Hedging Transaction Exposure Final exercise Updated 20121022: an interest calcluation was wrong

1. Hedging Transaction ExposureFinal exerciseUpdated 20121022: an interest calcluation was wrong ”There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can” Mark Twain Puddin’head Wilson’s New Calender Bo Sjö HT 2012

2. Exposure • FX exposure is a measure of the the potential for the firm’s profitablity, net cash flow and market value to change due to unexpected changes in the exchange rate. • Operating FX exposure is there even if you do not export and import, borrow or lend. Foreign competition, EU is still a free market. • The task of the CFO is to measure FX expoure Bo Sjö HT 2012

3. Hedging • In practice, exposure means identifying and measuring the risky position (long or short?) • Hedging is the decision to create an opposite position to the exposure that moves in the opposite way to the exposure • 100% or less? Bo Sjö HT 2012

4. Ways of Hedging Transaction (Contractual) Exposure: • 1) Stay unhedged • 2) Use Forwards (or Futures) • 3) Money market hedge (create synthetic forward/Futures) • Repeated money hedge is called matching • Swaps if repeated transactions using forward type of hedge • 4) Options Bo Sjö HT 2012

5. How and What to Do? • Identify and measure exposure position • Go through the consequences of doing this or that, look at the final cost. • Critical for the decision is where is the money you use or tie up coming from. What is the alternative cost for the firm? Bo Sjö HT 2012

6. Stay Unhedged? • Relay on given predictions • By whom? • Use forward rate as a prediction • Imply using interest rate differential as prediction • Requires effecient markets .. Develop argument • Use random walk St+1 = St + stochastic variation with mean zero • Supported by empirical observations for the short-run, • A benchmark to beat • Efficient market with a quite constant risk premium Bo Sjö HT 2012

7. Stay unhedged? • If the random walk hold, you will be right on average • Individual periods might involve big losses or gains • The questions is ”when speculation” can you survive the bad outcomes?” • Value at risk (VaR) and Cash Flow at Risk (CFR) tries to measure outcome ”a really bad day or week” on the market measured by confidence intervals based on historical data. Bo Sjö HT 2012

8. Forward (A/P) or (A/R) • Recieve foreign money (exports type) • Long position (draw the figure) • Sell forward creates an off-setting hedge through a short position (draw figure) • Selling FX forward mean that you get the forward bid-price quote. • Buying forward mean that you buy at the ask-price quote. Bo Sjö HT 2012

9. Money Hedge • Export example : Recieve money in the future. • Borrow the amount you will recieve net of interest. Change the borrowed amount into home currency today. • When export invoice is due, use proceeds to pay of debt with interest. Bo Sjö HT 2012

10. Money Hedge • Say you exported from Euro area from to the US goods for USD1m, 30 days to payment: • Money market rates are 1.15625 –1.0625 • Today you borrow in the US: • USD X = USD 1m/(1 + 0. 0115625(30/360)) = USD 0.9990m • Change into home currency EUR today • Price quotation 1.2197 – 1.2209 USD/EUR(Quotation is for USD as ‘Home currency’ :Dollar for one EUR.) • => Purchase EUR (foreign currency) with USD use USD 1.2209/EUR • You get USD 0.9990m * [1/(USD 1.2209/EUR] = EUR 0.8183m • YOU are hedged! Show positions in payoff diagrams Bo Sjö HT 2012

11. Comparing Forward w. Money Market Hedge • Forward is one-month in the future • We have EUR 0.8183 today from money hedge! • Over one month we have three alternatives: • 1) Invest in the EUR money market • 2) Substitue for a loan otherwise/already taken • 3) Let the money go into the operations of the firm Bo Sjö HT 2012

12. There are 3 rates for the cost of capital: 1) – 2) Invest or borrow in Euro money market at 2.1250 – 2.09375 Notice that we assume that these are the correct rates to compare with for this firm. 3) Use the Weighted Average Cost of Capital (WACC) of the firm; say 8% Comparing: On the margin where is the money being used? Bo Sjö HT 2012

13. #1and #2Cash to deposit or substitute loan #1) Invest the proceeds over one month EUR 0.8183m *(1 + 0.029375* (30/360)) = EUR0.8191 #2) Substitute loan (assume money market loan) EUR 0.8183m * (1 + 0.021250*(30/360)) = EUR 0.8197m Bo Sjö HT 2012

14. WACC vs. Forward • WACC = 8% p.a. => 0.67% p.m. • EUR 0.8180m * (1 + 0.08*(30/360)) = EUR 0.8237 • Selling forward at USD/EUR 1.2185 - 1.2199 Implies purchasing EUR at (1/USD/EUR1.2199) = • USD 1m * EUR0.8197/USD = EUR 0.8197 Bo Sjö HT 2012

15. Final Table • Forward : EUR 0.8197m • Money 1 (Deposit) : EUR 0.8191m • Money 2 (substi. borrow) : EUR 0.8197m* • Money 3 (WACC) : EUR 0.8237m • In this situation WACC is the best, if we do not consider reality, where is the money really coming from or used to? • * Is arbitrage – borrow and deposit • Forward look good Bo Sjö HT 2012

16. Outcome • Depends on actual aternative rates • WACC is standard norm here for a non-financial firm • Futures is an alternative if firm is cash rich, need money for the margin account: • Futures offers other advantages over forward, can go in and out of hedging easily • Options, not really in this course, a put offers the advantage of gain from an upward move without facing downside risk. (It hedges downside risk allows for upside gain) Bo Sjö HT 2012

17. Now! • Redo the example under the assumption that it is an import to the Euro area from the US. Euro is still home currency. • Investigate CIP, if you compare the proceeds from investing EUR10m in euro with investing in the USD say over 3 months, any difference? Bo Sjö HT 2012