Measuring and Managing Transaction Exposure

1
Measuring and Managing Transaction Exposure

• (Shapiro Chapter 10)

2
Transaction Exposure

• Arises from changes in the value of past
  contractual obligations in FC (e.g. payables and
  receivables, loans and deposits)
• Example Suppose, on January 1, 2004, Ford is
  awarded a contract to supply trucks to Dutch army
  forces. On December 31, 2004, Ford will receive a
  payment of Euro 25 million for these trucks.You
  have the following capital markets information as
  of January 1, 2004
• Spot US dollar /Euro 1 /Euro
• 1 year US interest rate 2 percent
• 1 year Euro interest rate 4 percent
• 1 year forward rate US dollar/ Euro 0.98 /Euro

3
Without hedging
The value of the cash flow in dollars (domestic
currency) depends on the XR on December 31,
2004. If Euro depreciates against dollar, the
dollar value of the Euro position decreases. Ex
for 0.93 USD/Euro, the value of the expected
cash flow becomes 0.93 x 25m USD
23.25m.Transaction loss 23.25m- (250.98)
m-1.25m If Euro appreciates against dollar, the
dollar value of the Euro position increases. Ex
for 1.05 USD/Euro, the value of the expected
cash flow becomes 1.05 x 25m USD 26.25m.
Transaction gain 26.25m-(250.98)m1.75m
4
Managing Transaction Exposure

• Forward Market Hedge
• Money Market Hedge
• Options Market Hedge
• Hedging Contingent Exposure
• Hedging Through Invoice Currency
• Hedging via Lead and Lag
• Exposure Netting

5
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
Forward Market Hedge

• Our example Ford is expected to receive Euro
  25m. in one year,
• thus it will sell forward Euro 25 m.
• Forward rate 0.98 USD/Euro
• A forward sale of Euro 25 million for delivery in
  one year will yield
• Ford 0.98x25m USD 24.5m

7
Forward Market Hedge an Example

• You are CFO of a U.S. importer of British woolens
  and have just ordered next years 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.
8
Forward Market Hedge
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 blue.
The importer will be better off if the pound
depreciates he still buys 100 m but at an
exchange rate of only 1.20/ he saves 30
million relative to 1.50/
0
Value of 1 in in one year
1.50/
Unhedged payable
But he will be worse off if the pound appreciates.
9
Forward Market Hedge
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.
Long forward
If he agrees to buy 100m in one year at 1.50/
his gain (loss) on the forward are shown in pink.
0
Value of 1 in in one year
1.50/
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.
10
Forward Market Hedge
Long forward
The red line shows the payoff of the hedged
payable. Note that gains on one position are
offset by losses on the other position.
30 m
Hedged payable
0
Value of 1 in in one year
1.50/
1.80/
1.20/
30 m
Unhedged payable
11
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.
• Its more efficient to 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.

12
Money Market Hedge
You, the importer of British woolens can hedge
your 100 million payable with a money market
hedge 1. Borrow 112.05 million in the U.S. 2.
Translate 112.05 million into pounds at the spot
rate S(/) 1.25/ 3. Invest 89.64 million in
the UK at i 11.56 for one year. In one year
the investment will have grown to 100 million.
13
Money Market Hedge
Where do the numbers come from? We owe our
supplier 100 million in one yearso 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/?
14
Money Market Hedge
If we borrow 112.05 million today, one year
later we will owe 120 million
120 112.05(1.071)
With this money market hedge, we have
redenominated our 100 million payable into a
120 million payable.
15
Money Market Hedge Step One

• 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.

16
Money Market Hedge Step Two

• at the prevailing spot rate.

At maturity, you will owe a x(1 i)T. Your
British investments will have grown to y. This
amount will service your payable and you will
have no exposure to the pound.
17
Money Market Hedge
2. Borrow the U.S. dollar value of payable at the
spot rate.
5. At maturity your pound sterling investment
pays your payable. 6. Repay your
dollar-denominated loan with x(1 i)T.
18
Money Market Hedge (Ford Example)

• Calculate the dollar value of the position if
  Ford wish to hedge its transaction exposure in
  the money market market.
• Explain the hedging strategy and present the
  calculations.

19
Money Market Hedge vs Forward Hedge

• If interest rate parity holds, the money market
  and
• forward hedge produce the same domestic
  currency cash flow.
• Why should you use money market hedge?
• the transaction costs in the forward market might
  be very high
• some MNC can get better a interest-rates
  differential

20
Options Market Hedge

• Options provide a flexible hedge against the
  downside, while preserving the upside potential.
• Options are more suitable for hedging when
• -- the company wants to benefit from
  favorable currency
• movements and limit the extent of currency
  loss
• -- the future foreign currency cash flow is
  uncertain (e.g.
• competitive bidding for a construction
  project abroad
• that might not be awarded)
• No free-lunch here hedging with options
  involves upfront premium costs

21
Options Market Hedge

• To hedge an expected foreign currency cash
  outflow (e.g. 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 an expected foreign currency cash inflow
  (e.g. receivable), buy puts on the currency.
• If the currency depreciates, your put option lets
  you sell the currency for the exercise price.

22
Options Market Hedge
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 blue.
The importer will be better off if the pound
depreciates he still buys 100 m but at an
exchange rate of only 1.20/ he saves 30
million relative to 1.50/
0
Value of 1 in in one year
1.50/
Unhedged payable
But he will be worse off if the pound appreciates.
23
Options Market Hedge
Profit
Long call on 100m
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.
5 m
Value of 1 in in one year
1.55 /
1.50/
loss
24
Options Market Hedge
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
5 m
Value of 1 in in one year
1.50/
Unhedged payable
loss
25
Options Market Hedge
If the exchange rate increases to 1.80/ the
importer makes 25 m 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
5 m
Value of 1 in in one year
1.50/
Unhedged payable
loss
26
Hedging certain future cash flows Ford example

• On January 1, 2004, S 1/Euro and F 0.98/Euro
• Suppose Ford purchased a put option on Euro 25m,
  with an exercise price 0.99 /Euro and a one-year
  expiration. The option premium was 0.02/Euro.
  Ford thus paid
• 500,000 (0.02 /Euro X Euro25m).
• The transaction provides Ford with a right, but
  not obligation, to sell Euro 25m for 0.99/Euro,
  regardless of the future spot rate.
• If at the expiration
• S1/Euro put is out-of-the-money. Ford will not
  exercise the option and exchange/sell the Euros
  at S1/Euro.
• Gross proceed Euro 25m X 1/Euro 25m.
• Net proceed Gross proceed cost
  25-0.524.5 m

27
Hedging certain future cash flows Ford example
If at the expiration (2) S0.95/Euro put is
in-the-money. Ford will exercise the option and
exchange/sell the Euros at S0.99/Euro. Gross
proceed Euro 25m X 0.99/Euro 24.75m. Cost
option premium 0.5m Net proceed Gross
proceed -cost 24.75-0.5
24.25 m.
28
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.

29
Hedging Contingent Exposure (Ford Example)

• Suppose Fords bid on the contract was submitted
  on January 1, but the announcement of the winning
  bid would not be known until April 1.
• Ford faces the following dilemma
• If Ford does not hedge, and the bid is selected
  and Euro depreciates, the dollar value of the
  Euro 25 million drops.
• If Ford sells forward the anticipated Euro 25
  million and loses the bid, it will remain with an
  outstanding exposure in the forward market that
  can lead to big losses.
• Thus, the best strategy in this case is for Ford
  to use put options. If the bid is unsuccessful,
  Ford will sell the option.

30
Hedging through Invoice Currency

• Operational technique
• The firm can shift or share
• shift exchange rate risk
• by invoicing foreign sales in home currency
• e.g. Ford can invoice at 25m rather than 25m.
• share exchange rate risk
• by pro-rating the currency of the invoice between
  foreign and home currencies

31
Hedging via Lead and Lag

• Operational technique
• 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.

32
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 its not a perfect hedge, it may be too
  expensive or impractical to hedge each currency
  separately.
• --MNCs centralize their FX exposure

33
Exposure Netting

• Many multinational firms use a reinvoice center -
  a financial subsidiary that nets out the
  intrafirm transactions.
• Once the residual exposure is determined, then
  the firm implements hedging.

34
What Risk Management Products do Firms Use?

• Most U.S. firms meet their exchange risk
  management needs with forward, swap, and options
  contracts.
• -- Forward contracts (93)
• -- Currency swaps (53)
• -- Options (44)
• The greater the degree of international
  involvement, the greater is the firms use of
  foreign exchange risk management.

35
Dayton Manufacturings Transaction Exposure
Scout Finch is the CFO of Dayton, a US-based
manufacturer of gas turbine equipment. He has
just concluded negotiations for the sale of a
turbine generator to Crown, a British firm, for
1 million. This single sale is quite large in
relation to Daytons present business, so
the currency risk of this sale is of particular
concern. The sale is made in March with payment
due three months later in June. Scout has
collected the following financial information
Spot rate 1.764 / 3-month forward rate 1.754
/
36
Dayton Manufacturings Transaction Exposure

• UK 3-month borrowing rate 10 a year
• UK 3-month lending rate 8 a year
• US 3-month borrowing rate 8 a year
• US 3-month lending rate 6 a year
• June put option for 1m strike price 1.75,
  premium 1.5
• Daytons advisory service forecasts that the spot
  rate in 3 months will be 1.76 /
• Calculate the dollar value of the unhedged
  position/receivable in three months. Explain
  your calculations.
• 1.76m.

37
Dayton Manufacturings Transaction Exposure

• 2. Calculate the dollar value of the position if
  Dayton wishes to hedge its transaction exposure
  in the forward market. Explain the hedging
  strategy and calculations.
• 1.754m. Sell forward 1m.
• 3. Calculate the dollar value of the position if
  Dayton wishes to hedge its transaction exposure
  in the money market. Explain the hedging strategy
  and calculations.
• Borrow 975,610 for 3 months change them spot
  for 1,720,976 and invest the at 1.5 for 3
  months

38

• 4. Calculate the dollar value of the position if
  Dayton wishes to hedge its transaction exposure
  in the option market. Explain the hedging
  strategy and calculations. Spot rate in 3 months
  is 1.76 /
• Cost of option 26,460 (no time value) Put
  expires out-of-money
• Net proceeds1,733,540