Managing Accounting Exposure [Shapiro: Chapter 9]
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Transcript Managing Accounting Exposure [Shapiro: Chapter 9]
“Wide German Protests Planned
Today in Dispute on Sick Pay”
(New York Times, 10-24-96)
“IG
Metall, Germany’s largest
union, said today that big rallies
were planned nationwide on
Thursday to protest possible cuts in
sick pay, after the collapse of talks
with employers aimed at resolving
the matter.”
“Wide German Protests Planned
Today in Dispute on Sick Pay”
(New York Times, 10-24-96)
“Given
German tradition, it is difficult
to see companies in one industry
having many different policies.” Wages
and labor policy in Germany have
traditionally been settled through
industry-wide contracts, not company
by company.
“Wide German Protests Planned
Today in Dispute on Sick Pay”
(New York Times, 10-24-96)
German
industry wants to reduce
sick-pay coverage to 80 percent of
base wages, in line with a new
legal minimum passed last month.
Until now, sick pay has been 100
percent of wages plus average
overtime.
“Wide German Protests Planned
Today in Dispute on Sick Pay”
(New York Times, 10-24-96)
Days
after Parliament passed the
legislation on Sept. 13, DaimlerBenz announced that it would cut
sick pay for its 220,000 German
employees. A number of large
companies followed with similar
announcements.
“Sweden’s cradle-to-grave welfare
starts to get ill”
[Intl. Herald Tribune, 9-25-02]
“…one
in 20 Swedish workers
were on sick leave for more than a
week last year, double the
European Union average, and that
paid sick leave averaged nearly 25
days, up from 14 days in 1998.”
“Sweden’s cradle-to-grave welfare
starts to get ill”
[Intl. Herald Tribune, 9-25-02]
“An
average of 430,000 Swedish
employees, 10 percent of the
country’s work force is on sick
leave at any given time.”
“Sweden’s cradle-to-grave welfare
starts to get ill”
[Intl. Herald Tribune, 9-25-02]
“The
government pays a benefit
equal to 80 percent of a person’s
salary during sick leave, no matter
how long, and an additional 10
percent in what is called “contract
insurance” for the first three
months.”
Average number of days a
Swedish worker is on sick leave
25
20
15
10
5
0
'96
'97
'98
Year
'99
'00
'01
Measuring and Managing Translation
and Transaction Exposure
[Shapiro: Chapter 9]
Hedging
“
... establishing an offsetting
currency position ...
... whatever is lost or gained on the
original currency exposure ...
is exactly offset by a
corresponding foreign exchange
gain or loss ...
on the currency hedge.”
Hedging
“Regardless
of what happens to
the future exchange rate ...
hedging locks in a dollar (home
currency) value for the currency
exposure.”
Managing Transaction
Exposure
Which
exposures to manage?
Those that are:
– large in size
– involve volatile currencies
– extend over long periods of time
Managing Transaction
Exposure
Which
exposures to manage?
How to manage the position?
How much of the position to
hedge?
Which exposure-reducing
techniques to employ?
Transaction Exposure
Committed
to a foreign currencydenominated transaction
Future foreign currency cash
inflow or outflow
Risk: exchange rate may vary
Hedge: offsetting cash flows
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Risk shifting
Pricing decisions
Exposure netting
Currency risk sharing
Currency collars
Currency
options
General Electric Example
1: contract for € 10 million
Dec 31: payment to be received
Current spot price: € =$1.3382
One-year forward: € =$1.2800
What are the risks to GE?
How would you manage those risks?
Jan.
Managing Transaction Exposure
Forward
market hedge:
– if long, sell currency forward
– if short, buy currency forward
Fix the dollar value of future
foreign currency cash flow
GE Forward Market Hedge
Spot Rate
(12/31)
€ = $1.3382
Original Gain (Loss) Total Cash
Receivable On Contract Flow ($)
13,382,000
(582,000) 12,800,000
GE Forward Market Hedge
Spot Rate
(12/31)
Original Gain (Loss) Total Cash
Receivable On Contract Flow ($)
€ = $1.3382
13,382,000
(582,000) 12,800,000
€ = $1.280
12,800,000
0 12,800,000
GE Forward Market Hedge
Spot Rate
(12/31)
Original Gain (Loss) Total Cash
Receivable On Contract Flow ($)
€ = $1.338
13,382,000
(582,000) 12,800,000
€ = $1.280
12,800,000
0 12,800,000
€ = $1.250
12,500,000
300,000 12,800,000
GE Forward Market Hedge
Spot Rate
(12/31)
Original Gain (Loss) Total Cash
Receivable On Contract Flow ($)
€ = $1.338
13,382,000
(582,000) 12,800,000
€ = $1.280
12,800,000
0 12,800,000
€ = $1.250
12,500,000
300,000 12,800,000
€ = $1.400
14,000,000 (1,200,000) 12,800,000
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Money Market Hedge
Simultaneous
borrowing and
lending in ...
two different currencies to ...
lock in the dollar value of a future
foreign currency cash flow.
Money Market Hedge
€
interest rate = 15%
$US interest rate = 10%
GE borrows € 8.70 (10/1.15)
million for one year
Convert € into $11.64 million (8.7
X 1.3382)
Money Market Hedge
Invest
$11.64 million for one year @
10%
On 12/31, GE receives $11.64 x 1.10 =
$12.8 million
GE collects its receivable from
Lufthansa: € 10 million
GE repays the € 10 million it owes (€
8.7 x 1.15)
GE Money Market Hedge
Spot Rate
(12/31)
Original Gain (Loss) Total Cash
Receivable On Hedge
Flow ($)
€ = $1.338
13,382,000
(582,000) 12,800,000
€ = $1.280
12,800,000
0 12,800,000
€ = $1.250
12,500,000
300,000 12,800,000
€ = $1.400
14,000,000 (1,200,000) 12,800,000
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Risk shifting
Risk Shifting
Price
transaction in dollars
Doesn’t eliminate currency risk
Shifts it from GE to Lufthansa
Zero-sum game
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Risk shifting
Pricing decisions
Pricing Decisions
€
10,000,000 X $1.3382 = $13,382,000
What
is the “real worth” of the
contract with Lufthansa? Why?
€ 10,000,000 X $1.28 = $12,800,000
$13,382,000 / 1.28 = € 10,454,688
Pricing Decisions
“The
general rule on credit sales
overseas is to convert between the
foreign currency price and the
dollar price by using the forward
rate, not the spot rate.”
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Risk shifting
Pricing decisions
Exposure netting
Exposure Netting
“...the
net gain or loss on the entire
currency exposure portfolio is what
matters, rather than the gain or loss
on any individual monetary unit.”
Exposure Netting
Portfolio
approach to hedging
Portfolio risk less than the sum of
individual risk positions
Exposure Netting
[Possible outcomes]
Offset
long and short positions in
the same currency
Offset long and short positions in
positively correlated currencies
Offset long (or short) positions in
negatively correlated currencies
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Risk shifting
Pricing decisions
Exposure netting
Currency risk sharing
Currency Risk Sharing
Imbedded
hedge contract
Price adjustment clause
Base price adjusted for certain
exchange rate changes
Risk is shared beyond “neutral
zone”
Currency Risk Sharing
rate: € 1 = $1.33
Neutral zone: $1.30 - $1.36
What happens at € 1 = $1.22?
Rate used = $1.29 : € 1
$1.29 = ($1.33 – (.08 / 2))
€ 10,000,000 X 1.29 = $12,900,000
$12,900,000 ÷ $1.22 = € 10,573,770
Base
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Risk shifting
Pricing decisions
Exposure netting
Currency risk sharing
Currency collars
Currency Collars
[“Range Forward”]
GE
accepts some but not all risk
GE buys protection outside a range
Range:
If e1
€ = $1.28 - $1.38
< $1.28, then RF = $1.28
If $1.28 ≤ e1 ≤ $1.38, then RF = e1
If e1 > $1.38, then RF =$1.38
Managing Transaction Exposure
Forward
market hedge
Money market hedge
Risk shifting
Pricing decisions
Exposure netting
Currency risk sharing
Currency collars
Foreign currency options
Foreign Currency Options
Uncertain
foreign currency flows
Example: competitive bid contract
GE buys a € 10 million put option
($1.28/€) for $100,000
GE loses bid; maximum loss =
$100,000
GE wins bid; e1 > $1.28; let option
expire, sell at spot