Transaction Exposure (or chapter 8)

Agenda Types of forex exposures? Causes of transaction exposure? Pros & cons of hedging transaction exposure? How to manage transaction exposure? Forward Market Hedge Money Market Hedge Option Market Hedge Institutional practices of forex risk management.

Types of forex exposure potential change in profitability, net cash flow, market value due to change in forex rate. Transaction Exposure changes in value of outstanding financial obligations incurred prior to change in forex, not due to settle until after forex change. Operating (Economic) Exposure change in firm PV resulting from change in expected future operating cash flows due to unexpected forex change Translation (Accounting) Exposure accounting-derived changes in owner equity due to consolidation in single currency. Tax Exposure varies by country, general rule only realized foreign losses are deductible for calculating income taxes

Why Hedge? Pros & Cons… Improves planning. Reduces likelihood of bankruptcy. Management better knows actual risks. vs. Currency risk management costly, may not increase expected cash flows. Shareholders more capable diversifying risk. Investors already factored forex exposure into valuation. Conducts hedging to benefit management.  Managers cannot outguess efficient market . Management criticized for forex losses but not for cost in avoiding forex losses.

Why Hedge? Hedged Unhedged NCF Net Cash Flow (NCF) Expected Cash Flow Reduction of risk? Increase/decrease in expected cash flow? Increase in value? Unhedged NCF Net Cash Flow (NCF) Expected Cash Flow

What causes transaction exposure? Purchasing or selling on credit. Borrowing or lending in foreign currency. Being party to unperformed forward contract. Acquiring assets/ incurring liabilities in foreign currency.

Open Account Purchasing/ Selling Seller quotes price t1 Buyer places order t2 Seller ships product t3 Buyer settles A/R t4 Quotation Exposure Time b/n quoting price & reaching sale. Backlog Exposure Contract Signed. Time to fill order. Billing Exposure Time to get paid. Anticipa-tion Exposure

Borrowing &Lending Grupo Embotellador de Mexico (Gemex) Dollar debt mid-December, 1994: $ 264 m  PS 3.45/$ = PS 910,800,000. Dollar debt in mid-January, 1995: $ 264 m  PS 5.50/$ = PS 1,452,000,000 (59% up!)

How to manage transaction exposure? Contractual hedge Operating hedges Risk-sharing agreements. Leads and lags in payment terms. Swaps. Natural hedge Financial hedge offsetting debt obligation. financial derivative such as swap.

Hedging Account Receivable Suppose October sale for £1,000,000, A/R January. Spot $1.764/£ 3m-forward $1.754/£ (2.27% discount) Cost of capital 12.0% annual British 3m borrowing rate 10% annual British 3m lending rate 8% annual US 3m borrowing rate is 8% annual US 3m lending rate is 6% annual Jan. put on £1,000,000 w/ strike $1.75/£; 1.5% premium. Forecasts 3m future spot $1.76/£. Budget rate (lowest acceptable amount) $1.70/£

Hedging Account Receivable Unhedged position: £1,000,000 x $1.76/£ = $1.76 m. Forward hedge: Forward contract & source of funds to fulfill the contract. Forward entered @ time A/R created (October). A/R recorded @ spot $1.764/£, so $1,764,000. Covered (perfect) vs. uncovered (open) forward hedge. Money market hedge: creates liability offset w/ asset in £: balance sheet hedge. borrow PV of £1,000,000: £1,000,000/1.025 = £975,610. exchange £975,610 at spot $1.764/£ for $1,720,976. Received today Invested in Rate Future value in 3 months $1,720,976 Treasury bill 6% annual or 1.5%/qtr $1,746,791 $1,720,976 Debt cost 8% annual or 2.0%/qtr $1,755,396 $1,720,976 Cost of capital 12% annual or 3.0%/qtr $1,772,605

Option Market Hedge Purchase put option. Breakeven price, option hedge 3 month put option @ ATM strike $1.75/£, premium 1.5%: Premium as of Jan $26,460  1.03 = $27,254. Unlimited upside, limited downside. Breakeven price, option hedge Upper bound: If pound appreciate above $1.754/£ + $0.0273/£ = $1.7813/£. Lower bound If pound depreciates below $1.75/£ - $0.0273/£ = $1.722/£.

A / R Hedges Uncovered ATM put option Money market $1,772,605 @ 12% 1.68 1.70 1.74 1.76 1.72 1.82 1.80 1.78 1.86 1.84 US$ value of £1,000,000 A/R Ending spot (US$/£) Uncovered Forward $1.7540/£ ATM put option min $1,722,746 Put strike $1.75/£ Money market $1,772,605 @ 12% Forward contract $1,754,000

Account Payable Hedge Assume £1,000,000 A/P in 90 days Unhedged position: expected pay $1,760,000. Forward market hedge: purchase forward @ $1.754/£, cost locked $1,754,000. Money market hedge: Offset £ obligation by £ asset w/ matching maturity. Exchange US$ spot & invest for 90 days in £. Carry the cost forward 90 days

Account Payable Hedge Option hedge: purchase call option on payable. ATM call option w/ strike $1,75/£ would be 1.5% premium. If spot less $1.75/£ option expire & £1,000,000 purchased on spot market. If spot above $1.75/£ option exercised: exchange £1,000,000 @ $1.75/£ less option premium: Carried forward 90 days @ 12% p.a. premium $27,254. Exercise call option (£1,000,000  $1.75/£ $1,750,000 Call premium (carried forward 90 days) $27,254 Total maximum expense of call option hedge $1,777,254

A / P Hedges Uncovered Money market $1,781,294 Forward contract 1.68 1.70 1.74 1.76 1.72 1.82 1.80 1.78 1.86 1.84 US$ value of £1,000,000 A/R Ending spot (US$/£) Uncovered Forward $1.754/£ Call strike $1.75/£ Call option: $1,777,254 Money market $1,781,294 Forward contract $1,754,000

Forex Risk Management for Real Goals? cost center vs. profit center. Exposures? backlog exposure? selectively hedge backlog & anticipated exposures? Contractual Hedges? Amount of risk covered, proportional hedges? Currency options?

Things to remember Types of forex exposures Transaction Operating Translation Tax How to hedge A/R & A/P transaction exposure? Money market? Forward market? Option market?