International Financial Management 5

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Chapter 5

Managing Transaction Exposure

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Objectives

A primary objective of the chapter is to provide an overview of hedging techniques . Yet, transaction exposure cannot always be hedged in all cases. Even when it can be hedged, the firm must decide whether a hedge is feasible. While a firm will only know for sure whether hedging is worthwhile after the period of concern, it can incorporate its expectations about future exchange rates, future inflows and outflows, as well as its degree of risk aversion to make hedging decisions. The specific objectives are to:

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Objectives

• identify the commonly used techniques for hedging transaction exposure;

• explain how each technique can be used to hedge future payables and receivables;

• compare the advantages and disadvantages of the identified hedging techniques;

• suggest other methods of reducing exchange rate risk when hedging techniques are not available.

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Transaction Exposure

• Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations.

• When transaction exposure exists, the firm faces three major tasks:

Identify its degree of transaction exposure,Decide whether to hedge its exposure, andChoose among the available hedging techniques if it decides on hedging.

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Identifying Net Transaction 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).• Note that sometimes, 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.

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Techniques to Eliminate Transaction Exposure

• Hedging techniques include:– Futures hedge,– Forward hedge,– Money market hedge, – Currency option hedge.

• MNCs will normally compare the cash flows that

could be expected from each hedging

technique before determining which technique

to apply.

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* 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.

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* 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. • Recall that forward contracts are common for large transactions, while the standardized futures contracts involve smaller amounts.

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• Forward Hedge versus No 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.

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Real cost of hedging payables (RCHp) =nominal cost of payables with hedging

– nominal cost of payables without hedging

Real cost of hedging receivables (RCHr) =nominal home currency revenues received without hedging – nominal home currency revenues received with hedging

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• 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.

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Example:

Durham Co. will need £100,000 in 90 days to pay for

British imports. Today’s 90-day forward rate of the

British pound is $1.40. To assess the future value of

British pound, Durham may develop a probability

distribution, as shown in the following exhibit. This

exhibit can be used to determine the probability that

a forward hedge will be more costly than no hedge. This is achieved by estimating the real cost of hedging

payables.

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Feasibility Analysis for Hedging Possible Nominal Cost Amounts in $ Needed Real Cost Spot Rate of £ of hedging to Buy £100,000 if of hedging in 90 days Probability £100,000 Firm Remains Unhedged £100,000 $1.30 5% $140,000 $1.30*100,000 =$130,000 $10,000 1.32 10 140,000 1.32*100,000 = 132,000 8,000 1.34 15 140,000 1.34*100,000 = 134,000 6,000 1.36 20 140,000 1.36*100,000 = 136,000 4,000 1.38 20 140,000 1.38*100,000 = 138,000 2,000 1.40 15 140,000 1.40*100,000 = 140,000 0 1.42 10 140,000 1.42*100,000 = 142,000 - 2,000 1.45 5 140,000 1.45*100,000 = 145,000 - 5,000

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The date indicate there is a 15% chance that the RCHp will

be negative . Using the information in the exhibit, Durham can estimate the

expected value of the RCHp, which is determined by E(RCHp) = Σ PiRCHi ( where Pi represent the probability that the ith outcome will occur.) = 5%($10,000) + 10%($8,000)+15%($6,000) + 20%($4,000) + 20%($2,000) + 15%(0) + 10%(-$2,000) + 5%(-$5,000) = $500 +$800 +$900 + $800 +$400 +0 – $200 - $250 = $2950. So, Durham may decide not to hedge.

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• 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.

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* Money Market Hedge• 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.

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• 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.

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Example : Ashland ,Inc., needs NZ$1,000,000 in 30 days, and it

can earn 6% annualized (.5% for 30 days) on a New Zealand security over this period. In this case, the amount needed to purchase a New Zealand one-month security is

NZ$1,000,000 1+ .005 Assume that the New Zealand dollar’s spot rate is

$.65, then $646,766 is needed to purchase the New Zealand security (computed as NZ995,025 * $.65). In 30 days, the security will mature and provide NZ$1,000,000 to Ashland, Inc., which can use this money to cover its payables.

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• 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 type of hedging is preferable.

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• 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.

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* 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.

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Example 1:

Clemson Corp. has payables of £100,000 90 days

from now. Assume there is a call option available

with the exercise price of $1.60. Assume that the

option premium is $.04 per unit. Clemson expects the

spot rate of the pound to be either $1.58, $1.62, or

$1.66 when the payables are due. The effect of

each of these scenarios on Clemson’s cost of

payables is shown in the following exhibit.

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Use of Currency Call Options for Hedging British Pound Payables (Exercise Price = $1.60; Premium = $.04) (1) (2) (3) (4) (5) = (4) + (3) (6) Spot Rate Premium Amount Total Amount Paid $ Amount Pai

d When per Unit Paid per per Unit (Including for £100,000 Payables Paid on Unit When the Premium ) When Owing Are Call Owing Call When Owing CallScenario Due Options Options Call Options Options 1 $1.58 $.04 $1.58 $ 1.62 $ 162,000 2 1.62 .04 1.60 1.64 164,000 3 1.66 .04 1.60 1.64 164,000

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Example 2: Knoxville, Inc., transport goods to New Zealand and expects to receive NZ$600,000 in about 90 days. Because it is concerned that the New Zealand dollar may depreciate against the U.S. dollar, Knoxville is considering purchasing put options to cover its ’ receivables. The New Zealand dollar put options considered here have an exercise price of $.50 and a premium of $.03 per unit. Knoxville anticipates that the spot rate in 90 days will be either $.44, $.46, or $.51. The amount to be received as a result of owing currency put options is shown in the following exhibit.

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Use of Currency Put Options for Hedging New Zealand DollarReceivable (Exercise Price = $0.50; Premium = $.03) (1) (2) (3) (4) (5) = (4)-(3) (6) Spot Rate Premium Amount Net Amount $ Amount Received When per Unit Received Received from Hedging

Payment on on Per Unit Per Unit NZ$600,000 Receivables Put When (after Accounting ReceivablesScenario Is Options Owning for Premium with Received Put Options Paid) Put Options 1 $.44 $.03 $.50 $ .47 $ 282,000 2 .46 .03 .50 .47 282,000 3 .51 .03 .51 .48 288,000

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Hedging Payables Hedging Receivables

Futures Purchase currency Sell currencyhedge futures contract(s). futures contract(s).

Forward Negotiate forward Negotiate forwardhedge contract to buy contract to sell

foreign currency. foreign currency.

Money Borrow local Borrow foreignmarket currency. Convert currency. Converthedge to and then invest to and then invest

in foreign currency. in local currency.

Currency Purchase currency Purchase currencyoption call option(s). put option(s)

Summary of Hedging Techniques

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• A comparison of hedging techniques should focus on minimizing payables, or maximizing receivables.

Example: Assume that Fresno Corp. will need £200,000 in

180 days. It considers using (1) a forward hedge, (2) a money market hedge, (3) an option hedge, or (4) no hedge. Its analysts develop the following information, which can be used to assess the alternative solutions:

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* Spot rate of pound = $1.50 * 180-day forward rate of pound = $1.47 Interest rates are as follows: U.K. U.S. 180-day deposit rate 4.5% 4.5% 180-day borrowing rate 5.0% 5.0% * A call option on pounds that expires in 180 days has an exercise price of $1.48 and a premium of $.03 * A put option on pounds that expires in 180 days has an exercise price of $1.49 and a premium of $.02

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Fresno Corp. forecasted the future spot rate in 180 days as follows: Possible Outcome Probability $ 1.43 20% $ 1.46 70% $ 1.52 10%Fresno Corp. then assess the alternative solutions, as shown in the following exhibit. Each alternative is analyzed to estimate the nominal dollar cost of paying for the payables denominated in pound.

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Comparison of Hedging Alternatives for Fresno Corp: Forward Hedge Purchase pounds 180 days forward. Dollar needed in 180 days = payables in £ * forward rate of £ = £200,000* $1.47 = $294,000 Money Market Hedge Borrow $, convert to £, invest £, repay $ loan in 180 days. Amount in £ to be invested = £200,000 / (1 + .045) = £191,388 Amount in $ needed to convert into £ for deposit = £191,388* $1.50 = $287,082

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Interest and principal owed on $ loan after 180 days = $287,082*(1+ .05) = $301,436 Call Option Purchase call option (Exercise price = $.1.48, Premium = $.03) Possible Spot Premium Exercise Total Price Total Price Probability Rate in per Unit Option? (Including Paid for 180 days Paid for Option Premium) £200,000 Option Paid per Unit $ 1.43 $.03 No $1.46 $ 292,000 20% 1.46 .03 No 1.49 298,000 70% 1.52 .03 Yes 1.51 302,000 10%

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Remain Unhedged Purchase £200,000 in the spot market 180 days from now. Future Spot Rate Dollars Needed to Expected in 180 days to Purchase £200,000 Probability

$1.43 $286,000 20% 1.46 292,000 70 1.52 304,000 10

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Conclusion:

A review of this exhibit shows that Fresno

Corp. is likely to perform best if it remains

unhedged, but if it prefers to hedge, it

should choose forward hedge.

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• 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.

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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).

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Limitations of Hedging

• 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.

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Hedging Long-TermTransaction 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.

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• 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.

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• 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.

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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.

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• 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.

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• 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.

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• With currency diversification, the firm diversifies its business among numerous countries whose currencies are not highly positively correlated.

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Questions and Applications

1.Assume that Stevens Point Co. has net

receivables of 100,000 Singapore dollars

in 90 days. The spot rate of the S$ is $.50,

and the Singapore interest rate is 2

percent over 90 days. Suggest how the

U.S. Firm could implement a money

market hedge. Be precise.

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2. Assume that Citadel Co. purchases some goods in Chile that are denominated in Chilean pesos. It also sells goods denominated in U.S. dollars to some firms in Chile. At the end of each

month, it has a large net payables position in Chilean pesos. How can this U.S. firm use an invoicing strategy to reduce this transaction exposure? List any limitations on the effectiveness of this strategy.

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3. Would Montana Co.’s real cost of hedging

Japanese yen receivables have been

positive, negative, or about zero on

average over a period in which the

dollar weakened consistently ? Explain.

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4. Cornell Co. purchases computer chips denominated in euros on a monthly basis from a Dutch supplier. To hedge its exchange rate risk, this U.S. firm negotiates a three-month forward contract three months before the next order will arrive. In other words, Cornell is always covered for the next three monthly

shipments. Because Cornell consistently hedges in this manner, it is not concerned with exchange rate movements.

Is Cornell insulated from exchange rate movements? Explain.

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5. Malibu, Inc., is a U.S. company that imports British goods. It plans to use call options to hedge payables of £100,000 in 90 days. Three call options are available that have an expiration date 90 days from now. Fill in the number of dollars needed to pay for the payables ( including the option premium paid) for each option available under each possible scenario.

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Questions and Applications Spot Rate Exercise Price Exercise Price Exercise Price of Pound = $1.74; = $1.76; = $1.79; 90 days Premium Premium PremiumScenario from Now = $.06 = $.05 = $.03 1 $1.65 2 1.70 3 1.75 4 1.80 5 1.85

If each of the five scenarios had an equal probability of occurrence, which option would you choose? Explain.

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6. a. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in

one year as follows: Future Spot Rate Probability $.61 20% .63 50 .67 30

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Assume that one-year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates: U.S. Singapore Deposit Rate 8% 5% Borrowing Rate 9 6

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Given this information, determine whether

a forward hedge, money market hedge, or

currency option hedge would be most

appropriate. Then, compare the most

appropriate hedge to an unhedged

strategy, and decide whether Carbondale

should hedge its receivables position.

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b. Assume that Baton Rouge, Inc., expects to need S$1 million in one year. Using any relevant information in part(a) of this question, determine whether a forward hedge, money market hedge, or a currency option hedge would be most appropriate. Then, compare the most appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its payables position.