Dealing with Transaction Risk in a Renminbi Contract

A paper by Group 10:

Edgar Chimal Alissa Courson Samar Hajhamdan Nancy Vargas Hernandez Sarah Ferguson Vogt Matthew Wallace December 4, 2013 IMS 3310.002

Introduction Most entrepreneurs find domestic business challenging enough, but only the brave venture into international trade. Beyond navigating the legal, sociocultural, and economic differences of a foreign nation, one must also inevitably deal in a different currency. The exchange rate can fluctuate daily, making it difficult to predict cash flows from international sales. This challenge is exacerbated when a significant amount of time exists between price agreement and payment delivery. The amount of revenue assumed at the time of sale can change if the exchange rates differ at the time of payment, exposing the multinational business to transaction risk. As an illustration, consider two U.S. multinational companies that both recently negotiated a contract for the sale of US$1 million in product to a German company. Both companies agree to receive payment in Euros one month after delivery. The first company manages to deliver on September 25, when the Euro is exchanging for $1.35, and receives delivery on October 25, when the exchange rate is $1.38. The second company needs more time, and only manages to deliver on October 8, setting in an exchange rate of $1.36, and receiving payment on November 8 when the rate is $1.34. Even though both companies sold similar products at similar times for the same price, the first company makes $22,222 more than expected on the sale, and the second loses $14,706. Moreover, if they are competitors, the first company has received $36,928 more revenue than the second company. Exposure to such transaction risk can have serious implications on a firms cash flow if left unchecked. As trade becomes more globally focused, U.S. multinational companies may find it unreasonable to avoid transaction risk entirely, though paths do exist. One way is to quote prices in US$. This pushes the risk onto the buyer, since they now face exposure versus the dollar. In a highly competitive market, however, buyers may have the bargaining power to demand that the trade be in their favor. Secondly, one can keep the foreign currency to use in future transactions within the country. This option is particularly attractive to companies that have a large, persistent presence in a given country (Kelley 32). If, however, receipts must be in a foreign currency, and the firm requires conversion, then the transaction is exposed.

The environmental forces that most strongly affect transaction risk are financial and political. The rate at which foreign currencies are exchanged is subject to financial forces like inflation, interest, and trade deficits. Political leaders make decisions affecting these financial variables irrespective of market forces, and public debt and political stability also affect currency exchange rates (Van Bergen). Case Objectives Much like other companies facing stiff international competition, our American multinational company agreed to a contract with transaction exposure. The sale of US$6 million worth of high-tech product hinged upon an agreement for payment to our firm in Chinese renminbi (RMB). Payments will not be made up front at the date of delivery; rather, they will extend over a long-term contract, with payments occurring at 6, 12, and 18 months. This extension in time subjects the firms cash flows to fluctuations in the exchange rate between the two currencies. While an upward fluctuation in the amount of US$/RMB works in our favor, a downward fluctuation will lower our expected revenues from the sale. A mere 5% decrease in the exchange rate, for example, would result in a loss of US$300,000 in revenue. As a company that does not engage in foreign currency transactions, the firm lacks expertise in how to manage the risk associated with transaction exposure. To protect our profits, it is paramount that we understand our options for mitigating risk and the forces that may impact the value of the contract. Evaluating such forces demands a look into Chinese currency policy. Historically, the RMB has exhibited incredible stability for an emerging market currency. Prior to 2005, it was officially tied to the value of the US$, and pegged to a stable, undervalued rate to drive export sales and a trade surplus with America (Kroeber). Since then, its value has been determined versus a basket of international currencies, allowing responsiveness to market forces and resulting in its general appreciation. China renewed its commitment to lessen currency control in 2010, which heralded a 12% appreciation in real terms over a 3year timeframe. Even with recent growth, the International Monetary Fund believes that it is still undervalued by 5-10% due to its large reserves of foreign currency, which nearly exceed the combined reserves of all other advanced economies. China has officially committed to several international

monetary standards, and if political pressure wins out, the value of the RMB should increase accordingly good news for the firm. If China lapses back into its old habit of undervaluing its currency, however, it could result in a corresponding decrease in the firms revenue (Report to Congress on International Economic and Exchange Rate Policies 13). Chinas currency policy makes transaction exposure risk low, though its inconsistency in adhering to promised conformity to international standards means risk remains.

Figure 1. Value of US$ per 1 for 1-year (left) and 10-year (right) horizons (Chinese Yuan (CN) US Dollar ($)).

Alternatives There are many hedging strategies with aims to reduce the risks of foreign exchange transactions. These risk-mitigating options all carry some cost; however, many firms favor hedging due to the benefits of certainty of cash flows. The six most commonly employed strategies, which will be considered for this case, include leading and lagging, exposure netting, money market hedging, forward market hedging, swap contract, and currency option hedging. Leading and Lagging Leading and lagging is a favorable option to firms who have control over the timing of their cash flows. Collecting payments early through leading or later through lagging allows a firm with knowledge of exchange rate movement to optimize realized value. Payment timings can be encouraged through incentives, and are especially effective between two firms that are regular trading partners. To minimize risk, the company must have strong forecast knowledge and the flexibility to alter payment dates (Ball 467). Given that the firm has already negotiated fixed dates, leading and lagging is not a viable risk-minimizing option. Exposure Netting 3

Like leading and lagging, exposure netting is another internal means of hedging foreign exchange risk. A multinational doing business in many countries can diversify their foreign currency contracts such that the gains expected in some currencies equal the losses expected in others (Ball 469). Our firm does not engage in foreign currency transactions as a standard practice, which discounts exposure netting as an option. Money Market Hedge Beyond internal measures, there are external hedging options available. A money market hedge minimizes transaction risk by eliminating the time duration of payments, and exchanging foreign currency at the current rate. A firm locks in this rate by borrowing money in the foreign market in the amount of total receivables, and converting it immediately into its domestic currency. This money is invested to offset the interest owed on the foreign loan. The loan is paid down as foreign revenue is collected in the native currency, matching the liability with the receivable (Ball 470). A drawback is that, since the exchange occurs immediately, there is no opportunity to profit from a rise in the foreign currency. Moreover, if domestic interest rates are lower than foreign rates, then interest payments will exceed interest revenues, and the firm will have less net revenue. In our case, Chinese interest rates are at 6% versus the Federal Reserve funds rate of 0.25% (figure 2), meaning there would be a substantial net cost of borrowing.

Figure 2. Chinese (left axis) versus U.S. (right axis) central bank interest rates (China Interest Rate).

Forward Market Hedge/Swap Contract 4

Forward market hedging and its relative, swap contract, are external strategies that also eliminate the unknown factor to protect against foreign currency movement. Different from a money market hedge, however, a fixed rate is negotiated with a third party (typically a bank) rather than set by the spot rate, with opportunity to be higher in appreciating currency markets. The agreement to exchange at this rate on a specific future date is legally binding to both parties. A swap contract is a longer-term agreement that may include several exchanges and negotiated rates (Osei-Kuffour). While a major benefit of forward market hedging is the prevention of uncertain losses, it also eliminates the potential for future gains by transferring all risk. In fact, the party selling the contract expects to gain from the exchange and prices its offered rate accordingly. Despite this drawback, benefits make it the most commonly-used hedging strategy in China, but only certain banks are allowed to enter into these deals, limiting competition for better rates (Zhang 9). Currency Option Hedge Similar to the forward market hedge, the currency option hedge offers a future exchange at a negotiated rate, but gives the participant the option without the obligation to make the exchange. Because these options come with so much flexibility, offerings bear high commission and premium costs (Kelley 34). They are best used in volatile markets, where premiums and commissions are still less than potential losses, but potential gains could be quite profitable. Currently, they are only available offshore in countries with foreign exchange control, such as Hong Kong and Singapore, requiring a third currencys involvement, and therefore usage is limited to companies with large transaction exposure, such as financial institutions (Zhang 10).

Recommendation Though the currency market in China is modestly optimistic, our novice firm should hedge to gain certainty of profit margins. With limited foreign currency contracts and a dearth of internal expertise in managing transaction risk, some options present as less attractive than others. Leading and lagging and exposure netting are not possibilities given the set nature of the contract and dealings with a single foreign currency. Money market hedging would be attractive in a foreign country with a similar interest rate to the U.S.; however, Chinas comparatively high interest rate would mean a high net borrowing cost for our company. The lack of volatility in the RMB versus the dollar guides us to expect that premium costs on currency options will exceed any expected losses, and cut too deeply into profit margins if the currency value falls. The option left is the forward market hedge, and its frequent use in China suggests the strength of the choice. In a depreciating RMB scenario, our firm is insulated from the loss due to currency movement by the negotiated higher rate. Though we will not realize any appreciated gain, historical modest appreciation of the RMB guides expectation that these gains would be modest as well, and certainty of cash flows is achieved. Conclusion Our recommendation was guided by first looking at problems that may arise from transaction exposure, and the environmental factors that could influence our realization of revenue from our foreign currency transaction. These factors shape Chinas currency, the result of political and financial forces, whose possible fluctuations must be known to properly deal with transaction risk. Of the six alternatives, forward market hedging was decided to be most in line with the firms needs. This conservative decision was informed by the lack of internal expertise, the large difference in central bank interest rates, and the high cost of purchasing currency options relative to anticipated future exchange rates. Our firm can now rest easy that the value of our contract can be preserved, and we can reap the benefits of international trade.

Works Cited Ball, Donald A., Michael Geringer, Jeanne M. McNett, and Michael S. Minor. International Business: The Challenge of Global Competition. New York: McGraw-Hill/Irwin, 2013. Print. China Interest Rate. tradingeconomics. Trading Economics. n.d. Web. 29 Nov. 2013. Chinese Yuan (CN) US Dollar ($). Google Finance. Google. n.d. Web. 29 Nov. 2013. Kelley, Michael P. "Foreign Currency Risk: Minimizing Transaction Exposure." Virginia Lawyer Jun./Jul. 2001: 32-35. Web. 24 Sept. 2013. Kroeber, Arthur R. The Renminbi: the Political Economy of a Currency. Brookings. Brookings Institute. 7 Sept. 2011. Web. 29 Nov. 2013. Osei-Kuffour, Paul. Managing Foreign Exchange Risk. New African. 390 (2000). Web. 28 Nov. 2013. Report to Congress on International Economic and Exchange Rate Policies. treasury.gov. U.S. Department of the Treasury, Office of International Affairs. 30 Oct. 2013. Web. 29 Nov. 2013. Van Bergen, Jason. 6 Factors that Influence Exchange Rates. Investopedia. n.p. 23 Jul. 2010. Web. 29 Nov. 2013. Zhang, Meng. Foreign Exchange Risk Hedging and Firm value: Empirical Study from MNCs in China. MS thesis. Tilburg University, 2013. Web. 29 Nov. 2013.