1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fourth Edition Chapter Objective: This chapter discusses various methods available for the management of transaction exposure facing multinational firms. 8 Chapter Eight Management of Transaction Exposure

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-1 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

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-2 Chapter Outline (continued) Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use?

4. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-3 Types of FX Exposure Transaction Exposure: The sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Economic Exposure: The extent to which the firm value would be affected by fluctuating exchange rates through their affects on the company's earnings, cash flows and foreign investments. Translation Exposure: The potential that the firm’s consolidated financial statements can be affected by changes in exchange rates.

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-4 Forward Market Hedge: an Example You are a U.S. importer of British branded food and have just ordered next year’s inventory. Payment of £100M is due in one year. Question: How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers £100M in one year—a long forward contract on the pound.

6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-5 Forward Market Hedge $1.50/£ Value of £1 in $ in one year Suppose the forward exchange rate is $1.50/£. If he does not hedge the £100m payable, in one year his gain (loss) on the unhedged position is shown in green. $0 $1.20/£ $1.80/£ –$30m $30m Unhedged payable The importer will be better off if the pound depreciates: he still buys £100m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/£ But he will be worse off if the pound appreciates. Gain Loss

7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-6 Forward Market Hedge $1.50/£ Value of £1 in $ in one year $1.80/£ If he agrees to buy £100m in one year at $1.50/£ his gain (loss) on the forward are shown in blue. $0 $30m $1.20/£ –$30m Long forward If you agree to buy £100 million at a price of $1.50 per pound, you will lose $30 million if the price of a pound is only $1.20. If you agree to buy £100 million at a price of $1.50 per pound, you will make $30 million if the price of a pound reaches $1.80. Gain Loss

8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-7 Forward Market Hedge $1.50/£ Value of £1 in $ in one year $1.80/£ The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. $0 $30 m $1.20/£ –$30 m Long forward Unhedged payable Hedged payable Net payoff But, by entering into the forward contract, the importer forgoes the opportunity to benefit from weaker £

9. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-8 Firm’s decision on hedging To decide whether to hedge or not, consider three scenarios: 1. E(S T ) = F where E(S T ) = firm’s expected spot exchange rate at T 2. E(S T ) > F 2. E(S T ) < F For an IMPORTING firm (with FC payables), Under scenario 1: the firm should be inclined to hedge as long as it is risk averse, to eliminate FX exposure Under scenario 2: the firm should be more inclined to hedge than under the first scenario. Under scenario 3: the firm should be less inclined to hedge because it doesn’t want to forgo the potential gain from expected FC weakening. However, whether to hedge depends on the degree of risk aversion.

10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-9 Money Market Hedge This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable.

11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-10 Money Market Hedge A U.S.–based importer of Italian bicycles In one year owes €100,000 to an Italian supplier. The spot exchange rate is $1.25 = €1.00 The one-year interest rate in Italy is i € = 4% $1.25 €1.00 Dollar cost today = $120,192.31 = €96,153.85 × €100,000 1.04 €96,153.85 =Can hedge this payable by buying today and investing €96,153.85 at 4% in Italy for one year. At maturity, he will have €100,000 = €96,153.85 × (1.04)

12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-11 Money Market Hedge $123,798.08 = $120,192.31 ×(1.03) With this money market hedge, we have redenominated a one-year €100,000 payable into a $120,192.31 payable due today. If the U.S. interest rate is i $ = 3% we could borrow the $120,192.31 today and owe in one year $123,798.08 = €100,000 (1+ i € ) T (1+ i $ ) T ×S ($/€) ×

13. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-12 Money Market Hedge: Step One Suppose you want to hedge a payable in the amount of £y with a maturity of T: 1. Borrow $x at t = 0 on a loan at a rate of i $ per year. $x = S ($/£) × £y (1+ i £ ) T 0T $x$x–$x(1 + i $ ) T Repay the loan in T years where

14. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-13 Money Market Hedge: Step Two at the prevailing spot rate. £y (1+ i £ ) T 2. Exchange the borrowed $x for Invest at i £ for the maturity of the payable. £y (1+ i £ ) T At maturity, you will owe a $x(1 + i $ ) T. Your British investments will have grown to £y. This amount will service your payable and your net exposure to the pound will be zero.

15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-14 Money Market Hedge 1. Calculate the present value of £y at i £ £y (1+ i £ ) T 2. Borrow the U.S. dollar value of payable at the spot rate. $x = S($/£)× £y (1+ i £ ) T 3. Exchange for £y (1+ i £ ) T 4. Invest at i £ for T years. £y (1+ i £ ) T 5. At maturity your pound sterling investment pays your payable. 6. Repay your dollar-denominated loan with $x(1 + i $ ) T. Hedging pound payable £y :

16. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-15 Forward and Money Market Hedging Forward hedge and money market hedge should yield the same result if the IRP holds. IRP: If the IRP is not holding, then one hedging method will dominate another. In a competitive and efficient market, however, any deviations from IRP are not likely to persist.

17. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-16 Options Market Hedge Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable, buy calls on the currency. If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. To hedge a foreign currency receivable, buy puts on the currency. If the currency depreciates, your put option lets you sell the currency for the exercise price.

18. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-17 Options Market Hedge $1.50/£ Value of £1 in $ in one year Suppose the forward exchange rate is $1.50/£. If an importer who owes £100m does not hedge the payable, in one year his gain (loss) on the unhedged position is shown in green. $0 $1.20/£ $1.80/£ –$30m $30m Unhedged payable The importer will be better off if the pound depreciates: he still buys £100m but at an exchange rate of only $1.20/£ he saves $30 million relative to $1.50/£ But he will be worse off if the pound appreciates.

19. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-18 Options Markets Hedge Profit loss –$5m $1.55/£ Long call on £100m Suppose our importer buys a call option on £100m with an exercise price of $1.50 per pound. He pays $.05 per pound for the call. $1.50/£ Value of £1 in $ in one year

20. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-19 Value of £1 in $ in one year Options Markets Hedge Profit loss –$5m $1.45 /£ Long call on £100m The payoff of the portfolio of a call and a payable is shown in red. He can still profit from decreases in the exchange rate below $1.45/£ but has a hedge against unfavorable increases in the exchange rate. $1.50/£ Unhedged payable $1.20/£ $25m

21. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-20 –$30 m $1.80/£ Value of £1 in $ in one year Options Markets Hedge Profit loss –$5 m $1.45/£ Long call on £100m If the exchange rate increases to $1.80/£ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of $5 million. This can be thought of as an insurance premium. $1.50/£ Unhedged payable $25 m

22. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-21 Options Markets Hedge IMPORTERS who owe foreign currency in the future should BUY CALL OPTIONS. If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price. EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS. If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.

23. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-22 Hedging Exports with Put Options Show the portfolio payoff of an exporter who is owed £1 million in one year. The current one-year forward rate is £1 = $2. Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2. The cost of this option is $0.05 per pound.

24. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-23 S($/£) 360 –$2m $2 Long receivable Long put $1,950,000 –$50k Options Market Hedge: Exporter buys a put option to protect the dollar value of his receivable. –$50k $2.05 Hedged receivable

25. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-24 S($/£) 360 $2 The exporter who buys a put option to protect the dollar value of his receivable –$50k $2.05 Hedged receivable has essentially purchased a call.

26. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-25 Hedging Imports with Call Options Show the portfolio payoff of an importer who owes £1 million in one year. The current one-year forward rate is £1 = $1.80; but instead of entering into a short forward contract, He buys a call option written on £1 million with an expiry of one year and a strike of £1 = $1.80 The cost of this option is $0.08 per pound.

27. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-26 LOSS (TOTAL) GAIN (TOTAL) S($/£) 360 Long currency forward Accounts Payable = Short Currency position Forward Market Hedge: Importer buys £1m forward. This forward hedge fixes the dollar value of the payable at $1.80m. $1.80

28. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-27 $1.8m S($/£) 360 $1.80 Unhedged obligation Call –$80k $1.88 $1,720,000 $1.72 Call option limits the potential cost of servicing the payable. Options Market Hedge: Importer buys call option on £1m.

29. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-28 S($/£) 360 $1.80 $1,720,000 $1.72 Our importer who buys a call to protect himself from increases in the value of the pound creates a synthetic put option on the pound. He makes money if the pound falls in value. –$80k The cost of this “insurance policy” is $80,000

30. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-29 Taking it to the Next Level Suppose our importer can absorb “small” amounts of exchange rate risk, but his competitive position will suffer with big movements in the exchange rate. Large dollar depreciations increase the cost of his imports Large dollar appreciations increase the foreign currency cost of his competitors exports, making him lose his customers as his competitors renew their focus on the domestic market.

31. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-30 Our Importer Buys a Second Call Option S($/£) 360 $1.80 $1,720,000 $1.72 –$80k This position is called a straddle $1.64$1.96 $1,640,000 –$160k 2nd Call $1.88 Importers synthetic put

32. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-31 Cross-Hedging Minor Currency Exposure The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Thai baht. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.

33. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-32 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.

34. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-33 Hedging Contingent Exposure If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options.

35. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-34 Hedging Recurrent Exposure with Swaps Recall that swap contracts can be viewed as a portfolio of a spot and multiple forward contracts at different maturities. Firms that have recurrent exposure can very likely 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.

36. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-35 Hedging through Invoice Currency The firm can shift, share, or diversify: shift exchange rate risk (to the counterparty)  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 eg. SDR Useful especially for long-term exposure for which no forward or options contracts are available.

37. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-36 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 (to lag) 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 (to lead); pay your obligations denominated in that currency as late as your contracts will allow. But what works to your advantage is at the counterparty’s disadvantage, so it might not be easy to use this strategy unless you provide substantial incentive eg. discounts.

38. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-37 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.

39. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-38 Exposure Netting Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual (net) exposure is determined, then the firm implements hedging. “Natural Hedge” arises when a firm has both receivables and payables in a given FC that can be netted out.

40. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-39 Exposure Netting: an Example Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions: $10 $35 $40$30 $20 $25 $60 $40 $10 $30 $20 $30

41. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-40 Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $10 $35 $40$30 $20 $40 $30 $20 $30 $20 $30 $10 $40$30$10 $30 $20 $60 $10 $35 $25 $60 $40 $20 $25 $10 $25 $10 $15 $10

42. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-41 Multilateral Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $25 $10 $20 $10 $15$10 $30 $15 $10 $40 $15 $40 $15

43. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-42 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 helped when management hedges.

44. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-43 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 (economies of scale). Default Costs  Hedging may reduce the firms cost of capital if it reduces the probability of default.

45. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-44 Should the Firm Hedge? Taxes can be a large market imperfection. Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have “boom and bust” cycles in their earnings stream.  The firm pays more taxes in high-earning periods than it saves it low-earning periods.

46. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 8-45 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.