Chapter 8 Transaction Exposure Prepared by Shafiq Jadallah

Chapter 8 Transaction Exposure Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman Copyright © 2003 Pearson Education, Inc.

Chapter 8 Transaction Exposure § Learning Objectives • Distinguish between the three major foreign exchange • • exposures experienced by firms Identify foreign exchange transaction exposure Analyze the pros and cons of hedging foreign exchange transaction exposure Identify the alternatives available to a firm for managing a large and significant transaction exposure Evaluate the institutional practices and concerns of foreign exchange risk management Copyright © 2003 Pearson Education, Inc.

Foreign Exchange 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 • These three components are the key financial elements of how we view a firm’s success, thus a financial manager must know how to limit the firm’s exposure to changes in exchange rates Copyright © 2003 Pearson Education, Inc.

Foreign Exchange Exposure § 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 rate changes Operating Exposure – also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates Copyright © 2003 Pearson Education, Inc.

Foreign Exchange Exposure • Translation Exposure – also called accounting • exposure, is the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements Tax Exposure – the tax consequence of foreign exchange exposure varies by country, however as a general rule only realized foreign losses are deductible for purposes of calculating income taxes Copyright © 2003 Pearson Education, Inc.

Foreign Exchange Exposure Moment in time when exchange rate changes Accounting exposure Operating exposure Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates Change in expected future cash flows arising from an unexpected change in exchange rates Transaction exposure Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates Time Copyright © 2003 Pearson Education, Inc.

Why Hedge - the Pros & Cons § Opponents of hedging give the following reasons: • Shareholders are more capable of diversifying risk than • • the management of a firm; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow Management often conducts hedging activities that benefit management at the expense of shareholders Copyright © 2003 Pearson Education, Inc.

Why Hedge - the Pros & Cons § Opponents of hedging give the following reasons (continued): • Managers cannot outguess the market; if and when markets are in • • equilibrium with respect to parity conditions, the expected NPV of hedging is zero Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss Efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation Copyright © 2003 Pearson Education, Inc.

Why Hedge - the Pros & Cons § Proponents of hedging give the following reasons: • Reduction in the risk of 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 Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm Markets are usually in disequilibirum because of structural and institutional imperfections Copyright © 2003 Pearson Education, Inc.

Why Hedge - the Pros & Cons Hedged Unhedged NCF Expected Value, E(V) Net Cash Flow (NCF) Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk. 10 Copyright © 2003 Pearson Education, Inc.

Measurement of Transaction Exposure § Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely • Purchasing or selling on credit goods or services when • • • prices are stated in foreign currencies Borrowing or lending funds when repayment is to be made in a foreign currency Being a party to an unperformed forward contract and Otherwise acquiring assets or incurring liabilities denominated in foreign currencies Copyright © 2003 Pearson Education, Inc.

Purchasing or Selling on Open Account § § Suppose Trident Corporation sells merchandise on open account to a Belgian buyer for € 1, 800, 000 payable in 60 days Further assume that the spot rate is $0. 9000/€ and Trident expects to exchange the euros for € 1, 800, 000 x $0. 9000/€ = $1, 620, 000 when payment is received • Transaction exposure arises because of the risk that Trident will • • something other than $1, 620, 000 expected If the euro weakens to $0. 8500/€, then Trident will receive $1, 530, 000 If the euro strengthens to $0. 9600/€, then Trident will receive $1, 728, 000 Copyright © 2003 Pearson Education, Inc.

Purchasing or Selling on Open Account § Trident might have avoided transaction exposure by § invoicing the Belgian buyer in US dollars, but this might have lead to Trident not being able to book the sale Even if the Belgian buyer agrees to pay in dollars, however, Trident has not eliminated transaction exposure, instead it has transferred it to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days Copyright © 2003 Pearson Education, Inc.

Purchasing or Selling on Open Account Life Span of a Transaction Exposure t 1 t 2 t 3 Seller quotes a price to buyer Buyer places firm order with seller at offered price Seller ships product and bills buyer t 4 Buyer settles A/R with cash in amount of currency quoted at t 1 Quotation Exposure Backlog Exposure Billing Exposure Time between quoting a price and reaching a contractual sale Time it takes to fill the order after contract is signed Time it takes to get paid in cash after A/R is issued Copyright © 2003 Pearson Education, Inc.

Borrowing and Lending § A second example of transaction exposure arises § when funds are loaned or borrowed Example: Pepsi. Co’s largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex) • On 12/94, Gemex had US dollar denominated debt of • • $264 million The Mexican peso (Ps) was pegged at Ps$3. 45/US$ On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$4. 65/US$ Copyright © 2003 Pearson Education, Inc.

Borrowing and Lending § Gemex’s peso obligation now looked like this • Dollar debt mid-December, 1994: – US$264, 000 Ps$3. 45/US$ = Ps$910, 800, 000 • Dollar debt in mid-January, 1995: – US$264, 000 Ps$5. 50/US$ = Ps$1, 452, 000 • Dollar debt increase measured in Ps – Ps$541, 200, 000 § Gemex’s dollar obligation increased by 59% due to transaction exposure Copyright © 2003 Pearson Education, Inc.

Other Causes of Transaction Exposure § When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure • Example: US firm wants to offset transaction exposure • of ¥ 100 million to pay for an import from Japan in 90 days Firm can purchase ¥ 100 million in forward market to cover payment in 90 days Copyright © 2003 Pearson Education, Inc.

Contractual Hedges § § § Transaction exposure can be managed by contractual, operating, or financial hedges The main contractual hedges employ forward, money, futures and options markets Operating and financial hedges use risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies A 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 or some type of financial derivative such as a swap Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Maria Gonzalez, CFO of Trident, has just concluded a § sale to Regency, a British firm, for £ 1, 000 The sale is made in March for settlement due in three months time, June • Assumptions – Spot rate is $1. 7640/£ – 3 month forward rate is $1. 7540/£ (a 2. 2676% discount) – Trident’s cost of capital is 12. 0% – UK 3 month borrowing rate is 10. 0% p. a. – UK 3 month investing rate is 8. 0% p. a. Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure • Assumptions – US 3 month borrowing rate is 8. 0% p. a. – US 3 month investing rate is 6. 0% p. a. – June put option in OTC market for £ 1, 000; strike price $1. 75; 1. 5% premium – Trident’s foreign exchange advisory service forecasts future spot rate in 3 months to be $1. 7600/£ § Trident operates on thin margins and Maria wants to secure the most amount of US dollars; her budget rate (lowest acceptable amount) is $1. 7000/£ Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Maria faces four possibilities: • • Remain unhedged Hedge in the forward market Hedge in the money market Hedge in the options market Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Unhedged position • Maria may decide to accept the transaction risk • If she believes that the future spot rate will be $1. 76/£, • then Trident will receive £ 1, 000 x $1. 76/£ = $1, 760, 000 in 3 months time However, if the future spot rate is $1. 65/£, Trident will receive only $1, 650, 000 well below the budget rate Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Forward Market hedge • A forward hedge involves a forward or futures contract • • and a source of funds to fulfill the contract The forward contract is entered at the time the A/R is created, in this case in March When this sale is booked, it is recorded at the spot rate. In this case the A/R is recorded at a spot rate of $1. 7640/£, thus $1, 764, 000 is recorded as a sale for Trident If Trident does not have an offsetting A/P in the same amount, then the firm is considered uncovered Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Forward Market hedge • Should Maria want to cover this exposure with a forward • • contract, then she will sell £ 1, 000 forward today at the 3 month rate of $1. 7540/£ She is now “covered” and Trident no longer has any transaction exposure In 3 months, Trident will received £ 1, 000 and exchange those pounds at $1. 7540/£ receiving $1, 754, 000 This sum is $6, 000 less than the uncertain $1, 760, 000 expected from the unhedged position This would be recorded in Trident’s books as a foreign exchange loss of $10, 000 ($1, 764, 000 as booked, $1, 754, 000 as settled) Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Money Market hedge • A money market hedge also includes a contract and a • source of funds, similar to a forward contract In this case, the contract is a loan agreement – The firm borrows in one currency and exchanges the proceeds for another currency – Hedges can be left “open” (i. e. no investment) or “closed” (i. e. investment) Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Money Market hedge • To hedge in the money market, Maria will borrow pounds in London, convert the pounds to dollars and repay the pound loan with the proceeds from the sale – To calculate how much to borrow, Maria needs to discount the PV of the £ 1, 000 to today – £ 1, 000/1. 025 = £ 975, 610 – Maria should borrow £ 975, 610 today and in 3 months time repay this amount plus £ 24, 390 in interest (£ 1, 000) from the proceeds of the sale Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Money Market hedge – Trident would exchange the £ 975, 610 at the spot rate of $1. 7640/£ and receive $1, 720, 976 at once – This hedge creates a pound denominated liability that is offset with a pound denominated asset thus creating a balance sheet hedge Assets Account receivable Liabilities and Net Worth £ 1, 000 Bank loan (principal) Interest payable £ 1, 000 Copyright © 2003 Pearson Education, Inc. £ 975, 610 24, 390 £ 1, 000

Trident’s Transaction Exposure § In order to compare the forward hedge with the money market hedge, Maria must analyze the use of the loan proceeds • Remember that the loan proceeds may be used today, • • but the funds for the forward contract may not Because the funds are relatively certain, comparison is possible in order to make a decision Three logical choices exist for an assumed investment rate for the next 3 months Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § § § First, if Trident is cash rich the loan proceeds might be invested at the US rate of 6. 0% p. a. Second, Maria could use the loan proceeds to substitute an equal dollar loan that Trident would have otherwise taken for working capital needs at a rate of 8. 0% p. a. Third, Maria might invest the loan proceeds in the firm itself in which case the cost of capital is 12. 0% p. a. Received today Invested in Rate Future value in 3 months $1, 720, 976 Treasury bill 6% p. a. or 1. 5%/quarter $1, 746, 791 $1, 720, 976 Debt cost 8% p. a. or 2. 0%/quarter $1, 755, 396 $1, 720, 976 Cost of capital 12% p. a. or 3. 0%/quarter $1, 772, 605 Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Because the proceeds in 3 months from the forward § § hedge will be $1, 754, 000, the money market hedge is superior to the forward hedge if Maria used the proceeds to replace a dollar loan (8%) or conduct general business operations (12%) The forward hedge would be preferable if Maria were to just invest the loan proceeds (6%) We will assume she uses the cost of capital as the reinvestment rate Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § A breakeven investment rate can be calculated in order to forgo numerous calculations and still aid Maria in her decision § To convert this 3 month rate to an annual rate, Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § In other words, if Maria can invest the loan proceeds § at a rate equal to or greater than 7. 68% p. a. then the money market hedge will be superior to the forward hedge The following chart shows the value of Trident’s A/R over a range of possible spot rates both uncovered and covered using the previously mentioned alternatives Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure Value in US dollars of Trident’s £ 1, 000 A/R Uncovered yields whatever the ending spot rate is in 90 days Forward rate is $1. 7540/£ 1. 84 1. 82 Money market hedge yields $1, 772, 605 1. 80 1. 78 1. 76 Forward contract hedge yields $1, 754, 000 1. 74 1. 72 1. 70 1. 68 1. 70 Copyright © 2003 Pearson Education, Inc. 1. 72 1. 74 1. 76 1. 78 1. 80 Ending spot exchange rate (US$/£) 1. 82 1. 84 1. 86

Trident’s Transaction Exposure § Option market hedge • Maria could also cover the £ 1, 000 exposure by purchasing a put option. This allows her to speculate on the upside potential for appreciation of the pound while limiting her downside risk – Given the quote earlier, Maria could purchase 3 month put option at an ATM strike price of $1. 75/£ and a premium of 1. 5% – The cost of this option would be Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § § Because we are using future value to compare the various hedging alternatives, it is necessary to project the cost of the option in 3 months forward Using a cost of capital of 12% p. a. or 3. 0% per quarter, the premium cost of the option as of June would be – $26, 460 1. 03 = $27, 254 Since the upside potential is unlimited, Trident would not exercise its option at any rate above $1. 75/£ and would purchase pounds on the spot market If for example, the spot rate of $1. 76/£ materializes, Trident would exchange pounds on the spot market to receive £ 1, 000 $1. 76/£ = $1, 760, 000 less the premium of the option ($27, 254) netting $1, 732, 746 Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § Unlike the unhedged alternative, Maria has limited § downside with the option Should the pound depreciate below $1. 75/£, Maria would exercise her option and exchange her £ 1, 000 at $1. 75/£ receiving $1, 750, 000 • Less the premium of the option, Maria nets $1, 722, 746 • Although this downside is less than that of the forward or money market hedge, the upside potential is not limited Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure § As with the forward and money market hedges, Maria can also calculate her breakeven price on the option • The upper bound of the range is determined by comparison of the forward rate – The pound must appreciate above $1. 754/£ forward rate plus the cost of the option, $0. 0273/£, to $1. 7813/£ • The lower bound of the range is determined in a similar manner – If the pound depreciates below $1. 75/£, the net proceeds would be $1. 75/£ less the cost of $0. 0273/£ or $1. 722/£ Copyright © 2003 Pearson Education, Inc.

Trident’s Transaction Exposure Value in US dollars of Trident’s £ 1, 000 A/R Uncovered Forward rate is $1. 7540/£ 1. 84 ATM put option 1. 82 1. 80 Money market 1. 78 1. 76 Forward contract 1. 74 1. 72 1. 70 1. 68 1. 70 Copyright © 2003 Pearson Education, Inc. 1. 72 1. 74 1. 76 1. 78 1. 80 Ending spot exchange rate (US$/£) 1. 82 1. 84 1. 86

Trident’s Transaction Exposure Put Option Strike Price Option cost (future cost) ATM Option $1. 75/£ $27, 254 Proceeds if exercised $1, 750, 000 Minimum net proceeds $1, 722, 746 Maximum net proceeds unlimited Breakeven spot rate (upside) $1. 7813/£ Breakeven spot rate (downside) $1. 7221/£ Copyright © 2003 Pearson Education, Inc.

Strategy Choice and Outcome § Trident, like all firms, must decide on a strategy to § undertake before the exchange rate changes but how will Maria choose among the strategies? Two criteria can be utilized to help Maria choose her strategy • Risk tolerance - of the firm, as expressed in its stated • policies and Viewpoint – Maria’s own view on the expected direction and distance of the exchange rate Copyright © 2003 Pearson Education, Inc.

Strategy Choice and Outcome § After all the strategies have been explained, Trident § now needs to compare the alternatives and their outcomes in order to choose a strategy There were four alternatives available to manage this account receivable and Maria has a budget rate at which she cannot fall below on this transaction Copyright © 2003 Pearson Education, Inc.

Strategy Choice and Outcome Hedging Strategy Outcome/Payout Remain uncovered Unknown Forward Contract hedge @ $1. 754/£ $1, 754, 000 Money market hedge @ 8% p. a. $1, 755, 396 Money market hedge @ 12% p. a. $1, 772, 605 Put option hedge @ strike $1. 75/£ Minimum if exercised $1, 722, 746 Maximum if not exercised Unlimited Copyright © 2003 Pearson Education, Inc.

Managing an Account Payable § Just as Maria’s alternatives for managing the receivable, the choices are the same for managing a payable • Assume that the £ 1, 000 was an account payable in 90 days § Remain unhedged – Trident could wait the 90 days and at that time exchange dollars for pounds to pay the obligation • If the spot rate is $1. 76/£ then Trident would pay $1, 760, 000 but this amount is not certain Copyright © 2003 Pearson Education, Inc.

Managing an Account Payable § Use a forward market hedge – Trident could purchase § a forward contract locking in the $1. 754/£ rate ensuring that their obligation will not be more than $1, 754, 000 Use a money market hedge – this hedge is distinctly different for a payable than a receivable • Here Trident would exchange US dollars spot and • invest them for 90 days in pounds The pound obligation for Trident is now offset by a pound asset for Trident with matching maturity Copyright © 2003 Pearson Education, Inc.

Managing an Account Payable § Using a money market hedge – • To ensure that exactly £ 1, 000 will be received in 90 days time, Maria discounts the principal by 8% p. a. • This £ 980, 392. 16 would require $1, 729, 411. 77 at the current spot rate Copyright © 2003 Pearson Education, Inc.

Managing an Account Payable § Using a money market hedge – • Finally, carry the cost forward 90 days in order to compare the payout from the money market hedge • This is higher than the forward hedge of $1, 754, 000 thus unattractive Copyright © 2003 Pearson Education, Inc.

Managing an Account Payable § Using an option hedge – instead of purchasing a put as with a receivable, Maria would want to purchase a call option on the payable • The terms of an ATM call option with strike price of $1, 75/£ would be a 1. 5% premium • Carried forward 90 days the premium amount is comes to $27, 254 Copyright © 2003 Pearson Education, Inc.

Managing an Account Payable § Using an option hedge – • If the spot rate is less than $1. 75/£ then the option • would be allowed to expire and the £ 1, 000 would be purchased on the spot market If the spot rate rises above $1. 75/£ then the option would be exercised and Trident would exchange the £ 1, 000 at $1. 75/£ less the option premium for the payable Exercise call option (£ 1, 000 $1. 75/£ Call option premium (carried forward 90 days) Total maximum expense of call option hedge Copyright © 2003 Pearson Education, Inc. $1, 750, 000 $27, 254 $1, 777, 254

Risk Management in Practice § Which Goals? • The treasury function of most firms is usual considered a cost • § center; it is not expected to add to the bottom line However, in practice some firms’ treasuries have become aggressive in currency management and act as profit centers Which Exposures? • Transaction exposures exist before they are actually booked yet • some firms do not hedge this backlog exposure However, some firms are selectively hedging these backlog exposures and anticipated exposures Copyright © 2003 Pearson Education, Inc.

Risk Management in Practice § Which Contractual Hedges? • Transaction exposure management programs are • generally divided along an “option-line; ” those which use options and those that do not Also, these programs vary in the amount of risk covered; these proportional hedges are policies that state which proportion and type of exposure is to be hedged by the treasury Copyright © 2003 Pearson Education, Inc.

Summary of Learning Objectives § § MNEs encounter three types of currency exposure: (1) transaction; (2) operating; and (3) translation exposure Transaction exposure measures gains or losses that arise from the settlement of financial obligations whose terms are stated in a foreign currency Operating exposure measures the change in the present value of the firm resulting from any change in future operating cash flows caused by an unexpected change in exchange rates Translation exposure is the potential for accounting-oriented changes in owner’s equity when a firm translates foreign subsidiaries’ financial statements to consolidated financial statements Copyright © 2003 Pearson Education, Inc.

Summary of Learning Objectives § Transaction exposure arises from (1) purchasing or § selling on credit and prices are stated in foreign currencies; (2) borrowing or lending funds when repayment is to be made in a foreign currency; (3) being party to an unperformed forward contract; and (4) otherwise acquiring assets or liabilities denominated in foreign currencies Considerable theoretical debate exists as to whether or not firms should hedge currency risk Copyright © 2003 Pearson Education, Inc.

Summary of Learning Objectives • Transaction exposure can be managed by • contractual techniques and certain operating strategies. Contractual techniques include forward contracts, money market and option hedges The choice of which hedge to use depends on the individual firm’s currency risk tolerance and its expectations of the probable movement of exchange rates over the transaction exposure period Copyright © 2003 Pearson Education, Inc.

Summary of Learning Objectives § In general, if an exchange rate is expected to move in § a firm’s favor, the preferred contractual hedges are those which allow the firm to participate in some of the upside potential, but protect it against adverse exchange rate movements In general, if an exchange rate is expected to move against the firm, the preferred contractual hedge is one which locks-in an exchange rate Copyright © 2003 Pearson Education, Inc.

Summary of Learning Objectives § Risk management in practice requires a firm’s § treasury department to identify its goals. Is the treasury a cost or a profit center? Treasury must also choose which contractual hedges it wishes to use and what proportion of the currency risk should be hedged. Additionally, treasury must determine whether the firm should buy and/or sell currency options, a strategy that has historically been risky for some firms and banks Copyright © 2003 Pearson Education, Inc.