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Chapter Objective:
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Chapter Thirteen
This chapter discusses various methods available for the management of transaction exposure facing multinational firms.
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? 1
Chapter Outline
Transaction Exposure
The sensitivity - due to unexpected changes in exchange rates of the domestic currency value of a firms contractual cash flows that are denominated in foreign currencies. Unlike economic exposure, transaction exposure is well-defined, transaction-specific and short-term. When transaction exposure exists, the firm faces three major tasks:
Identify its degree of transaction exposure, Decide whether to hedge its exposure, and Choose among the available hedging techniques if it decides on hedging.
Unhedged Position
Future FX Receipt
Future FX Payment
$30 m $0
Unhedged payable
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Long forward
$30 m
$0
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 $1.20.
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Future FX Payment
Today: Sell FX forward @ prevailing forward rate FX receipt date: Receive FX Sell FX from receipt for domestic currency at the contracted forward rate
Purchase FX with domestic currency at the contracted forward rate Receive FX from forward contract to cover FX payment
Futures Hedge
Currency Futures contract could also be considered, but would have two disadvantages over a forward contract. 1.
2.
Its more efficient to buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable.
S($/) = $1.25/
F360($/) = $1.20/ i$ = 7.10%
i =
11.56%
1. Borrow $112.05 million in Canada 2. Translate $112.05 million into pounds at the spot rate S($/) = $1.25/ 3. Invest 89.64 million in the UK at i = 11.56% for one year. In one year the investment will have grown to 100 million.
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Future FX Payment
Today: Borrow PV of FX receipt, exchange for domestic currency @ spot, invest domestically FX receipt date: Repay FX loan with FX receipt, close out domestic investment
Today: Purchase PV of FX payment @ spot using borrowed domestic currency, lend (or invest) the purchased FX FX payment date: Receive FX as repayment of lending (or investment), use it to make FX payment, repay domestic currency loan
In either case, company eliminates FX risk, cost of hedge determined by interest rates
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If the currency appreciates, your call option lets you buy the currency at the exercise price of the call.
If the currency depreciates, your put option lets you sell the currency for the exercise price.
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Profit
$5 m
$1.55 / $1.50/
$25 m
$5 m
$1.20/ $1.45 / $1.50/ loss
Unhedged payable
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Future FX Payment
Today: Buy put option to sell FX at FX receipt date at desired exercise price
Today: Buy call option to buy FX at FX payment date at desired exercise price
FX receipt date: If (S<X) Exercise the put option, sell FX at the exercise price. If (S>X) Do not exercise the put option. Sell FX received at that days spot rate.
FX payment date: If (S<X) Do not exercise the call option. Buy FX at that days spot rate to cover payment. If (S>X) Exercise the call option, buy FX at the exercise price.
Only hedge that allows firm to participate in favorable exchange rate movements, Only effective hedge for a contingent exposure
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Another type of cross-hedging is commodity-currency hedging, e.g. using oil futures contracts to hedge Mexican peso, or soybean or coffee futures to hedge Brazilian real. Works when a commodity futures prices move closely with an ex-rate.
Example: Use a Yen contract to cross-hedge Korean won currency risk (AR in won for a Canadian firm), assuming that the Yen/Won correlation is high.
Example: Brazil exports coffee to U.S. Dollar appreciates, real depreciates, dollar price of coffee futures falls on CME. Use coffee futures to hedge risk of real depreciating.
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by invoicing foreign sales in home currency by pro-rating the currency of the invoice between foreign and home currencies
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 its not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.
Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging.
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Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. In this case FX exposure management at the corporate level is redundant.
Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges. So corporate exposure management does not necessarily add to the value of the firm.
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The managers may have better information than the shareholders about the firms exposure position. The firm may be able to hedge at better prices than the shareholders. Hedging may reduce the firms cost of capital if it reduces the probability of default. 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.
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3. Default Costs
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