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Prepared by Shafiq Jadallah

Chapter 8 Transaction Exposure. Prepared by Shafiq Jadallah. To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman. Chapter 8 Transaction Exposure. Learning Objectives

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Prepared by Shafiq Jadallah

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  1. Chapter 8 Transaction Exposure Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

  2. Chapter 8Transaction Exposure • Learning Objectives • Distinguish between the three major foreign exchange exposures experienced by firms • Identify foreign exchange transaction exposure • Analyze the pros and cons of hedging foreign exchange transaction exposure • Identify the alternatives available to a firm for managing a large and significant transaction exposure • Evaluate the institutional practices and concerns of foreign exchange risk management

  3. Foreign Exchange Exposure • Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates • These three components are the key financial elements of how we view a firm’s success, thus a financial manager must know how to limit the firm’s exposure to changes in exchange rates

  4. Foreign Exchange Exposure • Types of foreign exchange exposure • Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes • Operating Exposure – also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates

  5. Foreign Exchange Exposure • Translation Exposure – also called accounting exposure, is the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements • Tax Exposure – the tax consequence of foreign exchange exposure varies by country, however as a general rule only realized foreign losses are deductible for purposes of calculating income taxes

  6. Moment in time when exchange rate changes Operating exposure Accounting exposure Change in expected future cash flows arising from an unexpected change in exchange rates Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates Transaction exposure Impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates Time Foreign Exchange Exposure

  7. Why Hedge - the Pros & Cons • Opponents of hedging give the following reasons: • Shareholders are more capable of diversifying risk than the management of a firm; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk • Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow • Management often conducts hedging activities that benefit management at the expense of shareholders

  8. Why Hedge - the Pros & Cons • Opponents of hedging give the following reasons (continued): • Managers cannot outguess the market; if and when markets are in equilibrium with respect to parity conditions, the expected NPV of hedging is zero • Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss • Efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation

  9. Why Hedge - the Pros & Cons • Proponents of hedging give the following reasons: • Reduction in the risk of future cash flows improves the planning capability of the firm • Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum • Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm • Markets are usually in disequilibirum because of structural and institutional imperfections

  10. Why Hedge - the Pros & Cons Hedged Unhedged Net Cash Flow (NCF) NCF Expected Value, E(V) Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk.

  11. Measurement of Transaction Exposure • Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely • Purchasing or selling on credit goods or services when prices are stated in foreign currencies • Borrowing or lending funds when repayment is to be made in a foreign currency • Being a party to an unperformed forward contract and • Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

  12. Purchasing or Selling on Open Account • Suppose Trident Corporation sells merchandise on open account to a Belgian buyer for €1,800,000 payable in 60 days • Further assume that the spot rate is $0.9000/€ and Trident expects to exchange the euros for €1,800,000 x $0.9000/€ = $1,620,000 when payment is received • Transaction exposure arises because of the risk that Trident will something other than $1,620,000 expected • If the euro weakens to $0.8500/€, then Trident will receive $1,530,000 • If the euro strengthens to $0.9600/€, then Trident will receive $1,728,000

  13. Purchasing or Selling on Open Account • Trident might have avoided transaction exposure by invoicing the Belgian buyer in US dollars, but this might have lead to Trident not being able to book the sale • Even if the Belgian buyer agrees to pay in dollars, however, Trident has not eliminated transaction exposure, instead it has transferred it to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days

  14. t1 t2 t3 t4 Seller quotes a price to buyer Buyer places firm order with seller at offered price Seller ships product and bills buyer Buyer settles A/R with cash in amount of currency quoted at t1 Quotation Exposure Time between quoting a price and reaching a contractual sale Backlog Exposure Time it takes to fill the order after contract is signed Billing Exposure Time it takes to get paid in cash after A/R is issued Purchasing or Selling on Open Account Life Span of a Transaction Exposure

  15. Borrowing and Lending • A second example of transaction exposure arises when funds are loaned or borrowed • Example: PepsiCo’s largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex) • On 12/94, Gemex had US dollar denominated debt of $264 million • The Mexican peso (Ps) was pegged at Ps$3.45/US$ • On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$4.65/US$

  16. Borrowing and Lending • Gemex’s peso obligation now looked like this • Dollar debt mid-December, 1994: • US$264,000,000  Ps$3.45/US$ = Ps$910,800,000 • Dollar debt in mid-January, 1995: • US$264,000,000  Ps$5.50/US$ = Ps$1,452,000,000 • Dollar debt increase measured in Ps • Ps$541,200,000 • Gemex’s dollar obligation increased by 59% due to transaction exposure

  17. Other Causes of Transaction Exposure • When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure • Example: US firm wants to offset transaction exposure of ¥100 million to pay for an import from Japan in 90 days • Firm can purchase ¥100 million in forward market to cover payment in 90 days

  18. Contractual Hedges • Transaction exposure can be managed by contractual, operating, or financial hedges • The main contractual hedges employ forward, money, futures and options markets • Operating and financial hedges use risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies • A natural hedge refers to an offsetting operating cash flow, a payable arising from the conduct of business • A financial hedge refers to either an offsetting debt obligation or some type of financial derivative such as a swap

  19. Trident’s Transaction Exposure • Maria Gonzalez, CFO of Trident, has just concluded a sale to Regency, a British firm, for £1,000,000 • The sale is made in March for settlement due in three months time, June • Assumptions • Spot rate is $1.7640/£ • 3 month forward rate is $1.7540/£ (a 2.2676% discount) • Trident’s cost of capital is 12.0% • UK 3 month borrowing rate is 10.0% p.a. • UK 3 month investing rate is 8.0% p.a.

  20. Trident’s Transaction Exposure • Assumptions • US 3 month borrowing rate is 8.0% p.a. • US 3 month investing rate is 6.0% p.a. • June put option in OTC market for £1,000,000; strike price $1.75; 1.5% premium • Trident’s foreign exchange advisory service forecasts future spot rate in 3 months to be $1.7600/£ • Trident operates on thin margins and Maria wants to secure the most amount of US dollars; her budget rate (lowest acceptable amount) is $1.7000/£

  21. Trident’s Transaction Exposure • Maria faces four possibilities: • Remain unhedged • Hedge in the forward market • Hedge in the money market • Hedge in the options market

  22. Trident’s Transaction Exposure • Unhedged position • Maria may decide to accept the transaction risk • If she believes that the future spot rate will be $1.76/£, then Trident will receive £1,000,000 x $1.76/£ = $1,760,000 in 3 months time • However, if the future spot rate is $1.65/£, Trident will receive only $1,650,000 well below the budget rate

  23. Trident’s Transaction Exposure • Forward Market hedge • A forward hedge involves a forward or futures contract and a source of funds to fulfill the contract • The forward contract is entered at the time the A/R is created, in this case in March • When this sale is booked, it is recorded at the spot rate. • In this case the A/R is recorded at a spot rate of $1.7640/£, thus $1,764,000 is recorded as a sale for Trident • If Trident does not have an offsetting A/P in the same amount, then the firm is considered uncovered

  24. Trident’s Transaction Exposure • Forward Market hedge • Should Maria want to cover this exposure with a forward contract, then she will sell £1,000,000 forward today at the 3 month rate of $1.7540/£ • She is now “covered” and Trident no longer has any transaction exposure • In 3 months, Trident will received £1,000,000 and exchange those pounds at $1.7540/£ receiving $1,754,000 • This sum is $6,000 less than the uncertain $1,760,000 expected from the unhedged position • This would be recorded in Trident’s books as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled)

  25. Trident’s Transaction Exposure • Money Market hedge • A money market hedge also includes a contract and a source of funds, similar to a forward contract • In this case, the contract is a loan agreement • The firm borrows in one currency and exchanges the proceeds for another currency • Hedges can be left “open” (i.e. no investment) or “closed” (i.e. investment)

  26. Trident’s Transaction Exposure • Money Market hedge • To hedge in the money market, Maria will borrow pounds in London, convert the pounds to dollars and repay the pound loan with the proceeds from the sale • To calculate how much to borrow, Maria needs to discount the PV of the £1,000,000 to today • £1,000,000/1.025 = £975,610 • Maria should borrow £975,610 today and in 3 months time repay this amount plus £24,390 in interest (£1,000,000) from the proceeds of the sale

  27. Assets Liabilities and Net Worth Account receivable £1,000,000 £1,000,000 Bank loan (principal) £ 975,610 Interest payable 24,390 £1,000,000 Trident’s Transaction Exposure • Money Market hedge • Trident would exchange the £975,610 at the spot rate of $1.7640/£ and receive $1,720,976 at once • This hedge creates a pound denominated liability that is offset with a pound denominated asset thus creating a balance sheet hedge

  28. Trident’s Transaction Exposure • In order to compare the forward hedge with the money market hedge, Maria must analyze the use of the loan proceeds • Remember that the loan proceeds may be used today, but the funds for the forward contract may not • Because the funds are relatively certain, comparison is possible in order to make a decision • Three logical choices exist for an assumed investment rate for the next 3 months

  29. Received today Invested in Rate Future value in 3 months Trident’s Transaction Exposure • First, if Trident is cash rich the loan proceeds might be invested at the US rate of 6.0% p.a. • Second, Maria could use the loan proceeds to substitute an equal dollar loan that Trident would have otherwise taken for working capital needs at a rate of 8.0% p.a. • Third, Maria might invest the loan proceeds in the firm itself in which case the cost of capital is 12.0% p.a. $1,720,976 Treasury bill 6% p.a. or 1.5%/quarter $1,746,791 $1,720,976 Debt cost 8% p.a. or 2.0%/quarter $1,755,396 $1,720,976 Cost of capital 12% p.a. or 3.0%/quarter $1,772,605

  30. Trident’s Transaction Exposure • Because the proceeds in 3 months from the forward hedge will be $1,754,000, the money market hedge is superior to the forward hedge if Maria used the proceeds to replace a dollar loan (8%) or conduct general business operations (12%) • The forward hedge would be preferable if Maria were to just invest the loan proceeds (6%) • We will assume she uses the cost of capital as the reinvestment rate

  31. Trident’s Transaction Exposure • A breakeven investment rate can be calculated in order to forgo numerous calculations and still aid Maria in her decision • To convert this 3 month rate to an annual rate,

  32. Trident’s Transaction Exposure • In other words, if Maria can invest the loan proceeds at a rate equal to or greater than 7.68% p.a. then the money market hedge will be superior to the forward hedge • The following chart shows the value of Trident’s A/R over a range of possible spot rates both uncovered and covered using the previously mentioned alternatives

  33. Value in US dollars of Trident’s £1,000,000 A/R Uncovered yields whatever the ending spot rate is in 90 days 1.84 Forward rate is $1.7540/£ 1.82 1.80 Money market hedge yields $1,772,605 1.78 1.76 1.74 Forward contract hedge yields $1,754,000 1.72 1.70 1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86 Ending spot exchange rate (US$/£) Trident’s Transaction Exposure

  34. Trident’s Transaction Exposure • Option market hedge • Maria could also cover the £1,000,000 exposure by purchasing a put option. This allows her to speculate on the upside potential for appreciation of the pound while limiting her downside risk • Given the quote earlier, Maria could purchase 3 month put option at an ATM strike price of $1.75/£ and a premium of 1.5% • The cost of this option would be

  35. Trident’s Transaction Exposure • Because we are using future value to compare the various hedging alternatives, it is necessary to project the cost of the option in 3 months forward • Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium cost of the option as of June would be • $26,460  1.03 = $27,254 • Since the upside potential is unlimited, Trident would not exercise its option at any rate above $1.75/£ and would purchase pounds on the spot market • If for example, the spot rate of $1.76/£ materializes, Trident would exchange pounds on the spot market to receive £1,000,000  $1.76/£ = $1,760,000 less the premium of the option ($27,254) netting $1,732,746

  36. Trident’s Transaction Exposure • Unlike the unhedged alternative, Maria has limited downside with the option • Should the pound depreciate below $1.75/£, Maria would exercise her option and exchange her £1,000,000 at $1.75/£ receiving $1,750,000 • Less the premium of the option, Maria nets $1,722,746 • Although this downside is less than that of the forward or money market hedge, the upside potential is not limited

  37. Trident’s Transaction Exposure • As with the forward and money market hedges, Maria can also calculate her breakeven price on the option • The upper bound of the range is determined by comparison of the forward rate • The pound must appreciate above $1.754/£ forward rate plus the cost of the option, $0.0273/£, to $1.7813/£ • The lower bound of the range is determined in a similar manner • If the pound depreciates below $1.75/£, the net proceeds would be $1.75/£ less the cost of $0.0273/£ or $1.722/£

  38. Value in US dollars of Trident’s £1,000,000 A/R Uncovered 1.84 Forward rate is $1.7540/£ 1.82 ATM put option 1.80 1.78 Money market 1.76 1.74 Forward contract 1.72 1.70 1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86 Ending spot exchange rate (US$/£) Trident’s Transaction Exposure

  39. Put Option Strike Price ATM Option $1.75/£ Trident’s Transaction Exposure Option cost (future cost) $27,254 Proceeds if exercised $1,750,000 Minimum net proceeds $1,722,746 Maximum net proceeds unlimited Breakeven spot rate (upside) $1.7813/£ Breakeven spot rate (downside) $1.7221/£

  40. Strategy Choice and Outcome • Trident, like all firms, must decide on a strategy to undertake before the exchange rate changes but how will Maria choose among the strategies? • Two criteria can be utilized to help Maria choose her strategy • Risk tolerance - of the firm,as expressed in its stated policies and • Viewpoint – Maria’s own view on the expected direction and distance of the exchange rate

  41. Strategy Choice and Outcome • After all the strategies have been explained, Trident now needs to compare the alternatives and their outcomes in order to choose a strategy • There were four alternatives available to manage this account receivable and Maria has a budget rate at which she cannot fall below on this transaction

  42. Hedging Strategy Outcome/Payout Strategy Choice and Outcome Remain uncovered Unknown Forward Contract hedge @ $1.754/£ $1,754,000 Money market hedge @ 8% p.a. $1,755,396 Money market hedge @ 12% p.a. $1,772,605 Put option hedge @ strike $1.75/£ Minimum if exercised $1,722,746 Maximum if not exercised Unlimited

  43. Managing an Account Payable • Just as Maria’s alternatives for managing the receivable, the choices are the same for managing a payable • Assume that the £1,000,000 was an account payable in 90 days • Remain unhedged – Trident could wait the 90 days and at that time exchange dollars for pounds to pay the obligation • If the spot rate is $1.76/£ then Trident would pay $1,760,000 but this amount is not certain

  44. Managing an Account Payable • Use a forward market hedge – Trident could purchase a forward contract locking in the $1.754/£ rate ensuring that their obligation will not be more than $1,754,000 • Use a money market hedge – this hedge is distinctly different for a payable than a receivable • Here Trident would exchange US dollars spot and invest them for 90 days in pounds • The pound obligation for Trident is now offset by a pound asset for Trident with matching maturity

  45. Managing an Account Payable • Using a money market hedge – • To ensure that exactly £1,000,000 will be received in 90 days time, Maria discounts the principal by 8% p.a. • This £980,392.16 would require $1,729,411.77 at the current spot rate

  46. Managing an Account Payable • Using a money market hedge – • Finally, carry the cost forward 90 days in order to compare the payout from the money market hedge • This is higher than the forward hedge of $1,754,000 thus unattractive

  47. Managing an Account Payable • Using an option hedge – instead of purchasing a put as with a receivable, Maria would want to purchase a call option on the payable • The terms of an ATM call option with strike price of $1,75/£ would be a 1.5% premium • Carried forward 90 days the premium amount is comes to $27,254

  48. Managing an Account Payable • Using an option hedge – • If the spot rate is less than $1.75/£ then the option would be allowed to expire and the £1,000,000 would be purchased on the spot market • If the spot rate rises above $1.75/£ then the option would be exercised and Trident would exchange the £1,000,000 at $1.75/£ less the option premium for the payable Exercise call option (£1,000,000  $1.75/£ $1,750,000 Call option premium (carried forward 90 days) $27,254 Total maximum expense of call option hedge $1,777,254

  49. Risk Management in Practice • Which Goals? • The treasury function of most firms is usual considered a cost center; it is not expected to add to the bottom line • However, in practice some firms’ treasuries have become aggressive in currency management and act as profit centers • Which Exposures? • Transaction exposures exist before they are actually booked yet some firms do not hedge this backlog exposure • However, some firms are selectively hedging these backlog exposures and anticipated exposures

  50. Risk Management in Practice • Which Contractual Hedges? • Transaction exposure management programs are generally divided along an “option-line;” those which use options and those that do not • Also, these programs vary in the amount of risk covered; these proportional hedges are policies that state which proportion and type of exposure is to be hedged by the treasury

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