Chapter_10_Managing_Transaction_Exposure_to_Currency_Risk

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Chapter 10Chapter 10Managing Transaction ExposureManaging Transaction Exposure

to Currency Riskto Currency RiskLearning objectives Transaction exposure

– An example Internal hedges

– Multinational netting and leading/lagging

Financial market (external) hedges– Currency forwards, futures, options, swaps, and money market hedges

Treasury management – best practicesButler, Multinational Finance, 4e

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Exposures to currency riskExposures to currency riskChange in firm value due to unexpected changes in foreign exchange rates- Transaction exposure

change in the value of contractual cash flows arising from the firm’s monetary assets and liabilities

- Operating exposure change in the value of noncontractual cash flows

arising from the firm’s real assets

Realassets

Monetaryassets

Commonequity

Monetaryliabilities

Transaction exposure

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A forward currency hedgeA forward currency hedgeUnderlying pound exposure

Short £ forward position

Net position

Net exposureV$/£

S$/£

shortpound

+£1,000,000

-£1,000,000+

$1,500,000

+$1,500,000

longpound


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Managing transaction exposureManaging transaction exposure

Managing transaction exposure internally- multinational netting (currency diversification) - leading and lagging

Managing transaction exposure in the financial markets- currency forwards- money market hedges- futures- options- swaps


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Multinational nettingMultinational netting

Germansubsidiary

U.S.subsidiary

U.K.parent

£100m

Cross rates €1.5000/£$1.2500/£$0.8333/€

£200m

$75m

$125m€150m

€60m

Internal hedges: Multinational netting

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Cash flows before nettingCash flows before netting

Germansubsidiary

U.S.subsidiary

U.K.parent

£100m

£200m

£60m

£100m£100m

£40m


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Cash flows after nettingCash flows after netting

Germansubsidiary

U.S.subsidiary

U.K.parent

£60m £140m


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Leading and laggingLeading and lagging Leading and lagging refers to altering

the timing of cash flows within the firm to offset foreign exchange exposuresFor example:- Leading - If a parent firm is short

euros, it can accelerate euro payments from its subsidiaries

- Lagging - If a parent firm is long euros, it can delay euro payments from its subsidiaries

Internal hedges: Leading and lagging

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Leading and laggingLeading and lagging Underlying cash flows

Leading

Lagging

-€10 million

+€7.5 million +€7.5 million +€7.5 million

-€10 million -€10 million

Jan Feb Mar Apr June May July Aug Internal hedges: Leading and lagging

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Currency forward contractsCurrency forward contracts

Advantages- Forwards can provide a perfect hedge of

transactions of known size and timing Disadvantages

- Bid-ask spreads can be large on small transactions, long-dated contracts, or infrequently traded currencies

- Forwards are a pure credit instrument, so forward contracts have credit risk

External hedges: Forwards

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Currency futures contractsCurrency futures contracts

The futures contract solution to the default risk of forward contracts- An exchange clearinghouse takes one side

of every transaction- Futures contracts are marked-to-market on

a daily basis- Initial and maintenance margins are

required on futures contracts

External hedges: Futures

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FX forwards versus futures contractsFX forwards versus futures contracts

Forwards FuturesCounterparty Bank Futures exchange

clearinghouseMaturity Negotiated StandardizedAmount Negotiated StandardizedFees Bid-ask CommissionsCollateral Negotiated Margin account

External hedges: Futures

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Currency futures contractsCurrency futures contracts

Advantages- Low cost if the size, currency and maturity

match the underlying exposure - Low credit risk with daily marking-to-

market Disadvantages

- Costs increase with transaction size- Exchange-traded futures come in limited

currencies and maturities- Daily marking-to-market can cause a cash

flow mismatchExternal hedges: Futures

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Money market hedgesMoney market hedges

Advantages- Synthetic forward positions can be

built in currencies for which there are no forward currency markets

Disadvantages- Relatively expensive hedge- Might not be feasible if there are

constraints on borrowing or lending

External hedges: Money market hedges

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Currency option hedgesCurrency option hedges

Advantages- Disaster hedge insures against

unfavorable currency movementsDisadvantages

- Option premiums reflect option values, so option hedges can be expensive in volatile currencies and at distant expiration dates

External hedges: Options

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A pound call is an option to buy pounds- the option holder gains if pound sterling

rises- the option holder does not lose if pound falls

Long pound callan option to buypounds sterling at a contractualexercise price

S$/£

V$/£

Option premium = $0.30/£

Exerciseprice

$1.50/£

-$0.30/£


A currency call optionA currency call option

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A call option hedgeA call option hedge

S$/£

V$/£

$1.50/£

-$1.50/£

Short exposureExternal hedges: Options

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S$/£

V$/£ Call option hedge

-$0.30/£

$1.50/£

-$1.50/£


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S$/£

V$/£ Call option hedge

Optionhedged position

-$0.30/£

$1.50/£

-$1.50/£-$1.80/£


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A pound put is an option to sell pounds- the option holder gains if pound sterling falls- the option holder does not lose if pound

risesLong pound putan option to sellpounds sterling at a contractualexercise price

S$/£

V$/£

Option premium = $0.30/£

Exerciseprice

$1.50/£

-$0.30/£


A currency put optionA currency put option

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A put option hedgeA put option hedge

S$/£

V$/£

Long exposure

+$1.50/£

$1.50/£


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S$/£

V$/£

Put option hedge

Long exposure

-$0.30/£

+$1.50/£+$1.20/£

$1.50/£


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S$/£

V$/£

Put option hedge

Long exposure

Optionhedged position

-$0.30/£

+$1.50/£+$1.20/£

$1.50/£


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Currency swaps…Currency swaps…“I’ll pay yours if you pay mine”“I’ll pay yours if you pay mine”

Currency swap- An agreement to exchange a principal

amount of two currencies and, after a pre-arranged length of time, re-exchange the original principal

- Interest payments are also usually swapped during the life of the contract

External hedges: Swaps

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Currency swap contractsCurrency swap contracts Advantages

- Quickly transforms the firm’s liabilities into other currencies or payout structures

- Low cost for plain vanilla swaps in actively traded currencies

- Swaps can be used to to hedge long-term exposures

Disadvantages- Not the best choice for near-term

exposures- Innovative or exotic swaps can be

expensiveExternal hedges: Swaps

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Financial market hedgesFinancial market hedgesVehicles Advantages DisadvantagesForward Exact hedge; Large bid-ask spreads on

Small bid-ask spread small or long-dated deals & for large deals thinly traded currencies

Future Low cost for small Only a few currencies &deals; low risk maturities; mark-to-market with mark-to-market can cause a CF mismatch

Money market Synthetic forward Relatively expensive; not hedge always possibleSwap Quick & low-cost Innovative swaps costly;

switch of payoff may not be best for structures near-term exposures

Option Disaster hedge Option premiums provides insurance can be expensive

External hedges

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10%

51%

10%

49%

6%

26%

Alter the size ofa hedge

Alter the timingof a hedge

Actively takepositions

Sometimes

Frequently

Active management of fx riskActive management of fx risk

Bodnar, Hayt, and Marston, “1998 Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms,” Financial Management (1998).

Financial management

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42%

24%17% 17%

Beginning-of-period forward

rates

Beginning-of-period spot

rates

Baselinepercenthedgedstrategy

Otherbenchmark

Risk management benchmarksRisk management benchmarks

Bodnar, Hayt, and Marston, “1998 Wharton Survey.”Financial management

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40%

21% 22%18%

Reducedvolatility

relative to abenchmark

Risk-adjustedperformance

Absolute profitor loss

Increasedprofit relative

to abenchmark

Performance evaluationPerformance evaluation

Bodnar, Hayt, and Marston, “1998 Wharton Survey.”Financial management

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Active treasuriesActive treasuries

Tend to be large firms with centralized risk management

Use sophisticated valuation methodologies such as value-at-risk for managing their exposures

Frequently mark their derivatives positions to marketGéczy, Minton, and Schrand, “Taking a View: Corporate Speculation, Governance, and Compensation” Journal of Finance (2007)


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Active treasuriesActive treasuriesmanage their managersmanage their managers

Managers’ actions are closely monitored Firms use compensation contracts to

align managers’ objectives with those of other stakeholders

Firms use derivatives-specific controls such as performance benchmarks to manage potential abuses Géczy, Minton, and Schrand, “Taking a View”


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Corporate use of derivativesCorporate use of derivativesUsed Total

Type of product often usageCurrency forwards 72.3%

93.1%Currency swaps 16.4 52.6OTC currency options 18.8 48.8Cylinder options 7.0 28.7Synthetic forwards 3.0 22.0Currency futures 4.1 20.1Exchange-traded (spot) options 3.6 17.3Exchange-traded futures options 1.8 8.9

Jesswein, Kwok & Folks, “What New Currency Risk Products Are Companies Using and Why?” Journal of Applied Corporate Finance (1995)


Chapter_10_Managing_Transaction_Exposure_to_Currency_Risk

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