Transaction Exposure or chapter 8 Agenda Types of

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Transaction Exposure (or chapter 8)

Transaction Exposure (or chapter 8)

Agenda • Types of forex exposures? • Causes of transaction exposure? • Pros &

Agenda • Types of forex exposures? • Causes of transaction exposure? • Pros & cons of hedging transaction exposure? • How to manage transaction exposure? – Forward Market Hedge – Money Market Hedge – Option Market Hedge • Institutional practices of forex risk management.

Types of forex exposure § § § Forex exposure – potential change in profitability,

Types of forex exposure § § § Forex exposure – potential change in profitability, net cash flow, market value due to change in forex rate. Transaction Exposure – changes in value of outstanding financial obligations incurred prior to change in forex, not due to settle until after forex change. Operating (Economic) Exposure – change in firm PV resulting from change in expected future operating cash flows due to unexpected forex change Translation (Accounting) Exposure – accounting-derived changes in owner equity due to consolidation in single currency. Tax Exposure – varies by country, general rule only realized foreign losses are deductible for calculating income taxes

Why Hedge? Pros & Cons… • Improves planning. • Reduces likelihood of bankruptcy. •

Why Hedge? Pros & Cons… • Improves planning. • Reduces likelihood of bankruptcy. • Management better knows actual risks. vs. • Currency risk management costly, may not increase expected cash flows. • Shareholders more capable diversifying risk. • Investors already factored forex exposure into valuation. • Conducts hedging to benefit management. • Managers cannot outguess efficient market. • Management criticized forex losses but not for cost in avoiding forex losses.

Why Hedge? • Reduction of risk? • Increase/decrease in expected cash flow? • Increase

Why Hedge? • Reduction of risk? • Increase/decrease in expected cash flow? • Increase in value? Hedged Unhedged NCF Expected Cash Flow Net Cash Flow (NCF) 5

What causes transaction exposure? § Purchasing or selling on credit. § Borrowing or lending

What causes transaction exposure? § Purchasing or selling on credit. § Borrowing or lending in foreign currency. § Being party to unperformed forward contract. § Acquiring assets/ incurring liabilities in foreign currency.

Open Account Purchasing/ Selling t 1 t 2 t 3 Seller quotes price Buyer

Open Account Purchasing/ Selling t 1 t 2 t 3 Seller quotes price Buyer places order Seller ships product Anticipation Exposure Quotation Exposure Time b/n quoting price & reaching sale. t 4 Buyer settles A/R Backlog Exposure Billing Exposure Contract Signed. Time to get paid. Time to fill order.

Borrowing &Lending § Grupo Embotellador de Mexico (Gemex) • Dollar debt mid-December, 1994: –

Borrowing &Lending § Grupo Embotellador de Mexico (Gemex) • Dollar debt mid-December, 1994: – $ 264 m PS 3. 45/$ = PS 910, 800, 000. • Dollar debt in mid-January, 1995: – $ 264 m PS 5. 50/$ = PS 1, 452, 000 (59% up!)

How to manage transaction exposure? § Contractual hedge § Operating hedges • Risk-sharing agreements.

How to manage transaction exposure? § Contractual hedge § Operating hedges • Risk-sharing agreements. • Leads and lags in payment terms. • Swaps. § Natural hedge § Financial hedge • offsetting debt obligation. • financial derivative such as swap.

Hedging Account Receivable § Suppose October sale for £ 1, 000, A/R January. –

Hedging Account Receivable § Suppose October sale for £ 1, 000, A/R January. – Spot $1. 764/£ – 3 m-forward $1. 754/£ (2. 27% discount) – Cost of capital 12. 0% annual – British 3 m borrowing rate 10% annual – British 3 m lending rate 8% annual – US 3 m borrowing rate is 8% annual – US 3 m lending rate is 6% annual – Jan. put on £ 1, 000 w/ strike $1. 75/£; 1. 5% premium. – Forecasts 3 m future spot $1. 76/£. – Budget rate (lowest acceptable amount) $1. 70/£

Hedging Account Receivable § § § Unhedged position: £ 1, 000 x $1. 76/£

Hedging Account Receivable § § § Unhedged position: £ 1, 000 x $1. 76/£ = $1. 76 m. Forward hedge: • • Forward contract & source of funds to fulfill the contract. Forward entered @ time A/R created (October). A/R recorded @ spot $1. 764/£, so $1, 764, 000. Covered (perfect) vs. uncovered (open) forward hedge. Money market hedge: • creates liability offset w/ asset in £: balance sheet hedge. • borrow PV of £ 1, 000: £ 1, 000/1. 025 = £ 975, 610. • exchange £ 975, 610 at spot $1. 764/£ for $1, 720, 976. Received today Invested in $1, 720, 976 Treasury bill $1, 720, 976 Debt cost $1, 720, 976 Cost of capital Rate Future value in 3 months 6% annual or 1. 5%/qtr $1, 746, 791 8% annual or 2. 0%/qtr $1, 755, 396 12% annual or 3. 0%/qtr $1, 772, 605

Option Market Hedge § Purchase put option. • 3 month put option @ ATM

Option Market Hedge § Purchase put option. • 3 month put option @ ATM strike $1. 75/£, premium 1. 5%: § • Premium as of Jan $26, 460 1. 03 = $27, 254. • Unlimited upside, limited downside. Breakeven price, option hedge • Upper bound: – If pound appreciate above $1. 754/£ + $0. 0273/£ = $1. 7813/£. • Lower bound – If pound depreciates below $1. 75/£ - $0. 0273/£ = $1. 722/£.

A / R Hedges US$ value of £ 1, 000 A/R Uncovered Forward $1.

A / R Hedges US$ value of £ 1, 000 A/R Uncovered Forward $1. 7540/£ 1. 84 1. 82 ATM put option min $1, 722, 746 Put strike $1. 75/£ 1. 80 1. 78 Money market $1, 772, 605 @ 12% 1. 76 Forward contract $1, 754, 000 1. 74 1. 72 1. 70 1. 68 1. 70 1. 72 1. 74 1. 76 Ending spot (US$/£) 1. 78 1. 80 1. 82 1. 84 1. 86

Account Payable Hedge § Assume £ 1, 000 A/P in 90 days • Unhedged

Account Payable Hedge § Assume £ 1, 000 A/P in 90 days • Unhedged position: expected pay $1, 760, 000. • Forward market hedge: purchase forward @ $1. 754/£, cost • locked $1, 754, 000. Money market hedge: – Offset £ obligation by £ asset w/ matching maturity. – Exchange US$ spot & invest for 90 days in £. – Carry the cost forward 90 days

Account Payable Hedge § Option hedge: • purchase call option on payable. • ATM

Account Payable Hedge § Option hedge: • purchase call option on payable. • ATM call option w/ strike $1, 75/£ would be 1. 5% • • premium. If spot less $1. 75/£ option expire & £ 1, 000 purchased on spot market. If spot above $1. 75/£ option exercised: exchange £ 1, 000 @ $1. 75/£ less option premium: • Carried forward 90 days @ 12% p. a. premium $27, 254. Exercise call option (£ 1, 000 $1. 75/£ Call premium (carried forward 90 days) Total maximum expense of call option hedge $1, 750, 000 $27, 254 $1, 777, 254

A / P Hedges US$ value of £ 1, 000 A/R Uncovered Forward $1.

A / P Hedges US$ value of £ 1, 000 A/R Uncovered Forward $1. 754/£ 1. 84 1. 82 Call strike $1. 75/£ 1. 80 Call option: $1, 777, 254 1. 78 Money market $1, 781, 294 1. 76 Forward contract $1, 754, 000 1. 74 1. 72 1. 70 1. 68 1. 70 1. 72 1. 74 1. 76 Ending spot (US$/£) 1. 78 1. 80 1. 82 1. 84 1. 86

Forex Risk Management for Real § Goals? • cost center vs. profit center. §

Forex Risk Management for Real § Goals? • cost center vs. profit center. § Exposures? • backlog exposure? • selectively hedge backlog & anticipated exposures? § Contractual Hedges? • Amount of risk covered, proportional hedges? • Currency options?

Things to remember § Types of forex exposures • • Transaction Operating Translation Tax

Things to remember § Types of forex exposures • • Transaction Operating Translation Tax § How to hedge A/R & A/P transaction exposure? • Money market? • Forward market? • Option market?