INTERNATIONAL FINANCIAL MANAGEMENT Fifth Edition EUN RESNICK Mc

INTERNATIONAL FINANCIAL MANAGEMENT Fifth Edition EUN / RESNICK Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Management of Transaction Exposure 8 Chapter Eight Chapter Objective: This chapter discusses various methods available for the management of transaction exposure facing multinational firms. This chapter ties together chapters 5, 6, and 7. 8 -1

Chapter Outline l l l 8 -2 Forward Market Hedge Money Market Hedge Options Market Hedge Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts

Chapter Outline (continued) l l l Hedging Through Invoice Currency Hedging via Lead and Lag Exposure Netting Should the Firm Hedge? What Risk Management Products do Firms Use? 3 8 -3

Forward Market Hedge l l 8 -4 If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.

Forward Market Hedge: an Example You are a U. S. importer of Italian shoes and have just ordered next year’s inventory. Payment of € 100 M is due in one year. Question: How can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers € 100 M in one year—a long forward contract on the euro. 8 -5

Forward Market Hedge Suppose the forward exchange rate is $1. 50/€. $30 m If he does not hedge the € 100 m $0 payable, in one year his gain (loss) on the –$30 m unhedged position is shown in green. The importer will be better off if the euro depreciates: he still buys € 100 m but at an exchange rate of only $1. 20/€ he saves $30 million relative to $1. 50/€ Value of € 1 in $ $1. 20/€ $1. 50/€ $1. 80/€ in one year But he will be worse off if the pound appreciates. Unhedged payable 6 8 -6

Forward Market Hedge If he agrees to buy € 100 m in one year at $30 m $1. 50/€ his gain (loss) on the forward $0 are shown in blue. –$30 m 8 -7 If you agree to buy € 100 million at a price of $1. 50/€, you will make $30 million if the price of the euro reaches $1. 80. Long forward Value of € 1 in $ $1. 20/€ $1. 50/€ $1. 80/€ in one year If you agree to buy € 100 million at a price of $1. 50 per pound, you will lose $30 million if the price of the euro falls 7 to $1. 20/€.

Forward Market Hedge The red line shows the payoff of the $30 m hedged payable. Note that gains on one position $0 are offset by losses on the –$30 m other position. Long forward Hedged payable Value of € 1 in $ $1. 20/€ $1. 50/€ $1. 80/€ in one year Unhedged payable 8 -8

Futures Market Cross-Currency Hedge Your firm is a U. K. based exporter of bicycles. You have sold € 750, 000 worth of bicycles to an Italian retailer. Payment (in euro) is due in six months. Your firm wants to hedge the receivable into pounds. Sizes of forward contracts are shown. 8 -9 Country U. S. $ equiv. Currency per U. S. $ Britain (£ 62, 500) $2. 0000 £ 0. 5000 1 Month Forward $1. 9900 £ 0. 5025 3 Months Forward $1. 9800 £ 0. 5051 6 Months Forward $2. 0000 £ 0. 5000 12 Months Forward $2. 1000 £ 0. 4762 Euro (€ 125, 000) $1. 4700 € 0. 6803 1 Month Forward $1. 4800 € 0. 6757 3 Months Forward $1. 4900 € 0. 6711 6 Months Forward $1. 5000 € 0. 6667 12 Months Forward $1. 5100 € 0. 6623

Futures Market Cross-Currency Hedge: Step One l l 8 -10 You have to convert the € 750, 000 receivable first into dollars and then into pounds. If we sell the € 750, 000 receivable forward at the six-month forward rate of $1. 50/€ we can do this with a SHORT position in 6 six-month euro futures contracts. € 750, 000 6 contracts = € 125, 000/contract

Futures Market Cross-Currency Hedge: Step Two Selling the € 750, 000 forward at the six-month forward rate of $1. 50/€ generates $1, 125, 000: $1. 50 $1, 125, 000 = € 750, 000 × € 1 l At the six-month forward exchange rate of $2/£, $1, 125, 000 will buy £ 562, 500. l We can secure this trade with a LONG position in 9 six-month pound futures contracts: l 9 contracts = 8 -11 £ 562, 500 £ 62, 500/contract

Money Market Hedge l l This is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. l l l 8 -12 Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable.

Money Market Hedge A U. S. –based importer of Italian bicycles l l l In one year owes € 100, 000 to an Italian supplier. The spot exchange rate is $1. 50 = € 1. 00 The one-year interest rate in Italy is i€ = 4% € 100, 000 Can hedge this payable by buying € 96, 153. 85 = 1. 04 today and investing € 96, 153. 85 at 4% in Italy for one year. At maturity, he will have € 100, 000 = € 96, 153. 85 × (1. 04) Dollar cost today = $144, 230. 77 = € 96, 153. 85 × $1. 50 € 1. 00 8 -13

Money Market Hedge l l With this money market hedge, we have redenominated a one-year € 100, 000 payable into a $144, 230. 77 payable due today. If the U. S. interest rate is i$ = 3% we could borrow the $144, 230. 77 today and owe in one year $148, 557. 69 = $144, 230. 77 × (1. 03) € 100, 000 T $148, 557. 69 = S($/€)× × (1+ i ) $ (1+ i€)T 8 -14

Money Market Hedge: Step One Suppose you want to hedge a payable in the amount of £y with a maturity of T: i. Borrow $x at t = 0 on a loan at a rate of i$ per year. £y $x = S($/£)× (1+ i )T £ $x 0 8 -15 Repay the loan in T years –$x(1 + i$)T T

Money Market Hedge: Step Two £y ii. Exchange the borrowed $x for (1+ i£)T at the prevailing spot rate. £y Invest at i£ for the maturity of the payable. T (1+ i£) At maturity, you will owe a $x(1 + i$)T. Your British investments will have grown to £y. This amount will service your payable and you will have no exposure to the pound. 8 -16

Money Market Hedge £y 1. Calculate the present value of £y at i£ (1+ i£)T 2. Borrow the U. S. dollar value of receivable at the spot rate. 3. Exchange $x = S($/£)× 4. Invest £y (1+ i£)T £y at i£ for T years. T (1+ i£) for £y (1+ i£)T 5. At maturity your pound sterling investment pays your receivable. 6. Repay your dollar-denominated loan with $x(1 + i$)T. 8 -17

Money Market Cross-Currency Hedge l. Your firm is a U. K. -based importer of bicycles. You have bought € 750, 000 worth of bicycles from an Italian firm. Payment (in euro) is due in one year. Your firm wants to hedge the payable into pounds. l l l. What Spot exchange rates are $2/£ and $1. 55/€ The interest rates are 3% in €, 6% in $ and 4% in £, all quoted as an APR. should you do to redenominate this 1 -year €denominated payable into a £-denominated payable with a 1 -year maturity? 8 -18

Money Market Cross-Currency Hedge Sell pounds for dollars at spot exchange rate, buy euro at spot exchange rate with the dollars, invest in the euro zone for one year at i€ = 3%, all such that the future value of the investment equals € 750, 000. Using the numbers we have: Step 1: Borrow £ 564, 320. 39 at i£ = 4%, Step 2: Sell pounds for dollars, receive $1, 128, 640. 78 Step 3: Buy euro with the dollars, receive € 728, 155. 34 Step 4: Invest in the euro zone for 12 months at 3% APR (the future value of the investment equals € 750, 000. ) Step 5: Repay your borrowing with £ 586, 893. 20 8 -19

Money Market Cross-Currency Hedge l Where do the numbers come from? € 750, 000 € 728, 155. 34 = (1. 03) $1. 55 $1, 128, 640. 77 = € 728, 155. 34 × € 1 £ 564, 320. 39 = $1, 128, 640. 77 × $2 £ 586, 893. 20 = £ 564, 320. 39 × (1. 04) 8 -20

Options Market Hedge l l Options provide a flexible hedge against the downside, while preserving the upside potential. To hedge a foreign currency payable buy calls on the currency. l l To hedge a foreign currency receivable buy puts on the currency. l 8 -21 If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. If the currency depreciates, your put option lets you sell the currency for the exercise price.

Options Market Hedge Suppose the forward exchange rate is $1. 50/€. If an importer who $30 m owes € 100 m does not hedge the $0 payable, in one year his gain (loss) on the unhedged position is shown –$30 m in green. 8 -22 The importer will be better off if the euro depreciates: he still buys € 100 m but at an exchange rate of only $1. 20/€ he saves $30 million relative to $1. 50/€ Value of € 1 in $ $1. 20/€ $1. 50/€ $1. 80/€ in one year But he will be worse off if the euro appreciates. Unhedged payable

Options Markets Hedge Profit Suppose our importer buys a call option on € 100 m with an exercise price of $1. 50 per –$5 m pound. He pays $. 05 per euro for the loss call. 8 -23 Long call on € 100 m $1. 55/€ $1. 50/€ Value of € 1 in $ in one year

Options Markets Hedge Profit The payoff of the portfolio of a call and a payable is shown in red. $25 m He can still profit from decreases in the exchange rate –$5 m below $1. 45/€ but has a hedge against unfavorable increases in the loss exchange rate. 8 -24 Long call on € 100 m $1. 20/€ $1. 45 /€ $1. 50/€ Value of € 1 in $ in one year Unhedged payable

Options Markets Hedge Profit If the exchange rate increases to $1. 80/€ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of –$5 million. –$30 m This can be thought of as an insurance premium. loss 8 -25 Long call on € 100 m $1. 45/€ $1. 50/€ Value of € 1 in $ $1. 80/€ in one year Unhedged payable

Options Markets Hedge With an exercise price denominated in local currency IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS. l l 8 -26 If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price. EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS. l l If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.

Hedging Exports with Put Options l l l Show the portfolio payoff of an exporter who is owed £ 1 million in one year. The current one-year forward rate is £ 1 = $2. Instead of entering into a short forward contract, he buys a put option written on £ 1 million with a maturity of one year and a strike price of £ 1 = $2. l 8 -27 The cost of this option is $0. 05 per pound.

Options Market Hedge: Exporter buys a put option to protect the dollar value of his receivable. H ed ge d re ce iv ab le $1, 950, 000 –$50 k $2 $2. 05 –$2 m Lo ng re ce iv ab le Long put S($/£)360 28 8 -28

H ed ge d re ce iv ab le The exporter who buys a put option to protect the dollar value of his receivable has essentially purchased a call. S($/£)360 –$50 k $2 $2. 05 29 8 -29

Hedging Imports with Call Options l l l 8 -30 Show the portfolio payoff of an importer who owes £ 1 million in one year. The current one-year forward rate is £ 1 = $1. 80; but instead of entering into a long forward contract, He buys a call option written on £ 1 million with an expiry of one year and a strike of £ 1 = $1. 80 The cost of this option is $0. 08 per pound.

GAIN (TOTAL) Forward Market Hedge: Importer buys £ 1 m forward. Long currency forward $1. 80 LOSS 8 -31 (TOTAL) This forward hedge fixes the dollar value of the payable at $1. 80 m. S($/£)360 Accounts Payable = Short Currency position 31

$1. 8 m $1, 720, 000 Options Market Hedge: Importer buys call option on £ 1 m. Call option limits the potential cost of servicing the payable. S($/£)360 –$80 k d ge ed nh U $1. 80 $1. 72 $1. 88 n io at lig ob 8 -32 32

$1, 720, 000 Our importer who buys a call to protect himself from increases in the value of the pound creates a synthetic put option on the pound. He makes money if the pound falls in value. S($/£)360 –$80 k $1. 80 $1. 72 The cost of this “insurance policy” is $80, 000 33 8 -33

Taking it to the Next Level l Suppose our importer can absorb “small” amounts of exchange rate risk, but his competitive position will suffer with big movements in the exchange rate. l l 8 -34 Large dollar depreciations increase the cost of his imports Large dollar appreciations increase the foreign currency cost of his competitors exports, costing him customers as his competitors renew their focus on the domestic market.

Our Importer Buys a Second Call Option $1, 720, 000 This position is called a straddle 2 nd Call $1, 640, 000 –$80 k –$160 k S($/£)360 $1. 64 $1. 80 $1. 96 $1. 72 $1. 88 Importers synthetic put 35 8 -35

$1, 720, 000 Suppose instead that our importer is willing to risk large exchange rate changes but wants to profit from small changes in the exchange rate, he could lay on a butterfly spread. Sell 2 puts $1. 90 strike. butterfly spread S($/£)360 –$80 k $1. 80 $1. 90 $1. 72 Importers synthetic put $2 buy a put $2 strike A butterfly spread is analogous to an interest rate collar; indeed it’s sometimes called a zero-cost collar. Selling the 2 puts comes close to offsetting the cost of buying the other 2 puts. 8 -36 36

Options l l l A motivated financial engineer can create almost any risk-return profile that a company might wish to consider. Straddles and butterfly spreads are quite common. Notice that the butterfly spread costs our importer quite a bit less than a naïve strategy of buying call options. 37 8 -37

Cross-Hedging Minor Currency Exposure l l l 8 -38 The major currencies are the: U. S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a minor currency, like the Thai bhat. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.

Cross-Hedging Minor Currency Exposure l l Cross-Hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging depends upon how well the assets are correlated. l 8 -39 An example would be a U. S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way.

Hedging Contingent Exposure l l 8 -40 If only certain contingencies give rise to exposure, then options can be effective insurance. For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U. S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options.

Hedging Recurrent Exposure with Swaps l l l 8 -41 Recall that swap contracts can be viewed as a portfolio of forward contracts. Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along. It is also the case that swaps are available in longer-terms than futures and forwards.

Hedging through Invoice Currency l The firm can shift, share, or diversify: l shift exchange rate risk l l share exchange rate risk l l by pro-rating the currency of the invoice between foreign and home currencies diversify exchange rate risk l 8 -42 by invoicing foreign sales in home currency by using a market basket index

Hedging via Lead and Lag l l 8 -43 If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.

Exposure Netting l A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. l l 8 -44 As an example, consider a U. S. -based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U. S. dollar, the firm can just wait until these accounts come due and just buy yen with won. Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.

Exposure Netting l l l Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once the residual exposure is determined, then the firm implements hedging. In the following slides, a firm faces the following exchange rates: £ 1. 00 = $2. 00 € 1. 00 = $1. 50 SFr 1. 00 = $0. 90 8 -45

Exposure Netting SFr 150 $150 0 5 1 € 150 £ 150 8 -46 £ 150 SFr 150 r F S 0 5 1 50 $1 $150 50 £ 1 € 150 €

$2. 00 $0. 90 $1. 50 £ 150× $300 SFr 150× SFr 1 = $135 € 150× € 1 = $225 Exposure £ 1 = Netting SFr 150 $135 $150 $225 € 150 £ 150 $300 8 -47 $300 £ 150 SFr 150 $135 0 5 5 1 r 3 S$$1 F 1 50 $1 $150 500 £$13 $225 € 150 $225 50 5 2 $€ 21

Exposure Netting $ $150 50 $1 5 3 1 $ $75 $300 8 -48 0 9 $ $225 $135 5 2 2 00 $3 50 $1 $225 $75 $150 $15 $300 $165 $135

Exposure Netting 510= $72 5 $21 +$2 $75 8 -49 $165 $180 = $165 +$180 $15 0 9 $ += 51205 $12 $75 $15

Exposure Netting: an Example Consider a U. S. MNC with three subsidiaries and the following foreign exchange transactions: $20 $30 $40 $10 $35 $10 $25 $20 $30 $40 $60 50 8 -50

Exposure Netting: an Example Bilateral Netting would reduce the number of foreign exchange transactions by half: $20 $10 $30 $10$25$35 $40 $20 $15 $10 $25 $20 $10 $30$10$40 $60 51 8 -51

Multilateral Netting: an Example Consider simplifying the bilateral netting with multilateral netting: $10 $15$25 $10 $20 $30 $40 $15 $10 8 -52 $10

Should the Firm Hedge? l Not everyone agrees that a firm should hedge: l l 8 -53 Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.

Should the Firm Hedge? l In the presence of market imperfections, the firm should hedge. l Information Asymmetry l l Differential Transactions Costs l l The firm may be able to hedge at better prices than the shareholders. Default Costs l 8 -54 The managers may have better information than the shareholders. Hedging may reduce the firms cost of capital if it reduces the probability of default.

Should the Firm Hedge? l Taxes can be a large market imperfection. l 8 -55 Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have “boom and bust” cycles in their earnings stream.

What Risk Management Products do Firms Use? l l 8 -56 Most U. S. firms meet their exchange risk management needs with forward, swap, and options contracts. The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.

End Chapter Eight 8 -57