Chapter 11

Managing Transaction Exposure


Transaction Exposure
exists when future cash transactions of a firm are affected by exchange rate fluctuations


Is hedging worthwhile?


Should the firm¶s hedging strategy be to use forward contracts for all of its future foreign exchange transactions?

If the forward rate is an unbiased estimate of the future spot rate Sometimes it is higher and other times it is lower but it balances out over the long run Firm does not bear the cost of hedging

By hedging, MNC knows with certainty what its future cash outflows and inflows will be. This makes planning much easier for the MNC. Should the firm hedge a future foreign exchange transaction if it feels the exchange rate will move in an unfavorable direction?

If it is fairly good at forecasting exchange rate movements

Conclusions The MNC¶s level of risk aversion. and its ability (and desire) to forecast exchange rates determine:  If it will hedge  How much it will hedge  How it will hedge 6 .

McDonald¶s Corporation. This reduces the impact of fluctuating foreign currencies on cash flows and shareholders¶ billion for the years ended 2005 and 2004.pdf 7 .com/corp/invest/pub/2005_Financial_Report.ContentPar. the Company¶s restaurants purchase goods and services in local currencies resulting in natural hedges. Total foreign currency denominated debt. In 2005. including the effects of foreign currency exchange agreements.The Company uses foreign currency debt and derivatives to hedge the foreign currency risk associated with certain royalties.0001. In addition. where practical.RowPar. respectively. was $8.DownloadFiles.1 billion and $6.File.0002. p 18 http://www.ColumnPar.0001. the Company used foreign currency debt to hedge the foreign currency risk associated with foreign currency denominated cash and equivalents related to HIA. 2005 Financial Report. intercompany financings and longterm investments in foreign subsidiaries and affiliates.

Identifying Net Transaction Exposure Do this on a currency-by-currency basis 8 .

S.U. Based MNC (millions of $) £ Subsidiary How could the London + $100 MNC use forward Munich .$110 contracts to hedge Toronto + $30 against its Consolidated + $20 transaction exposure to £¶s? London and Toronto subsidiaries could sell £¶s forward and Munich subsidiary could buy £¶s forward OR MNC could sell $20m worth of £¶s forward 9 .

$50 + $0 What could the MNC do about its transaction exposure to the ¥? It may decide it has no transaction exposure to the ¥ 10 .$110 + $30 + $20 C$ -$60 -$80 +$70 -$70 ¼ -$80 +$120 -$10 +$30 ¥ .$30 + $80 .(millions of $) Subsidiary London Munich Toronto Consolidated £ + $100 .

Should ³net´ exposure be viewed from the subsidiary level or be centralized (from the view of the entire MNC)? Favoring Centralized Control Goal of financial decision maker is to maximize the value of the overall MNC. not the value of individual subsidiaries 11 .

$30 Munich + $80 Toronto . then the MNC overall becomes exposed 12 .$50 Consolidated +$0 If all three subsidiaries hedge.Implications If exposure of subsidiaries nets out no hedge is necessary Subsidiary ¥ London . MNC experiences unnecessary expenses If a single subsidiary hedges.

Local creditors may look unfavorably toward subsidiary¶s exposure if it doesn¶t handle its own exposure 2. Subsidiary¶s management may feel more comfortable handling their own exposure so they will not be hurt by adverse movements in exchange rates which make them look bad on their job record 13 .Favoring Decentralized (Subsidiary) Control 1.

In the past Kodak would bill its subsidiaries in $¶s for supplies it provided so each subsidiary had to deal with its own transaction exposure Now Kodak bills its subsidiaries in their local currencies and Kodak¶s main headquarters handles any transaction exposure 14 .

and its main headquarters does any necessary hedging 15 .Fiat (Italian auto maker) has a centralized system for 421 subsidiaries in 55 countries. uses a comprehensive reporting system to keep track of cash flows in each currency.

Techniques for Managing Transaction Exposure  Invoicing Strategy  Pricing Strategy  Futures (Forward) Contracts  Money Market Hedge  Options Hedge  Go Uncovered 16 .

000.51/¼ have a premium of 6¢ /¼ and put options with a strike price of $0. 1-year ¼ call options with a strike price of $0.000. annual interest rates are 5% on deposits and 7% on borrowed funds.E. 17 .000 for the blades. German annual interest rates are 6% on deposits and 8% on borrowed funds and U.Today G. The blades will be delivered to Lufthansa one year from today and G. will receive ¼25.54/¼.55/¼ and the 1-year futures rate is $0.58/¼ have a premium of 5¢ /¼.E. Currently the spot rate is $0.S. is awarded a contract to supply turbine blades to Lufthansa (German company). The size of a futures contract is ¼125.

000 in the future 0 1 + ¼25.Is G.000.000 .E. it will set up a situation which will require it to pay ¼25.000 ¼0 If G.000.¼25.000.000 one year from today HEDGING 18 .E. decides it wants to offset this long position. long or short in ¼¶s? LONG because they will receive ¼25.000.

E.E. could have insisted on being paid in U.e. G. $¶s rather than ¼¶s Could this cause problems for G. is buying parts from a German firm for delivery in one year. it could agree to pay for them in ¼¶s (i.Invoicing Strategy If G.S.E.? Lufthansa may award the contract to a company that prices their blades in ¼¶s 19 . Invoice price is in ¼¶s) Pricing Strategy When negotiating the contract with Lufthansa.

000 at $0. sells 25 .Futures Contract Hedge Should G.E.54/¼ 20 .E. buy or sell a futures contract? Since it will receive ¼¶s in the future and wants to convert them to $¶s. it should sell ¼ Futures Contracts Today 1.000 ! 200 contracts 125 . G.000 .

E.E. receives (25.000.000. thinks the future spot rate will be 21 .One Year from Today 1. hedge with a Futures Contract or maintain its long position in ¼¶s? That depends on what G.E.500.54) = $13. G. G.000)(0. delivers ¼¶s on Futures Contract G.000 from Lufthansa 2.000 Should G. receives ¼25.E.E.

54/¼ $0.54) + (45%)($0. do not hedge 22 .Develop a probability distribution for what the spot rate will be one year from today Possible Future Spot Rates $0.542/¼ Since E[spot] > Future Rate.53) + (40%)($0.55) =$0.53/¼ $0.55/¼ Probability 15% 40% 45% Calculate the expected spot rate E[spot] = (15%)($0.

000.If GE doesn¶t hedge.000 Compare this to GE¶s revenue if it hedges (25.550.000 is worth the risk of going unhedged 23 .000 GE will have to decide if the extra ³expected´ revenue of $50.000)($0.500.54) = $13.000)($0.542) = $13. what is the probability it made the correct choice? 40% + 45% = 85% What is GE¶s expected revenue without hedging? (25.000.

000 to build a new plant in the U.000.Money Market Hedge Take a money market position to offset a future foreign currency payables or receivables position EXAMPLE #1 Suppose GE needs to borrow $15. GE can borrow ¼¶s today instead of $¶s with the idea of using the ¼25.000 it receives from Lufthansa to repay this loan 24 .000.S. ¼Borrowed(1 + iGer) = ¼25.Should GE borrow ¼25.000.000.148 ¼Borrowed = 1  8% 25 .000 ! ¼23.000? It should borrow less than ¼25.000 25.

148. Use the $¶s to help build the new plant in the U. Convert ¼¶s to $¶s at current spot rate (23.148)($0.S.Today 1.731.481 3.148 from German bank at 8% for 1 year 2.55) = $12.148. GE borrows ¼23. 26 .

000 to repay loan from the German bank (23.148. GE receives ¼25.One Year from Today 1.148)(1 + 8%) = ¼25.000. Use the ¼25.000.000 27 .000.000 from Lufthansa 2.

731.481 3.148.148 from German bank at 8% for 1 year 2. Deposit $¶s in U.148. GE borrows ¼23. Convert ¼¶s to $¶s at spot rate (23.S.148)($0. bank for 1 year at 5% 28 .55) = $12.EXAMPLE #2 GE does not need to borrow $¶s to help finance construction of a new plant Today 1.

000 3.731.481)(1 + 5%) = $13. bank (12.000.148)(1 + 8%) = ¼25. Use these ¼¶s to repay loan from German bank (23. GE receives ¼25.000. GE receives $¶s from U.000 from Lufthansa 2.One Year from Today 1.S.148.368.055 29 .

the Money Market hedge or the Futures hedge? GE gets $13.055 with this Money Market hedge 30 .500.368.000 with the Futures hedge compared to $13.Which is better for GE.

How many ¼¶s should GE deposit in a German bank? 03. Use a Money market hedge.Suppose GE must pay ¼203.015 EXAMPLE #1 GE has excess $¶s it does not need during the next 90 days 31 .75% and on deposits in Germany is 1.S. is 1.000 1.000 to a German company three months from today.000 ! ¼ 00. The 90-day interest rate on borrowed funds in the U.5%.

5% for 90 days Three Months from Today 1.000 2.000 2.000(0.015) = ¼203. GE uses these ¼¶s to pay German company 32 .000(1. GE deposits ¼200.55) = $110.Today 1. GE receives ¼¶s from German bank 200. GE converts appropriate amount of $¶s to ¼¶s 200.000 in a German bank at 1.

Convert $110. GE deposits ¼¶s in German bank for 90 days at 1.000 2. bank 200.000 3.000 to ¼200.000(0.5% 33 .S.55) = $110.75% from U.EXAMPLE #2 GE does not have excess cash (or has excess but doesn¶t want to use it for this purpose) Today 1. GE borrows the right amount of $¶s for 90 days at 1.

GE receives ¼¶s from German bank 200.925 Compare the amount repaid to the U.000(1.S. GE repays loan 110.000(1.015) = ¼203. bank to the cost of getting the needed £¶s with a Futures Contract to determine which is best 34 . GE uses these ¼¶s to pay German company 3.0175) = $111.Three Months from Today 1.000 2.

54/¼ (the Futures rate today) i.e.Consider the ¼¶s GE will receive from Lufthansa. that the ¼ will depreciate below the current Futures rate A Futures Contract and a Money Market Hedge will protect GE from the bad effects of this occurring 35 . What ³bad´ could happen which would cause GE to be interested in buying a Futures Contract? That one year from today the spot rate will be BELOW $0.

54/¼ (the futures rate today) Would a Futures Contract or a Money Market Hedge allow GE to benefit from this situation occurring? What would allow GE to benefit from this situation occurring? 36 .What would GE like to see happen to the spot rate over the next 12 months if it did not hedge? One year from today the spot rate to be ABOVE $0.

Currency Option Hedge Should GE use a Put or a Call? Put Option Should GE buy or sell a ¼ Put? BUY 37 .

Today 1.58 .000.000.000 38 .000 with a strike price of $0.250.58/¼ and a premium of 5¢/¼ Cost: (25. GE buys 200 Put Options to sell ¼25.250.000)($0.000)(5¢) = $1.000.000 GE is now guaranteed that the minimum they will receive for the turbine blades is (25.5¢) = $13.

000.000 . GE receives ¼25.500.250.250.000 from Lufthansa How does GE decide if it should exercise the Put? Compare the spot rate to the strike price If spot $0.000($0.000.000 clears $14.$1.000 = $13.One Year from Today 1.58) = $14.500.000 39 .58 GE should exercise the Put receives 25.

63 GE recoups some of the 5¢ premium If $0.000 Note: If $ < spot < $0.250.$1.000(spot rate) .63 < spot GE recoups all of the 5¢ premium plus more 40 .58 GE should not exercise the Put GE sells the ¼¶s in the spot market GE receives 25.If spot $0.000(spot rate) clears 25.

54/¼ $0.58/¼ 5 cent premium That depends on what the spot rate is one year from today If spot rate is $0.Which would have been better for GE? Buy Put Option strike Sell Futures Contract $0.58/¼? Futures Contract 41 .52/¼? Futures Contract If spot rate is $0.

If spot rate is $0.65/¼? Put Option If spot rate is $0.595/¼? Put Option Futures Contract is better if spot < $0.59 42 .59 = $0.54 + 5¢ Put premium Futures rate Put Option is better if spot > $0.

the best course of action for GE to take today would be not to hedge at all GE will not know this until after it had to make a decision Not hedging would leave GE unprotected if ¼ depreciated below $0.54 one year from today.NOTE If the spot rate is greater than $0.54/¼ 43 .

GE¶s Future (Forward) hedge.50/¼ $0. Possible Future Spot Rates $0.53/¼ $0. Money Market hedge. Put Option hedge. and going uncovered can be compared visually.60/¼ Probability 10% 30% 60% 44 .

000 Money Market Hedge 100% 80% 60% 40% 20% $13.055 45 .500.Future's Contract Hedge 100% 80% 60% 40% 20% $13.368.

58 and premium 5¢ 100% 80% 60% 40% 20% $13.000 spot is 60¢ spot is 50¢ or 53¢ don¶t exercise put exercise put 46 .250.750.Put Option Hedge Strike price $0.000 $13.

500.000 spot is 50¢ $13.Uncovered Position 100% 80% 60% 40% 20% $12.000 spot is 53¢ $ spot is 60¢ 47 .

Hedging Long-term Transaction Exposure Some MNC¶s know they will be exposed for many years into the future (Disney with theme parks in France & Japan) 48 .

49 . Japanese yen. and Swiss francs. maturities up to 10 years or more are sometimes available for the major currencies. Canadian dollars. Because forward contracts are tailored to the needs of the customer.Long-term Forward Contracts Many large international banks offer terms up to five years on British pounds.

Currency Swaps There are many forms of Currency Swaps EXAMPLE A Japanese firm is doing business in England and will receive £¶s over the next few years. 50 . It gets together with a British firm which is doing business in Japan and will receive ¥¶s over the next few years.

They agree to exchange their foreign currency cash flows at a specific rate ¥¶s ¥¶s ¥¶s £¶s ¥¶s ¥¶s £¶s £¶s £¶s £¶s Brokers employed by large banks will act as middlemen and will charge a fee for their services 51 .

Alternative Hedging Techniques Leading & Lagging Adjust timing of payables and receivables depending on expectation of exchange rate movement 52 .

EXAMPLE French firm ships supplies to its subsidiary in Switzerland and will be paid in SF¶s What should the French firm do if it thinks the SF will depreciate against the ¼? Speed up the payment Leading What should the French firm do if it thinks the SF will appreciate against the ¼? Slow down the payment Lagging 53 .

Cross-Hedging Suppose a firm has transaction exposure against a currency where a hedge does not exist Identify another foreign currency which is highly positively correlated with the currency needed (relative to movements against the home currency) and for which a hedge does exist 54 .

appreciate. depreciate.Building Blocks for FINC 445 Skills: Communication Problem Solving Hedging: Invoicing strategy. Asian Crisis Forward Contracts: Forward Premium MNC¶s and consumers Investors Central Banks Speculators Motives: Involved in foreign financial markets European Monetary System: Euro Fiscal Policy: budget deficit money supply inflation Put Options Futures Contracts margin Exchange Rate Determination: Exports and imports pair of currency markets supply. FTAA. wealth of shareholders Trade Issues: Japan & China. Bretton Woods. arbitrage Bank participation in foreign exchange markets Trade Agreements: U. surpluses. indirect Call Options Contingency Graph Speculating on anticipated exchange rate movement Triangular Arbitrage Interest Rate Parity Exchange Rate Systems: fixed.S. expectations about future exchange rates Familiar Setting: U. trade barriers. grocery store Buyer vs seller Currency Conversion: The basics. Socialism Communism Balance of Payments: Current Account Capital Account Official Reserve Acct Goal of Corp: Max. Floating Exchange Rate System Economic Systems: Capitalism. futures contract hedge. direct & indirect. leading & lagging hedging technique. pegged. WTO Problem of Scarcity: Comparative Advantage Interdependence FX Systems: Euro. equilibrium Arbitrage Adjustment of Market Equilibrium: Inflation. national income. demand. pricing strategy. value. currency option hedge.-Canada. NAFTA. cross rates. Mercosur. Dollarization. uncovered position. Mexico. sterilized. income levels. interest rates. managed float. money market hedge. interest rates. EU. cross-hedging International Fisher Effect: Interest rates Locational Arbitrage Purchasing Power Parity: inflation Measuring Exposure to Exchange Rate Fluctuations Covered Interest Arbitrage Monetary Policy: Fed Intervention: direct. deficits. purchasing power Spot Market: Bid & ask rates. floating. GATT.S. trading partners Perfect Markets: labor interest Economic Factors: Inflation. CAFTA. capital controls MNC vs domestic firm Risk of doing business internationally Intl Agencies: World Bank IMF Ethical Considerations PV of MNC¶s cashflows 55 .

Image created by: Ralph A. Clevenger 56 .

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