Transcript INTL303chpt11 hedging

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Managing Transaction Exposure
Chapter 11
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Overview
 Identify
techniques for hedging
transaction exposure
 Describe how each technique hedges
an MNC’s payables and receivables
 Compare the different hedging
techniques
 Observe other methods that reduce
exchange rate risk
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Exchange Rate Exposure
There are 3 forms by which a MNC is
exposed to exchange rate fluctuations
 1. Transaction exposure
 2. Economic Exposure
 3. Translation Exposure
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Transaction Exposure
Exposure exists when future cash transactions
are affected by exchange rate fluctuations
 Affects
future cash flows
– e.g., MNC from US has payables
denominated in German marks
 1.
identify degree of exposure
 2. decide whether to hedge and if so, then what
percent of payables to hedge
 3. select the hedging technique
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Before Hedging
 Before
making any decisions about
hedging
 you should identify the net transaction
exposure on a currency-by-currency
basis
 Net means all inflows and outflows
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Before Hedging
 If
it turns out that the inflows and
outflows, across all the subsidiaries
offset each other, then you do not need
to hedge !!!
 Problem is, individual managers do not
like to be exposed because they think it
looks bad on their record
Page 335
 So they may hedge
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Before Hedging
 If
the individual managers hedge, they
might erode some of the offset
advantages that the whole firm has
 It must be kept in mind that the goal of
the MNC is to be profitable as a whole not just each subsidiary
 remember when hedging there are
transaction costs - its not free Page 335
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Transaction Exposure
Identifying Net Transaction Exposure
 Conduct
analysis by currency
– calculate the “net” exposure for each
currency
– make hedging decisions on MNC-wide basis
 consolidates
all subsidiaries
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Transaction Exposure
 Hedging
within MNC and agency theory
– MNC should hedge at the corporate level
– subsidiary managers may try to protect
their own cash flows
 redundant
hedging may occur within MNC
MNC X:
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Transaction Exposure
 Corporate
level hedging practices may:
– 1. create unhedged positions of subsidiary
– 2. may increase riskiness of subsidiary’s
cash flow
 Subsidiary
hedging without MNC
approval:
– may leave MNC exposed
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Text’s example of
Eastman Kodak Company’s
Example of Kodak’s centralized currency
management approach
 Irrelevant
to us in Canada
 we just don’t have that many companies
who are so large and have
manufacturing and business in so many
places that such questions of hedging
would be relevant
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Is Hedging Worthwhile ?
 “…
on the average it will not reduce the
MNCs costs … it could be argued that
hedging is not worthwhile…”
text page 336
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Canadian companies that
might use hedging
 Magna
 BCE
/ Nortel
 Noranda
 Air Canada
 Celestica
 Xerox
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Canadian companies that use
hedging
 Bombardier
 Alcan
 Canadian Airlines
 McCains
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Top companies in Canada that
might need to do centralized
foreign currency management
…
from the class
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Transaction Exposure
Approaches to Hedging
 1)
Hedge only when currency expected
to move in direction that makes hedging
feasible eg. approach of Black & Decker
– if MNC expects the DM to depreciatePage
in 336
value
 hedge
only inflow exposure (receivables)
– if MNC expects the DM to appreciate in
value
 hedge
only outflow exposure (payables)
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Transaction Exposure
Approaches to Hedging
 2)
Hedge 100 percent of net exposures
in foreign currency (Seagram Company)
– eliminates uncertainty when valuing
expected cash flows
– - they don’t do it to make any money, but
rather to prevent losing a lot of money,
which then helps a lot with planning
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 “Most
MNCs do not perceive their
foreign exchange management as a
profit center”
 that is they do not do hedging to make
money -they do it to
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1. Measure exposure in order to assess risk
2. Determine whether the exposure should be
hedged
3. Determine HOW the exposure should be
hedged
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Adjusting the Invoice Policy to
Manage Exposure
 Sometimes
a large company will have
to pay for things in “x” from “X” country
 It might also sell stuff to “X” country
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denominated in dollars
 One of the things you can do is
denominate it in “x” so you balance your
exposure

textbook example uses paying in Swiss francs
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Transaction Exposure Hedging
Techniques
 1)
Futures hedge
 2) Forward hedge
 3) Money market hedge
 4) Currency option hedge
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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1. Futures Hedge (Currency Futures)
 Characteristics
of contract
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– buyer of futures contracts
– depends if your purpose is payables or
receivables




entitled to receive a specified amount in a specified
currency for a stated price on a specified date
expects the currency to appreciate in value
if it appreciates, then they will have saved money because
in the future, they will not have had to pay at the higher
price
sometimes they can backfire
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2. Forward Hedge (Forward Contract)
Page 339
 Used
heavily by large corporations
– usually because they have to pay for a large
amount of material, supplies or component
parts
– “… contract specifies the exchange rate at
which currencies will be exchanges”
– if you don’t know the amount, then you have to
lock in the rate
– if you know the amount, then you could do a currency futures hedge
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2. Forward Hedge
 Hedging
vs not hedging on payables
– MNC compares possible outcomes
 hedging
produces known results
 not hedging permits range of possibilities to
exist
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2. Forward Hedge
 Hedging
vs not hedging on receivables
– MNC compares possible outcomes
 hedging
produces known results
 not hedging permits range of possibilities to exist
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3. Money Market Hedge
Page 344
 Hedge
on payables
 basically, if you have the money
available, you can but it in the bank, in
the denomination of the currency you will
need, and the small amount of interest
you will earn might cover the possible
drop if you did not take this action
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3. Money Market Hedge
Page 344
 Hedge
on payables
 If you take this action, it requires you do
2 things
 1. Borrow funds in the particular currency
 2. Make a short term investment in that
currency
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3. Money Market Hedge on Receivables
Page 345
 Hedging
on receivables
 If you expect some large amount of
money coming in (say, $2M Pounds)
 Maybe you expect the Pound to drop in
the next few weeks so that incoming
money will be less in value
 What you can do is borrow the 2 million
pounds now
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3. Money Market Hedge on Receivables
Page 345
 Hedging
on receivables, continued,,,
 Now, for a short period of time you will
have to pay interest in the 2 million
pounds, but when you payment comes
in from the person you are doing
business with, you can take that 2
million pounds, and use it to pay back
the other 2 million pounds you borrowed
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3. Money Market Hedge on Receivables
Page 345
 Hedging
on receivables, continued,,,
 The reason you would want to do this is
just in case Pounds dropped very low,
the incoming Pounds may not mean
much in dollars, but they would still be
OK to pay off a short term loan
denominated in Pounds !
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4. Currency Option Hedge
 Unhedged
strategies
– may outperform hedging strategies
 when
a payables currency depreciates
 when a receivables currency appreciates
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4. Currency Option Hedge
Page 346
 Sometimes
using a Forward Hedge
(Forward Contract) and a Currency
Hedge (Currency Futures Contract) can
backfire,
 therefore, people use currency options only problem is you have to pay a
premium for them, which sometimes
could negate any small advantages
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4. Currency Option Hedge
 Hedging
payables with call option
(buying)
– provides right to buy a specified amount of
a currency at a specific price with a
specified time period
– does not obligate the owner to buy the
currency
Page 346
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4. Currency Option Hedge
 Hedging
receivables with currency put
options
– provides right to sell a specified amount of
a currency at a specific price within a
specified time period
– does not obligate the owner to sell the
currency
Page 347
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4. Currency Option Hedge
 Hedging
receivables with currency put
options
– if the existing spot rate of the foreign
currency is above the exercise (strike)
price when the firm receives the foreign
currency, the firm can sell the currency
received at the spot rate and let the put
option expire
Page 347
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Page 348
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In the textbook, they spend some pages
explaining the different hedge techniques
on pages 349, 350 and 351, only to
conclude on page 352 that
Page 352
“… Fresno Corporation is likely to perform
best
if it remains unhedged…”
“…While the hedging techniques described in
this chapter can be useful, they have limited
effectiveness for the long term”
Page 355
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Limitation of Repeated
Short-term Hedging
 Long-term
hedging
– may be more effective than a series of
short-term hedges
 when
a currency enters a long cycle of strength
or weakness
– e.g., Deutsche mark strengthened against
most currencies in the early 1990s
 long
term hedges would have been more
effective
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Long-term Transaction Exposure
 Hedging
methods
– long-term forward contract
– currency swap
– parallel loan
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Long-term Transaction Exposure:
Hedging
 Long-term
forward contract
– time horizon up to five years
 long-term
payables (outflow) exposure
 long-term receivables (inflow) exposure
– commonly used for major currencies
– MNCs that benefit most from this hedging:
 have
established fixed-price contracts
Page 357
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Long-term Transaction Exposure:
Hedging
Page 357
Currency swap
 works well for two companies that have
long term expectations of being exposed
to a currency, so they get their bankers to
“swap” the exposure for a better currency,
or their own
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Long-term Transaction Exposure:
Hedging
Page 357
Currency swap
 see handout given to class from WWW
 http://www.finpipe.com/currswaps.htm
 Currency swaps give companies extra
flexibility to exploit their comparative
advantage in their respective borrowing
markets
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Long-term Transaction Exposure:
Hedging
Currency swap
 from
Page 357
http://www.finpipe.com/currswaps.htm
 Currency
swaps allow companies to
exploit advantages across a matrix of
currencies and maturities

Because of the exchange and re-exchange of notional
principal amounts, the currency swap generates a
larger credit exposure than the interest rate swap
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Long-term Transaction Exposure:
Currency swap Hedging
 from

Page 357
http://www.finpipe.com/currswaps.htm
Companies have to come up with the funds to deliver the
notional at the end of the contract. They are obliged to
exchange one currency's notional against the other
currency's notional at a fixed rate. The more actual market
rates have deviated from this contracted rate, the greater the
potential loss or gain. This potential exposure is magnified
with time. Volatility increases with time. The longer the
contract, the more room for the currency to move to one side
or other of the agreed upon contracted rate of principal
exchange. This explains why currency swaps tie up greater
credit lines than regular interest rate swaps.
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Long-term Transaction Exposure:
Hedging
 Example
of a swap serving two MNCs
– MNC A is a French firm
 committed
to a four year contract in the US
 expects to receive $6,000,000 at end of fourth year
– MNC B is a US firm with a contract in France
 will
receive FF35,000,000 in four years
– MNCs A and B, with a bank’s help, arrange swap
 permits
the exchange of $US for FF at an agreed price
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Long-term Transaction Exposure:
Hedging
 Parallel
loan
– a two-step currency exchange agreement
– two MNCs agree to:
 1)
exchange FF for $US
 2) re-exchange $US for FF at a specified
exchange rate and a specified time
– requires two currency swaps
 at
inception of loan and at the second
exchange
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Alternative Hedging Techniques
 Three
common methods
– leading and lagging
– cross hedging
– currency diversification
 Reduce
exposures formed from poor
forecasts
– standard hedging works best when MNCs
accurately forecast future exchange rates
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Slide 49 of 52
Alternative Hedging Techniques
 Leading
and lagging
– adjust the timing of payments or receipts
 expects
currency change to affect receivables
or payables
– leading, moves up transaction
– lagging, postpones transaction
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Slide 50 of 52
Alternative Hedging Techniques
 Cross
hedging
– reduces transaction exposure in a currency
that cannot be hedged directly
– hedges with a currency that is highly
correlated with the desired currency
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Slide 51 of 52
Alternative Hedging Techniques
 Currency
diversification
– takes a portfolio approach to currencies
– MNC with transactions in many currencies
benefit most
 Coca
Cola
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Summary
 Techniques
to hedge transaction
exposures
– futures hedge
– forward hedge
– money market hedge
– currency option hedge
 Alternative
methods
– used to hedge payables and receivables
exposures
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson