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Transaction ExposureTransaction Exposure

(or chapter 8)(or chapter 8)

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Agenda• Types of forex exposures?

• Causes of transaction exposure?

• Pros & cons of hedging transaction exposure?

• How to manage transaction exposure?– Forward Market Hedge

– Money Market Hedge

– Option Market Hedge

• Institutional practices of forex risk management.

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Types of forex exposure Forex exposure

– potential change in profitability, net cash flow, market value due to change in forex rate.

Transaction Exposure – changes in value of outstanding financial obligations incurred prior

to change in forex, not due to settle until after forex change.

Operating (Economic) Exposure– change in firm PV resulting from change in expected future

operating cash flows due to unexpected forex change

Translation (Accounting) Exposure– accounting-derived changes in owner equity due to consolidation

in single currency.

Tax Exposure – varies by country, general rule only realized foreign losses are

deductible for calculating income taxes

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Why Hedge? Pros & Cons…• Improves planning.• Reduces likelihood of bankruptcy.• Management better knows actual risks.vs.• Currency risk management costly, may not increase

expected cash flows.• Shareholders more capable diversifying risk.• Investors already factored forex exposure into valuation.• Conducts hedging to benefit management. • Managers cannot outguess efficient market .• Management criticized for forex losses but not for cost in

avoiding forex losses.

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Expected Cash Flow Net Cash Flow (NCF)NCF

•Reduction of risk?•Increase/decrease in expected cash flow?•Increase in value?

Unhedged

Hedged

Why Hedge?

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What causes transaction exposure?

Purchasing or selling on credit.

Borrowing or lending in foreign currency.

Being party to unperformed forward contract.

Acquiring assets/ incurring liabilities in foreign currency.

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Open Account Purchasing/ Selling

Quotation Exposure

Time b/n quoting price & reaching

sale.

Backlog Exposure

Contract Signed.

Time to fill order.

Billing Exposure

Time to get paid.

Seller quotes price

t1

Buyer places order

t2

Seller ships product

t3

Buyer settles A/R

t4

Anticipa-tion

Exposure

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Borrowing &Lending Grupo Embotellador de Mexico (Gemex)

• Dollar debt mid-December, 1994:– $ 264 m PS 3.45/$ = PS 910,800,000.

• Dollar debt in mid-January, 1995:– $ 264 m PS 5.50/$ = PS 1,452,000,000 (59% up!)

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How to manage transaction exposure? Contractual hedge Operating hedges

• Risk-sharing agreements.

• Leads and lags in payment terms.

• Swaps.

Natural hedge Financial hedge

• offsetting debt obligation.

• financial derivative such as swap.

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Hedging Account Receivable Suppose October sale for £1,000,000, A/R January.

– Spot $1.764/£

– 3m-forward $1.754/£ (2.27% discount)

– Cost of capital 12.0% annual

– British 3m borrowing rate 10% annual

– British 3m lending rate 8% annual

– US 3m borrowing rate is 8% annual

– US 3m lending rate is 6% annual

– Jan. put on £1,000,000 w/ strike $1.75/£; 1.5% premium.

– Forecasts 3m future spot $1.76/£.

– Budget rate (lowest acceptable amount) $1.70/£

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Hedging Account Receivable Unhedged position: £1,000,000 x $1.76/£ = $1.76 m. Forward hedge:

• Forward contract & source of funds to fulfill the contract.

• Forward entered @ time A/R created (October).

• A/R recorded @ spot $1.764/£, so $1,764,000.

• Covered (perfect) vs. uncovered (open) forward hedge.

Money market hedge:• creates liability offset w/ asset in £: balance sheet hedge.

• borrow PV of £1,000,000: £1,000,000/1.025 = £975,610.

• exchange £975,610 at spot $1.764/£ for $1,720,976.Received today Invested in Rate Future value in 3 months

$1,720,976 Treasury bill 6% annual or 1.5%/qtr $1,746,791$1,720,976 Debt cost 8% annual or 2.0%/qtr $1,755,396$1,720,976 Cost of capital 12% annual or 3.0%/qtr $1,772,605

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Option Market Hedge

Purchase put option. • 3 month put option @ ATM strike $1.75/£, premium 1.5%:

• Premium as of Jan $26,460 1.03 = $27,254.

• Unlimited upside, limited downside.

Breakeven price, option hedge• Upper bound:

– If pound appreciate above $1.754/£ + $0.0273/£ = $1.7813/£.

• Lower bound– If pound depreciates below $1.75/£ - $0.0273/£ = $1.722/£.

$26,460. $1.7640 x 0.015 x £1,000,000

rate)(spot x (premium) x option) of (Sizeost

C

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A / R Hedges

1.68 1.70 1.74 1.761.72 1.821.801.78 1.861.84

US$ value of£1,000,000 A/R

1.68

Ending spot (US$/£)

1.70

1.72

1.74

1.76

1.78

1.80

1.82

1.84 Forward$1.7540/£

Forward contract $1,754,000

Uncovered

ATM put option min $1,722,746

Money market$1,772,605 @ 12%

Put strike$1.75/£

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Account Payable Hedge Assume £1,000,000 A/P in 90 days

• Unhedged position: expected pay $1,760,000.

• Forward market hedge: purchase forward @ $1.754/£, cost locked $1,754,000.

• Money market hedge: – Offset £ obligation by £ asset w/ matching maturity.

– Exchange US$ spot & invest for 90 days in £.

– Carry the cost forward 90 days

£980,392,

36090

x .081

£1,000,000

.$1,729,412 $1.764/£ £980,392

.294,781,1$360

90 x12.01 x 412,729,1$

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Account Payable Hedge Option hedge:

• purchase call option on payable.

• ATM call option w/ strike $1,75/£ would be 1.5% premium.

• If spot less $1.75/£ option expire & £1,000,000 purchased on spot market.

• If spot above $1.75/£ option exercised: exchange £1,000,000 @ $1.75/£ less option premium:

• Carried forward 90 days @ 12% p.a. premium $27,254.Exercise call option (£1,000,000 $1.75/£ $1,750,000

Call premium (carried forward 90 days) $27,254

Total maximum expense of call option hedge $1,777,254

$26,460 $1.75/£ x 0.015 x £1,000,000

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A / P Hedges

1.68 1.70 1.74 1.761.72 1.821.801.78 1.861.84

US$ value of£1,000,000 A/R

1.68

Ending spot (US$/£)

1.70

1.72

1.74

1.76

1.78

1.80

1.82

1.84 Forward$1.754/£

Forward contract$1,754,000

Uncovered

Money market$1,781,294

Call strike$1.75/£

Call option:

$1,777,254

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Forex Risk Management for Real Goals?

• cost center vs. profit center.

Exposures?• backlog exposure?

• selectively hedge backlog & anticipated exposures?

Contractual Hedges?• Amount of risk covered, proportional hedges?

• Currency options?

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Things to remember Types of forex exposures

• Transaction

• Operating

• Translation

• Tax

How to hedge A/R & A/P transaction exposure?• Money market?

• Forward market?

• Option market?