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IBUS 302: International Finance

IBUS 302: International Finance. Topic 12–Transaction Exposure I Lawrence Schrenk, Instructor. Learning Objectives. Explain the three forms of exposure to FX risk. ▪ Discuss the benefits and disadvantage to hedging Construct and compare no hedging with forward and option market hedges. ▪.

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IBUS 302: International Finance

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  1. IBUS 302: International Finance Topic 12–Transaction Exposure I Lawrence Schrenk, Instructor

  2. Learning Objectives • Explain the three forms of exposure to FX risk.▪ • Discuss the benefits and disadvantage to hedging • Construct and compare no hedging with forward and option market hedges.▪

  3. Exposure • Transaction • Risk to cash flows due to changes in FX rates. • Economic • Risk to firm value, i.e., market value, due to changes in FX rates. • Translation • Risk to accounting statements , i.e., book value, due to changes in FX rates.

  4. Example • Your company, based in the U.S., supplies machine tools to manufacturers in Germany and Brazil. Prices are quoted in each country’s currency, so fluctuations in the €/$ and R$/$ exchange rate have a big impact on the firm’s revenues. How can the firm hedge these risks? Should it?

  5. Why Hedge? Con • Hedging is Irrelevant or Wasteful • Purely financial transaction • Diversified shareholders don’t care about firm-specific risks • Since markets are efficient, risk management does not add to firm value • Active risk management wastes resources • Agency cost

  6. Why Hedge? Pro • Hedging creates Value • Helps ensure that cash is available for positive NPV investments • Reduces dependence on (expensive) external finance • Reduces probability of financial distress • Improves performance evaluation and compensation • Reduces tax obligation

  7. Do Firms Hedge? • Overall, Firms’ Behavior Diverse • 50% of surveyed firms do use derivatives for risk management–especially large firms (83%), and especially for FX risk. • Mainly hedging, but some speculation. • 1998 Wharton/CIBC World Markets Survey of Financial Risk Management by US Non-Financial Firms

  8. Hedging Instruments • Forwards and futures • A contract to exchange an asset in the future at a specified price • Obligation for both • Options • Gives the holder the right to buy (call option) or sell (put option) an asset at a specified price and time. • Preserve the upside potential • Buyer has the choice

  9. Forward Market Hedge • 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.

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

  11. FX Hedging Example • Your company, headquartered in the U.S., supplies auto parts to Jaguar PLC in Britain. You have just signed a contract worth ₤18.2 million to deliver parts next year. Payment is certain and occurs at the end of the year. • The $/₤ exchange rate is currently S($/₤) = 1.4794. • How do fluctuations in exchange rates affect dollar ($) revenues? How can you hedge this risk?

  12. Timeline Now One Year 0 1 S($/₤) = 1.4794 F1($/₤) = 1.4513 CF = ₤18.2 million $ ???

  13. Possibility 1: Do Not Hedge • Expected Cash Flow • E[S1($/₤)] = F1($/₤) = 1.4513 • Expected Cash Flow = 1.4513 x ₤18.2 million = $26.41 million • Risk • Upside FX Exposure: Yes • Downside FX Exposure: Yes • Cost of Hedge Position: $0

  14. Possibility 1: Payoff $28.21 Cash Flow ($) $27.30 $26.41 $25.48 $24.57 S1($/₤) 1.35 1.40 1.45 1.50 1.55

  15. Possibility 2: Forward Market Hedge • Known Cash Flow • E[S1($/₤)] = F1($/₤) = 1.4513 • Lock in Revenues 1.4513 x ₤18.2 million = $26.41 million • Risk • Upside FX Exposure: No • Downside FX Exposure: No • Cost of Hedge Position: Minimal

  16. Possibility 2: Payoff $28.21 Cash Flow ($) $27.30 $26.41 $25.48 $24.57 S1($/₤) 1.35 1.40 1.45 1.50 1.55

  17. Possibility 3: Option Market Hedge • The relevant option has three possible strike prices: Put Options Strike Min. Rev. Premium Cost (×18.2 M) 1.35 $24.6 M $0.012 $221,859 1.40 $25.5 M $0.026 $470,112 1.45 $26.4 M $0.047 $862,771 NOTE: Premium from Black-Scholes Formula

  18. Possibility 3: Option Market Hedge • Minimum Cash Flow • E[S1($/₤)] = F1($/₤) = 1.4513 • Lock in Minimum Revenue 1.4513 x ₤18.2 million = $26.41 million • Risk • Upside FX Exposure: Yes • Downside FX Exposure: No • Cost of Hedge Position: $862,771

  19. Possibility 3: Payoff Value ▪ $28.21 Cash Flow ($) $27.30 Profit ▪ $26.41 -$862,771 $25.48 $24.57 S1($/₤) 1.35 1.40 1.45 1.50 1.55

  20. Payoff Comparisons $28.21 No Hedge Option Market Hedge Cash Flow ($) $27.30 Forward Market Hedge $26.41 $25.48 $24.57 S1($/₤) 1.35 1.40 1.45 1.50 1.55

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