International Financial Management P G Apte

CHAPTER - 13 Hedging Speculation and Management of Transactions Exposure • International Financial Management • P G Apte

Management of Transactions Exposure • Hedgingwill be understood to mean a transaction undertaken specifically to offset some exposure arising out of the firm's usual operations • Speculationwill refer to deliberate creation of a position for the express purpose of generating a profit from exchange rate fluctuations, accepting the added risk • Management of transactions exposure has two significant dimensions • The treasurer must decide whether and to what extent an exposure should be explicitly hedged • The treasurer must evaluate alternative hedging strategies

Hedging Transactions Exposure with Forward Contracts • The net exposure in a given currency at a given date is the difference between the total inflows and total outflows to be settled on that date • The Cost of a Forward Hedge • Common fallacy to claim that the cost of forward hedging is the forward discount or premium • The forward hedge must be compared not with today's spot rate but the ex-ante value of the payable if the firm does not hedge • The relevant comparison is between the forward rate and the expected spot rate on the day the transaction is to be settled

Hedging Transactions Exposure with Forward Contracts • If speculators are risk neutral and there are no transaction costs, . the forward rate at time t for transactions maturing at T equals the expectation at time t, of the spot rate at time T Ft,T = Set,T • If the speculators in the foreign exchange market are not risk neutral Ft,T > Set,T or Ft,T < Set,T • Even in the case when speculators are not risk neutral the expected cost of hedging with forwards is zero except for the fact that bid/offer spreads are somewhat wider in forwards than in spot

Hedging Transactions Exposure with Forward Contracts • Choice of Invoice Currency • Choice of invoice currency has important implications for operating exposure of the exporter/importer but the transactions exposure component of it is relatively unimportant provided both parties have access to well functioning, liquid forward markets • The choice of currency of invoicing is often dictated by marketing considerations and exchange control factors • Any gains from the choice of currency of invoicing made by one party are always at the expense of the other party

Hedging Transactions Exposure with Forward Contracts • Exposures with uncertain timing • The timing of the exposure may be uncertain though the amount is known with certainty • Option forwards are generally an expensive device to deal with exposures with uncertain timing and using swaps may turn out to be cheaper • Book a fixed date contract, roll it over with a swap if exposure is extended.

Exposures Maturing at Different Dates • A firm has exposures in a particular foreign currency maturing at different dates. Some are inflows some outflows. On some dates there are both inflows and outflows. • The firm can hedge the net exposure at each date with a separate forward contract. • Can all the exposures be hedged with a single forward contract? • It can be done provided either that interest rates for all future periods are known with certainty or contracts known as Forward Rate Agreements (FRA) are available in the currency of exposure.

Hedging with the Money Market • Close connection between Eurodeposit markets and forward exchange premiums and discounts on account of covered interest arbitrage • Firms which have access to international money markets for short-term borrowing as well as investment, can use the money market for hedging transactions exposure • To hedge receivable – Borrow FC, convert spot to HC, repay FC loan with receivable. • To hedge payable - Borrow HC, convert spot to FC, deposit, use deposit to settle payable, repay HC loan

Hedging with Money Market : An Example • Suppose a Swiss firm has a 90-day USD payable of USD 10,000,000. It has access to Eurodeposit markets in CHF as well as USD. To cover this exposure it can execute the following sequence of transactions : • 1. Borrow CHF in the Zurich money market for 90 days. • 2. Convert spot to USD • 3. Deposit USD in a bank earning interest for 90 days • 4. Use the maturing deposit to settle payable; repay CHF loan • If CIP holds will this be any different from forward cover?

Hedging with Money Market : An Example Suppose: USD/CHF Spot: 1.5650/55 90-day forward: 1.5435/60 CHF interest rates : 2.50/2.60 USD interest rates : 8.00/8.20 These rates do not imply a covered interest arbitrage opportunity. Let us compare forward cover against the money market cover. With forward cover, each USD bought will lead to an outflow of CHF 1.5460, 90 days later. To have 1 USD 90 days later, deposit USD(1.0/1.02) today. = USD 0.9804 = CHF (0.9804)(1.5655) = CHF 1.5348 today. Borrow this. Repay 1.5348[1+(0.026)(0.25) = CHF 1.5448, 90-days later. A saving of CHF 0.0012 per USD

Hedging with the Money Market • Absence of covered interest arbitrage opportunities does not necessarily imply that forward cover and money market cover would be equivalent if the firm has access to interest rates other than Euromarket rates which govern spot-forward margins • Sometimes the money market hedge may turn out to be the more economical alternative because of some constraints imposed by governments e.g. not allowing non-residents to invest in home money markets or forcing resident firms to borrow HC only in home money markets etc. These create a wedge between home money market rates and Euromarket rates for the same currency. • Cost saving opportunities do arise from time to time. Must be examined before deciding on a hedging device

Hedging with Currency Options • Currency options provide a more flexible means to cover transactions exposure • Options are particularly useful for hedging contingent exposures e.g. bidding for foreign contracts -Foreign exchange inflows/outflows will materialize only if the bid is successful • Foreign currency receivables with substantial default risk or political risk • Risky portfolio investment e.g. foreign equities portfolio • Options permit limited risk speculation

Hedging with Currency Options A US firm has a 90 day EUR 1m payable Spot EUR/USD : 1.1950 90-day Fwd: 1.1725 A 90-day European call on EUR ATMF (At-the-Money-Forward) : $0.03 per EUR Outflow at 90 days: Open position: $(S90) m Forward : $1.1725m Option: If S90 > 1.1725: $(1.1725+0.03)m If S90 1.1725: $(S90+0.03)m

Hedging with Currency Options Open Position Option Outflow ($ Mill) Forward 1.14251.1725 1.2025S90

Hedging with Currency Futures • Hedging with Currency Futures • Hedging contractual foreign currency flows with currency futures is in many respects similar to hedging with forward contracts • A futures hedge differs from a forward hedge because of the intrinsic features of futures contracts • Since amounts and delivery dates for futures are standardized, a perfect futures hedge is generally not possible • Basis risk - imperfect correlation between spot and futures prices • Futures unlike forwards, give rise to intermediate cash flows due to the marking-to-market feature

Hedging with Currency Futures • The advantage of futures over forwards is firstly easier access and secondly greater liquidity • Currency futures are used by commercial banks to hedge positions taken in the forward markets • Most corporations use OTC forwards to hedge transactions exposures arising out of operations • Chapter 9 contains examples of hedging with futures

Third-Currency Forwards  Suppose an Indian firm has a 6-month payable of JPY 20 million. The market rates are as follows: Mumbai : USD/INR spot : 45.50/52 6-months : 45.80/85 Singapore : USD/JPY spot : 110.25/111.10 6-months : 111.50/112.00 From this the JPY/INR 6-month forward cross rate is : 40.89/41.12 (per 100 JPY) If the firm buys JPY forward against INR it will have to pay : Rs.[20,000,000/100](41.12) = Rs.82,24,000.00

Third Currency Forwards.. The firm feels that the US dollar is overvalued in the forward market. It buys JPY 20 million forward against USD and leaves the USD position uncovered. It has to deliver USD[20,000,000/111.50] = USD 1,79,372.20 Six months later, its view turns out to be correct. The spot USD/INR rate is 45.60/65. It buys the required US dollars in the spot market to deliver against its forward contract. It has to pay : Rs.[179372.20  45.65] = Rs.81,88,340.90 Thus the firm saves Rs.35,659. Note however, that this is a speculative strategy.

Forward-Forwards Today is July 30. A firm is expecting an import shipment to arrive on October 1. Payment due on January 1 and the invoice will be for USD 100,000. The market rates are as follows : USD/INR Spot : 45.50/60 2-months swap : 25/30 Outrights : 45.75/45.90 5-months swap : 75/85 Outrights : 46.25/46.45 The firm would like to lock-in the 70 paise swap premium between October 1 and January 1 but feels that the dollar is likely to weaken somewhat between July 30 and October 1. It does the following set of transactions on July 29 : (1) Buy USD spot, sell value October 1. (2) Sell USD spot buy value January 1.

Forward-Forwards.. It has essentially created a swap position, with an outflow of USD on October 1 and a matching inflow on January. The premium locked in is 46.45-45.75 = 0.70. By September 15 the dollar has weakened and the current spot is 44.80/90. The firm buys spot at 44.90 and delivers on the forward 15 days later at 45.75 gaining 0.85 per USD. On January 1, the firm pays 46.45 per USD. The net price paid is 45.60. It is as if the firm could lock in the 3-month premium over October 1 and "pick any spot rate" between July 29 and October 1 to which the premium would then be added.

Hedging Contingent Currency Exposure – Private Equity / Buyout XYZ Capital LLC acquired a majority interest in a struggling publicly traded metal recycling company in US. Having acquired the company’s senior and subordinated debt at 10 cents on the dollar for US$78 million, XYZ Capital converted the debt into a significant equity stake in a going-private transaction. Four years later, XYZ Capital decided to sell its profitable holding company to a Canadian waste recycling company. The acquisition was an all-cash deal. The total transaction value was approximately CAD$280 million. The deal was expected to close four months later and as a result, the buyout firm’s exposure was to a weaker CAD, and stronger USD between the announcement and closing. The agreement required both shareholder and Canadian regulatory approval. With the Canadian general election in two months XYZ Capital was concerned about the potential for a sudden weakening of the Canadian Dollar. In order to reduce premium the buyout firm purchased an out of the money CAD Put/USD Call option with expiry in 4 months, this protected them against an adverse currency move and also provided full optionality in case the deal failed to gain the necessary approval.

Hedging Currency Exposure – UK Manufacturing, Clinical Trials & Operations in Europe A New England venture-backed biotech company is focused on the development and commercialization of therapeutic products. They have an exclusive right to sell in Europe for 10 years via their EU-granted orphan drug status. The company has exposure of 10m GBP per year to cover manufacturing and clinical trials in the UK. To manage these currency exposures, we advised on a series of hedging strategies to mitigate risk. In order to stabilize the USD costs of the GBP exposure and allow the client to avail of cost savings from a favorable market move, the client booked a series of Quarterly Participating Forwards. We also advised on a series of Vanilla Window Forwards to accommodate the flexible delivery dates for the remaining British pound needs. In addition, the company booked Monthly Vanilla Forwards for their 5m euro payroll need to their European workforce.

Internal Hedging Strategies • Some of the commonly used or recommended methods • Invoicing : A firm may be able to shift the entire exchange risk to the other party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency • Trade between developed countries in manufactured products is generally invoiced in the exporter's currency

Internal Hedging Strategies • Trade in primary products and capital assets is generally invoiced in a major vehicle currency such as the US dollar • Trade between a developed and a less developed country tends to be invoiced in the developed country's currency • If a country has a higher and more volatile inflation rate than its trading partners, there is a tendency not to use that country's currency in trade invoicing • Another hedging tool in this context is the use of "currency cocktails" for invoicing • Still another possibility is risk sharing

Internal Hedging Strategies Risk Sharing via a Price Adjustment Clause A French firm has imported computers from a US supplier. Invoice is for EUR 10m. If at settlement EUR/USD is between 1.17 and 1.19, French firm pays USD equivalent of EUR 10m at a rate of USD 1.18 per EUR. If rate falls to say 1.13, the two parties share the loss (to US firm) 50-50: French firm pays USD equivalent of EUR 10m using a rate of USD 1.16 per USD. [1.18- 0.5(1.17-1.13)] If rate rises to say 1.27 again the gain to US firm is shared 50-50. French firm pays USD equivalent of EUR 10m using a rate of USD 1.22 per EUR [1.18+0.5(1.27-1.19)]

Internal Hedging Strategies • Netting and Offsetting: A firm with receivables and payables in diverse currencies can net out its exposure in each currency by matching receivables with payables • Netting also assumes importance in the context of cash management in a multinational corporation with a number of subsidiaries and extensive intra-company transactions • To be able to use netting effectively, the company must have continuously updated information on inter-subsidiary payments position as well as payables and receivables to outsiders

Internal Hedging Strategies • Some countries impose restrictions on netting as part of their exchange control regulations • Leading and Lagging: The general rule is lead i.e. advance payables and lag i.e. postpone receivables in "strong" currencies and, conversely, lead receivables and lag payables in weak currencies • Leading and Lagging involve trading off interest rate differentials against expected currency appreciation or depreciation – leading a payable has interest savings (demand discount for early payment); lagging has interest cost (Supplier will include interest cost in the invoice). Reverse for receivables. • Compare interest gain/cost against forward premia/discounts

Internal Hedging Strategies • The use of leads and lags must be evaluated in the overall framework of financing and exposure management. • Leading/Lagging may interfere with cash management, customer relations and effective use of credit lines for some subsidiaries • This consideration must be kept in mind when evaluating the performance of the local management. It may also adversely affect the interests of local minority shareholders • There may also be some legal constraints in free use of leading and lagging as exposure management devices since it may put pressure on a currency which is already under attack.

Internal Hedging Strategies • Leads and lags in combination with netting form an important cash management strategy for multinationals with extensive intra-company payments • Typical hedging situation and the dilemmas facing the decision maker : • Should the exposure be hedged? Fully or partially? • What is the optimum hedge? • What will be the performance benchmark? • How will it affect margins? Cash-flows? • Importance of having a clearly articulated risk policy cannot be overemphasized

Speculation in Foreign Exchange and Money Markets • Speculation in contrast to hedging involves deliberately creating positions in order to profit from exchange rate and/or interest rate movements • Outright speculation in foreign exchange markets a high-risk activity • The risk of an open position depends upon the covariance of exchange rate with other assets in the speculator's portfolio • Not hedging a transactions exposure can also be seen as speculation.

A TYPICAL HEDGING SITUATION The treasurer’s dilemma is illustrated by the famous case of Lufthansa. In January 1985 it purchased twenty 737 jets from Boeing for a total cost of USD 500,000,000 to be paid on delivery of the jets in January 1986. The US dollar had been continuously rising since about mid-1981 and had reached approximately DEM 3.2 by January 1985. This represented a substantial exposure with a potential for a huge cash loss if the dollar continued to rise.

LUFTHANSA’S HEDGING PROBLEM Herr Heinz Ruhnau, the Chairman of the airline believed (with many others) that the dollar had peaked and would shortly turn down. One-year forward dollar could be purchased at approximately DEM 3.2. Put options on DEM (call options on USD) at a strike price of DEM 3.2 could be bought for a total premium amounting to about 6% of the contract value or DEM 96 million. Among the choices available to him were:

A TYPICAL HEDGING SITUATION 1 Be very conservative. Cover the whole payable forward i.e. buy $500 m forward at DEM 3.2 per dollar 2 Trust his instincts. Leave it completely uncovered, buy 500 million dollars spot in January 1986 3 Take a limited risk. Cover partially e.g. buy half forward leave half open. 4 Buy put options on DEM. Go with your instinct but protect yourself on the downside, of course at a cost. 5 Buy US dollars now and hold them in a deposit for a year to settle the payable. What should he have done?

LUFTHANSA’s HEDGING DECISION 1) Full forward cover is the most conservative no-risk approach. It would involve a payment of DEM 1.6 billion on delivery of the aircraft. 2) Remaining completely unhedged is the maximum- risk alternative. The DEM outlay would be 500ST million where ST is the spot USD/DEM rate at the time of settling the payment. 3) Cover 50% leave the rest open. The DEM outflow on settlement would be (800+250ST) million. 4) With a put option the cost would be either DEM 1696m if ST exceeds 3.2 or DEM (500ST+96)m otherwise.

LUFTHANSA’S HEDGING PROBLEM

LUFTHANSA’s HEDGING DECISION • Lufthansa’s management ultimately opted for strategy (3) - 50% forward cover and rest left open. • The dollar had fallen to DEM 2.3 by January 1986. The DEM outflow was thus 1.375 billion. With no hedge at all, it would have been 1.150 billion and with a put option, 1.246 billion. • Lufthansa’s board criticized Herr Ruhnau for not trusting his instincts and thus not opting for the no hedge alternative or at least the put option. • Some of them questioned his decision to acquire the planes when the dollar was riding so high while others wanted to know why he had not selected Airbus Industries to supply the aircraft – it is a European firm and the payment would probably have been in DEM.

LESSONS FROM THE LUFTHANSA STORY • YOU MUST HAVE A CLEARLY ARTICULATED RISK MANAGEMENT POLICY. THIS MEANS, CLEAR GUIDELINES ON ACTIVE/PASSIVE POSTURE AND RISK TOLERANCE • EXCHANGE RATE FORECASTING IS VERY DIFFICULT IF NOT IMPOSSIBLE. • BUDGET RATE MUST BE CURRENTLY ACCESSIBLE, RELEVANT FORWARD RATE. WITH HINDSIGHT ANYONE CAN BE A GENIUS.

EXPOSURE MANAGEMENT PRACTICES • SOME SURVEY RESULTS • MOST FIRMS CANNOT QUANTIFY THEIR CURRENCY RISK PROFILES. • MOST OF THEM HAVE SOME QUALITATIVE UNDERSTANDING - DIRECTION OF IMPACT OF EXCHANGE RATE MOVEMENTS ON THEIR CASH FLOWS, PROFITS ETC. • MOST FIRMS WORRY ONLY ABOUT SHORT-TERM TRANSACTIONS EXPOSURE. • MOST FIND IT VERY HARD IF NOT IMPOSSIBLE TO QUANTIFY THEIR OPERATING/STRATEGIC EXPOSURE • OPERATING EXPOSURE IS DEALT WITH BY MEANS OF CONTRACTUAL ARRANGEMENTS AND RESTRUCTURING OPERATIONS.

International Financial Management P G Apte