INTERNATIONAL FINANCE Lecture 24

Review Measuring the Potential Impact Currency Variability Currency Correlations Currency Correlation over time Value at Risk method (For longer time Horizons) Source: Adopted from South-Western/ Thomson Learning 2006

Transaction, Economic & Translation Exposures Lecture 24

Objectives To identify the commonly used techniques for hedging transaction exposure; To show how each technique can be used to hedge future payables and receivables; To compare the pros and cons of the different hedging techniques; and To suggest other methods of reducing exchange rate risk.

EXAMPLE ABC, Inc., a U.S. exporting firm, expects to receive substantial payments denominated in Indonesian rupiah and Thai baht in one month. Based on today’s spot rates, the dollar value of the funds to be received is estimated at $600,000 for the rupiah and $400,000 for the baht. Thus, ABC is exposed to a currency portfolio weighted 60 percent in rupiah and 40 percent in baht. ABC wants to determine the maximum expected one-month loss due to a potential decline in the value of these currencies, based on a 95 percent confidence level. Based on data for the last 20 months, it estimates the standard deviation of monthly percentage changes to be 7 percent for the rupiah and 8 percent for the baht, A correlation coefficient of.50 between the rupiah and baht. The portfolio’s standard deviation is

11 - 6

When transaction exposure exists, the firm faces three major tasks:  Identify its degree of transaction exposure.  Decide whether to hedge this exposure.  Choose a hedging technique if it decides to hedge part or all of the exposure. Transaction Exposure

To identify net transaction exposure, a centralized group consolidates all subsidiary reports to compute the expected net positions in each foreign currency for the entire MNC. Note that sometimes, a firm may be able to reduce its transaction exposure by pricing its exports in the same currency that it will use to pay for its imports. Transaction Exposure

Hedging techniques include: ¤ Futures hedge, ¤ Forward hedge, ¤ Money market hedge, and ¤ Currency option hedge. MNCs will normally compare the cash flows that would be expected from each hedging technique before determining which technique to apply. Techniques to Eliminate Transaction Exposure

A futures hedge uses currency futures, while a forward hedge uses forward contracts, to lock in the future exchange rate. The forward contracts are commonly negotiated for large transactions, while the standardized futures contracts tend to be used for smaller amounts. Futures and Forward Hedges

The hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged, and taking into consideration the firm’s degree of risk aversion. Futures and Forward Hedges

The real cost of hedging measures the additional expenses beyond those incurred without hedging. Real cost of hedging payables (RCH p ) = nominal cost of payables with hedging – nominal cost of payables without hedging Real cost of hedging receivables (RCH r ) = nominal revenues received without hedging – nominal revenues received with hedging Real Cost of Hedging

Review ¤ Identify its degree of transaction exposure. ¤ Decide whether to hedge this exposure. ¤ Choose a hedging technique if it decides to hedge part or all of the exposure. Hedging Techniques ¤ Futures hedge, ¤ Forward hedge, ¤ Money market hedge, and ¤ Currency option hedge. Source: Adopted from South-Western/ Thomson Learning 2006