout from a Call Suppose you buy a 30 day call on 125,000 Euros at a strike price of $1.20 For spot rates less than $1.20, the option is worthless (“out of the money”) If the spot rate is $1.25, your profit is ($.05)*($125,000) = $6,250

Payout from a Put Suppose you buy a put on 125,000 Euros at a strike price of $1.20 For spot rates greater than $1.20, the option is worthless (“out of the money”) For example, if the spot rate is $1.15, your profit is ($.05)*($125,000) = $6,250

Hedging with Options Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. Spot Rate: $ Month Call w/strike price of $1.85 is selling at a premium of $.05 (GBP 100,000) You pay $.05(100,000) = $5,000 today. Your cost of GBP in 90 days = MIN [ spot rate, $1.85]

Remember, you pay (.05)*100,000 = $5,000 Today! Exchange Rate ProbabilityCost w/out hedge Cost w/hedge Value of Hedge $1.741%$174,000$179,000-$5,000 $1.774%$177,000$182,000-$5,000 $1.8125%$181,000$186,000-$5,000 $1.8540%$185,000$190,000-$5,000 $1.8925%$189,000$190,000$1,000 $1.934%$193,000$190,000$3,000 $1.961%$196,000$190,000$6,000 Current Spot Rate: $1.88 Expected Value: -$3,070

The option hedge is more expensive on average, but protects you from large negative outcomes!

Hedging Techniques Type of Exposure Forward/FuturesMoney MarketOptions Payables (Cash Outflow) Long PositionBorrow Domestically/Lend Abroad Call Option Receivables (Cash Inflow) Short PositionLend Domestically/Borro w Abroad Put Option

Cross Hedging Suppose that you have entered an agreement to buy PLN 100,000 (Polish Zloty) worth of imports. ($1 = 3.17PLN). Zloty futures are not traded. What do you do? You notice that the Zloty is highly correlated with the Euro (E 1 = 4.09 PLN) Act as if you are hedging (100,000/4.09) = E 24,454

Some more advanced hedging strategies… Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. You are in the process of negotiating a deal to sell GBP 200,000 worth of goods to Britain. Case #1: The export deal falls through and you will need to buy GBP 100,000 in one 90 days Case #2: The export deal succeeds and you will need to sell GBP 100,000 in one 90 days How do you hedge this?

A currency straddle is a combination of a put (the right to sell) and a call (the right to buy) e ($/L) Value 1.85 e ($/L) Value 1.85 e ($/L) Value 1.85 Cost = $0.06/L Cost = $0.12/L(L 100,000) = $12,000

Currency Straddles: Four Possibilities  NCF = L100,000, e > $1.85  Let Put Expire  Buy $ in Spot Market  Buy GPB with Call  Sell GBP in Spot Market  NCF = L100,000, e < $1.85  Let Call Expire  Use Put to sell GBP  NCF = - L100,000, e > $1.85  Let Put Expire  Use Call to Buy GBP  NCF = - L100,000, e < $1.85  Let Call Expire  Buy GBP in Spot Market  Sell GBP with Put

e ($/L) Value 1.89 e ($/L) Value 1.84 e ($/L) Value 1.84 Cost = $0.03/LCost = $0.04/L Cost = $0.07/L(L 100,000) = $7,000 Straddles hedge your exposure under all circumstances, but are very expensive (in this case, $12,000 in premium costs ) 1.89 Un-hedged Region

Another way to save money is to only hedge particular ranges (i.e. a 95% confidence interval!) Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. e ($/L) Value 1.85 e ($/L) Value 1.89 Cost = $0.05/LCost = $0.08/L

You could hedge the range from $1.85 to $1.89 by selling a call w/ a strike price of $1.89 and using the proceeds to buy a call with a strike price of $1.85 e ($/L) Value 1.85 e ($/L) Value 1.89 Cost = $0.05/LCost = $0.08/L Value 1.85 Cost = $ $0.05 = $0.03 e ($/L) 1.89

Hedging…the possibilities are endless! There are many different types of hedges available. Each hedge has a cost and a level of protection. Its your choice to decide what coverage you need and how much you are willing to pay for it!!

Transaction Exposure vs. Economic Exposure Profits = e (Price – Unit Costs) Q Transaction exposure refers to changes in the $ value of costs/revenues due to exchange rate movements Economic exposure refers to changes in the $ value of costs/revenues due to changes in demand (caused by exchange rate movements)

Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$4 *.75 = $3 $303 $50 C$200 *.75 = $150 $200 $30 $60 $43 Canadian sales and costs are unaffected by exchange rate movements, but are subject to transaction exposure US costs are independent of the Exchange rate, but US sales rise when the Canadian dollar strengthens (Canadian goods become more expensive)

If the Canadian Dollar Strengthens, both Costs and Sales are Affected. Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$4 *.75 = $3 $303 $50 C$200 *.75 = $150 $200 $30 $60 $43 Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable $310 C$4 *. 80 = $3.20 $ $55 C$200 *. 80 = $160 $215 $30 $33 1 CD = $.75 1 CD = $.80 EBIT$35.20 $63

Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$4 *.75 = $3 $303 $50 C$200 *.75 = $150 $200 $30 $60 $43 If Pepsi could raise its Canadian Sales and lower its Canadian costs, it would be better insulated from exchange rate changes

Increasing Canadian sales and lowering Canadian costs lowers exposure Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable Total EBIT $300 C$20 *.75 = $15 $315 $140 C$100 *.75 = $75 $215 $30 $60 $40 Sales US Canadian Total Costs of Goods Sold US Canadian Total Operating Expenses US: Fixed US: Variable $310 C$20 *. 80 = $16 $326 $145 C$100 *. 80 = $80 $225 $30 $33 1 CD = $.75 1 CD = $.80 EBIT$38 $63

Increasing Canadian sales and lowering Canadian costs lowers exposure EBIT E $/CD Old Structure New Structure $43 $35.20 $40 $38

Searching for economic exposure Economic exposure is much more general than transaction exposure (it can come from many sources). Therefore, it can be much more difficult to find!  Exchange rates change market competition  Exchange rates are correlated with Macroeconomic conditions  Exchange rates change the value of foreign currency cash flows (transaction exposure)

Changes in currency prices can have all kinds of economic impacts. A general way to estimate economic exposure would be as follows: Percentage change in the exchange rate ($/F) Percentage change in cash flows (measured in home currency)

Regression Results VariableCoefficientsStandard Errort Stat Intercept % Change in Exchange Rate Regression Statistics R Squared.63 Standard Error1.20 Observations1,000 Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3.35%

Suppose you have three different facilities … Regression Results VariableCoefficientsStandard Errort Stat Intercept % Change in e ($/Euro) You first run a regression using consolidated income statements Plant A Plant B Plant C Overall, your cash flows are negatively related to the value of the Euro

Now, try isolating the exact location … Regression Results VariablePlant APlant BPlant C Coefficient T-Stat Now, run a regression using individual plant income statements Plant A Plant B Plant C Aha!!! Plant B is the culprit! (And they would’ve gotten away with it if it weren’t for those meddling kids!!!)

Now, try isolating the specific income statement items … Regression Results VariableSales Cost of GoodsExpenses Coefficient T-Stat Now, run a regression using individual plant income statements Plant B Ultimately, it looks like sales from plant B are the underlying currency problem Sales Costs of Goods Sold Operating Expenses

Now, what do we do about it?  Pricing Policy: If sales drop when the Euro appreciates, then consider lowering prices during strong Euro periods to maintain market share  Cash flow matching: If sales (and hence, cash inflows) are dropping during periods with a weak dollar, try adjusting production locations so that your costs will drop at the same time.  Futures, Forwards, and Options