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Internal hedges
Multinational netting and leading/lagging
- Operating exposure
change in the value of noncontractual cash flows arising from the firms real assets
Monetary liabilities
Common equity
10-2
+$1,500,000
Transaction exposure
10-3
markets
currency forwards money market hedges futures options swaps
10-4
Transaction exposure
Multinational netting
100m $75m
60m
U.K. parent
150m
$125m
200m
German subsidiary
Cross rates
U.S. subsidiary
40m
U.K. parent
200m
German subsidiary
100m
100m
U.S. subsidiary
10-6
U.K. parent
German subsidiary
U.S. subsidiary
10-7
Leading and lagging refers to altering the timing of cash flows within the firm to offset foreign exchange exposures For example: - Leading - If a parent firm is short euros, it can accelerate euro payments from its subsidiaries - Lagging - If a parent firm is long euros, it can delay euro payments from its subsidiaries
10-8
-10 million
-10 million
-10 million
Leading
Lagging
Jan
Feb
Mar
Apr
May
June
July
Aug
10-9
- Forwards can provide a perfect hedge of transactions of known size and timing
Disadvantages
- Bid-ask spreads can be large on small transactions, long-dated contracts, or infrequently traded currencies - Forwards are a pure credit instrument, so forward contracts have credit risk
10-10
The
10-11
Counterparty
Maturity Amount Fees
Bank
Negotiated Negotiated Bid-ask
Collateral
External hedges: Futures
Negotiated
Margin account
10-12
- Low cost if the size, currency and maturity match the underlying exposure - Low credit risk with daily marking-to-market
Disadvantages
- Costs increase with transaction size - Exchange-traded futures come in limited currencies and maturities - Daily marking-to-market can cause a cash flow mismatch
External hedges: Futures 10-13
- Synthetic forward positions can be built in currencies for which there are no forward currency markets
Disadvantages
- Relatively expensive hedge - Might not be feasible if there are constraints on borrowing or lending
10-14
- Option premiums reflect option values, so option hedges can be expensive in volatile currencies and at distant expiration dates
External hedges: Options 10-15
- the option holder gains if pound sterling rises - the option holder does not lose if pound falls V$/ Long pound call an option to buy pounds sterling at a contractual exercise price S$/
Exercise price
$1.50/ -$0.30/
S$/
-$1.50/
Short exposure
External hedges: Options 10-17
-$0.30/
-$1.50/
Short exposure
External hedges: Options 10-18
-$0.30/
-$1.50/ -$1.80/
Short exposure
External hedges: Options 10-19
- the option holder gains if pound sterling falls - the option holder does not lose if pound rises V$/ Long pound put an option to sell pounds sterling at a contractual exercise price S$/
Exercise price
$1.50/ -$0.30/
+$1.50/
$1.50/
S$/
10-21
+$1.50/ +$1.20/
$1.50/ -$0.30/
S$/
Put option hedge
10-22
+$1.50/ +$1.20/
$1.50/ -$0.30/
S$/
Put option hedge
10-23
swap
- An agreement to exchange a principal amount of two currencies and, after a prearranged length of time, re-exchange the original principal - Interest payments are also usually swapped during the life of the contract
10-24
- Quickly transforms the firms liabilities into other currencies or payout structures - Low cost for plain vanilla swaps in actively traded currencies - Swaps can be used to to hedge long-term exposures
Disadvantages
- Not the best choice for near-term exposures - Innovative or exotic swaps can be expensive
External hedges: Swaps 10-25
Future
Synthetic forward
Quick & low-cost switch of payoff structures Disaster hedge provides insurance
Option
External hedges
51%
49%
6%
Bodnar, Hayt, and Marston, 1998 Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms, Financial Management (1998).
Financial management 10-27
42%
Other benchmark
Performance evaluation
40%
21%
22%
18%
Reduced Risk-adjusted Absolute profit Increased volatility performance or loss profit relative relative to a to a benchmark benchmark
Active treasuries
Tend Use
Frequently
Financial management
10-30
use compensation contracts to align managers objectives with those of other stakeholders use derivatives-specific controls such as performance benchmarks to manage potential abuses
Gczy, Minton, and Schrand, Taking a View
Firms
Financial management
10-31
Jesswein, Kwok & Folks, What New Currency Risk Products Are Companies Using and Why? Journal of Applied Corporate Finance (1995)
Financial management 10-32