1. International Financial Management Vicentiu Covrig 1 Management of Transaction Exposure Management of Transaction Exposure (chapter 13)

2. International Financial Management Vicentiu Covrig 2 Transaction Exposure Arises from changes in the value of past contractual obligations in FC (e.g. payables and receivables, loans and deposits) Example: Suppose that on January 1, 2005 Ford is awarded a contract to supply trucks to Dutch army forces. On December 31, 2005, Ford will receive a payment of Euro 25 million for these trucks.You have the following capital markets information as of January 1, 2005:  Spot US dollar /Euro= 1 $/Euro  1 year US interest rate= 2 percent  1 year Euro interest rate= 4 percent  1 year forward rate US dollar/ Euro= 0.98 $/Euro

3. International Financial Management Vicentiu Covrig 3 Hedging Hedging a particular currency exposure means establishing an offsetting currency position Whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge Hedging’s basic objective reduce/eliminate volatility of accounting earnings and future cash flows as a result of exchange rate changes.

4. International Financial Management Vicentiu Covrig 4 Without hedging The value of the cash flow in dollars (domestic currency) depends on the XR on December 31, 2005 If the Euro (FC) depreciates against dollar (DC), the dollar (DC) value of the Euro (FC) position decreases Ex: for 0.93 USD/Euro the value of the expected cash flow becomes 0.93 x 25m = USD 23.25m Hedging costs can be seen as “insurance” premium the firm has to pay to avoid steep currency losses

5. International Financial Management Vicentiu Covrig 5 Hedging strategies Using financial derivatives: Hedging in the forward/futures market Hedging in the options market Using operational techniques: Hedging through invoice currency Hedging via lead and lag Exposure netting

6. International Financial Management Vicentiu Covrig 6 Forward market hedge A company that is going to receive (has receivables) foreign currency in the future will sell the foreign currency forward A company that is going to owe (has payables) foreign currency in the future will buy the foreign currency forward The forward contract is entered into at the time the exposure is created Our example: Ford is expected to receive Euro 25m. in one year, thus it will sell forward Euro 25 m. Forward rate= 0.98 USD/Euro A forward sale of Euro 25 million for delivery in one year will yield Ford 0.98x25m = USD 24.5m

7. International Financial Management Vicentiu Covrig 7 Forward Market Hedge Why futures are not so popular for hedging? - standardized contracts: lack of flexibility - marking-to-market Example: You are the CFO of a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100m. is due in one year. Spot rate is 1.25$/£. Forward rate is 1.20$/£. Question: How can you hedge this currency exposure? What are the dollar payments with hedging?

8. International Financial Management Vicentiu Covrig 8 Options Market Hedge Options provide a flexible hedge against the downside, while preserving the upside potential Options are more suitable for hedging when: - the company wants to benefit from favorable currency movements and limit the extent of currency loses - the future FC cash flow is uncertain (ex. Competitive bidding for a construction project abroad that might not be awarded) No “free-lunch” here: hedging with options involve upfront premium costs

9. International Financial Management Vicentiu Covrig 9 Options Market Hedge To hedge an expected FC cash outflow (payable) buy calls on the FC - If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. To hedge an expected FC cash inflow (receivable) currency receivable buy puts on the currency. - If the currency depreciates, your put option lets you sell the currency for the exercise price.

10. International Financial Management Vicentiu Covrig 10 Hedging certain future cash flows: Ford example On January 1, 2005 S= 1$/Euro and F = 0.98$/Euro Suppose that Ford purchased a put option on 25m. Euro with an exercise price 0.99 $/Euro and a one-year expiration. The option premium was 0.02$/Euro. Ford thus paid $500,000(=0.02xEuro25mx1$/Euro) The transaction provides Ford with right, but not the obligation, to sell 25. Euro for 0.99$/Euro, regardless of the future spot rate. If at the expiration : (1)S=1$/Euro; put is out-of-the-money. Ford does not exercise the option and change/sell the Euros at S=1$/Euro. Proceeds: Euro 25m X 1$/Euro= $25m. Costs: option premium= $0.5m (without the time value of money) Costs: 0.5x1.02= $0.51m (with the time value of money) Net proceeds= Proceeds-costs= 25-0.5=$24.5 m.

11. International Financial Management Vicentiu Covrig 11 (2)S=0.95$/Euro; put is in-of-the-money. Ford exercise the option and change/sell the Euros at S=0.99$/Euro. Proceeds: Euro 25m X 0.99$/Euro= $24.75m. Costs: option premium= $0.5m Net proceeds = Proceeds-costs = 24.75-0.5=$24.25 m.

12. International Financial Management Vicentiu Covrig 12 Options Hedging: importer of British woolens The importer can hedge his £100 million payable by buying a call option. Consider that the strike price X=1.3$/£; premium=$0.02; Calculate the net proceeds if at the maturity (1) S=1.4$/£, and (2) S=1.2 $/£. Disregard the time-value-of-money of the premium.

13. International Financial Management Vicentiu Covrig 13 Hedging through Invoice Currency Operational technique The firm can shift, share, or diversify: - shift exchange rate risk  by invoicing foreign sales in home currency  Ex: Ford can invoice $25m than Euro 25m. - 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

14. International Financial Management Vicentiu Covrig 14 Hedging via Lead and Lag  Operational technique  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.  Caveats: - can hamper the relations with your customers/suppliers - involves forecasting the XRs  Useful for intrafirm payables and receivables

15. International Financial Management Vicentiu Covrig 15 Exposure Netting A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. - As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. - Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately. MNCs centralize their FX exposure

16. International Financial Management Vicentiu Covrig 16 Observations It is virtually (if not actually) impossible to forecast future changes in foreign exchange rates. Attempting to profit from foreign exchange forecasting is speculating, not hedging FC transactions and hedging choices should be evaluated upon forward rate and not current spot rate If financial markets are efficient, firms cannot hedge against expected rate changes

17. International Financial Management Vicentiu Covrig 17 Should the Firm Hedge? Not everyone agrees that a firm should hedge: - Exposure is hard to measure and hedging hard to understand - Management often speculates instead of hedge - Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves

18. International Financial Management Vicentiu Covrig 18 Should the Firm 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.

19. International Financial Management Vicentiu Covrig 19 Learning outcomes What is transaction exposure and how is it different from economic and translation exposure? Know how to implement a hedging transaction with forwards (numerical application) Know how to implement a hedging transaction with options (numerical application) Discuss the following operational hedging techniques: invoice;lead and lag; exposure netting Discuss the arguments against hedging. Discuss three arguments for hedging. Recommended end-of-chapter questions:1, 3, 4, 5, 6, 7 Recommended end-of-chapter problems:3a,b,c