1. Managing Transaction Exposure C H A P T E R 11

2. Chapter Overview A. Transaction Exposure B. Hedging Exposure to Payables C. Hedging Exposure to Receivables D. Cross hedging

3. Foreign Exchange Exposure Types of foreign exchange exposure Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not to be settled until after the exchange rate changes Operating (Economic)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 Question: Is transaction exposure part of economic exposure, or vice versa?

4. 9-4 Foreign Exchange Exposure Translation Exposure – also called accounting exposure, is the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements Tax Exposure – the tax consequence of foreign exchange exposure varies by country, however as a general rule only realized foreign losses are deductible for purposes of calculating income taxes

5. Conceptual Comparison of Transaction, Operating, and Translation Foreign Exchange Exposure

6. Why Hedge? Hedging protects the owner of an asset (future stream of cash flows) from loss However, it also eliminates any gain from an increase in the value of the asset hedged against Since the value of a firm is the net present value of all expected future cash flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against

7. 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; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow Management often conducts hedging activities that benefit management at the expense of shareholders

8. Why Hedge - the Pros & Cons Opponents of hedging give the following reasons (continued): Managers cannot outguess the market; if and when markets are in equilibrium with respect to parity conditions, the expected NPV of hedging is zero Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss 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

9. Why Hedge - the Pros & Cons Proponents of hedging give the following reasons: Reduction in risk in 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 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

10. Impact of Hedging on the Expected Cash Flows of the Firm

11. 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

12. The Life Span of a Transaction Exposure

13. Alternative ways of hedging transaction exposure Transaction exposure: The value of a firm’s future transactions in foreign currencies is affected by exchange rate movements. The sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements is transaction exposure. Using financial contract to hedge transaction risk Forward (Future) Market Hedge Money Market Hedge Options Market Hedge Call Put

14. Hedging Currency Payable Using financial contract to hedge transaction risk involved with currency receivable: Forward or Futures Hedge contract specifies a. Fixed amount of currency b. Fixed exchange rate c. Fixed delivery date Forward (Future) Market Hedge – long position If you are going to owe foreign currency in the future, agree to …… the foreign currency now by entering into long position in a forward contract Money Market Hedge Involves taking a money market position to cover a future payables position Options Market Hedge Call – pay call option premium to purchase call options

15. Alternative ways of hedging transaction exposure A U.S.–based importer of Italian bicycles In one year owes €100,000 to an Italian supplier. The spot exchange rate is $1.18 = €1.00 The one year forward rate is $1.20 = €1.00 The one-year interest rate in Italy is i € = 5% The one-year interest rate in US is i $ = 8% Approach one: Using forward contract to hedge on payable Can hedge this payable by set up a forward contract to buy Euros in one year today. Cost in $ (one year later)= payables * forward rate = €100,000 * 1.2 $/ € = $120,000

16. Alternative ways of hedging transaction exposure on payable A U.S.–based importer of Italian bicycles In one year owes €100,000 to an Italian supplier. The spot exchange rate is $1.18 = €1.00 The one year forward rate is $1.20 = €1.00 The one-year interest rate in Italy is i € = 5% The one-year interest rate in US is i $ = 8% Approach two: Using money market to hedge on payable $1.18 €1.00 Dollar cost today = $112381 = €95238 × €100,000 1.05 €95,238 = Can hedge this payable by buying today and investing €95238 at 5% in Italy for one year. At maturity, he will have €100,000 = €95238 × (1.05)

17. Money Market Hedge on payable With this money market hedge, we have redenominated a one-year €100,000 payable into a $112381 payable due today, or So $112381 is the “locked in” cost in dollars today But if you do not have excess $, you can borrow at US bank @ 8%. So one year later, you need to pay back to US bank of $112381*(1+0.08) = $121371 Net exposure to Euro is zero at the maturity The money market hedge is fully self-financing A money market hedge also includes a contract and a source of funds, similar to a forward contract In this case, the contract is a loan agreement The firm borrows in one currency and exchanges the proceeds for another currency Question: What are the differences of the two approaches?

18. Alternative ways of hedging transaction exposure on payable Today, borrowed $112,381 today @ 8% in US market and convert to €95, 238 at spot rate Today, deposit €95, 238 in Foreign market @5%, due one year later One year later, need to payback $121371 to the bank, for the loan of $112,381 Payback the payable of €100,000 one year later

19. Options Market Hedge on payable Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency. To hedge a foreign currency receivable buy puts on the currency. 8-19

20. Alternative ways of hedging transaction exposure on payable A U.S.–based importer of Italian bicycles In one year owes €100,000 to an Italian supplier. The spot exchange rate is $1.18 = €1.00 The one year forward rate is $1.20 = €1.00 The one-year interest rate in Italy is i € = 5% The one-year interest rate in US is i $ = 8% Call option exercise price is $1.2/ € with premium of $0.03. Approach two: Buy call options to hedge on payable

21. Alternative ways of hedging transaction exposure on payable Approach two: Buy call options to hedge on payable Possible outcomes: When one year’s spot rate >=$1.2  exercise call option @$1.2  Total cost = €100,000 *($1.2+$0.03)=$123000. When one year’s spot rate <$1.2  let go call option and convert at low spot rate  Total cost = €100,000 *(spot rate+$0.03) So, the expected value of cost of using call options = 119000 * 0.2 + 123000*0.7+123000*0.1=$122200.

22. 11.1 Contingency Graph for Hedging Payables With Call Options

23. Alternative ways of hedging transaction exposure on payable Which of the three hedging approaches are optimal? We can compare the final costs and the least expensive one is optimal. However, the expected cost based on call option depends on the forecast (probability) of future exchange rate. What about the final cost without any hedge? So, the expected value of cost of no hedging = 116000 * 0.2 + 122000*0.7+124000*0.1=$121000. 8-23

24. 11.4 Graphic Comparison of Techniques to Hedge Payables

25. Hedging Currency Receivable Using financial contract to hedge transaction risk involved with currency receivable: If you are going to receive foreign currency in the future, agree to …….. the foreign currency now by entering into short position in a forward contract – such as receivable Money Market Hedge – invest in the money market This is the same idea as covered interest arbitrage. Options Market Hedge Put – pay call option premium to purchase put options for the right to sell foreign currency at strike price

26. Alternative ways of hedging transaction exposure A U.S.–based exporter of US bicycles to Swiss distributors In 6 months receive SF200,000 from an Swiss distributor The spot exchange rate is $0.71 = SF1.00 The 6 month forward rate is $0.71 = SF1.00 The one-year interest rate in Swiss is i SF = 5% The one-year interest rate in US is i $ = 8% Approach one: Using forward contract to hedge on receivable Can hedge this receivable by sell a 6 month forward contract in Swiss Francs. Value in $ (6 month later)= receivable * forward rate = SF200,000 * 0.71 $/ € = $142,000

27. Alternative ways of hedging transaction exposure on Receivable A U.S.–based exporter of US bicycles to Swiss distributors In 6 months receive SF200,000 from an Swiss distributor The spot exchange rate is $0.70 = SF1.00 The 6 month forward rate is $0.71 = SF1.00 The 6 month interest rate in Swiss is i SF = 3% The 6 month interest rate in US is i $ = 2% Approach two: Using money market to hedge on receivable Dollar received today = $135922 = SF194175 * 0.70 $/SF And 6 month later, dollar value = $135922*(1+0.02)=$138640. SF200,000 1.03 SF194175 = Can hedge this receivable by borrowing today and investing SF194175 at 3% in Swiss for 6 months. At maturity, firm will have SF200,000 = SF194175× (1.03) to payback the loan of SF200,000. And firm can convert the proceeds to $ today from borrowed SF200,000 and invest $ in US market. If so,

28. Alternative ways of hedging transaction exposure on receivable Borrowed SF194,175 today @ 3% in foreign market Convert to $ at 0.70 $/SF today: $135,922 Deposit the $135,922 @ 2% in US market due 6 month later- Final value: $138,640. Use the receivable, SF200,000, due 6 month later, to payback the loan of SF194,175

29. Money Market Hedge on receivable With this money market hedge, we have redenominated a 6 month SF200,000 receivable into a $135922 receivable today, or So $135922 is the “locked in” value in dollars today Net exposure to Swiss Francs is zero at the maturity The money market hedge is fully self-financing Question: What are the differences of the two approaches?

30. Options Market Hedge on receivable Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency. To hedge a foreign currency receivable buy puts on the currency.

31. Alternative ways of hedging transaction exposure on receivable A U.S.–based exporter of US bicycles to Swiss distributors In 6 months receive SF200,000 from an Swiss distributor The spot exchange rate is $0.70 = SF1.00 The 6 month forward rate is $0.71 = SF1.00 The 6 month interest rate in Swiss is i SF = 3% The 6 month interest rate in US is i $ = 2% Put option exercise price is $0.72/ SF with premium of $0.02. Approach two: Buy put options to hedge on receivable

32. Alternative ways of hedging transaction exposure on payable Approach three: Buy call options to hedge on receivable Possible outcomes: When 6 month’s spot rate <=$0.72  exercise put option @$0.72  Total value =SF200,000 *($0.72-$0.02)=$140000. When 6 month’s spot rate >$0.72  let go put option and convert at high spot rate  Total value = SF200,000 *(spot rate-$0.02) So, the expected value of using put options = 140000 * 0.3 + 144000*0.4+148000*0.3=$144000

33. 11.5 Contingency Graph for Hedging Receivable with Put Options

34. Alternative ways of hedging transaction exposure on payable Which of the three hedging approaches are the most optimal? We can compare the final value and the highest one is the most optimal. However, the expected value based on put option depends on the forecast (probability) of future exchange rate. What about the final value without any hedge? So, the expected value of cost of no hedging = 142000 * 0.3 + 148000*0.4+152000*0.3=$147400. 8-34

35. 11.4 Graphic Comparison of Techniques to Hedge receivables Refer to Exhibit 11.9 for a review of the Alternatives for hedging on page 324.

36. Cross-Hedging Minor Currency Exposure The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Thai bhat. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.

37. Cross-Hedging Minor Currency Exposure Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated. To hedge Thai bhat, you can hedge Japanese Yen, since Thai bhat and Japanese Yen are highly correlated.