1. Copyright © 2012 by the McGraw-Hill Companies, Inc. All rights reserved. Management of Transaction Exposure Chapter Eight

2. Chapter Outline  Forward Market Hedge  Money Market Hedge  Options Market Hedge  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  Should the Firm Hedge?  What Risk Management Products Do Firms Use? 8-2

3. Forward Market Hedge: Imports  If you expect to owe foreign currency in the future, you can hedge by agreeing today to buy the foreign currency in the future at a set price by entering into a long position in a forward contract. Forward Contract Counterparty Importer Foreign Supplier Foreign currency Goods or Services Foreign currency Domestic Currency 8-3

4. Forward Market Hedge: Exports  If you are going to receive foreign currency in the future, agree to sell the foreign currency in the future at a set price by entering into short position in a forward contract. Forward Contract Counterparty Exporter Foreign Customer Goods or Services Foreign Currency Domestic Currency Foreign Currency 8-4

5. Importer’s Forward Market Hedge Forward Contract Counterparty U.S. Importer Italian Supplier €1,000,000 Shoes €1,000,000 $1,500,000 A U.S.-based importer of Italian shoes has just ordered next year’s inventory. Payment of €100M is due in one year. If the importer buys €100M at the forward exchange rate of $1.50/€, the cash flows at maturity look like this: 8-5

6. Exporter’s Futures Market Cross-Currency Hedge Your firm is a U.K.- based exporter of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer. Payment (in euros) is due in six months. Your firm wants to hedge the receivable into pounds. Country U.S. $ equiv. Currency per U.S. $ Britain (£62,500) $2.0000£0.5000 1 Month Forward $1.9900£0.5025 3 Months Forward $1.9800£0.5051 6 Months Forward $2.0000£0.5000 12 Months Forward $2.1000£0.4762 Euro (€125,000) $1.4700€0.6803 1 Month Forward $1.4800€0.6757 3 Months Forward $1.4900€0.6711 6 Months Forward $1.5000€0.6667 12 Months Forward $1.5100€0.6623 Sizes of forwards on this exchange are £62,500 and €125,000. 8-6

7.  The exporter has 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/€, we can do this with a SHORT position in 6 six-month euro futures contracts. 6 contracts = €750,000 €125,000/contract 8-7  Selling the €750,000 forward at the six-month forward rate of $1.50/€ generates $1,125,000: $1,125,000 = €750,000 × €1 $1.50 At the six-month forward exchange rate of $2/£, $1,125,000 will buy £562,500. We can secure this trade with a LONG position in 9 six-month pound futures contracts: 9 contracts = £562,500 £62,500/contract Exporter’s Futures Market Cross-Currency Hedge

8. Exporter’s Futures Market Cross-Currency Hedge: Cash Flows at Maturity Exporter Customer €750,000 $1,125,000 Short position in 6 six-month euro futures on €125,000 at $1.50/€1 Long position in 9 six-month pound futures on £62,500 at $2.00/£1 Bicycles $1,125,000 £562,500 8-8

9. Importer’s Money Market Hedge  This is the same idea as covered interest arbitrage.  To hedge a foreign currency payable, buy the present value of that foreign currency payable today and put it in the bank at interest. –Buy the present value of the foreign currency payable today at the spot exchange rate. –Invest that amount at the foreign rate. –At maturity your investment will have grown enough to cover your foreign currency payable. 8-9

10. Importer’s Money Market Hedge A U.S.–based importer of Italian bicycles owes €100,000 to an Italian supplier in one year. –The spot exchange rate is $1.50 = €1.00. –The one-year interest rate in Italy is i € = 4%. –The importer can hedge this payable by buying and investing €96,153.85 at 4% in Italy for one year. At maturity, he will have €100,000 = €96,153.85 × (1.04). $1.50 €1.00 Dollar cost today = $144,230.77 = €96,153.85 × €100,000 1.04 €96,153.85 = 8-10

11. Importer’s Money Market Hedge $148,557.69 = $144,230.77 × (1.03)  With this money market hedge, we have redenominated a one-year €100,000 payable into a $144,230.77 payable due today.  If the U.S. interest rate is i $ = 3%, we could borrow the $144,230.77 today and owe $148,557.69 in one year. $148,557.69 = €100,000 (1+ i € ) T (1+ i $ ) T ×S($/€)× 8-11

12. $144,230.77 Importer’s Money Market Hedge: Cash Flows Now and at Maturity Importer Supplier bicycles Spot Foreign Exchange Market €100,000 $144,230.77€96,153.85 U.S Bank $148,557.69 Italia Bank €100,000 T= 1 cash flows deposit i € = 4% €96,153.85 8-12

13. $119,047.62 Exporter’s Money Market Hedge Exporter Customer shoes Spot Foreign Exchange Market €100,000 $119,047.62€95,238.10 U.S Bank $127,500.00 Crédit Agricole €100,000 T= 1 cash flows deposit i $ = 7.10% €95,238.10 Borrow i € = 5% An American exporter has just sold €100,000 worth of shoes to a French customer. Payment is due in one year. Interest rates in dollars are 7.10 percent in the U.S. and 5 percent in the euro zone. The spot exchange rate is $1.25/€1.00. Use a money market hedge to eliminate the exporter’s exchange rate risk. 8-13

14. Importer’s Money Market Cross-Currency Hedge Your firm is a U.K.-based importer of bicycles. You have bought €750,000 worth of bicycles from an Italian firm. Payment (in euros) is due in one year. Your firm wants to hedge the payable into pounds. –Spot exchange rates are $2/£ and $1.55/€ –The interest rates are 3% in €, 6% in $ and 4% in £, all quoted as an APR. What should you do to redenominate this 1-year €-denominated payable into a £-denominated payable with a 1-year maturity? 8-14

15.  Sell pounds for dollars at spot exchange rate, buy euro at spot exchange rate with the dollars, invest in the euro zone for one year at i € = 3%, all such that the future value of the investment equals €750,000. Using the numbers we have: –Step 1: Borrow £564,320.39 at i £ = 4%. –Step 2: Sell pounds for dollars, receive $1,128,640.78. –Step 3: Buy euro with the dollars, receive €728,155.34. –Step 4: Invest in the euro zone for 12 months at 3% APR (the future value of the investment equals €750,000). –Step 5: Repay your borrowing with £586,893.20. (see next slide for where the numbers come from) 8-15 Importer’s Money Market Cross-Currency Hedge

16. Where Do the Numbers Come From? £586,893.20 = £564,320.39 × (1.04) €728,155.34 = €750,000 (1.03) = $1,128,640.78 = €728,155.34 × €1 $1.55 £564,320.39 = $1,128,640.78 × $2 £1 The present value of the euro payable = The dollar cost of buying the present value of the euro payable today Cost today in pounds of the present dollar value of the euro payable FV in pounds of the cost in pounds of being able to pay the supplier €750,000 8-16

17. Importer’s Money Market Cross-Currency Hedge: Cash Flows Now and at Maturity Importer Supplier bicycles Spot Foreign Exchange Market €750,000 £564,320.39 $1,128,640.77 Spot Foreign Exchange Market $1,128,640.77 €728,155.34 €728,155.34 deposit i € = 3% U.K Bank £564,320.39 £586,893.20 Italia Bank €750,000 T= 1 cash flows 8-17

18. Options  A motivated financial engineer can create almost any risk-return profile that a company might wish to consider.  An important consideration when using options is the hedge ratio that we covered in the last chapter.  Without due consideration of the hedge ratio, the careless use of options can undo attempts at hedging. 8-18

19. Using Options to Hedge: Exports  A British exporter who is owed €100,000 in one period has many choices: –Buy call options on the pound with a strike in dollars while also buying put options on the euro with a strike in dollars. –Buy call options on the pound with a strike in euros. –Buy put options on the euro with a strike in pounds.  For any options market hedge, the exporter should use the hedge ratio to know how many options are needed. –Spot rates are S 0 (£/€) = £0.80/€, S 0 ($/€) = $2.00/€, S 0 ($/£) = $2.50/£; i £ = 15½% and i € = 5%. –In the next year, suppose that there are two possibilities: S 1 (£/€) = £1.00/€ or S 1 (£/€) = £0.75/€ 8-19

20. Options Market Cross-Currency Hedge At first it seems logical that a British exporter with a €100,000 receivable should buy 10 put options on €10,000—but that doesn’t work well. 10 × p 0 = £2,077.92 (strike price of £.80/€) The hedge ratio of this option is − 1 / 5 £10,000 £7,500 €10,000 = £8,000 p 1 = £0 up p 1 = £500 down £0 – £500 £10,000 – £7,500 –£500 £2,500 == − 1 / 5 = H = S 1 – S 1 downup p 1 – p 1 up down With a hedge ratio of –0.20 our exporter would actually be better hedged with a long position in 50 PHLX puts. S 1 (£/€) = £1.00/€ S 1 (£/€) = £0.75/€ p 0 = £207.79 8-20

21. Option Dealer £80,000 Put Buying Exporter €100,000 Option Dealer T = 1 Spot Market Sell €100,000 £100,000€100,000 Put Buying Exporter S 1 (£/€) = £1.00/€. S 1 (£/€) = £0.75/€ K 0 (£/€) = £0.80/€ Out-of-the-Money: S 1 (£/€) = £1.00/€ K 0 (£/€) = £0.80/€ 10 Puts on €10,000 (Strike £8,000) is Not a Hedge 10×p 0 = £2,077.92 customer €100,000 Goods Notice that our exporter doesn’t have a hedge when he buys 10 put options. The future value of the receivable net of the cost of 10 options is either £97,600 = £100,000 − £2,077.92 × 1.155 or £77,600 = £80,000 − £2,077.92 × 1.155 €100,000 Goods 8-21

22. Option Dealer £400,000 Put Buying Exporter €500,000 Option Dealer T = 1 Spot Market Sell €100,000 £100,000€100,000 Put Buying Exporter S 1 (£/€) = £1.00/€. In-the-Money Puts S 1 (£/€) = £0.75/€ K 0 (£/€) = £0.80/€ Out-of-the-Money: S 1 (£/€) = £1.00/€ K 0 (£/€) = £0.80/€ Long 50 Puts = Perfect Hedge customer €100,000 Goods The future value of the receivable net of the cost of 50 puts is £88,000 = £100,000 − £10,389.61 × 1.155 or £88,000 = £400,000 − £10,389.61 × 1.155 − £300,000 €100,000 Goods T = 1 Spot Market Buy €400,000 S 1 (£/€) = £0.75/€. €400,000 £300,000 50 × p 0 = £10,389.61 8-22

23. Options Hedges and Money Market Hedges and Forward Market Hedges  The next two slides show that the hedge of buying 50 puts has the exact same payoffs as a forward market hedge and a money market hedge.  Recall the story: A British exporter is owed €100,000 in one period.  S 0 (£/€) = £0.80/€, S 0 ($/€) = $2.00/€, S 0 ($/£) = $2.50/£ –i £ = 15½% and i € = 5% –In the next year, there are two possibilities: S 1 (£/€) = £1.00/€ or S 1 (£/€) = £0.75/€ 8-23

24. Money Market Cross-Currency Hedge Exporter Customer €100,000 Spot Foreign Exchange Market Goods $190,476.19£76,190.48 Spot Foreign Exchange Market €95,238.10$190,476.19 €95,238.10 U.K Bank £76,190.48 £88,000 Italia Bank €100,000 T= 1 cash flows S 0 (£/€) = £0.80/€, i £ = 15½% i € = 5% Perfect hedge whether S 1 (£/€) = £1.00/€ or S 1 (£/€) = £0.75/€. Borrow PV of €100,000 at i € = 5% 8-24

25. Forward Market Cross-Currency Hedge A U.K.-based exporter sold a €100,000 order to an Italian retailer. Payment is due in 1 year and the exporter used a forward hedge. Exporter Customer €100,000 $209,523.81 Euro Forward Contract Counterparty Pound Forward Contract Counterparty Goods $209,523.81£88,000 Perfect hedge whether S 1 (£/€) = £1.00/€ or S 1 (£/€) = £0.75/€. S 0 (£/€) = £0.80/€, S 0 ($/€) = $2.00/€, S 0 ($/£) = $2.50/£ i £ = 15½% i € = 5% i $ = 10% 8-25

26. Call-Buying Importer Consider a British importer who owes €100,000 in one year. The importer can use a money market or forward market hedge to redenominate this into a £88,000 liability. He could also use OTC call options on the euro with a pound strike. £10,000 £7,500 £8,000 c 1 = £2,000 up c 1 = £0 down c 0 = £900.43 H = S 1 – S 1 down up £2,000– £0 £10,000 – £7,500 £2,000 £2,500 4 5 == = c 1 –c 1 updown With a hedge ratio of.80 our importer can hedge with a long position in 1 OTC call on €125,000. 8-26

27. Option Dealer £100,000 Call Buying Importer €125,000 Option Dealer T = 1 Spot Market Buy €100,000 £75,000€100,000 Call Buying Importer S 1 (£/€) = £0.75/€. In-the-Money Calls: S 1 (£/€) = £1.00/€ K 0 (£/€) = £0.80/€ Out-of-the-Money: S 1 (£/€) = £0.75/€ K 0 (£/€) = £0.80/€ 1 Call on €125,000 = Perfect Import Hedge Supplier €100,000 Goods The future value of the receivable net of the cost of the call is £88,000 = £75,000 + £13,000 or £88,000 = £100,000 + £13,000 − £25,000 €100,000 Goods T = 1 Spot Market Sell €25,000 S 1 (£/€) = £1.00/€. €25,000 £25,000 8-27

28. Cross-Hedging Minor Currency Exposure  The major world currencies are the U.S. dollar, Canadian dollar, British pound, euro, Swiss franc, Mexican peso, and Japanese yen.  Everything else is a minor currency (for example, the Swedish krona).  It is difficult, expensive, and sometimes even impossible to use financial contracts to hedge exposure to minor currencies. 8-28

29. Cross-Hedging Minor Currency Exposure  Cross-hedging involves hedging a position in one asset by taking a position in another asset.  The effectiveness of cross-hedging depends upon how well the assets are correlated. –An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive, it can be a good hedge. But they need to co-vary in a predictable way. 8-29

30. Hedging Recurrent Exposure with Swaps  Recall that swap contracts can be viewed as a portfolio of forward contracts.  Firms that have recurrent exposure can usually hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along.  It is also the case that swaps are available in longer-terms than futures and forwards. 8-30

31. Exposure Netting  A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.  Once the residual exposure is determined, we hedge that.  Multilateral netting is an efficient and cost-effective mechanism for settling interaffiliate foreign exchange transactions and thus determining the firm’s residual exposure.  In the following slides, a firm faces the following exchange rates: 8-31 £1.00=$2.00 €1.00=$1.50 SFr 1.00=$0.90

32. €150 £150 $150 SFr150 £150 $150 SFr150 €150 8-32

33. €150 £150 $150 £150 $150 Exposure Netting $225 = = $135 SFr150 €150 = $135 SFr150 $225 = = $300= $225 $300 $150 $135 $300 $150 $135 $225 8-33

34. $225 $300 $150 $135 $300 $150 $135 $225 $15 $75 $165 $90 $150 $75 $165 $90 $150 $75 $15 8-34

35. $75 $165 $90 $150 + $75 = $225 $75 $15 $150 $225 = $210 + $15 $15 $210 $180 = $165 + $15 $180 $90 $210 8-35

36. Exposure Netting: How to Double Check Your Answer  It’s always good practice to check your work.  It’s better for you to find your mistakes than for your professor to (or your boss!).  You can check your work in exposure netting by adding up each subsidiary’s debits and credits.  When you’re done, check that you haven’t destroyed or “created” any money.  A new example follows for practice checking answers. 8-36

37. $125 $155 $100 $80 $155 $100 $80 $125 –$240 $100 +$125 +$155 $140 –$465 $80 +$100 +$125 –$160 –$375 $100 +$80 +$155 –$40 –$300 $125 +$80 +$155 $60 $125 $155 $100 $80 $155 $100 $80 $125 8-37

38. $25 $30 $75 $20 $55 $45 +$75 $20 +$45 $140 –$30 –$75 –$55 –$160 –$25 +$30 –$45 –$40 $25 +$55 –$20 $60 $25 $30 $75 $20 $55 $45 8-38

39. $100 $40 +$40 $100 $140 –$60 –$100 –$160 –$40 $60 $100 $40 $60 8-39

40. $140 –$20 –$140 –$160 –$40 $60 $20 $40 Alternative Solution 8-40

41. Netting with Central Depository Some firms use a central depository as a cash pool to facilitate funds mobilization and reduce the chance of misallocated funds. Central depository $60 $160 $140 8-41 $40

42. Other Hedging Strategies  Hedging through invoice currency. –The firm can shift, share, or diversify: Shift exchange rate risk by invoicing foreign sales in home currency Share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies Diversify exchange rate risk by using a market basket index  Hedging via lead and lag. –If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. –If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow. 8-42

43. 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 benefitted when management hedges. 8-43

44. What Risk Management Products do Firms Use?  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. 8-44