Chapter 14 Transaction Exposure to Currency Risk 14

Chapter 14 Transaction Exposure to Currency Risk 14. 1 14. 2 An Example of Transaction Exposure to Currency Risk Managing Transaction Exposure Internally » Multinational netting » Leading and lagging 14. 3 Managing Transaction Exposure in the Financial Markets » » » 14. 4 Currency forwards Currency futures Money market hedges Currency options Currency swaps Summary Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -1

Economic exposure to currency risk Economic exposure Û change in firm value due to unexpected changes in exchange rates F Transaction exposure –change in the value of contractual cash flows –change in the value of monetary assets and liabilities F Operating exposure –change in the value of noncontractual cash flows –change in the value of real assets Monetary assets Real assets Monetary liabilities Common equity Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -2

A survey of corporate treasurers Do you agree or disagree with the following statements? Mean score “Managing transaction exposure is important. ” “Managing economic exposure is important. ” “Managing translation exposure is important. ” 1. 4 1. 8 2. 4 Key: 1= strongly agree, . . . 3=neutral, . . . 5= strongly disagree Source: Kurt Jesswein, Chuck C. Y. Kwok, William R. Folks, Jr. , “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics, ” Journal of Applied Corporate Finance, Fall 1995. + Transaction exposure is viewed as the most important currency risk exposure Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -3

Currency risk versus currency risk exposure Rd/f sd/f Currency risk exposure Currency risk sd/f Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -4

Exposure to foreign exchange risk (contract price FF 40, 000) Expected receipt in francs at E[S 1$/FF] = $0. 25/FF +FF 40, 000 Û +$10, 000 at $0. 25/FF Actual exchange S 1$/FF = $0. 20/FF +FF 40, 000 Û +$8, 000 at $0. 20/FF Net loss from original position Risk (or payoff) profile of underlying exposure -$2, 000 DV$/FF -$0. 05/FF DS$/FF -$0. 05/FF Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -5

Currency hedging with forwards (contract price FF 40, 000) +$10, 000 Buy $10, 000 forward at F 1$/FF = $0. 25/FF Sell FF 40, 000 forward -FF 40, 000 Market exchange of FF for $ at S 1$/FF = $0. 20/FF +$8, 000 -FF 40, 000 Net gain on forward Risk (or payoff) profile of forward contract +$2, 000 DV$/FF +$0. 05/FF -$0. 05/FF DS$/FF Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -6

Net currency exposure +FF 40, 000 Underlying position (long francs) +$10, 000 Sell francs forward (short francs and long dollars) -FF 40, 000 +$10, 000 Net position Net exposure short francs DV$/FF long francs DS$/FF Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -7

Managing transaction exposure F Managing transaction exposure internally » leading and lagging » currency diversification and multinational netting F Managing » » » transaction exposure in financial markets currency forwards money market hedges futures options swaps Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -8

Multinational netting Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -9

Cash flows before multinational netting Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -10

Cash flows after multinational netting Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -11

Leading and lagging F Timing of cash flows within the corporation to offset underlying currency exposures. » Leading - If a U. S. parent is short euros, the parent can accelerate euro repatriations from its European affiliates. » Lagging - If a U. S. parent is long euros, the parent can accelerate euro payments to its European affiliates. F Like multinational netting, leading and lagging works best when the currency needs of the individual units within the corporation offset one another. Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -12

Financial market instruments used to hedge currency risk Currency forward contracts F Advantages – Currency forwards can provide a perfect hedge of transactions of known size and timing F Disadvantages – Bid-ask spreads can be large on long-dated contracts or infrequently traded currencies – A pure credit instrument, so currency forward contracts have credit risk Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -13

Financial market instruments used to hedge currency risk Currency futures contracts F Advantages – Low cost if the currency and maturity match the underlying exposure – Low credit risk because of daily marking-to-market F Disadvantages – Exchange-traded futures come in limited currencies and maturities – Daily marking-to-market can cause a cash flow mismatch Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -14

Financial market instruments used to hedge currency risk Money market hedges F Advantages – Forward positions can be built in currencies for which there are no forward currency markets F Disadvantages – Relatively expensive hedge – Might not be feasible if there are contraints on borrowing or lending Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -15

Financial market instruments used to hedge currency risk Currency option contracts F Advantages – Disaster hedge insures against unfavorable currency movements F Disadvantages – Option premiums reflect option values, so option hedges can be expensive in volatile currencies and at distant expiration dates Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -16

Financial market instruments used to hedge currency risk Currency swap contracts F Advantages – Quickly transforms liabilities into other currencies or payout structures (e. g. , fixed vs. floating) – Low cost for plain vanilla swaps in actively traded currencies – Able to hedge long-term exposures F Disadvantages – Not the best choice for near-term exposures – Innovative or exotic swaps can be expensive Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -17

Corporate use of currency risk management products Used Type of product often Forward contracts 72. 3% Foreign currency swaps OTC currency options Currency futures contracts Exchange-traded currency (spot) options Exchange-traded futures options 1. 8 Foreign currency warrants Cylinder options 7. 0 Synthetic forwards 3. 0 Used once sometimes 17. 9% 2. 9% 16. 4 17. 0 18. 8 19. 4 4. 1 10. 7 Never or twice 0. 0% 19. 3 10. 6 5. 3 3. 6 6. 5 7. 1 3. 0 1. 8 9. 9 8. 9 4. 2 11. 7 10. 1 4. 2 1. 2 8. 8 12. 5 heard of 1. 2 6. 5 1. 2 3. 6 22. 3 Source: Jesswein, Kwok, and Folks, “What New Currency Risk Products Are Companies Using and Why? ” Journal of Applied Corporate Finance 8, Fall 1995, pages 115 -124. Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 14 -18