FIN 40500 International Finance Hedging Foreign Exchange Risk

FIN 40500: International Finance Hedging Foreign Exchange Risk

To hedge or not to hedge…. that is the question” Suppose that you have signed an agreement to purchase GBP 100, 000 worth of goods from England payable 90 days from now. Spot Rate: $1. 88 90 Day Forward: $1. 85 (-1. 6%) If you were to “lock in” your price with the forward/futures contract, you would pay $185, 000 for the goods (with certainty)

Suppose you have the following forecast for the percentage change in the British pound over the upcoming 90 days % Change in e ($/GBP) Mean: -1. 6% Std. Dev: 2% [ -3. 6% , 0. 4%] [ -5. 6% , 2. 4%] [ -7. 6%, 4. 4%] -1. 6%

Given a standard deviation, we can approximate a distribution for the exchange rate in 90 days. Current Spot Rate: $1. 88 Standard Deviations Percentage Change Exchange Rate Probability -3 -7. 6% $1. 74 1% -2 -5. 6% $1. 77 4% -1 -3. 6% $1. 81 25% 0 -1. 6% $1. 85 40% 1 . 4% $1. 89 25% 2 2. 4% $1. 93 4% 3 4. 4% $1. 96 1%

Given the distribution of exchange rates, we can estimate the expected cost of the hedge Current Spot Rate: $1. 88 Exchange Rate Probability Cost w/out hedge Cost w/hedge Value of Hedge $1. 74 1% $174, 000 $185, 000 -$11, 000 $1. 77 4% $177, 000 $185, 000 -$8, 000 $1. 81 25% $181, 000 $185, 000 $-4, 000 $1. 85 40% $185, 000 $0 $1. 89 25% $189, 000 $185, 000 $4, 000 $1. 93 4% $193, 000 $185, 000 $8, 000 $1. 96 1% $196, 000 $185, 000 $11, 000 Expected Value: $0

From the previous table, we can show the distribution of gains from the hedge If forward rates are unbiased, most of the weight will be at zero!

Money Market Hedges Suppose that you have signed an agreement to purchase GBP 100, 000 worth of goods from England payable 90 days from now. Spot Rate = $1. 88 British 90 Day Interest Rate = 2. 6% US 90 Day interest rate = 1%

Money Market Hedges Spot Rate = $1. 88 British 90 Day Interest Rate = 2. 6% US 90 Day interest rate = 1% Today 90 Days ØBorrow $183, 236 @ 1% for 90 Days ØConvert to GBP @ $1. 88 ØInvest in 90 Day British Asset @ 2. 6% GBP 100, 000 1. 026 ØCollect GBP 100, 000 to pay for imports ØPay of loan + interest = $185, 000 $1. 88 = $183, 236 (1. 01) = $185, 000 Present Value of 100, 000 in 90 days

Money Market Forward/Futures VS. Hedges Hedge Recall Covered Interest Parity If covered interest parity holds (and it does!), then the forward rate reflects the interest differential and the money market hedge is identical to the forward/future hedge!

Currency Options n With options, you have the right to buy/sell currency, but not the requirement q Call: The right to buy at a specific “strike price” Put: The right to sell at a specific “strike price” The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option. The buyer must pay an up front price for the contract q n n

Payout from a Call n n n Suppose you buy a 30 day call on 125, 000 Euros at a strike price of $1. 20 For spot rates less than $1. 20, the option is worthless (“out of the money”) If the spot rate is $1. 25, your profit is ($. 05)*($125, 000) = $6, 250

Payout from a Put n n n Suppose you buy a put on 125, 000 Euros at a strike price of $1. 20 For spot rates greater than $1. 20, the option is worthless (“out of the money”) For example, if the spot rate is $1. 15, your profit is ($. 05)*($125, 000) = $6, 250

Hedging with Options Suppose that you have signed an agreement to purchase GBP 100, 000 worth of goods from England payable 90 days from now. Spot Rate: $1. 88 3 Month Call w/strike price of $1. 85 is selling at a premium of $. 05 (GBP 100, 000) You pay $. 05(100, 000) = $5, 000 today. Your cost of GBP in 90 days = MIN [ spot rate, $1. 85]

Remember, you pay (. 05)*100, 000 = $5, 000 Today! Current Spot Rate: $1. 88 Exchange Probability Rate Cost w/out Cost hedge w/hedge Value of Hedge $1. 74 1% $174, 000 $179, 000 -$5, 000 $1. 77 4% $177, 000 $182, 000 -$5, 000 $1. 81 25% $181, 000 $186, 000 -$5, 000 $1. 85 40% $185, 000 $190, 000 -$5, 000 $1. 89 25% $189, 000 $190, 000 $1. 93 4% $193, 000 $190, 000 $3, 000 $1. 96 1% $196, 000 $190, 000 $6, 000 Expected Value: -$3, 070

The option hedge is more expensive on average, but protects you from large negative outcomes!

Hedging Techniques Type of Exposure Forward/Futures Money Market Options Payables (Cash Outflow) Long Position Borrow Domestically/Lend Abroad Call Option Lend Domestically/Borro w Abroad Put Option Receivables Short Position (Cash Inflow)

Cross Hedging Suppose that you have entered an agreement to buy PLN 100, 000 (Polish Zloty) worth of imports. ($1 = 3. 17 PLN). Zloty futures are not traded. What do you do? You notice that the Zloty is highly correlated with the Euro (E 1 = 4. 09 PLN) Act as if you are hedging (100, 000/4. 09) = E 24, 454

Some more advanced hedging strategies… Suppose that you have signed an agreement to purchase GBP 100, 000 worth of goods from England payable 90 days from now. You are in the process of negotiating a deal to sell GBP 200, 000 worth of goods to Britain. Case #1: The export deal falls through and you will need to buy GBP 100, 000 in one 90 days Case #2: The export deal succeeds and you will need to sell GBP 100, 000 in one 90 days How do you hedge this?

A currency straddle is a combination of a put (the right to sell) and a call (the right to buy) Value Cost = $0. 06/L 1. 85 Cost = $0. 06/L e ($/L) Value 1. 85 e ($/L) Cost = $0. 12/L(L 100, 000) = $12, 000 1. 85 e ($/L)

Currency Straddles: Four Possibilities ØNCF = L 100, 000, e > $1. 85 ØLet Put Expire ØBuy $ in Spot Market ØBuy GPB with Call ØSell GBP in Spot Market ØNCF = - L 100, 000, e > $1. 85 ØLet Put Expire ØUse Call to Buy GBP ØNCF = L 100, 000, e < $1. 85 ØLet Call Expire ØUse Put to sell GBP ØNCF = - L 100, 000, e < $1. 85 ØLet Call Expire ØBuy GBP in Spot Market ØSell GBP with Put

Value Cost = $0. 04/L 1. 89 e ($/L) Value Straddles hedge your exposure under all circumstances, but are very expensive (in this case, $12, 000 in premium costs) Cost = $0. 03/L 1. 84 e ($/L) Cost = $0. 07/L(L 100, 000) = $7, 000 1. 84 1. 89 e ($/L) Un-hedged Region

Another way to save money is to only hedge particular ranges (i. e. a 95% confidence interval!) Suppose that you have signed an agreement to purchase GBP 100, 000 worth of goods from England payable 90 days from now. Value Cost = $0. 08/L 1. 85 e ($/L) Value Cost = $0. 05/L 1. 89 e ($/L)

You could hedge the range from $1. 85 to $1. 89 by selling a call w/ a strike price of $1. 89 and using the proceeds to buy a call with a strike price of $1. 85 Value Cost = $0. 08/L e ($/L) Cost = $0. 08 - $0. 05 = $0. 03 e ($/L) 1. 85 1. 89 Cost = $0. 05/L 1. 89 e ($/L)

Hedging…the possibilities are endless! There are many different types of hedges available. Each hedge has a cost and a level of protection. Its your choice to decide what coverage you need and how much you are willing to pay for it!!

Transaction Exposure vs. Economic Exposure Profits = e (Price – Unit Costs) Q Economic exposure refers to changes in the $ value of costs/revenues due to changes in demand (caused by exchange rate movements) Transaction exposure refers to changes in the $ value of costs/revenues due to exchange rate movements

Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales US Canadian Total $300 C$4 *. 75 = $3 $303 Costs of Goods Sold US Canadian Total $50 C$200 *. 75 = $150 $200 Operating Expenses US: Fixed US: Variable Total EBIT $30 $60 $43 Canadian sales and costs are unaffected by exchange rate movements, but are subject to transaction exposure US costs are independent of the Exchange rate, but US sales rise when the Canadian dollar strengthens (Canadian goods become more expensive)

If the Canadian Dollar Strengthens, both Costs and Sales are Affected. 1 CD = $. 75 Sales US Canadian Total Sales $300 C$4 *. 75 = $3 $303 Costs of Goods Sold US Canadian Total EBIT US Canadian Total $310 C$4 *. 80 = $3. 20 $313. 20 Costs of Goods Sold $50 C$200 *. 75 = $150 $200 Operating Expenses US: Fixed US: Variable Total 1 CD = $. 80 US Canadian Total $55 C$200 *. 80 = $160 $215 Operating Expenses $30 US: Fixed US: Variable $60 $43 $30 $33 $63 EBIT $35. 20

Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement. Sales US Canadian Total $300 C$4 *. 75 = $3 $303 Costs of Goods Sold US Canadian Total $50 C$200 *. 75 = $150 $200 Operating Expenses US: Fixed US: Variable Total EBIT $30 $60 $43 If Pepsi could raise its Canadian Sales and lower its Canadian costs, it would be better insulated from exchange rate changes

Increasing Canadian sales and lowering Canadian costs lowers exposure 1 CD = $. 75 Sales US Canadian Total Sales $300 C$20 *. 75 = $15 $315 Costs of Goods Sold US Canadian Total EBIT US Canadian Total $310 C$20 *. 80 = $16 $326 Costs of Goods Sold $140 C$100 *. 75 = $75 $215 Operating Expenses US: Fixed US: Variable Total 1 CD = $. 80 US Canadian Total $145 C$100 *. 80 = $80 $225 Operating Expenses $30 US: Fixed US: Variable $60 $40 $33 $63 EBIT $38

Increasing Canadian sales and lowering Canadian costs lowers exposure EBIT Old Structure New Structure $43 $40 $38 $35. 20 E $/CD. 75 . 80

Searching for economic exposure Economic exposure is much more general than transaction exposure (it can come from many sources). Therefore, it can be much more difficult to find! ØExchange rates change market competition ØExchange rates are correlated with Macroeconomic conditions ØExchange rates change the value of foreign currency cash flows (transaction exposure)

Changes in currency prices can have all kinds of economic impacts. A general way to estimate economic exposure would be as follows: Percentage change in cash flows (measured in home currency) Percentage change in the exchange rate ($/F)

Regression Results Variable Coefficients Intercept % Change in Exchange Rate Standard Error . 05 1. 5 . 03 -3. 35 . 97 -3. 45 Regression Statistics R Squared Standard Error Observations t Stat . 63 1. 20 1, 000 Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3. 35%

Suppose you have three different facilities … Plant C Plant A Overall, your cash flows are negatively related to the value of the Euro Plant B You first run a regression using consolidated income statements Regression Results Variable Coefficients Standard Error t Stat Intercept . 001 2 . 0005 % Change in e ($/Euro) -4. 35 . 5 -8. 70

Now, try isolating the exact location … Plant C Plant A Aha!!! Plant B is the culprit! (And they would’ve gotten away with it if it weren’t for those meddling kids!!!) Plant B Now, run a regression using individual plant income statements Regression Results Variable Coefficient T-Stat Plant A Plant B Plant C 1. 50 -4. 6 -. 4 1. 2 -6. 50 -1. 5

Now, try isolating the specific income statement items … Sales Costs of Goods Sold Plant B Operating Expenses Ultimately, it looks like sales from plant B are the underlying currency problem Now, run a regression using individual plant income statements Regression Results Variable Sales Cost of Goods Expenses Coefficient -3. 67 -2. 23 0. 02 T-Stat -5. 59 -. 65 4. 0

Now, what do we do about it? v. Pricing Policy: If sales drop when the Euro appreciates, then consider lowering prices during strong Euro periods to maintain market share v. Cash flow matching: If sales (and hence, cash inflows) are dropping during periods with a weak dollar, try adjusting production locations so that your costs will drop at the same time. v. Futures, Forwards, and Options