Chapter Objective:

This chapter discusses various methods available for the management of transaction exposure facing multinational firms.This chapter ties together chapters 4, 5, and 6.

13Chapter Thirteen

Management of Transaction Exposure

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13-2

Chapter Outline Forward (Futures) Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure

13-3

Transaction Exposure: Definition

The potential change in the value of financial positions due to changes in the exchange rate between the inception of a contract and the settlement of the contract.

A special case of economic exposure. But often explored and discussed as a type

of exposure hedging.

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Forward Market Hedge: Imports If you expect to owe foreign currency in the

future, you can hedge by agreeing today to buy the foreign currency in the future at a set price by entering into a long position in a forward contract.

Forward Contract

Counterparty

Importer

Foreign Supplier

Foreign

currencyGoods or

Services

Fore

ign

curr

ency

Domes

tic

Curre

ncy

13-5

Forward Market Hedge: Exports If you are going to receive foreign currency in

the future, you can hedge by agreeing today to sell the foreign currency in the future at a set price by entering into short position in a forward contract.

Forward Contract

Counterparty

Exporter

Foreign Custome

r

Goods or

Services Foreign

CurrencyDom

estic

Curre

ncy

Fore

ign

Curre

ncy

13-6

Importer’s Forward Market Hedge

Forward Contract

Counterparty

U.S. Import

er

Italian Supplie

r

€1,000,000

Shoes

€1,00

0,000$1

,500

,000

A U.S.-based importer of Italian shoes has just ordered next year’s inventory. Payment of €1M is due in one year. If the importer buys €1M at the forward exchange rate of $1.50/€, the cash flows at maturity look like this:

7

Forward Market Hedge

$1.50/€Value of €1 in $

in one year

Suppose the forward exchange rate is $1.50/€.

If he does not hedge the €1m payable, in one year his gain (loss) on the unhedged position is shown in green.

$0

$1.20/€ $1.80/€

–$0.3m

$0.3m

Unhedged payable

The importer will be better off if the euro depreciates: he still buys €1m but at an exchange rate of only $1.20/€ he saves

$0.3 million relative to $1.50/€

But he will be worse off if the pound appreciates.

13-7

8

Forward Market Hedge

$1.50/€Value of €1 in $

in one year$1.80/€

If he agrees to buy €1m in one year at $1.50/€ his gain (loss) on the forward are shown in blue. $0

$0.3m

$1.20/€

–$0.3m

Long forward

If you agree to buy €1 million at a price of $1.50 per pound, you will lose

$0.3 million if the price of the euro falls to $1.20/€.

If you agree to buy €1 million at a price of $1.50/€, you will make $0.3 million if the price of the euro reaches $1.80.

13-8

Forward Market Hedge

$1.50/€Value of €1 in $

in one year$1.80/€

The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position.

$0

$0.3 m

$1.20/€

–$0.3 m

Long forward

Unhedged payable

Hedged payable

13-9

13-10

Exporter’s Futures Market Cross-Currency Hedge

Your firm is a U.K.-based exporter of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer. Payment (in euros) is due in six months. Your firm wants to hedge the receivable into pounds.

CountryU.S. $ equiv.

Currency per U.S. $

Britain (£62,500) $2.0000 £0.5000

1 Month Forward $1.9900 £0.5025

3 Months Forward $1.9800 £0.5051

6 Months Forward $2.0000 £0.5000

12 Months Forward $2.1000 £0.4762

Euro (€125,000) $1.4700 €0.6803

1 Month Forward $1.4800 €0.6757

3 Months Forward $1.4900 €0.6711

6 Months Forward $1.5000 €0.6667

12 Months Forward $1.5100 €0.6623

Sizes of forwards on this exchange are £62,500 and €125,000.

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The exporter has to convert the €750,000 receivable first into dollars and then into pounds.

If we sell the €750,000 receivable forward at the six-month forward rate of $1.50/€, we can do this with a SHORT position in 6 six-month euro futures contracts.

6 contracts = €750,000

€125,000/contract Selling the €750,000 forward at the six-month forward

rate of $1.50/€ generates $1,125,000:$1,125,000 = €750,000 ×

€1

$1.50

At the six-month forward exchange rate of $2/£, $1,125,000 will buy £562,500. We can secure this trade with a LONG position in 9 six-month pound futures contracts: 9 contracts =

£562,500

£62,500/contract

Exporter’s Futures Market Cross-Currency Hedge

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Exporter’s Futures Market Cross-Currency Hedge: Cash Flows at

Maturity

Exporter Customer€750,000

€750,000

$1,125,000

Short position in 6 six-month euro futures on

€125,000at $1.50/€1

Long position in 9 six-month pound futures on £62,500 at

$2.00/£1

Bicycles

$1,125,000

£562,500

13-13

Importer’s Money Market Hedge This is the same idea as covered interest

arbitrage. To hedge a foreign currency payable, buy

the present value of that foreign currency payable today and put it in the bank at interest.– Buy the present value of the foreign

currency payable today at the spot exchange rate.

– Invest that amount at the foreign rate.– At maturity your investment will have

grown enough to cover your foreign currency payable.

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Importer’s Money Market HedgeA U.S.–based importer of Italian bicycles owes €100,000 to an Italian supplier in one year.– The spot exchange rate is $1.50 =

€1.00.– The one-year interest rate in Italy is i€ =

4%.– The importer can hedge this payable by

buying

and investing €96,153.85 at 4% in Italy for one year. At maturity, he will have €100,000 = €96,153.85 × (1.04).

$1.50€1.00Dollar cost today = $144,230.77 = €96,153.85 ×

€100,0001.04€96,153.85 =

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Importer’s Money Market Hedge

$148,557.69 = $144,230.77 × (1.03)

With this money market hedge, we have redenominated a one-year €100,000 payable into a $144,230.77 payable due today.

If the U.S. interest rate is i$ = 3%, we could borrow the $144,230.77 today and owe $148,557.69 in one year.

$148,557.69 =€100,000(1+ i€)T (1+ i$)T×S($/€)×

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$144,230.77

Importer’s Money Market Hedge: Cash Flows Now and at Maturity

Importer

Supplier

bicycles

Spot Foreign Exchange

Market

€100,000

$144,230.77

€96,153.85

U.S Bank$1

48,5

57.6

9

Italia Bank

€100,000

T= 1 cash

flows

deposit i€ = 4%

€96,153.85

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$119,047.62

Exporter’s Money Market Hedge

Exporter

Customer

shoes

Spot Foreign Exchange

Market€100,000

$119,047.62

€95,238.10

U.S Bank$1

27,5

00.0

0

Crédit Agricole

€100,000

T= 1 cash

flows

deposit i$ = 7.10%

€95,238.10Borrow i€ = 5%

An American exporter has just sold €100,000 worth of shoes to a French customer. Payment is due in one year.Interest rates in dollars are 7.10 percent in the U.S. and 5 percent in the euro zone.The spot exchange rate is $1.25/€1.00. Use a money market hedge to eliminate the exporter’s exchange rate risk.

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Importer’s Money Market Cross-Currency Hedge

Your firm is a U.K.-based importer of bicycles. You have bought €750,000 worth of bicycles from an Italian firm. Payment (in euros) is due in one year. Your firm wants to hedge the payable into pounds.

– Spot exchange rates are $2/£ and $1.55/€

– The interest rates are 3% in €, 6% in $ and 4% in £, all quoted as an APR.

What should you do to redenominate this 1-year €-denominated payable into a £-denominated payable with a 1-year maturity?

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Sell pounds for dollars at spot exchange rate, buy euro at spot exchange rate with the dollars, invest in the euro zone for one year at i€ = 3%, all such that the future value of the investment equals €750,000. Using the numbers we have:

– Step 1: Borrow £564,320.39 at i£ = 4%.– Step 2: Sell pounds for dollars, receive

$1,128,640.78.– Step 3: Buy euro with the dollars, receive

€728,155.34.– Step 4: Invest in the euro zone for 12 months at

3% APR (the future value of the investment equals €750,000).

– Step 5: Repay your borrowing with £586,893.20.

(see next slide for where the numbers come from)

Importer’s Money Market Cross-Currency Hedge

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Where Do the Numbers Come From?

£586,893.20 = £564,320.39 × (1.04)

€728,155.34 =€750,000

(1.03)

= $1,128,640.78 = €728,155.34 × €1

$1.55

£564,320.39 = $1,128,640.78 × $2£1

The present value of the euro payable =

The dollar cost of buying the present value of the

euro payable today

Cost today in pounds of the present dollar value of the

euro payable

FV in pounds of the cost in pounds of being able to pay

the supplier €750,000

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Importer’s Money Market Cross-Currency Hedge: Cash Flows Now and

at Maturity

Importer

Supplier

bicycles

Spot Foreign Exchange

Market €750,000

£564,320.39

$1,128,640.77

Spot Foreign Exchange

Market

$1,128,640.77

€728,155.34 €728,155.34 deposit i€ = 3%

U.K Bank

£564,320.39 £586

,893

.20

Italia Bank

€750,000

T= 1 cash

flows

Options Market Hedge

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.

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Options Market Hedge

$1.50/€Value of €1 in $

in one year

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 green.

$0

$1.20/€ $1.80/€

–$30m

$30m

Unhedged payable

The importer will be better off if the euro depreciates: he still buys €100m but at an exchange rate of

only $1.20/€ he saves $30 million relative to $1.50/€

But he will be worse off if the euro appreciates.

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Options Markets Hedge

Profit

loss

–$5m$1.55/€

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 euro for the call.

$1.50/€

Value of €1 in $ in one year

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Value of €1 in $ in one year

Options Markets Hedge

Profit

loss

–$5m

$1.45 /€

Long call on €100m

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.

$1.50/€ Unhedged payable

$1.20/€

$25m

13-25

–$30 m

$1.80/€Value of €1 in $

in one year

Options Markets Hedge

Profit

loss

–$5 m

$1.45/€

Long call on €100m

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.

$1.50/€ Unhedged payable

$25 m

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Options Markets Hedge X

IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS. If the price of the currency goes

up, his call will lock in an upper limit on the dollar cost of his imports.

If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.

EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS. If the price of the currency goes down,

puts will lock in a lower limit on the dollar value of his exports.

If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.

With an exercise price denominated in local currency

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Hedging Exports with Put Options Show the portfolio payoff of an exporter who

is owed £1 million in one year. The current one-year forward rate is £1 = $2. Instead of entering into a short forward

contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2. The cost of this option is $0.05 per pound.

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29

S($/£)360

–$2m

$2

Long

receiv

able Long put

$1,950,000

–$50k

Options Market Hedge:Exporter buys a put option to protect the dollar value of his receivable.

–$50k

$2.05

Hedge

d rec

eivab

le13-29

30

S($/£)360

$2

The exporter who buys a put option to protect the dollar value of his receivable

–$50k

$2.05

Hedge

d rec

eivab

le

has essentially purchased a call.

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Hedging Imports with Call Options

Show the portfolio payoff of an importer who owes £1 million in one year.

The current one-year forward rate is £1 = $1.80; but instead of entering into a long forward contract,

He buys a call option written on £1 million with an expiry of one year and a strike of £1 = $1.80 The cost of this option is $0.08 per pound.

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32LOSS(TOTAL)

GAIN(TOTAL)

S($/£)360

Long currency forward

Accounts Payable = Short Currency position

Forward Market Hedge:Importer buys £1m forward.

This forward hedge fixes the dollar value

of the payable at $1.80m.

$1.80

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33

$1.8m

S($/£)360

$1.80

Unhedged obligation

Call

–$80k

$1.88

$1,720,000

$1.72

Call option limits the potential cost of

servicing the payable.

Options Market Hedge:Importer buys call option on £1m.

13-33

34

S($/£)360

$1.80

$1,720,000

$1.72

Our importer who buys a call to protect himself from increases in the value of the pound creates a synthetic put option on the pound.

He makes money if the pound falls in value.

–$80k

The cost of this “insurance policy” is $80,000

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Taking it to the Next Level X

Suppose our importer can absorb “small” amounts of exchange rate risk, but his competitive position will suffer with big movements in the exchange rate. Large dollar depreciations increase the cost of his

imports Large dollar appreciations increase the foreign

currency cost of his competitors exports, costing him customers as his competitors renew their focus on the domestic market.

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36

Our Importer Buys a Second Call Option X

S($/£)360

$1.80

$1,720,000

$1.72

–$80k

This position is called a straddle

$1.64 $1.96

$1,640,000

–$160k

2ndCall

$1.88

Importers synthetic put

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37

XS($/£)360

$1.80

$1,720,000

$1.72

Suppose instead that our importer is willing to risk large exchange rate changes but wants to

profit from small changes in the exchange rate, he could lay on a butterfly spread.

–$80k

A butterfly spread is analogous to an interest rate collar; indeed it’s sometimes called a zero-cost collar. Selling the 2 puts comes close to offsetting the cost of buying the other 2 puts.

$2 buy a put $2 strike

butterfly spread

Sell 2 puts $1.90 strike.

$1.90Importers synthetic put

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Options

A motivated financial engineer can create almost any risk-return profile that a company might wish to consider.

Straddles and butterfly spreads are quite common. Notice that the butterfly spread costs our importer

quite a bit less than a naïve strategy of buying call options.

13-38