Transaction exposure - Currency risk when a firm faces contractual CFs fixed (invoiced) in another currency - receive or pay fixed amount of foreign currency in the future, i.e. any receivable (AR), or payable (AP) in a foreign currency. Source of currency risk from transaction exposure for MNC could be either a) export/import activities, or b) borrowing/lending activities - anytime future CFs (to be paid or received) are fixed in a foreign currency.
Example: U.S. firm sells its product to a German client for €1m, payable in 3 months, now faces transaction exposure since the CFs are fixed in Euros, and the future value of the Euro is uncertain, meaning that the dollars received are uncertain. Worried about??
Example: U.S. firm borrows in U.K. pounds, owes £1m in one year, faces transaction exposure since the CFs are fixed in a foreign currency. Worried about??
Unlike many forms of economic exposure, transaction exposure is always easily identifiable and quantifiable, because it is the exact amount of the payable or receivable, which is known and certain. An example of economic exposure is the effect of future currency fluctuations on sales revenue for Merck or GM, which is more uncertain and harder to quantify. Transaction exposure always involves known and certain CFs, so the risk exposure is well defined. Financial contracts (derivatives) and operational techniques (see p. 303) can be used to deal with transaction exposure. An important part of Intl. Finance is the management of transaction exposure. To illustrate, consider the case of Boeing, p. 304.
Boeing, a U.S. MNC, exports a 747 to British Airways, invoice is for £10m, payable in one year. Int. rates and FX rates are:
U.S. interest rate (one year) = 6.1%
U.K. interest rate = 9%
S = $1.50/£
F1 = $1.46/£
Check for IRP: 1.061 = 1.09 x ($1.46 / $1.50) IRP Holding (6.1% ≈ 9% - 2.9%)
Without a hedge, Boeing is exposed to currency risk, see Exhibit 13.1 on p. 305. Hedging Options:
1. Forward Hedge. Most direct and popular way to hedge currency risk is a currency forward contract, sell the £10m forward at $1.46/£ for a guaranteed receipt of $14.6m (£10m x $1.46/£), regardless of what happens to the spot rate. See Exhibits 13.2 and 13.3 on p. 305:
If £ depreciates to $1.40 (what Boeing is worried about), they only receive $14m, but the forward profit is $0.6m to make up the difference and Boeing nets $14.6m. If £ appreciates to $1.50, Boeing will receive $15m, but will lose $0.4m on the forward contract, for a net of $14.6m. No matter what happens to S, Boeing will net $14.6m with forward hedge, and will lock in ex-rate of $1.46/£.
Currency Futures contract could also be considered,
and would essentially have the same outcome as a forward contract.
2. Money Market Hedge. Another strategy for Boeing: Borrow for 1 year in the U.K. in BPs, with a £10m payoff, use the £10m receivable from British Air to pay off the loan in U.K.
Steps:
1. Borrow £10m / 1.09 = £9,174,312 today for
one year @ 9%, pay back £10m in one year
2. Convert the pounds into dollars today @S=$1.50, for $13,761,468 (£9,174,312
x $1.50/£)
3. Invest $13,761,468 in the U.S. @ 6.1%.
4. Collect £10m in one year from British Airways
and pay off the loan in U.K.
5. Receive the dollar proceeds of the investment in U.S. of
$14,600,918 ($13,761,468 x 1.061)
See CF diagram, Exhibit 13.4 on p. 307. The payoff is the same
as with the forward contract, because IRP is holding.
IF IRP is not holding, then either the forward contract or the money market
hedge may dominate the other. These options, being considered
by many MNCs in competitive financial markets, would help to eliminate
deviations from IRP. (Assumes that there is a single interest rate in both
countries for borrowing and lending.)
3. Options Market Hedge. Possible disadvantage of complete hedge with forward, futures contracts, money market hedge? Eliminates ALL currency risk, even the favorable exchange rate changes that can increase profits by raising revenues in the home currency, or lowering costs in home currency. Optimal amount of risk is not zero!
Example: If the spot rate goes to $1.60/£, Boeing would get $16m instead of $14.6m, and gain $1.4m in additional revenues. In other words, hedging would COST the firm $1.4m on an ex post (after the fact) basis. Boeing might regret hedging when the pound appreciates.
Currency Options provide a solution by limiting the downside risk (£ depreciating) while preserving the upside risk potential (£ appreciating), in this case by buying a BP put option. Suppose that BP put options are selling for 2¢, or $0.02/BP, with an exercise price of $1.46/BP, 1 year expiration. Boeing buys £10m worth of put options for $200,000 (£10m x $0.02/£), giving it the right to sell £10m @ $1.46/£ for $14,600,000. Option Payoff Diagram:
Option premium is due now, so considering the time value of money, the future dollar cost (one year) of the put options is $200,000 (1.061) = $212,200 ($200,000 + $12,200 in foregone U.S. interest).
Suppose S = $1.30/£ in one year. Boeing exercises the option and receives $14.6m in gross proceeds for the £10m as follows:
a. £10m x $1.30/£ = $13m (Converting £10m AR in BP to USD @ S = $1.30/£)
b. ($1.46/£ - $1.30/£) x £10m = $1.6m profit on Options Contract
TOTAL $14.6m Gross Dollars Proceeds
c. Options Cost (inc. opp. cost) ($212,200)
NET PROCEEDS $14,387,800
(Effective Ex-rate: $1.4387/£)
If the BP does depreciate significantly (worried about), this establishes the minimum dollar receipt possible (vs. $13m without option in this case), and sets a floor for the £10m receivable. The put premium is like buying an insurance policy now for $200,000 that will guarantee that Boeing will get a MIN of $14,387,800 in one year, and maybe more if _____________.
Suppose S = $1.40/£ in one year. Boeing exercises the option and receives $14.6m in gross proceeds for the £10m as follows:
a. £10m x $1.40/£ = $14m (Converting £10m AR in BP to USD @ S = $1.40/£)
b. ($1.46/£ - $1.40/£) x £10m = $0.6m profit on Options Contract
TOTAL $14.6m Gross Dollars Proceeds
c. Options Cost (inc. opp cost) ($212,200)
NET PROCEEDS $14,387,800
(Effective Ex-rate: $1.4387/£)
S = $1.50/£ in one year. Now Boeing does not exercise the option.
a. £10m x $1.50/£ = $15m (Converting £10m AR in BP to USD @ S = $1.50/£)
b. Options Cost (inc. opp cost) ($212,200)
NET PROCEEDS $14,787,800
(Effective Ex-rate: $1.4787/£)
S = $1.60/£ in one year. Boeing does not exercise the option.
a. £10m x $1.60/£ = $16m (Converting £10m AR in BP to USD @ S = $1.60/£)
b. Options Cost (inc. opp cost) ($212,200)
NET PROCEEDS $15,787,800
(Ex-rate: $1.5787/£)
See Exhibits 13.5 and 13.6, p. 309. Break-even S* between put option and forward contract is $1.48/£. If S > $1.48, put option is better alterative, if S < $1.48 then forward hedge is slightly better by $212,600, the cost of the put option (assumes no cost for a forward contract). Put option allows Boeing to significantly limit the downside risk (£ falling), but preserve the upside potential (£ rising). Minimum proceeds of $14,387,800 and minimum ex-rate of $1.4387/£.
Another advantage of put option vs. forward contract: Forward Contracts are only available at one forward rate for a given maturity vs. put options are available at several exercise prices. For example, Boeing could buy another put option with a Ex-P higher than $1.46, (e.g., $1.48/£) and increase the minimum net dollar proceeds. Problem? See Exhibit 9.7 on p. 212 for quotes on the Euro put options.
See Exhibit 13.7, p. 310 for summary of 3 hedging strategies: Forward Contract,
Money
Market, Put Options.
Cross-Hedging Currency Risk is possible when forward contracts are not available for minor currencies like Korean won, Thai baht, Brazilian real, Mexican peso, etc. Markets are too thin for those currencies, or nonexistent, or inefficient because of currency controls or regulations. Strategy: Use a currency futures or forward contract for a major currency to hedge currency risk for a highly correlated minor currency.
Example: Use a Yen contract to cross-hedge Korean won currency risk (AR in won for U.S. MNC), assuming that the Yen/Won correlation is high. Another type of cross-hedging is commodity-currency hedging, e.g. using oil or silvers futures contracts to hedge Mexican peso, copper futures to hedge Peruvian currency, gold for S. African rand, wool for Australian dollar, cocoa for Nigerian currency, coffee for Colombian peso, cotton for Indian rupee, or soybean or coffee futures to hedge Brazilian real. Works when a commodity futures prices move closely with an ex-rate.
Example: Brazil exports coffee to U.S. and produces 25% of world market, correlation between world coffee price in dollars and the Brazilian currency (real) should be high. Suppose there is a real shock, an increase in demand for coffee. What happens to real? _________ What happens to futures price of coffee in US? ______________
Suppose there is a nominal shock, overall price inflation in the U.S., and the dollar price of coffee in the US goes______ in the spot and futures market, and the dollar goes _____ and the real goes ______ in the currency markets. Therefore there should be a ________ correlation between coffee prices on NYBOT.
Hedging Examples: a) Suppose GM buys transmissions from a company in Brazil and has a 90-day payable (A/P) for 1m reals. It would be worried about the dollar ____ and the real ____, so it would take a _______ position on 3-month coffee futures. (Assume there are no currency futures contracts for reals.)
b) Suppose GM sells engines to a company in Brazil and has a 90-day receivable (A/R) for 1m reals. It would be worried about the real _____ and would take a _____ position on 3-month coffee futures.
HEDGING CONTINGENT EXPOSURE
Options are also useful for a "contingent exposure," when a firm may or may not be exposed to currency risk. The risk is contingent on whether some future event happens.
GE (in U.S.) makes a competitive bid on a hydroelectric plant in Canada, outcome won't be known for 3 months. IF GE gets bid, it will receive an initial down payment of C$100m. IF NOT, it will get 0. Forward hedge is not useful (sell C$ forward), because GE may not have the C$ to sell if it doesn't get the bid. Doing nothing is risky (if C$ ____). Buying a 3 month C$ currency put option for C$100m is ideal solution.
Four outcomes:
1. Bid accepted, S < Ex-P, Exercise put option and sell C$100m
for USD @ Ex-P.
2. Bid accepted, S > Ex-P, Let option expire, convert
C$100 @ S.
3. Bid not accepted, S < Ex-P, Exercise option
and either make money or reduce cost of premium.
4. Bid not accepted, S > Ex-P, Let option expire, lose
premium.
See Exhibit 13.8 on p.
312 for a summary of outcomes for 3 cases: a) no hedging, b) hedge with a short
position on a forward contract, and c) hedge with put option. The option premium is like the cost of an insurance policy
to protect the firm from contingent (potential) transaction exposure.
HEDGING THROUGH INVOICE CURRENCY (OPERATIONAL TECHNIQUES)
Assume that Boeing has a contract to build five 747s for British Airways, and deliver one each year for the next 5 years, and receive £10m per plane. By negotiating and adjusting terms of the invoice, Boeing can shift, share or diversify currency risk.
a) If Boeing can invoice in USD, then it has eliminated currency risk for itself and shifted it to British Airways. Now if S = $1.50/£, British Airways has a $15m AP and Boeing has a $15m AR.
b) Boeing could split (share) the currency risk with British Airways by invoicing 50% in USD and 50% in BP: $7.5m + £5m for each plane, and each company shares half the risk. Potential disadvantage for Boeing of shifting or sharing? Less favorable terms may result in lost sales. Who has more power in the deal, and who is more desperate to make the deal? Buyers' market or sellers' market? "He who cares the least.....WINS."
c) Invoice in a basket of currencies to diversify
and reduce currency
risk with a portfolio of currencies: e.g. SDRs ($, €, ¥, £; weights are 38%, 37%, 13%, 12%)
or in the past, ECUs (11 currencies). Companies can issue bonds denominated in SDRs
or ECU (prior to euro) to diversify risk, Egyptian govt. charges in SDRs for passage
through the Suez Canal. Invoicing in currency baskets can be a useful hedging tool when no
forward or currency contracts are available, and have the advantage of
_________.
SPEEDING/SLOWING AR AND AP IN FOREIGN CURRENCY
General rules: For AR
(Accounts Receivable) in foreign currency: Speed up (or lead)
collections of depreciating currencies (e.g., peso ARs), and Slow down (or lag) collections
of appreciating currencies (e.g., Euro ARs).
For AP
(Accounts Payable) in foreign currency: Speed up (or lead) payments of appreciating foreign
currencies (e.g. Euro APs, when dollar is depreciating), and Slow down (or lag) payments
of depreciating currencies (e.g., Mexican peso APs when dollar is appreciating).
TO HEDGE OR NOT TO HEDGE - SHOULD THE FIRM HEDGE?
Does hedging create value for the firm (shareholders)? Extreme view: Nobel Prize economists Modigliani and Miller:
i) Capital structure (mix of debt and equity), and ii) Dividend policy (investors care about total return and don't care whether they get dividends or capital gains) are irrelevant and don't affect the value of the firm; therefore hedging doesn't affect the value of the firm since it is just a form of financing. And since hedging is costly (option premiums), it may lower value of the firm. "Don't do for shareholders what they can do for themselves." Shareholders can hedge on their own if they want to using? ___________________
Although M&M may be right in theory if capital markets are perfect, a case can be made for hedging based on various capital market imperfections.
1. Information Asymmetry. Managers know more about the various risks the firm is exposed to, therefore it makes more sense for the managers of the firm to determine optimal hedging, not the shareholders.
2. Transaction Costs. The firm is in a better position to achieve low cost hedging compared to shareholders, and may have full-time risk management professionals/specialists, trained in financial engineering.
3. Default Costs. Hedging can reduce probability of default, resulting in better credit rating for the MNC, which will lower overall financing costs, an outcome that shareholders cannot achieve on their own.
4. Progressive Corporate Taxes. Assume that corporations pay 20% tax on income from $0-10m, and 40% tax on earnings above $10m. In this tax environment, it would be better to receive a fixed, stable annual income of $10m (hedged) with a tax rate of 20%, compared to $5m one year and $15m the next year (unhedged), since $5m of the $15m would be taxed at 40%. Hedging could result in lower overall tax liability by stabilizing CFs in the face of a progressive corporate tax system.
See Exhibit 13.10 on p. 318 for a summary of currency risk products used by corporations. Forward contracts are used most often, followed by currency swaps and currency options.