Topic7 Management of Transaction Exposure (1)

- Forward Market Hedge

- Money Market Hedge

Opponents of hedging (1)

Stockholders are much more capable ofdiversifying currency risk than management of thefirm.

Currency risk management does not add value tothe firm. It does, however, use precious resourcesof the firm, which leads too a net reduction in value.

Management often conducts hedging activity thatbenefits management at the expenses of thestockholder.

Opponents of Hedging (2)

• Managers can’t outguess the market. If and whenmarkets are in equilibrium with respect to parityconditions, the expected net present value of thehedging is zero.

• Management’s motivation to reduce variability issometimes driven by accounting reasons.

• Efficient market theorists believe that investors cansee through the accounting veil and thereforealready factored the foreign exchange effect into afirm’s market valuation.

Proponents of Hedging

Reduction of risk in future cash flows improves the planningcapability of the firm.

Reduction of risk in future cash flows reduces the likelihoodthat firm’s cash flows will fall below a necessary minimum.

Management has a comparative advantage over the individualstockholder in knowing the actual currency risk of the firm.

Management is in a better position than stockholders torecognize disequilibrium conditions and to take advantage ofone time opportunities to enhance firm value from selectivehedging.

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

- Identify its degree of transaction exposure,

- Decide whether to hedge its exposure, and

- Choose among the available hedging techniques if it decides on hedging.

Mgt of Transaction Exposure

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).

Transaction Exposure Information System (1)

Information system should be forward looking.

Frequency of reporting needs to be adequate.

- Monthly reporting

The flow of information should be direct to the treasury rather than being routed via other departments, such as accounting departments,which can create delays.

Transaction Exposure Information System (2)

The need for information must be sold to management in subsidiary companies

Information system should be timely, succinct and oriented to decision and control.

Use of Hedging Instruments

Forward Market Hedge

Foreign currency receipt

- Sell forward to lock in home currency receipt

Foreign currency payment

- Buy forward to lock in home currency cost

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

Techniques to Eliminate Transaction Exposure

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.

Techniques to Eliminate Transaction Exposure

Nominal Cost Nominal Cost Real CostProbability With Hedging Without Hedging of Hedging

5 % $1.40 $1.30 $0.10

10 $1.40 $1.32 $0.08

15 $1.40 $1.34 $0.06

20 $1.40 $1.36 $0.04

20 $1.40 $1.38 $0.02

15 $1.40 $1.40 $0.00

10 $1.40 $1.42 - $0.02

5 $1.40 $1.45 - $0.05

Expected RCHp = PiRCHi = $0.0295

The Real Cost of Hedging for Each £in Payables

There is a 15% chance that the real cost of hedging will be negative.

The Real Cost of Hedging for Each £in Payables

0%

5%

10%

15%

20%

25%

-$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10

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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.

Techniques to Eliminate Transaction Exposure

The Real Cost of Hedging British Pounds Over Time

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

0.4

1975 1980 1985 1990 1995 2000

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

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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.

Limitations of Hedging

Time

ForwardRateSpotRate

Repeated Hedging of Foreign Payables

when the Foreign Currency is Appreciating

Costs areincreasing …

although there are savings

from hedging.

Non-Deliverable Forward Contracts- Principle

Doesn’t result in actual exchange of the

currencies at the future date

- No delivery

One party to the agreement makes a payment to the other party based on the exchange rate at the future date.

Non-Deliverable Forward Contracts- Example

US importer buys €100m

Settlement date: Jan.22 ( 90days from now)

Reference index: €’s closing rate(in dollars) in London Forex market in 90 days.

Reference index now: $1.23/€

90 days later:

- $1.3/ €, the bank will pay $7m to the US importer.

- $1.1/ €, the US importer will pay $13m to the bank.

Use of Option forward

Uncertain settlement date

Continuing stream of foreign currency cash flow

Bank’s pricing principle

- To choose the least favorable price to the customer, or

- To choose the most favorable price to itself

Use of Option Forward

( Uncertain settlement date)

Suppose it is Sep, 28, 2003.A UK exporter exports

to a French company.The French company will pay

€5m before Dec, 28, 2003.The UK exporter enters a

forward option contract with a bank to sell €.

In London market:

Spot rate €2.2210 - 2.2310

1 month forward 2.2197 - 2.2272

2 months forward 2.2140 - 2.2186

3 months forward 2.2110 - 2.2135

Use of Option Forward(Continuing stream of fc cash flow)

A UK exporter will probably receive $1m in the next year.

London:

SR: £1= $1.6234-1.6255

1 month FR £1 = $1.6340-1.6369

2 months FR £1……

12months FR £1 = $1.6780-1.6800

Use of Forex Swap(Uncertain settlement date)

A UK exporter exports to France. The expected settlement date is

uncertain(maybe because delivery date is equally uncertain).The UK

exporter takes out a forward contract on 1May,2002 for an arbitrary

period of 2 months. So, he sells €5m forward for delivery on 1July,2002.

On 20 June ,2002, the UK exporter and the French importer agree that

the settlement will take place on 1 Aug,2002.On 1 May,2002,the outright exchange rates quote:

Spot Rate: 1.423/4 -- 1.431/2

1 month forward: 1.387/8 –1.3920

2 month forward: 1.36 -- 1.373/8

3 month forward: 1.331/8 -- 1.345/8

On 20,June,2002, the outright exchange rate quote:

Spot rate: 1.34--1.35

11 days forward: 1/4c--1/2c discount

1 month forward: 1/2c-3/4c discount

42 days forward: 3/4c-1c discount

Solutions

May 1st ：

- Sell 2 months € 5m

June 20：rollover

- Buy 11days €5m

- Sell 42 days €5m

July 1st

- Delivery of two previous forward transactions

Aug, 1st :

- Take delivery

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.

Techniques to Eliminate Transaction Exposure

Money Market Hedge- Foreign Currency Receivable

A US firm expects to receive S$400,000 in 90

days.

US dollar interest rate: 7.20% / 7.50%pa

Singapore Dollar interest rate : 7.65% / 8.00%pa

Spot rate now: $0.5500/S$

If the US firm chooses to use money market

hedge, how is the final result?

Realexchange rate

$0.5489/S$

2. Holds $215,686

Exchange at $0.5500/S$

1. Borrows S$392,157

Borrows at 8.00%for 90 days

3. Pays S$400,000

3. Receives $219,568

Deposits at 7.20% for 90

days

Solution

Money Market Hedge- Foreign Currency Payable

A US firm needs to pay NZ$1,000,000 in 30 days.

US dollar interest rate :8.10%/8.40%pa

NZ$ interest rate: 6.00%/6.30%pa

Spot rate now: $0.6500/NZ$

If the US firm chooses to use money market hedge,how

is the final result?

Solution

Realexchange rate$0.6513/NZ$

2. Holds NZ$995,025

Exchange at $0.6500/NZ$

1. Borrows $646,766

Borrows at 8.40%for 30 days 3. Pays

$651,293

3. Receives NZ$1,000,000

Deposits at 6.00% for 30

days

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.

Techniques to Eliminate Transaction Exposure

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 the type of hedging that is preferable.

Techniques to Eliminate Transaction Exposure

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.

Techniques to Eliminate Transaction Exposure

Prerequisites

Developed money market

No control in the financial markets