Chapter 10 Transaction Exposure Learning Objectives Distinguish between

Chapter 10 Transaction Exposure

Learning Objectives • Distinguish between the three major foreign exchange exposures experienced by firms • Analyze the pros and cons of hedging foreign exchange transaction exposure • Examine the alternatives available to a firm for managing a large and significant transaction exposure • Evaluate the institutional practices and concerns of conducting foreign exchange risk management • Explore advanced dimensions of foreign currency hedging 10 -2 © 2016 Pearson Education, Inc. All rights reserved.

Transaction Exposure • Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates. • An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm. • Exhibit 10. 1 shows schematically the three main types of foreign exchange exposure: transaction, translation, and operating. 10 -3 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 10. 1 The Foreign Exchange Exposures of the Firm 10 -4 © 2016

Types of Foreign Exchange Exposure • Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. • Thus, this type of exposure deals with changes in cash flows the result from existing contractual obligations. 10 -5 © 2016 Pearson Education, Inc. All rights reserved.

Types of Foreign Exchange Exposure • Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. 10 -6 © 2016 Pearson Education, Inc. All rights reserved.

Types of Foreign Exchange Exposure • Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. • The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness. 10 -7 © 2016 Pearson Education, Inc. All rights reserved.

Types of Foreign Exchange Exposure • Translation exposure, also called accounting exposure, is the potential for accountingderived changes in owner’s equity to occur because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements. 10 -8 © 2016 Pearson Education, Inc. All rights reserved.

Why Hedge? • MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. • These three financial price risks are the subject of the growing field of financial risk management. • Many firms attempt to manage their currency exposures through hedging. 10 -9 © 2016 Pearson Education, Inc. All rights reserved.

Why Hedge? • Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position. • While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against. 10 -10 © 2016 Pearson Education, Inc. All rights reserved.

Why Hedge? • The value of a firm, according to financial theory, is the net present value of all expected future cash flows. • Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. • A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows. • Exhibit 10. 2 illustrates the distribution of expected net cash flows of the individual firm. 10 -11 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 10. 2 Hedging’s Impact on the Expected Cash Flows of the Firm 10

Why Hedge? • Proponents of hedging cite: – Reduction in risk in future cash flows improves the planning capability of the firm – Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress) – Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm – Management is in better position to take advantage of disequilibrium conditions in the market 10 -13 © 2016 Pearson Education, Inc. All rights reserved.

Why Hedge? • Opponents of hedging state: – Shareholders are much more capable of diversifying currency risk than the management of the firm – Currency risk management does not increase the expected cash flows of the firm – Management often conducts hedging activities that benefit management at the expense of the shareholders – Managers cannot outguess the market – Management’s motivation to reduce variability is sometimes for accounting reasons. – Hedging only adds costs from an efficient market perspective. 10 -14 © 2016 Pearson Education, Inc. All rights reserved.

Measurement of Transaction Exposure • Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. • The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. Exhibit 10. 3 demonstrates how this exposure comes about. 10 -15 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 10. 3 The Life Span of Transaction Exposure 10 -16 © 2016 Pearson

Measurement of Transaction Exposure • Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges. • The main contractual hedges employ the forward, money, futures, and options markets. • Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies. 10 -17 © 2016 Pearson Education, Inc. All rights reserved.

Measurement of Transaction Exposure • The term natural hedge refers to an offsetting operating cash flow, a payable arising from the conduct of business. • A financial hedge refers to either an offsetting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap. • Care should be taken to distinguish operating hedges from financing hedges. 10 -18 © 2016 Pearson Education, Inc. All rights reserved.

Ganado’s Transaction Exposure • With reference to Ganado’s transaction exposure, the CFO, Maria Gonzalez, has four alternatives: – remain unhedged; – hedge in the forward market; – hedge in the money market; or – hedge in the options market. • These choices apply to an account receivable and/or an account payable. • See Exhibit 10. 4 10 -19 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 10. 4 Ganado’s Transaction Exposure 10 -20 © 2016 Pearson Education, Inc. All

Ganado’s Transaction Exposure • A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract. • In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date. • This type of hedge is “open” or “uncovered” and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract. • The purchase of such funds at a later date is referred to as covering. 10 -21 © 2016 Pearson Education, Inc. All rights reserved.

Ganado’s Transaction Exposure • A money market hedge also involves a contract and a source of funds to fulfill that contract. • The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. • Funds to fulfill the contract may be generated from business operations, in which case the money market hedge is covered. • Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge). 10 -22 © 2016 Pearson Education, Inc. All rights reserved.

Ganado’s Transaction Exposure • Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk. • The choice of option strike prices is a very important aspect of utilizing options as option premiums, and payoff patterns will differ accordingly. • Exhibit 10. 5 shows the value of Ganado’s £ 1, 000 account receivable over a range of possible ending spot exchange rates and hedging alternatives. • Exhibit 10. 6 shows alternatives for an A/P 10 -23 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 10. 5 Ganado’s A/R Transaction Exposure Hedging Alternatives 10 -24 © 2016 Pearson

Exhibit 10. 6 Ganado’s A/P Transaction Exposure Hedging Alternatives 10 -25 © 2016 Pearson

Risk Management in Practice • The treasury function of most private firms, the group typically responsible for transaction exposure management, is usually considered a cost center. • The treasury function is not expected to add profit to the firm’s bottom line. • Currency risk managers are expected to err on the conservative side when managing the firm’s money. 10 -26 © 2016 Pearson Education, Inc. All rights reserved.

Risk Management in Practice • Firms must decide which exposures to hedge: – Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy – Many firms feel that until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100% – An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures – Anticipated exposures are transactions for which there are no contracts or agreements between parties 10 -27 © 2016 Pearson Education, Inc. All rights reserved.

Risk Management in Practice • As might be expected, transaction exposure management programs are generally divided along an “option-line, ” those that use options and those that do not. • Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges. 10 -28 © 2016 Pearson Education, Inc. All rights reserved.

Risk Management in Practice • Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging. • These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures. • The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level. 10 -29 © 2016 Pearson Education, Inc. All rights reserved.

Advanced Topics in Hedging • There are other theoretical dimensions to currency hedging that are not often considered in actual industry practice: – optimal hedge ratio; – hedge symmetry; – hedge effectiveness; and – hedge timing. 10 -30 © 2016 Pearson Education, Inc. All rights reserved.

Chapter 10 Appendix Complex Option Hedges