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Management of
Transaction Exposure INTERNATIONAL 13
FINANCIAL
MANAGEMENT
Chapter Objective:
McGraw-Hill/Irwin 13-1 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Chapter Outline (continued)
Hedging Through Invoice Currency
Hedging via Lead and Lag
Exposure Netting
Should the Firm Hedge?
What Risk Management Products do Firms Use?
McGraw-Hill/Irwin 13-2 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Introduction
As the nature of business becomes international, firms
are exposed to the risk of fluctuating exchange rates
It is thus important for a financial managers to know
the firm’s foreign currency exposure and properly
manage the exposure
Three types of exposures
Transaction exposure
Economic exposure
Translation exposure
13-3
Introduction
Transaction exposure
The extent to which firm’s contractual cash flows are
affected by fluctuations in exchange rate
Economic exposure
The extent to which value of firm is affected by
fluctuations in exchange rate
Translation exposure
The extent to which consolidated financial statements
of the firm are affected by fluctuations in exchange
rates
13-4
Transaction Exposure
The extent to which firm’s contractual cash flows
are affected by fluctuations in exchange rate
Whenever a firm has foreign currency
denominated receivables or payables it is
subject to transaction exposure
Regarded as short term economic exposure
Transaction exposure arises from fixed price
contracting where exchange rates are changing
randomly
13-5
Hedging Transaction Exposure
The following are the ways available to hedge the
transaction exposure,
Financial Contracts Contractual Positions
Forward market hedge Choice of invoice currency
Money market hedge Lead / lag strategy
Option market hedge Exposure netting
SWAP market hedge
13-6
Forward Market Hedge
The most direct and popular way of hedging transaction exposure
is by currency forward contract
If you are going to pay 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.
Rate at which forward contract is entered into is called forward
rate
Once forward contract is entered into exchange rate risk
becomes irrelevant
13-7
Forward Market Hedge
Forward contract is entered into with bank
It is obligatory to exercise forward contract
Normal positions taken by importers and exporters in
forward contract:-
Importer
Takes long position in forward contract
Long position to buy foreign currency
Exporter
Takes short position in forward contract
Short position to sell foreign currency
13-8
Forward Market Hedge: an Example
You are an Indian importer of US woolens and
have just ordered next year’s inventory.
Payment of $100M is due in one year.
13-9
Money Market Hedge
Transaction exposure can also be hedged by lending
and borrowing in domestic and foreign money market
A firm may borrow in foreign currency to hedge its
foreign currency receivables, thereby matching its
assets and liabilities in the same currency
Foreign Money Domestic Money
Market Market
Foreign currency receivables Borrow Lend/Invest
Foreign currency payables Lend/Invest Borrow
13-10
Money Market Hedge – Example
An Indian Exporter received an order from its client in
USA for supply of goods worth $ 10,000.
Amount ($10,000) is receivable after one year.
The spot exchange rate is $1=`70
Interest rates in Indian and USA money market are
India: 6.10%
USA: 9%
Here Indian exporter has foreign currency receivables so
he will
Borrow from US money market and Invest in Indian money market
13-11
Step:1 Indian exporter will borrow USD loan from USA
money market of such amount that amount repayable after
one year becomes equal to $10,000
$10,000/1.09= $ 9,174
Step:2 Convert USD loan proceed into INR at spot
exchange rate
$9,174*70 = ` 6,42,180
Step:3 Invest ` 6,42,180 in India
Step:4 After one year repay USD loan $10,000 from the
USDs received form US client
In this way Indian exporter’s USD exposure becomes zero
Step:5 Sale Indian investment
` 6,42,180*1.061= ` 6,81,352
This is the guaranteed INR proceed for Indian exporter
13-12
Options Market Hedge
One possible shortcoming of both forward and
money market hedge is that these methods
completely eliminates exchange exposure
Consequently the firm has to forgo the
opportunity to benefit from favorable exchange
rate changes
Options provide a flexible hedge against the
downside, while preserving the upside potential.
13-13
Options Market Hedge
To hedge a foreign currency payable buy calls
on the currency.
If the home currency depreciates, your call option lets
you buy the foreign currency at the exercise price of the
call.
To hedge a foreign currency receivable buy puts
on the currency.
If the home currency appreciates, your put option lets
you sell the foreign currency for the exercise price.
McGraw-Hill/Irwin 13-14 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Options Market Hedge
Use of call option and put option by importer and
exporter
Importer
Buys call option on foreign currency
Will get right to buy foreign currency
Exporter
Buys put option on foreign currency
Will get right to sell foreign currency
13-15
Cross-Hedging
Minor Currency Exposure
If a firm has receivables and payables in major
currencies (USD, Yen, Pound, Euro) it can easily
use forward and money market to manage its
exposure
In contrast if the firm has position in minor
currencies (Korean Won, Thai Bhat, and Czech
Koruna) it may be either very costly or
impossible to use financial contracts in these
currencies
13-16
Cross-Hedging
Minor Currency Exposure
The major currencies are the: U.S. dollar,
Canadian dollar, British pound, French franc,
Swiss franc, Mexican peso, Italian lira, German
mark, Japanese yen, and now the euro.
Everything else is a minor currency
It is difficult, expensive, or impossible to use
financial contracts to hedge exposure to minor
currencies.
McGraw-Hill/Irwin 13-17 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Cross-Hedging
Minor Currency Exposure
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.
13-18
Cross-Hedging
Minor Currency Exposure
US firm has account receivables in Koran Won
As Won-Dollar exchange rate is correlated with
Won-Yen Exchange rate US firm will sell yen
amount which is equivalent to Won receivable
forward against the dollar.
13-19
Hedging Contingent Exposure
Contingent exposure is the situation in which a firm may
or may not be subject to exchange rate exposure
In case of contingent exposer option contracts 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.
13-20
Hedging Recurrent Exposure
with Swaps
Recurrent exposure is the exposure which keep on
occurring at regular time interval
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.
Swaps are very flexible in terms of maturity, the
maturity may range from few months to few years
13-21
Hedging Recurrent Exposure
with Swaps Example
An Indian company has taken loan from US bank
and liable to repay it in 12 EMIs of 5,000 USD
A US company has taken loan from Indian bank
and liable o repay it 12 EMIs of 3,50,000
Both the companies may enter into 1 year SWAP
at the exchange rate of 1USD=70 INR
Doing this they can lock in exchange rate for next
12 months
McGraw-Hill/Irwin 13-22 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Hedging through
Invoice Currency
The firm can shift, share, or diversify the
exchange risk by choosing the currency of invoice
Suppose that Boeing Corporation exported Boeing
747 to British airways for £10 Million
So here Boeing can eliminate the exchange rate
exposure by invoicing the transaction in USD
rather than in GBP
McGraw-Hill/Irwin 13-23 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Hedging through
Invoice Currency
If boing invoices $15 Million rather than £10
Million than the entire exchange risk is shifted
from Boing to British Airways
Boing can share the exposure with British
Airways by invoicing half of the amount in USD
and remaining half in British Pound ($7.5 Million
and £5 Million)
McGraw-Hill/Irwin 13-24 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Hedging via Lead and Lag
To ‘Lead’ means to pay or collect early
To ‘Lag’ means to pay or collect late
If a currency is appreciating, pay those bills
denominated in that currency early (Use ‘Lead’
strategy)
If a currency is depreciating, pay those bills
denominated in that currency late (Use ‘Lag’
strategy)
13-25
Hedging via Lead and Lag
Value of Foreign Currency
Appreciation in Depreciation in
Foreign Currency Foreign Currency
Foreign Currency Payables Suffer Benefit
Foreign Currency Receivables Benefit Suffer
13-26
Exposure Netting
A multinational firm should not consider deals in
isolation, but should focus on hedging the firm as
a portfolio of currency positions.
13-27
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:
$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
McGraw-Hill/Irwin 13-28 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
McGraw-Hill/Irwin 13-29 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
McGraw-Hill/Irwin 13-30 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
McGraw-Hill/Irwin 13-31 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$10 $35 $10 $10
$25
$60
$20
$30
McGraw-Hill/Irwin 13-32 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$10 $35 $10 $10
$25
$60
$20
$30
McGraw-Hill/Irwin 13-33 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$10 $35 $10 $10
$25
$60
$10
McGraw-Hill/Irwin 13-34 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$10 $35 $10 $10
$25
$60
$10
McGraw-Hill/Irwin 13-35 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$25 $10 $10
$25
$60
$10
McGraw-Hill/Irwin 13-36 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$40
$25 $10 $10
$25
$60
$10
McGraw-Hill/Irwin 13-37 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$20
$25 $10 $10
$25
$10
McGraw-Hill/Irwin 13-38 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$20
$25 $10 $10
$25
$10
McGraw-Hill/Irwin 13-39 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Bilateral Netting would reduce the number of foreign
exchange transactions by half:
$10
$20 $15
$25 $10
$10
McGraw-Hill/Irwin 13-40 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$20 $15
$25 $10
$10
McGraw-Hill/Irwin 13-41 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$20 $15
$15 $10 $10
$10
McGraw-Hill/Irwin 13-42 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$20 $15
$15 $10
$10
McGraw-Hill/Irwin 13-43 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$20 $15
$15 $10
$10
McGraw-Hill/Irwin 13-44 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$30 $15
$15 $10
McGraw-Hill/Irwin 13-45 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$30 $15
$15 $10
McGraw-Hill/Irwin 13-46 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$30 $15
$15 $10
McGraw-Hill/Irwin 13-47 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$15
$30
$10
McGraw-Hill/Irwin 13-48 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$15
$30
$10
McGraw-Hill/Irwin 13-49 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$15
$30
$10
McGraw-Hill/Irwin 13-50 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$15
$30
$10
McGraw-Hill/Irwin 13-51 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$15
$30
$10
McGraw-Hill/Irwin 13-52 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$15
$40
McGraw-Hill/Irwin 13-53 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Clearly, multilateral netting can simplify things greatly.
$15
$40
McGraw-Hill/Irwin 13-54 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
Compare this:
$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
McGraw-Hill/Irwin 13-55 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Exposure Netting: an Example
With this:
$15
$40
McGraw-Hill/Irwin 13-56 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Should the Firm Hedge?
McGraw-Hill/Irwin 13-57 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Should the Firm Hedge?
In the presence of market imperfections, the firm
should hedge.
Information Asymmetry
The managers may have better information than the
shareholders.
Differential Transactions Costs
The firm may be able to hedge at better prices than the
shareholders.
Default Costs
Hedging may reduce the firms cost of capital if it reduces the
probability of default.
McGraw-Hill/Irwin 13-58 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
Should the Firm Hedge?
Taxes can be a large market imperfection.
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.
McGraw-Hill/Irwin 13-59 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
End Chapter Thirteen
McGraw-Hill/Irwin 13-60 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights