Description
This is a presentation about what is transaction exposure and how should the firm hedge transaction exposure.
Submitted by – Group 4
Managing Transaction Exposure
Transaction Exposure
? Transaction exposure exists when the future cash
transactions of a firm are affected by exchange rate
fluctuations.
? Three major tasks in case of transaction exposure
? Identify the degree: how much
? Decision whether to hedge
? Choose among one of the techniques of hedging
Step 1: Identifying net 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).
? A firm may be able to reduce its transaction exposure
by pricing some of its exports in the same currency as
that needed to pay for its imports.
Step 2: 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.
Step 2: Should the firm hedge
? An exposure to exchange rate movements need not
necessarily be hedged, despite the ease of futures
and forward hedging.
? Based on the firm’s degree of risk aversion, the
hedge-versus-no-hedge decision can be made by
comparing the known result of hedging to the possible
results of remaining unhedged.
Step 2: Should the firm hedge
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
Step 2: Should the firm hedge
? 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.
The Real Cost of Hedging for Each £ in
Payables
Nominal Cost Nominal Cost
Real Cost
Probability With Hedging Without Hedging of
Hedging
5 % $1.40 $1.30 $0.10
10 $1.40 $1.32 $0.08
15 $1.40 $1.34 $0.06
20 $1.40 $1.36 $0.04
20 $1.40 $1.38 $0.02
15 $1.40 $1.40 $0.00
10 $1.40 $1.42 - $0.02
5 $1.40 $1.45 - $0.05
Expected RCH
p
= E P
i
× RCH
i
= $0.0295
The Real Cost of Hedging for Each £ in
Payables
0%
5%
10%
15%
20%
25%
-$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10
P
r
o
b
a
b
i
l
i
t
y
There is a 15% chance that the real cost of
hedging will be negative.
Step 2: Should the firm hedge
? 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
The Real Cost of Hedging British Pounds Over
Time
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
0.4
1975 1980 1985 1990 1995 2000
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
R
C
H
(
r
e
c
e
i
v
a
b
l
e
s
)
R
C
H
(
p
a
y
a
b
l
e
s
)
Step 2: 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.
Step 3: Techniques of hedging
? Hedging techniques include:
? Futures hedge,
? Forward hedge,
? Money market hedge, and
? Currency option hedge.
? MNCs will normally compare the cash flows that could
be expected from each hedging technique before
determining which technique to apply.
Futures hedge
? A futures hedge involves the use of currency futures.
? To hedge future payables, the firm may purchase a
currency futures contract for the currency that it will
be needing.
? To hedge future receivables, the firm may sell a
currency futures contract for the currency that it will
be receiving.
Forward hedge
? A forward hedge differs from a futures hedge in that
forward contracts are used instead of futures contract
to lock in the future exchange rate at which the firm
will buy or sell a currency. To hedge future payables,
the firm may purchase a currency futures contract for
the currency that it will be needing.
? 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.
Forward hedge
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.
Money Market hedge
? This is the same idea as covered interest arbitrage
? 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
Example 1
2. Holds
NZ$995,025
Exchange at
$0.6500/NZ$
1. Borrows
$646,766
Borrows at 8.40%
for 30 days
3. Pays $651,293
3. Receives
NZ$1,000,000
Lends at 6.00% for 30
days
A firm needs to pay NZ$1,000,000 in 30 days.
Effective
exchange rate
$0.6513/NZ$
Example 2
Effective
exchange rate
$0.5489/S$
2. Holds $215,686
Exchange at
$0.5500/S$
1. Borrows
S$392,157
Borrows at 8.00%
for 90 days
3. Pays S$400,000
3. Receives $219,568
Lends at 7.20% for 90
days
A firm expects to receive S$400,000 in 90 days.
Explanation – money market hedge
? 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.
? 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.
? 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.
More examples
The importer of British woolens can hedge his £100 million payable with a
money market hedge:
Borrow $112.05 million in the U.S.
Translate $112.05 million into pounds at the spot rate S($/£) = $1.25/£
Invest £89.64 million in the UK at i
£
= 11.56% for one year.
In one year your investment will have grown to £100 million.
Spot exchange rate S($/£) = $1.25/£
360-day forward rate F
360
($/£) = $1.20/£
U.S. discount rate i
$
= 7.10%
British discount rate i
£
= 11.56%
Explanation
Where do the numbers come from?
We owe our supplier £100 million in one year—so we know that
we need to have an investment with a future value of £100
million. Since i
£
= 11.56% we need to invest £89.64 million at
the start of the year.
How many dollars will it take to acquire £89.64 million at the
start of the year if the spot rate S($/£) = $1.25/£?
1.1156
£100
£89.64=
£1.25
$1.00
£89.64 $112.05 × =
Explanation
? Suppose you want to hedge a payable in the amount
of £y with a maturity of T:
i. Borrow $x at t = 0 on a loan at a rate of i
$
per year.
(Note that $x = £y/(1+ i
£
)
T
at the spot rate.)
ii. Exchange $x for £y/(1+ i
£
)
T
at the prevailing spot rate,
invest
£y/(1+ i
£
)
T
at i
£
for the maturity of the payable to achieve
£y.
? At maturity, you will owe a $x(1 + i
$
).
? Your British investments will have grown enough to
service
your payable and you will have no exposure to the
pound.
Explanation
Suppose you want to hedge a £ receivable in the
amount of £y with a maturity of T:
i. Borrow £y/(1+ i
£
)
T
at t = 0.
ii. Exchange £y/(1+ i
£
)
T
for $x at the prevailing spot
rate.
At maturity, you will owe a $y which can be paid with
your receivable.
You will have no exposure to the dollar-pound exchange
rate.
Currency option hedge
? A currency option hedge involves the use of currency
call or put options to hedge transaction exposure.
? Since options need not be exercised, firms will be
insulated from adverse exchange rate movements,
and may still benefit from favorable movements.
? However, the firm must assess whether the premium
paid is worthwhile.
Currency options hedge (contd.)
? 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.
Using Call Options for Hedging Payables
For each £ :
Nominal Cost Nominal
Cost
Scenario without Hedging with Hedging
= Spot Rate =
Min(Spot,$1.60)+$.04
1 $1.58 $1.62
2 $1.62 $1.64
3 $1.66 $1.64
British Pound Call Option:
Exercise Price = $1.60, Premium = $.04.
Using Put Options for Hedging
Receivables
For each NZ$ :
Nominal Income Nominal Income
Scenario without Hedging with Hedging
= Spot Rate =
Max(Spot,$0.50)- $.03
1 $0.44 $0.47
2 $0.46 $0.47
3 $0.51 $0.48
New Zealand Dollar Put Option:
Exercise Price = $0.50, Premium = $.03.
Comparison between hedging techniques
Hedging Payables Hedging
Receivables
Futures Purchase currency Sell currency
hedge futures contract(s). futures contract(s).
Forward Negotiate forward Negotiate forward
hedge contract to buy
contract to sell
foreign currency. foreign currency.
Money Borrow local Borrow foreign
market currency. Convert currency. Convert
hedge to and then invest to and then invest
in local currency. in foreign currency.
Currency Purchase currency Purchase currency
option call option(s). put option(s).
Comparison (contd.)
? A comparison of hedging techniques should focus on
minimizing payables, or maximizing receivables.
? Note that the cash flows associated with currency
option hedging and remaining unhedged cannot be
determined with certainty.
? In general, hedging policies vary with the MNC
management’s degree of risk aversion and exchange
rate forecasts.
? The hedging policy of an MNC may be to hedge most
of its exposure, none of its exposure, or to selectively
hedge its exposure.
What Risk Management Products do
Firms Use?
? Most U.S. firms meet their exchange risk
management needs with forward, swap, and options
contracts.
? The greater the degree of international involvement,
the greater the firm’s use of foreign exchange risk
management.
Limitations of hedging
? Some international transactions involve an uncertain
amount of foreign currency, such that overhedging
may result.
? One way of avoiding overhedging is to hedge only the
minimum known amount in the future transaction(s).
? 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.
Limitations of Hedging
Time
Forward
Rate
Spot
Rate
Repeated Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Costs are
increasing …
although there are
savings from
hedging.
Hedging long-term transaction exposure
? MNCs that are certain of having cash flows denominated in
foreign currencies for several years may attempt to use long-
term hedging.
? Three commonly used techniques for long-term hedging are:
? long-term forward contracts,
? currency swaps, and
? parallel loans.
? Long-term forward contracts, or long forwards, with maturities
of ten years or more, can be set up for very creditworthy
customers.
? Currency swaps can take many forms. In one form, two
parties, with the aid of brokers, agree to exchange specified
amounts of currencies on specified dates in the future.
? A parallel loan, or back-to-back loan, involves an exchange of
currencies between two parties, with a promise to re-exchange
the currencies at a specified exchange rate and future date.
Hedging long-term transaction exposure
Long-Term Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Year
Spot Rate
Long-Term Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Savings from
hedging
0 1 2 3
1-yr
forward
2-yr
forward
3-yr
forward
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, 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.
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.
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
Alternative hedging techniques
? Sometimes, a perfect hedge is not available (or is too
expensive) to eliminate transaction exposure.
? To reduce exposure under such a condition, the firm
can consider:
? leading and lagging,
? cross-hedging, or
? currency diversification.
Minor currency exposure – cross hedging
? The major currencies are the: U.S. dollar, Canadian
dollar, British pound, French franc, Swiss franc,
Mexican peso, Italian lira, German mark, Japanese
yen, and now the euro.
? Everything else is a minor currency, like the Polish
zloty.
? It is difficult, expensive, or impossible to use financial
contracts to hedge exposure to minor currencies.
? When a currency cannot be hedged, a currency that
is highly correlated with the currency of concern may
be hedged instead.
? The stronger the positive correlation between the
two currencies, the more effective this cross-hedging
strategy will be.
Cross Hedging
? 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.
? An example would be a U.S. importer with liabilities in
Czech koruna hedging with long or short forward
contracts on the euro. If the koruna is expensive when
the euro is expensive, or even if the koruna is cheap
when the euro is expensive it can be a good hedge. But
they need to co-vary in a predictable way.
Leading and lagging
? The act of leading and lagging refers to an adjustment
in the timing of payment request or disbursement to
reflect expectations about future currency
movements.
? Expediting a payment is referred to as leading, while
deferring a payment is termed lagging.
? 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.
Currency diversification
? With currency diversification, the firm diversifies its
business among numerous countries whose
currencies are not highly positively correlated.
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.
Which is a financial subsidiary that nets out the
intrafirm transactions.
? Once the residual exposure is determined, then the
firm implements hedging.
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:
$1
0
$3
5
$40 $30
$2
0
$2
5 $60
$4
0
$1
0
$3
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$40 $30
$2
0
$2
5 $60
$4
0
$1
0
$3
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$40 $30
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$40 $30
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5
$20
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5
$20
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$1
5
$20
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$2
5
$10
$1
5
$2
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$2
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$2
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$2
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$4
0
Exposure Netting: an Example
Clearly, multilateral netting can simplify things greatly.
$1
5
$4
0
Exposure Netting: an Example
Compare this:
$1
0
$3
5
$40 $30
$2
0
$2
5 $60
$4
0
$1
0
$3
0
$2
0 $3
0
Exposure Netting: an Example
With this:
$1
5
$4
0
Impact of Hedging Transaction Exposure
on an MNC’s Value
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Hedging Decisions on
Transaction Exposure
Thank You
doc_645966451.pptx
This is a presentation about what is transaction exposure and how should the firm hedge transaction exposure.
Submitted by – Group 4
Managing Transaction Exposure
Transaction Exposure
? Transaction exposure exists when the future cash
transactions of a firm are affected by exchange rate
fluctuations.
? Three major tasks in case of transaction exposure
? Identify the degree: how much
? Decision whether to hedge
? Choose among one of the techniques of hedging
Step 1: Identifying net 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).
? A firm may be able to reduce its transaction exposure
by pricing some of its exports in the same currency as
that needed to pay for its imports.
Step 2: 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.
Step 2: Should the firm hedge
? An exposure to exchange rate movements need not
necessarily be hedged, despite the ease of futures
and forward hedging.
? Based on the firm’s degree of risk aversion, the
hedge-versus-no-hedge decision can be made by
comparing the known result of hedging to the possible
results of remaining unhedged.
Step 2: Should the firm hedge
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
Step 2: Should the firm hedge
? 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.
The Real Cost of Hedging for Each £ in
Payables
Nominal Cost Nominal Cost
Real Cost
Probability With Hedging Without Hedging of
Hedging
5 % $1.40 $1.30 $0.10
10 $1.40 $1.32 $0.08
15 $1.40 $1.34 $0.06
20 $1.40 $1.36 $0.04
20 $1.40 $1.38 $0.02
15 $1.40 $1.40 $0.00
10 $1.40 $1.42 - $0.02
5 $1.40 $1.45 - $0.05
Expected RCH
p
= E P
i
× RCH
i
= $0.0295
The Real Cost of Hedging for Each £ in
Payables
0%
5%
10%
15%
20%
25%
-$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10
P
r
o
b
a
b
i
l
i
t
y
There is a 15% chance that the real cost of
hedging will be negative.
Step 2: Should the firm hedge
? 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
The Real Cost of Hedging British Pounds Over
Time
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
0.4
1975 1980 1985 1990 1995 2000
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
R
C
H
(
r
e
c
e
i
v
a
b
l
e
s
)
R
C
H
(
p
a
y
a
b
l
e
s
)
Step 2: 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.
Step 3: Techniques of hedging
? Hedging techniques include:
? Futures hedge,
? Forward hedge,
? Money market hedge, and
? Currency option hedge.
? MNCs will normally compare the cash flows that could
be expected from each hedging technique before
determining which technique to apply.
Futures hedge
? A futures hedge involves the use of currency futures.
? To hedge future payables, the firm may purchase a
currency futures contract for the currency that it will
be needing.
? To hedge future receivables, the firm may sell a
currency futures contract for the currency that it will
be receiving.
Forward hedge
? A forward hedge differs from a futures hedge in that
forward contracts are used instead of futures contract
to lock in the future exchange rate at which the firm
will buy or sell a currency. To hedge future payables,
the firm may purchase a currency futures contract for
the currency that it will be needing.
? 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.
Forward hedge
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.
Money Market hedge
? This is the same idea as covered interest arbitrage
? 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
Example 1
2. Holds
NZ$995,025
Exchange at
$0.6500/NZ$
1. Borrows
$646,766
Borrows at 8.40%
for 30 days
3. Pays $651,293
3. Receives
NZ$1,000,000
Lends at 6.00% for 30
days
A firm needs to pay NZ$1,000,000 in 30 days.
Effective
exchange rate
$0.6513/NZ$
Example 2
Effective
exchange rate
$0.5489/S$
2. Holds $215,686
Exchange at
$0.5500/S$
1. Borrows
S$392,157
Borrows at 8.00%
for 90 days
3. Pays S$400,000
3. Receives $219,568
Lends at 7.20% for 90
days
A firm expects to receive S$400,000 in 90 days.
Explanation – money market hedge
? 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.
? 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.
? 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.
More examples
The importer of British woolens can hedge his £100 million payable with a
money market hedge:
Borrow $112.05 million in the U.S.
Translate $112.05 million into pounds at the spot rate S($/£) = $1.25/£
Invest £89.64 million in the UK at i
£
= 11.56% for one year.
In one year your investment will have grown to £100 million.
Spot exchange rate S($/£) = $1.25/£
360-day forward rate F
360
($/£) = $1.20/£
U.S. discount rate i
$
= 7.10%
British discount rate i
£
= 11.56%
Explanation
Where do the numbers come from?
We owe our supplier £100 million in one year—so we know that
we need to have an investment with a future value of £100
million. Since i
£
= 11.56% we need to invest £89.64 million at
the start of the year.
How many dollars will it take to acquire £89.64 million at the
start of the year if the spot rate S($/£) = $1.25/£?
1.1156
£100
£89.64=
£1.25
$1.00
£89.64 $112.05 × =
Explanation
? Suppose you want to hedge a payable in the amount
of £y with a maturity of T:
i. Borrow $x at t = 0 on a loan at a rate of i
$
per year.
(Note that $x = £y/(1+ i
£
)
T
at the spot rate.)
ii. Exchange $x for £y/(1+ i
£
)
T
at the prevailing spot rate,
invest
£y/(1+ i
£
)
T
at i
£
for the maturity of the payable to achieve
£y.
? At maturity, you will owe a $x(1 + i
$
).
? Your British investments will have grown enough to
service
your payable and you will have no exposure to the
pound.
Explanation
Suppose you want to hedge a £ receivable in the
amount of £y with a maturity of T:
i. Borrow £y/(1+ i
£
)
T
at t = 0.
ii. Exchange £y/(1+ i
£
)
T
for $x at the prevailing spot
rate.
At maturity, you will owe a $y which can be paid with
your receivable.
You will have no exposure to the dollar-pound exchange
rate.
Currency option hedge
? A currency option hedge involves the use of currency
call or put options to hedge transaction exposure.
? Since options need not be exercised, firms will be
insulated from adverse exchange rate movements,
and may still benefit from favorable movements.
? However, the firm must assess whether the premium
paid is worthwhile.
Currency options hedge (contd.)
? 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.
Using Call Options for Hedging Payables
For each £ :
Nominal Cost Nominal
Cost
Scenario without Hedging with Hedging
= Spot Rate =
Min(Spot,$1.60)+$.04
1 $1.58 $1.62
2 $1.62 $1.64
3 $1.66 $1.64
British Pound Call Option:
Exercise Price = $1.60, Premium = $.04.
Using Put Options for Hedging
Receivables
For each NZ$ :
Nominal Income Nominal Income
Scenario without Hedging with Hedging
= Spot Rate =
Max(Spot,$0.50)- $.03
1 $0.44 $0.47
2 $0.46 $0.47
3 $0.51 $0.48
New Zealand Dollar Put Option:
Exercise Price = $0.50, Premium = $.03.
Comparison between hedging techniques
Hedging Payables Hedging
Receivables
Futures Purchase currency Sell currency
hedge futures contract(s). futures contract(s).
Forward Negotiate forward Negotiate forward
hedge contract to buy
contract to sell
foreign currency. foreign currency.
Money Borrow local Borrow foreign
market currency. Convert currency. Convert
hedge to and then invest to and then invest
in local currency. in foreign currency.
Currency Purchase currency Purchase currency
option call option(s). put option(s).
Comparison (contd.)
? A comparison of hedging techniques should focus on
minimizing payables, or maximizing receivables.
? Note that the cash flows associated with currency
option hedging and remaining unhedged cannot be
determined with certainty.
? In general, hedging policies vary with the MNC
management’s degree of risk aversion and exchange
rate forecasts.
? The hedging policy of an MNC may be to hedge most
of its exposure, none of its exposure, or to selectively
hedge its exposure.
What Risk Management Products do
Firms Use?
? Most U.S. firms meet their exchange risk
management needs with forward, swap, and options
contracts.
? The greater the degree of international involvement,
the greater the firm’s use of foreign exchange risk
management.
Limitations of hedging
? Some international transactions involve an uncertain
amount of foreign currency, such that overhedging
may result.
? One way of avoiding overhedging is to hedge only the
minimum known amount in the future transaction(s).
? 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.
Limitations of Hedging
Time
Forward
Rate
Spot
Rate
Repeated Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Costs are
increasing …
although there are
savings from
hedging.
Hedging long-term transaction exposure
? MNCs that are certain of having cash flows denominated in
foreign currencies for several years may attempt to use long-
term hedging.
? Three commonly used techniques for long-term hedging are:
? long-term forward contracts,
? currency swaps, and
? parallel loans.
? Long-term forward contracts, or long forwards, with maturities
of ten years or more, can be set up for very creditworthy
customers.
? Currency swaps can take many forms. In one form, two
parties, with the aid of brokers, agree to exchange specified
amounts of currencies on specified dates in the future.
? A parallel loan, or back-to-back loan, involves an exchange of
currencies between two parties, with a promise to re-exchange
the currencies at a specified exchange rate and future date.
Hedging long-term transaction exposure
Long-Term Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Year
Spot Rate
Long-Term Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Savings from
hedging
0 1 2 3
1-yr
forward
2-yr
forward
3-yr
forward
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, 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.
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.
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
Alternative hedging techniques
? Sometimes, a perfect hedge is not available (or is too
expensive) to eliminate transaction exposure.
? To reduce exposure under such a condition, the firm
can consider:
? leading and lagging,
? cross-hedging, or
? currency diversification.
Minor currency exposure – cross hedging
? The major currencies are the: U.S. dollar, Canadian
dollar, British pound, French franc, Swiss franc,
Mexican peso, Italian lira, German mark, Japanese
yen, and now the euro.
? Everything else is a minor currency, like the Polish
zloty.
? It is difficult, expensive, or impossible to use financial
contracts to hedge exposure to minor currencies.
? When a currency cannot be hedged, a currency that
is highly correlated with the currency of concern may
be hedged instead.
? The stronger the positive correlation between the
two currencies, the more effective this cross-hedging
strategy will be.
Cross Hedging
? 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.
? An example would be a U.S. importer with liabilities in
Czech koruna hedging with long or short forward
contracts on the euro. If the koruna is expensive when
the euro is expensive, or even if the koruna is cheap
when the euro is expensive it can be a good hedge. But
they need to co-vary in a predictable way.
Leading and lagging
? The act of leading and lagging refers to an adjustment
in the timing of payment request or disbursement to
reflect expectations about future currency
movements.
? Expediting a payment is referred to as leading, while
deferring a payment is termed lagging.
? 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.
Currency diversification
? With currency diversification, the firm diversifies its
business among numerous countries whose
currencies are not highly positively correlated.
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.
Which is a financial subsidiary that nets out the
intrafirm transactions.
? Once the residual exposure is determined, then the
firm implements hedging.
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:
$1
0
$3
5
$40 $30
$2
0
$2
5 $60
$4
0
$1
0
$3
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$40 $30
$2
0
$2
5 $60
$4
0
$1
0
$3
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$40 $30
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$40 $30
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$2
0 $3
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$1
0
$3
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5 $60
$4
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5
$20
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$2
5
$20
$1
0
$1
0
$1
0
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$2
5
$10
$1
5
$20
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$2
5
$10
$1
5
$2
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$2
0
$1
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$2
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$2
0
$1
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
$1
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$10
$1
5
$3
0
Exposure Netting: an Example
Consider simplifying the bilateral netting with
multilateral netting:
$1
5
$4
0
Exposure Netting: an Example
Clearly, multilateral netting can simplify things greatly.
$1
5
$4
0
Exposure Netting: an Example
Compare this:
$1
0
$3
5
$40 $30
$2
0
$2
5 $60
$4
0
$1
0
$3
0
$2
0 $3
0
Exposure Netting: an Example
With this:
$1
5
$4
0
Impact of Hedging Transaction Exposure
on an MNC’s Value
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Hedging Decisions on
Transaction Exposure
Thank You
doc_645966451.pptx