Chapter 14 Transaction Exposure to Currency Risk

1
Chapter 14Transaction Exposure to Currency Risk

• 14.1 An Example of Transaction Exposure to
  Currency Risk
• 14.2 Managing Transaction Exposure Internally
• Multinational netting
• Leading and lagging
• 14.3 Managing Transaction Exposure in the
  Financial Markets
• Currency forwards
• Currency futures
• Money market hedges
• Currency options
• Currency swaps
• 14.4 Summary

2
Economic exposure to currency risk

• Economic exposure Û change in firm value due to
  unexpected changes in exchange rates
• Transaction exposure
• change in the value of contractual cash flows
• change in the value of monetary assets and
  liabilities
• Operating exposure
• change in the value of noncontractual cash flows
• change in the value of real assets

Monetary assets
Monetary liabilities
Real assets
Common equity
3
A survey of corporate treasurers

• Do you agree or disagree with the following
  statements?
• Mean score
• Managing transaction exposure is
  important. 1.4
• Managing economic exposure is important. 1.8
• Managing translation exposure is
  important. 2.4
• Key 1 strongly agree, ... 3neutral, ... 5
  strongly disagree
• Source Kurt Jesswein, Chuck C.Y. Kwok, William
  R. Folks, Jr., Adoption of Innovative Products
  in Currency Risk Management Effects of
  Management Orientations and Product
  Characteristics, Journal of Applied Corporate
  Finance, Fall 1995.
• Transaction exposure is viewed as the most
  important currency risk exposure

4
Currency risk versus currency risk exposure
Rd/f
Currency risk exposure
sd/f
Currency risk
sd/f
5
Exposure to foreign exchange risk(contract price
FF40,000)
FF40,000 Û 10,000 at 0.25/FF

• Expected receipt in francs
• at ES1/FF 0.25/FF
• Actual exchange
• S1/FF 0.20/FF
• Net loss from
• original position
• Risk (or payoff) profile
• of underlying exposure

FF40,000 Û 8,000 at 0.20/FF
-2,000
DV/FF
-0.05/FF
DS/FF
-0.05/FF
6
Currency hedging with forwards(contract price
FF40,000)

• Buy 10,000 forward 10,000
• at F1/FF 0.25/FF
• Sell FF40,000 forward -FF40,000
• Market exchange of FF 8,000
• for at S1/FF 0.20/FF
• -FF40,000
• Net gain on forward 2,000
• Risk (or payoff) profile
• of forward contract

DV/FF
0.05/FF
DS/FF
-0.05/FF
7
Net currency exposure

• Underlying position
• (long francs)
• Sell francs forward
• (short francs and long dollars)
• Net position
• Net exposure

FF40,000
10,000
-FF40,000
10,000
DV/FF
long francs
short francs
DS/FF
8
Managing transaction exposure

• Managing transaction exposure internally
• leading and lagging
• currency diversification and multinational
  netting
• Managing transaction exposure in financial
  markets
• currency forwards
• money market hedges
• futures
• options
• swaps

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Multinational netting
10
Cash flows before multinational netting
11
Cash flows after multinational netting
12
Leading and lagging

• Timing of cash flows within the corporation to
  offset underlying currency exposures.
• Leading - If a U.S. parent is short euros, the
  parent can accelerate euro repatriations from its
  European affiliates.
• Lagging - If a U.S. parent is long euros, the
  parent can accelerate euro payments to its
  European affiliates.
• Like multinational netting, leading and lagging
  works best when the currency needs of the
  individual units within the corporation offset
  one another.

13
Financial market instrumentsused to hedge
currency risk

• Currency forward contracts
• Advantages
• Currency forwards can provide a perfect hedge of
  transactions of known size and timing
• Disadvantages
• Bid-ask spreads can be large on long-dated
  contracts or infrequently traded currencies
• A pure credit instrument, so currency forward
  contracts have credit risk

14
Financial market instrumentsused to hedge
currency risk

• Currency futures contracts
• Advantages
• Low cost if the currency and maturity match the
  underlying exposure
• Low credit risk because of daily
  marking-to-market
• Disadvantages
• Exchange-traded futures come in limited
  currencies and maturities
• Daily marking-to-market can cause a cash flow
  mismatch

15
Financial market instrumentsused to hedge
currency risk

• Money market hedges
• Advantages
• Forward positions can be built in currencies for
  which there are no forward currency markets
• Disadvantages
• Relatively expensive hedge
• Might not be feasible if there are contraints on
  borrowing or lending

16
Financial market instrumentsused to hedge
currency risk

• Currency option contracts
• Advantages
• Disaster hedge insures against unfavorable
  currency movements
• Disadvantages
• Option premiums reflect option values, so option
  hedges can be expensive in volatile currencies
  and at distant expiration dates

17
Financial market instrumentsused to hedge
currency risk

• Currency swap contracts
• Advantages
• Quickly transforms liabilities into other
  currencies or payout structures (e.g., fixed vs.
  floating)
• Low cost for plain vanilla swaps in actively
  traded currencies
• Able to hedge long-term exposures
• Disadvantages
• Not the best choice for near-term exposures
• Innovative or exotic swaps can be expensive

18
Corporate use of currency risk management products

• Used Used Used once Never
• Type of product often sometimes or twice heard of
• Forward contracts 72.3 17.9 2.9 0.0
• Foreign currency swaps 16.4 17.0 19.3 1.2
• OTC currency options 18.8 19.4 10.6 6.5
• Currency futures contracts 4.1 10.7 5.3 1.2
• Exchange-traded
• currency (spot) options 3.6 6.5 7.1 3.6
• Exchange-traded
• futures options 1.8 3.0 4.2 4.2
• Foreign currency warrants 1.8 1.2 1.2 22.3
• Cylinder options 7.0 9.9 11.7 8.8
• Synthetic forwards 3.0 8.9 10.1 12.5
• Source Jesswein, Kwok, and Folks, What New
  Currency Risk Products Are Companies Using and
  Why? Journal of Applied Corporate Finance 8,
  Fall 1995, pages 115-124.