Topic7 Management of Transaction Exposure (1)

Transcription

1 Topic7 Management of Transaction Exposure (1) - Forward Market Hedge - Money Market Hedge

2 Opponents of hedging (1) Stockholders are much more capable of diversifying currency risk than management of the firm. Currency risk management does not add value to the firm. It does, however, use precious resources of the firm, which leads too a net reduction in value. Management often conducts hedging activity that benefits management at the expenses of the stockholder.

3 Opponents of Hedging (2) Managers can t outguess the market. If and when markets are in equilibrium with respect to parity conditions, the expected net present value of the hedging is zero. 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 already factored the foreign exchange effect into a firm s market valuation.

4 Proponents of Hedging Reduction of risk in future cash flows improves the planning capability of the firm. Reduction of risk in future cash flows reduces the likelihood that firm s cash flows will fall below a necessary minimum. Management has a comparative advantage over the individual stockholder in knowing the actual currency risk of the firm. Management is in a better position than stockholders to recognize disequilibrium conditions and to take advantage of one time opportunities to enhance firm value from selective hedging.

5 Mgt of Transaction Exposure When transaction exposure exists, the firm faces three major tasks: - Identify its degree of transaction exposure, - Decide whether to hedge its exposure, and - Choose among the available hedging techniques if it decides on hedging.

6 Identifying Net Transaction Exposure Centralized Approach - A centralized group consolidates subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency for the upcoming period(s).

7 Transaction Exposure Information System (1) Information system should be forward looking. Frequency of reporting needs to be adequate. - Monthly reporting The flow of information should be direct to the treasury rather than being routed via other departments, such as accounting departments,which can create delays.

8 Transaction Exposure Information System (2) The need for information must be sold to management in subsidiary companies Information system should be timely, succinct and oriented to decision and control.

9 Use of Hedging Instruments

10 Forward Market Hedge Foreign currency receipt - Sell forward to lock in home currency receipt Foreign currency payment - Buy forward to lock in home currency cost

11 Techniques to Eliminate Transaction Exposure Real cost of hedging payables (RCH p ) = + nominal cost of payables with hedging nominal cost of payables without hedging Real cost of hedging receivables (RCH r ) = + nominal home currency revenues received without hedging nominal home currency revenues received with hedging

12 Techniques to Eliminate Transaction Exposure If the real cost of hedging is negative, then hedging is more favorable than not hedging. To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate, and then use it to develop a probability distribution for the real cost of hedging.

13 The Real Cost of Hedging for Each in Payables Probability Nominal Cost Nominal Cost Real Cost With Hedging Without Hedging of Hedging 5 % $1.40 $1.30 $ $1.40 $1.32 $ $1.40 $1.34 $ $1.40 $1.36 $ $1.40 $1.38 $ $1.40 $1.40 $ $1.40 $ $ $1.40 $ $0.05 Expected RCH p = P i RCH i = $0.0295

14 Probability The Real Cost of Hedging for Each in Payables 25% 20% 15% 10% 5% 0% -$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10 There is a 15% chance that the real cost of hedging will be negative.

15 Techniques to Eliminate Transaction Exposure If the forward rate is an accurate predictor of the future spot rate, the real cost of hedging will be zero. If the forward rate is an unbiased predictor of the future spot rate, the real cost of hedging will be zero on average.

16 RCH (payables) The Real Cost of Hedging British Pounds Over Time RCH (receivables)

17 Limitations of Hedging In the long run, the continual hedging of repeated transactions may have limited effectiveness. For example, the forward rate often moves in tandem with the spot rate. Thus, an importer who uses one-period forward contracts continually will have to pay increasingly higher prices during a strong-foreign-currency cycle.

18 Limitations of Hedging Repeated Hedging of Foreign Payables when the Foreign Currency is Appreciating Costs are increasing Forward Rate Spot Rate although there are savings from hedging. Time

19 Non-Deliverable Forward Contracts - Principle Doesn t result in actual exchange of the currencies at the future date - No delivery One party to the agreement makes a payment to the other party based on the exchange rate at the future date.

20 Non-Deliverable Forward Contracts - Example US importer buys 100m Settlement date: Jan.22 ( 90days from now) Reference index: s closing rate(in dollars) in London Forex market in 90 days. Reference index now: $1.23/ 90 days later: - $1.3/, the bank will pay $7m to the US importer. - $1.1/, the US importer will pay $13m to the bank.

21 Use of Option forward Uncertain settlement date Continuing stream of foreign currency cash flow Bank s pricing principle - To choose the least favorable price to the customer, or - To choose the most favorable price to itself

22 Use of Option Forward ( Uncertain settlement date) Suppose it is Sep, 28, 2003.A UK exporter exports to a French company.the French company will pay 5m before Dec, 28, 2003.The UK exporter enters a forward option contract with a bank to sell. In London market: Spot rate month forward months forward months forward

23 Use of Option Forward (Continuing stream of fc cash flow) A UK exporter will probably receive $1m in the next year. London: SR: 1= $ month FR 1 = $ months FR 1 12months FR 1 = $

24 Use of Forex Swap (Uncertain settlement date) A UK exporter exports to France. The expected settlement date is uncertain(maybe because delivery date is equally uncertain).the UK exporter takes out a forward contract on 1May,2002 for an arbitrary period of 2 months. So, he sells 5m forward for delivery on 1July,2002. On 20 June,2002, the UK exporter and the French importer agree that the settlement will take place on 1 Aug,2002. On 1 May,2002,the outright exchange rates quote: Spot Rate: 1.423/ /2 1 month forward: 1.387/ month forward: /8 3 month forward: 1.331/ /8 On 20,June,2002, the outright exchange rate quote: Spot rate: days forward: 1/4c--1/2c discount 1 month forward: 1/2c-3/4c discount 42 days forward: 3/4c-1c discount

25 Solutions May 1st : - Sell 2 months 5m June 20:rollover - Buy 11days 5m - Sell 42 days 5m July 1 st - Delivery of two previous forward transactions Aug, 1st : - Take delivery

26 Techniques to Eliminate Transaction Exposure A money market hedge involves taking one or more money market position to cover a transaction exposure. Often, two positions are required. Payables: Borrow in the home currency, and invest in the foreign currency. Receivables: borrow in the foreign currency, and invest in the home currency.

27 Money Market Hedge - Foreign Currency Receivable A US firm expects to receive S$400,000 in 90 days. US dollar interest rate: 7.20% / 7.50%pa Singapore Dollar interest rate : 7.65% / 8.00%pa Spot rate now: $0.5500/S$ If the US firm chooses to use money market hedge, how is the final result?

28 Solution 1. Borrows S$392,157 Borrows at 8.00% for 90 days 3. Pays S$400,000 Exchange at $0.5500/S$ 2. Holds $215,686 Deposits at 7.20% for 90 days Real exchange rate $0.5489/S$ 3. Receives $219,568

29 Money Market Hedge - Foreign Currency Payable A US firm needs to pay NZ$1,000,000 in 30 days. US dollar interest rate :8.10%/8.40%pa NZ$ interest rate: 6.00%/6.30%pa Spot rate now: $0.6500/NZ$ If the US firm chooses to use money market hedge,how is the final result?

30 Solution 1. Borrows $646,766 Borrows at 8.40% for 30 days 3. Pays $651,293 Exchange at $0.6500/NZ$ 2. Holds NZ$995,025 Deposits at 6.00% for 30 days Real exchange rate $0.6513/NZ$ 3. Receives NZ$1,000,000

31 Techniques to Eliminate Transaction Exposure Note that taking just one money market position may be sufficient. A firm that has excess cash need not borrow in the home currency when hedging payables. Similarly, a firm that is in need of cash need not invest in the home currency money market when hedging receivables.

32 Techniques to Eliminate Transaction Exposure For the two examples shown, the known results of money market hedging can be compared with the known results of forward or futures hedging to determine which the type of hedging that is preferable.

33 Techniques to Eliminate Transaction Exposure If interest rate parity (IRP) holds, and transaction costs do not exist, a money market hedge will yield the same result as a forward hedge. This is so because the forward premium on a forward rate reflects the interest rate differential between the two currencies.

34 Prerequisites Developed money market No control in the financial markets