Chapter 14 Foreign Exchange Risk Management
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To explain why there is concern about FX risk. To illustrate how to manage transaction, economic and translation exposure.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Why Is There No Need To Worry About FX Risk? If international parity conditions hold, FX risk will not arise. If it is possible to forecast exchange rates accurately, FX risk can be controlled. Shareholders are naturally hedged though diversification.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Why Worry About FX Risk? Parity conditions do not hold. Forecasting exchange rates is rather difficult. Hedging produces a more stable income stream.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Why is a Stable Income Stream Desirable? If a progressive tax rate is in operation, more stable before-tax income produces higher after-tax income. It is more conducive to sales. Volatile earnings may imply lack of job security.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Managing Short-Term Transaction Exposure Forward hedging Money market hedging Futures hedging Option hedging
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Forward Hedging Forward hedging entails locking in the exchange rate at which payables and receivables are converted from the domestic currency into a foreign currency, and vice versa.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Forward Hedging (no-hedge) (hedge) V
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Financial Hedging By taking an affecting position on a hedging instrument (forward), the profit/loss on the unhedged position is offset by the loss/profit on the hedging instrument.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Offsetting Profit/Loss on Payables + Long forward Payables – (a) (par)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Offsetting Profit/Loss on Payables (cont.) + Long forward Payables – (b) (premium)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 Offsetting Profit/Loss on Payables (cont.) + Long forward Payables – (c) (discount)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 Introducing the Bid-Offer Spread HN-H Payables Receivables
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Futures Hedging Futures hedging results may differ quantitatively from those of forward hedging. Because of the standardisation of contracts, it may not be possible to hedge the exact amount.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 Futures Hedging (cont.) The due date may not coincide with the settlement date. Marking-to-market introduces some variation.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 Money Market Hedging A money market hedge amounts to taking a money market position to cover expected payables or receivables. By borrowing and lending, a synthetic forward contract is created.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Money Market Hedging of Payables
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Money Market Hedging of Receivables
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Money Market Hedging of Payables with Bid-Offer Spreads
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Money Market Hedging of Receivables with Bid-Offer Spreads
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Option Hedging The outcome of option hedging is not known with certainty, since it depends on whether or not the option is exercised.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Hedging with a Call Option
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Hedging with a Put Option
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Contingent Exposure A contingent exposure arises only if a certain outcome materialises, such as winning a contract.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 Hedging a Contingent Long Exposure
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 Managing Long-Term Transaction Exposure Long-term forward contracts Currency swaps Parallel loans Leading and lagging
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 Managing Long-Term Transaction Exposure (cont.) Cross hedging Currency diversification Exposure netting Price variation and currency of invoicing
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Managing Long-Term Transaction Exposure (cont.) Risk-sharing arrangements Currency collars
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 AUD Value of Receivables With and Without Risk-Sharing Arrangement
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 AUD Value of Receivables With and Without Currency Collar
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 Economic Exposure Economic exposure arises because revenues and costs vary with changes in the real exchange rate.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 The Effect of Real Appreciation Assuming elastic demand, real appreciation of the foreign currency leads to: Increase in domestic sales revenue Increase in foreign sales revenue Increase in the costs of imported raw materials and foreign borrowing
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 The Effect of Real Depreciation Assuming elastic demand, real depreciation of the foreign currency leads to: Decrease in domestic sales revenue Decrease in foreign sales revenue Decrease in the costs of imported raw materials and foreign borrowing
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 34 Hedging Economic Exposure Reducing economic exposure requires: Changing sales in new or existing foreign markets Changing dependence on foreign supply of raw materials Establishing or eliminating production facilities abroad Changing the level of foreign debt
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 35 Why Worry About Translation Exposure? Translation exposure does not affect the economic value of the firm. Different translation methods affect reported earnings per share and other financial indicators.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 36 Hedging Translation Exposure Fund adjustment Forward contracts Exposure netting and balance sheet hedging