Transaction Exposure

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Transaction Exposure (or chapter 8)
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Agenda

• Types of forex exposures?
• Causes of transaction exposure?
• Pros cons of hedging transaction exposure?
• How to manage transaction exposure?
• Forward Market Hedge
• Money Market Hedge
• Option Market Hedge
• Institutional practices of forex risk management.

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Types of forex exposure

• Forex exposure
• potential change in profitability, net cash flow,
  market value due to change in forex rate.
• Transaction Exposure
• changes in value of outstanding financial
  obligations incurred prior to change in forex,
  not due to settle until after forex change.
• Operating (Economic) Exposure
• change in firm PV resulting from change in
  expected future operating cash flows due to
  unexpected forex change
• Translation (Accounting) Exposure
• accounting-derived changes in owner equity due
  to consolidation in single currency.
• Tax Exposure
• varies by country, general rule only realized
  foreign losses are deductible for calculating
  income taxes

4
Why Hedge? Pros Cons

• Improves planning.
• Reduces likelihood of bankruptcy.
• Management better knows actual risks.
• vs.
• Currency risk management costly, may not increase
  expected cash flows.
• Shareholders more capable diversifying risk.
• Investors already factored forex exposure into
  valuation.
• Conducts hedging to benefit management. ?
• Managers cannot outguess efficient market .
• Management criticized for forex losses but not
  for cost in avoiding forex losses.

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Why Hedge?

• Reduction of risk?
• Increase/decrease in expected cash flow?
• Increase in value?

Net Cash Flow (NCF)
NCF
Expected Cash Flow
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What causes transaction exposure?

• Purchasing or selling on credit.
• Borrowing or lending in foreign currency.
• Being party to unperformed forward contract.
• Acquiring assets/ incurring liabilities in
  foreign currency.

7
Open Account Purchasing/ Selling
Anticipa-tion Exposure
8
Borrowing Lending

• Grupo Embotellador de Mexico (Gemex)
• Dollar debt mid-December, 1994
• 264 m ? PS 3.45/ PS 910,800,000.
• Dollar debt in mid-January, 1995
• 264 m ? PS 5.50/ PS 1,452,000,000 (59 up!)

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How to manage transaction exposure?

• Contractual hedge
• Operating hedges
• Risk-sharing agreements.
• Leads and lags in payment terms.
• Swaps.
• Natural hedge
• Financial hedge
• offsetting debt obligation.
• financial derivative such as swap.

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Hedging Account Receivable

• Suppose October sale for 1,000,000, A/R January.
• Spot 1.764/
• 3m-forward 1.754/ (2.27 discount)
• Cost of capital 12.0 annual
• British 3m borrowing rate 10 annual
• British 3m lending rate 8 annual
• US 3m borrowing rate is 8 annual
• US 3m lending rate is 6 annual
• Jan. put on 1,000,000 w/ strike 1.75/ 1.5
  premium.
• Forecasts 3m future spot 1.76/.
• Budget rate (lowest acceptable amount) 1.70/

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Hedging Account Receivable

• Unhedged position 1,000,000 x 1.76/ 1.76
  m.
• Forward hedge
• Forward contract source of funds to fulfill the
  contract.
• Forward entered _at_ time A/R created (October).
• A/R recorded _at_ spot 1.764/, so 1,764,000.
• Covered (perfect) vs. uncovered (open) forward
  hedge.
• Money market hedge
• creates liability offset w/ asset in balance
  sheet hedge.
• borrow PV of 1,000,000 1,000,000/1.025
  975,610.
• exchange 975,610 at spot 1.764/ for 1,720,976.

1,720,976 Treasury bill 6 annual or
1.5/qtr 1,746,791
1,720,976 Debt cost 8 annual or
2.0/qtr 1,755,396
1,720,976 Cost of capital 12 annual or
3.0/qtr 1,772,605
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Option Market Hedge

• Purchase put option.
• 3 month put option _at_ ATM strike 1.75/, premium
  1.5
• Premium as of Jan 26,460 ? 1.03 27,254.
• Unlimited upside, limited downside.
• Breakeven price, option hedge
• Upper bound
• If pound appreciate above 1.754/ 0.0273/
  1.7813/.
• Lower bound
• If pound depreciates below 1.75/ - 0.0273/
  1.722/.

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A / R Hedges
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Account Payable Hedge

• Assume 1,000,000 A/P in 90 days
• Unhedged position expected pay 1,760,000.
• Forward market hedge purchase forward _at_
  1.754/, cost locked 1,754,000.
• Money market hedge
• Offset obligation by asset w/ matching
  maturity.
• Exchange US spot invest for 90 days in .
• Carry the cost forward 90 days

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Account Payable Hedge

• Option hedge
• purchase call option on payable.
• ATM call option w/ strike 1,75/ would be 1.5
  premium.
• If spot less 1.75/ option expire 1,000,000
  purchased on spot market.
• If spot above 1.75/ option exercised exchange
  1,000,000 _at_ 1.75/ less option premium
• Carried forward 90 days _at_ 12 p.a. premium
  27,254.

Exercise call option (1,000,000 ?
1.75/ 1,750,000 Call premium (carried forward
90 days) 27,254 Total maximum expense of
call option hedge 1,777,254
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A / P Hedges
Call option 1,777,254
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Forex Risk Management for Real

• Goals?
• cost center vs. profit center.
• Exposures?
• backlog exposure?
• selectively hedge backlog anticipated
  exposures?
• Contractual Hedges?
• Amount of risk covered, proportional hedges?
• Currency options?

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Things to remember

• Types of forex exposures
• Transaction
• Operating
• Translation
• Tax
• How to hedge A/R A/P transaction exposure?
• Money market?
• Forward market?
• Option market?