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CHAPTER TEN
MANAGEMENT OF
COMPARISON OF OCCURRENCE TIME OF THE THREE FOREIGN EXCHANGE EXPOSURES ON THE TIME LINE
Time point when the exchange rate changes
TRANSACTION EXPOSURE
Translation exposure
Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates
Operating exposure
Change in expected future cash flows for following years arising from an unexpected change in exchange rates
Transaction exposure
Impact of settling existing obligations, which entered into before changes in exchange rates but to be settled after changes in exchange rates
Time
TYPES OF FOREIGN EXCHANGE EXPOSURE
There are three types of exposures: 1. Transaction exposure
2. Translation exposure
3. Operation exposure
SHOULD THE FIRM HEDGE?
• Not everyone agrees that a firm should hedge:
– Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves.
– Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.
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SHOULD THE FIRM HEDGE? WHY HEDGE?
• In the presence of market imperfections, the firm should hedge.
– Information Asymmetry
• The managers may have better information than the shareholders.
– Differential Transactions Costs
• The firm may be able to hedge at better prices than the shareholders.
– Default Costs
• Hedging may reduce the firms cost of capital if it reduces the probability of default.
• Taxes can be a large market imperfection.
– Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have “boom and bust” cycles in their earnings stream.
• What is to be gained by the firm from hedging?
– The major motive for firms to hedge is to increase the present value of firms
– The value of a firm, according to financial theories, is the present value of all expected future cash flows in the future
– For expected cash flows with higher uncertainty (or risk), a higher discount rate should be applied to calculating the present value and thus a lower present value for these cash flows is generated
– A firm that hedges these foreign exchange exposures reduces the variance (or risk) in the value of future expected cash flows (see Exhibit 10.1 on the next slide)
– Thus, a lower discount rate is employed to calculate the present value of expected future cash flows, which implies the increase of the present value of the firm
WHAT RISK MANAGEMENT PRODUCTS DO FIRMS USE?
EXHIBIT 10.1 IMPACT OF HEDGING ON THE EXPECTED CASH FLOWS OF THE FIRM
• Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts.
• The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.
※Hedging will not increase the expected value for a cash flow. Actually, if taking the hedging cost into account, hedge transactions will decrease the expected cash flow
※Hedging reduces the variability of future cash flows about the expected value of the distribution. This reduction of distribution variance is a reduction of risk
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MANAGEMENTOFTRANSACTION EXPOSURE MANAGEMENT OF TRANSACTION EXPOSURE
Various methods available for the management of transaction exposure facing multinational firms.
• Forward Market Hedge • Money Market Hedge
• Options Market Hedge
• A financial hedge refers to either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap
– To eliminate the transaction exposure, firms can borrow foreign currencies today to prepare for the settlement of A/Rs in foreign currencies in the future
• Cross-Hedging Minor Currency Exposure • Hedging Contingent Exposure
• Hedging Recurrent Exposure with Swap Contracts • Hedging Through Invoice Currency
• Hedging via Lead and Lag
• Exposure Netting
– Due to the borrowing activities, this kind of hedge is classified as financial hedge
• Contractual hedges employ the forward, futures, and options contracts to hedge transaction exposures
• The Trident case as follows illustrates how contractual and financial hedging techniques may be used to protect against transaction exposure
MANAGEMENT OF TRANSACTION EXPOSURE FORWARD MARKET HEDGE
• Transaction exposure can be managed by operating, financial, and contractual hedges
• The term operating hedge refers to an off-setting operating cash flow arising form the conduct of business
– For example, the payments in a foreign currency could be offset by the foreign currency cash inflow generated from operating activities, e.g., from sales. This kind of hedge for the transaction exposure is also termed natural hedge
– Operating hedge could also employ the use of risk-sharing agreements, leads and lags in payment terms, and other strategies
• If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract.
• If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.
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FORWARD MARKET HEDGE: AN EXAMPLE FORWARD MARKET HEDGE
You are a U.S. importer of Italian shoes and have just ordered next year’s inventory. Payment of €100M is due in one year.
Question: How can you fix the cash outflow in dollars?
If he agrees to buy €100m in one year at $1.50/€ his gain
(loss) on the
forward are shown $30m
in blue.
If you agree to buy €100 million at a price of $1.50/€, you will make $30 million if the price of the euro reaches $1.80.
Long forward
$0
$1.20/€ $1.50/€ $1.80/€
Value of €1 in $ in one year
–$30m If you agree to buy €100 million at a price of $1.50 per pound, you will lose $30 million if the
price of the euro falls to $1.20/€.
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FORWARD MARKET HEDGE FORWARD MARKET HEDGE
Suppose the forward exchange rate is $1.50/€.
If he does not hedge the €100m payable, in one year
his gain (loss) on the $30m unhedged position is shown in green.
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/€
The red line shows the payoff of the hedged payable.
Note that gains on
one position are $30 m
offset by losses on
Long forward
$0
$1.20/€ $1.50/€ $1.80/€
Value of €1 in $ in one year
the other position.
$0
Hedged payable
Value of €1 in $ $1.20/€ $1.50/€ $1.80/€ in one year
–$30m
But he will be worse off if the pound appreciates.
Unhedged payable
14
–$30 m
Unhedged payable
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FUTURES MARKET CROSS-CURRENCY HEDGE FUTURES MARKET CROSS-CURRENCY HEDGE: STEP TWO
Your firm is a U.K.-based exporter of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer. Payment (in euro) is due in six months. Your firm wants to hedge the receivable into pounds.
Sizes of contracts are shown.
Country
Britain (£62,500)
1 Month Forward
3 Months Forward
6 Months Forward
12 Months Forward
Euro (€125,000)
1 Month Forward
U.S. $ equiv.
$2.0000
$1.9900
$1.9800
$2.0000
$2.1000
$1.4700
$1.4800
Currency per U.S. $
£0.5000
£0.5025
£0.5051
£0.5000
£0.4762
€0.6803
€0.6757
• Selling the €750,000 forward at the six-month forward rate of $1.50/€ generates $1,125,000:
$1,125,000 = €750,000 × $1.50
o At the six-month forward exchange rate of $2/£, $1,125,000 will buy £562,500.
o Or we can secure this trade with a LONG position in 9 six-month pound futures contracts:
3 Months Forward
6 Months Forward
12 Months Forward
$1.4900
$1.5000
$1.5100
€0.6711
€0.6667 9 contracts = €0.6623
£562,500
£62,500/contract
FUTURES MARKET CROSS-CURRENCY HEDGE: STEP ONE
• You have 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/€. Or we can do this with a SHORT position in 6 six-month euro futures contracts.
MONEY MARKET HEDGE
• This is the same idea as covered interest arbitrage.
• To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it.
– Buy the present value of the foreign currency payable today.
– Invest that amount at the foreign rate.
– At maturity your investment will have grown enough
6 contracts =
€750,000 to cover your foreign currency payable. €125,000/contract
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