Chapter 8 Outline Transaction exposure Should the Firm Hedge? Contractual hedge Risk Management in practice 1 / 51
Transaction exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. Foreign exchange transaction exposure can be managed by contractual hedges. The main contractual hedges employ the forward, money, futures, and options markets 2 / 51
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Should the Firm Hedge? Opponents of hedging state (among other things): 1 Shareholders are much more capable of diversifying currency risk than the management of the firm 2 Currency risk management does not increase the expected cash flows of the firm 3 Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict) 4 Managers cannot outguess the market 4 / 51
Should the Firm Hedge? Proponents of hedging cite: 1 Reduction in risk in future cash flows improves the planning capability of the firm 2 Reduction of risk in future cash flows reduces the likelihood that the firm s cash flows will fall below a necessary minimum (the point of financial distress) 3 Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm 4 Management is in better position to take advantage of disequilibrium conditions in the market 5 / 51
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. 6 / 51
An Example You are a U.S. importer of British woolens and have just ordered next year s inventory. Payment of 100m is due in one year. Question: How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers 100m in one year a long forward contract on the pound. Suppose the forward exchange rate is $1.50/. If he does not hedge the 100m payable, in one year his gain (loss) on the unhedged position is shown in green. 7 / 51
$30m $0 $30m Value of 1 in $ $1.20/ $1.50/ $1.80/ in one year Unhedged payable 8 / 51
The importer will be better off if the pound depreciates: he still buys 100m but at an exchange rate of only $1.20/ he saves $30 million relative to $1.50/ But he will be worse off if the pound appreciates. If he agrees to buy 100m in one year at $1.50/ his gain (loss) on the forward are shown in blue. 9 / 51
Long forward $30m $0 $30m $1.20/ $1.50/ Value of 1 in $ $1.80/ in one year 10 / 51
If you agree to buy 100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80. If you agree to buy 100 million at a price of $1.50 per pound, you will lose $30 million if the price of a pound is only $1.20 The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. 11 / 51
Long forward $30 m $0 $30 m $1.20/ $1.50/ Hedged payable Value of 1 in $ $1.80/ in one year Unhedged payable 12 / 51
Money Market Hedge This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable. 13 / 51
A U.S.-based importer of Italian bicycles In one year owes e100,000 to an Italian supplier. The spot exchange rate is $1.25 = e1.00 The one-year interest rate in Italy is i e = 4% 14 / 51
Can hedge this payable by buying e96, 153.85 = e100, 000/1.04 today and investing e96,153.85 at 4% in Italy for one year. At maturity, he will have e100, 000 =e96, 153.85 (1.04) Dollar cost today $120, 192.31 =e96, 153.85 e1.00 $1.25 With this money market hedge, we have redenominated a one-year e100, 000 payable into a $120, 192.31 payable due today. If the U.S. interest rate is i $ = 3% we could borrow the $120,192.31 today and owe in one year $123, 798.08 = $120, 192.31 1.03 $123, 798.08 = S ($/e) e100, 000 (1 + i e ) T (1 + i $) T 15 / 51
Payable Suppose you want to hedge a payable in the amount of y with a maturity of T : 1 Borrow $x at t = 0 on a loan at a rate of i $ per year. y $x = S ($/ ) (1 + i ) T Repay the loan in T years $x $x(1 + i $ ) T 0 T 16 / 51
Payable y (1+i ) T 2 Exchange the borrowed $x for at the prevailing spot rate. 3 Invest at i for the maturity of the payable. y (1+i ) T 4 At maturity, you will owe a $x(1 + i $ ) T. 5 Your British investments will have grown to y. 6 This amount will service your payable and you will have no exposure to the pound. 17 / 51
Receivable 1 Calculate the present value of y at i : 2 Borrow this present value at the spot rate. 3 Exchange $x = S ($/ ) y (1+i ) T 4 Invest $x at i $ for T years. y (1+i ) T 5 At maturity your pound sterling receivable pays your pound-denominated loan. 18 / 51
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. 19 / 51
Suppose the forward exchange rate is $1.50/. If an importer who owes 100M does not hedge the payable, in one year his gain (loss) on the unhedged position is shown in green. The importer will be better off if the pound depreciates: he still buys 100m but at an exchange rate of only $1.20/ he saves $30 million relative to $1.50/ But he will be worse off if the pound appreciates. 20 / 51
$30m $0 $30m Value of 1 in $ $1.20/ $1.50/ $1.80/ in one year Unhedged payable 21 / 51
Suppose our importer buys a call option on 100M with an exercise price of $1.50 per pound. He pays $.05 per pound for the call. Profit Long call on 100m $5m $1.55/ $1.50/ Value of 1 in $ in one year loss 22 / 51
The payoff of the portfolio of a call and a payable is shown in red. He can still profit from decreases in the exchange rate below $1.45/ but has a hedge against unfavorable increases in the exchange rate. Profit Long call on 100m $25m $5m $1.20/ $1.45 / Value of 1 in $ in one year loss $1.50/ Unhedged payable 23 / 51
If the exchange rate increases to $1.80/ the importer makes $25m on the call but loses $30 m on the payable for a maximum loss of $5 million. This can be thought of as an insurance premium. Profit Long call on 100m $25 m $5 m $30 m loss $1.45/ Value of 1 in $ $1.80/ in one year $1.50/ Unhedged payable 24 / 51
IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS. If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price. EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS. If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price. 25 / 51
Hedging Exports with Put Options Show the portfolio payoff of an exporter who is owed 1 million in one year. The current one-year forward rate is 1 = $2. Instead of entering into a short forward contract, he buys a put option written on 1 million with a maturity of one year and a strike price of 1 = $2. The cost of this option is $0.05 per pound. Exporter buys a put option to protect the dollar value of his receivable. 26 / 51
$1,950,000 Hedged receivable $50k $2m Long receivable $2 $2.05 S($/ ) 360 Long put 27 / 51
The exporter who buys a put option to protect the dollar value of his receivable has essentially purchased a call. Hedged receivable $50k S($/ ) 360 $2 $2.05 28 / 51
Hedging Imports with Call Options Show the portfolio payoff of an importer who owes 1 million in one year. The current one-year forward rate is 1 = $1.80; but instead of entering into a forward contract, he buys a call option written on 1 million with an expiry of one year and a strike of 1 = $1.80 The cost of this option is $0.08 per pound. Importer buys 1m forward. 29 / 51
GAIN (TOTAL) Long currency forward S($/ ) 360 $1.80 LOSS (TOTAL) Accounts Payable = Short Currency position 30 / 51
This forward hedge fixes the dollar value of the payable at $1.80m. Importer buys call option on 1m. Call option limits the potential cost of servicing the payable. $1.8m $1,720,000 Call $80k $1.80 $1.72 $1.88 Unhedged obligation S($/ ) 360 31 / 51
Our importer who buys a call to protect himself from increases in the value of the pound creates a synthetic put option on the pound. He makes money if the pound falls in value. The cost of this insurance policy is $80,000 32 / 51
$1,720,000 $80k $1.80 $1.72 S($/ ) 360 33 / 51
practice 1 XYZ Corporation, located in the United States, has an accounts payable obligation of 750 million payable in one year to a bank in Tokyo. The current spot rate is 116/$1.00 and the one year forward rate is 109/$1.00. The annual interest rate is 3 percent in Japan and 6 percent in the United States. XYZ can also buy a one-year call option on yen at the strike price of $0.0086 per yen for a premium of 0.012 cent per yen. Assume that the forward rate is the best predictor of the future spot rate. The future dollar cost of meeting this obligation using the option hedge is 34 / 51
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practice 2 A Japanese IMPORTER has a e1,000,000 PAYABLE due in one year. Spot exchange rates 1-year Forward Rates Contract size $1.20 = e1.00 $1.25 = e1.00 e62,500 $1.00 = 100 $1.00 = 120 12,500,000 The one-year risk free rates are i $ = 4.03%; i e = 6.05%; and i = 1%. Detail a strategy using futures contracts that will hedge his exchange rate risk. Have an estimate of how many contracts of what type. 36 / 51
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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. 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. 38 / 51
Cross-Hedging Minor Currency Exposure An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way. 39 / 51
Hedging Contingent Exposure If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if your firm is bidding on a hydroelectric dam project in Canada, and will receive CAD100M if you win the contract You will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options. 40 / 51
Hedging Contingent Exposure Accepted Rejected Do nothing An unhedged long no position sell CAD forward no An unhedged short position buy put option if S < E, if S < E, exercise exercise if S > E, if S > E, let it expire let it expire 41 / 51
Hedging Recurrent Exposure with Swaps Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards. 42 / 51
Hedging through Invoice Currency The firm can shift, share, or diversify: shift exchange rate risk by invoicing foreign sales in home currency share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies diversify exchange rate risk by using a market basket index 43 / 51
Hedging via Lead and Lag If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow. 44 / 51
Exposure Netting A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if it s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately. Many multinational firms use a reinvoice center that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging. 45 / 51
Exposure Netting: an Example Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions: $20 $30 $40 $10 $35 $10 $30 $40 $25 $60 $20 $30 46 / 51
Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $20 $10 $30 $10 $25 $35 $40 $20 $15 $10 $25 $30 $10 $40 $60 $20 $30 $10 47 / 51
Exposure Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $10 $15 $20 $30 $40 $15 $15$25 $10 $10 $10 $10 48 / 51
Should the Firm Hedge? Not everyone agrees that a firm should hedge: Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges. 49 / 51
Should the Firm Hedge? In the presence of market imperfections, the firm should hedge. Information Asymmetry The managers may have better information than the shareholders. Differential Transactions Costs The firm may be able to hedge at better prices than the shareholders. Default Costs Hedging may reduce the firms cost of capital if it reduces the probability of default. Taxes can be a large market imperfection. Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have boom and bust cycles in their earnings stream. 50 / 51
Risk Management in practice Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging. These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures. The remaining portion of the exposure is then selectively hedged on the basis of the firm s risk tolerance, view of exchange rate movements, and confidence level. The greater the degree of international involvement, the greater the firm s use of foreign exchange risk management. 51 / 51