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IF07.pptChapter 07
Currency Exposure Management
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
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Learning Objectives
- A. Discuss reasons for hedging.
- B. Discuss which type of firms hedge and what types of exposures are hedged.
- C. Discuss operational considerations concerning hedging.
- D. Implement a forward hedge, compare with unhedged.
- E. Implement a money market hedge.
- F. Implement an option hedge.
- G. Discuss operating decisions to mitigate transaction exposure.
- H. Discuss operating decisions to mitigate operating exposure.
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A1. Why Hedge? Strategic Reason
- Suppose a firm faces potential FX losses,
what are alternatives to hedging? None are good!
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| Alternative I | Alternative II | Alternative III | |
| Action | Issue stocks, bonds; raise private equity or debt | Combine with another firm (e.g., joint venture, merger) | Forgo R&D expense |
| Advantage | Invites external monitoring; ensures continued operations | Obtain expertise and financing from another entity | NONE |
| Dis-advantage | Because of financial problems financing may be costly | Must share benefits; relinquish partial control of firm | Miss product cycle and head toward long-term failure |
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A2. Why Hedge? Save Taxes
A firm expects taxable incomes of $10 million and $100 million over a period of two years.
Assume that the variation in incomes is because of currency exposure and that the firm can eliminate this risk substantially through hedging, producing incomes of $50 million and $60 million over this two-year period. Assume that the tax code indicates rates of 20% for incomes up to $50 million and 30% for incomes above $50 million. Calculate taxes in the two scenarios and identify the benefit of hedging.
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A2. Why Hedge? Save Taxes (cont.)
Solution:
Unhedged scenario tax calculations:
Year 1 taxes = 20% (10) = 2
Year 2 taxes = 20% (50) 30% (100-50) = 25
We make similar calculations for the hedged scenario and complete the table below.
Discussion: With hedging, total taxes are reduced from 27to 23. The benefit of hedging equals 4.
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| Year 1 | Year 2 | Total taxes | |||
| Scenario | Income | Taxes | Income | Taxes | |
| Unhedged | 10 | 2 | 100 | 25 | 27 |
| Hedged | 50 | 10 | 60 | 13 | 23 |
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A3. Why Hedge? Other Reasons
- Managerial Compensation: managers may desire stability (using hedging), but some who are given options may wish instability (unhedged)
- Managerial Risk Aversion: managers are ill-diversified, so wish hedging.
- Debtors: prefer stable cash flows (prefer hedging)
- Suppliers and Customers: prefer stable cash flows
- Market inefficiency: hedging may actually give extra value because derivatives may be mispriced relative to FX values (e.g., buy an FX cheaply)
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B1. Which Firms Hedge?
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| Hedging Activity by US Non-financial firms | |
| Category | Percent of Firms Hedging |
| Size: | |
| Large | 83% |
| Medium | 45% |
| Small | 12% |
| Type of Firm: | |
| Primary Products | 68% |
| Manufacturing | 48% |
| Services | 42% |
| Source: Bodnar, Hayt and Marston, 1998, 1998 Wharton Survey of Financial Risk Management by US non-financial firms, Financial Management 27.4, 70-91. |
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B2. Which Types of Exposure are Hedged?
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| What types of currency exposure are hedged? | |||||
| Exposure | Percent of firms responding in the following ranges for proportion of exposure hedged | ||||
| 0-25% | 26-50% | 51-75% | 76-100% | Average Proportion Hedged | |
| On Balance Sheet Commitments | 40% | 13% | 12% | 35% | 49% |
| Off Balance Sheet Commitments | 72% | 11% | 5% | 13% | 23% |
| Anticipated Transactions < 1 year | 42% | 22% | 9% | 27% | 42% |
| Anticipated Transactions > 1 year | 78% | 11% | 4% | 6% | 16% |
| Competitive Exposure | 90% | 6% | 2% | 3% | 7% |
| Translation | 84% | 6% | 3% | 8% | 12% |
| Repatriation | 50% | 14% | 5% | 31% | 40% |
| Source: Bodnar, Hayt and Marston, 1998 |
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C. Operational Issues in Hedging
- Partial vs. Full Hedging: firms rarely hedge 100% because of cost and precision concerns.
- Hedging Instruments:
- Matching: maturity and currency must ideally match
- Symmetry: forwards & futures provide symmetric hedges, options provide asymmetric hedges (clarified using examples later in chapter)
- Hedging Horizon: typically matches maturity of FX position, but sometimes firms decide to use a short-term hedge to solve a long-term problem mostly because of uncertainty.
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D1. Forward Hedge
EXAMPLE: A Brazilian exporter to Europe invoices goods in EUR and expects to receive EUR 4 million in 3-months. A 3-month forward contract is available at a EURBRL rate of 2.7513. Explain the hedging strategy and show its result.
Solution:
The exporter takes a short position in the forward contract with a notional value of EUR 4 million. At maturity, he delivers EUR 4 and receives:
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D2. Forward vs. Unhedged
An Indian garment exporter to the US is concerned about the weakening dollar and is considering a 6-month currency forward at a rate (USDINR) of 42. The firm internally forecasts USD values as follows: USDINR = 40 (probability = 50%) and USDINR = 45 (probability = 50%). Evaluate the hedging decision. Assume that the firm has receivables of USD 2 million.
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| Cash Flows (INR) | ||||
| Scenario | USDINR | Probability | Unhedged | Hedged |
| I | 40 | 50% | 80,000,000 | 84,000,000 |
| I | 45 | 50% | 90,000,000 | 84,000,000 |
| 85,000,000 | 84,000,000 | |||
| 5,000,000 | 0 |
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E1. Money Market Hedge
- Involves the pre-emptive conversion of currencies.
- FX Receivables: Borrow FX today, convert to home currency today, repay loan using receivables.
- FX Payables: Borrow home currency today, convert to FX today, lend and use FX to meet payables.
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E1. Money Market Hedge (cont.)
- In equilibrium (if interest rates are in harmony with spot and forward FX) money market hedge is equivalent to forward hedge.
- Quick method of determining results of money market hedge: use formula below making appropriate adjustments for time period :
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E2. Money Market Receivables Hedge Example
A US-firm has receivables of EUR 5 million in 9 months. The spot and forward (EURUSD) rates are 1.55 and 1.52 respectively. Assume that the firm can borrow as well as lend at the following Eurocurrency rates: 2% (USD) and 4% (EUR). Show details of the money market hedge.
EUR to be borrowed =
USD to be deposited =
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F1. Options Hedge
- Option hedges are asymmetric hedges. They protect against FX losses and at the same time preserve FX gains. You pay a premium for this benefit.
- FX receivables are hedged using put options (the FX is sold for the option strike price).
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F1. Options Hedge (cont.)
- FX payables are hedged using call options (the FX is bought at the option stock price).
- Unlike forward hedges, the resulting CF has some volatility (but option hedge sigma is lower than the sigma of the unhedged position, see example that follows)
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F2. Some Useful Equations for Option Hedge Calculations
Call Option Payables Hedge:
Put Option Receivables Hedge:
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F3. An Options Hedge CF Calculation
EXAMPLE: A US firm has EUR-payables that mature in 180-days. It hedges using a call option on EUR with a strike price of USD 1.50 and a premium of USD 0.04. Suppose the maturity value of EURUSD is 1.60. Assume that the USD-denominated LIBOR rate is 4% (actual/360 simple interest). Calculate the (net) cash flow to the payables hedge.
Solution:
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F4. Summarizing an Option Hedge
Consider again the previous example involving an option hedge by a US-firm. The call option is on EUR with a strike price of USD 1.50 and a premium of USD 0.04. The firm forecasts that the EURUSD is equally likely to be 1.45 or 1.60 at maturity. Assume payables of EUR 25,000. Assume that the USD-denominated LIBOR rate is 4% (actual/360 simple interest). Calculate the cash flow of the call option hedge in the two scenarios. What are expected value and standard deviation?
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F4. Summarizing an Option
Hedge (cont.)
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| Call Option / Payables Hedge | |||||||
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | |
| Scenario | Amount | S | FV(C) | Max(0, S-X) | CF / unit = -(3)-(4)+(5) | CF = (1) × (6) | |
| I | 25,000 | 50% | 1.45 | 0.0408 | 0 | -1.4908 | -37,270 |
| II | 25,000 | 50% | 1.60 | 0.0408 | 0.10 | -1.5408 | -38,520 |
| -37,895 | |||||||
| 625 |
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F5. Another Options Hedge Example
A U.S. firm’s CAD-receivables mature in 270-days. It hedges using a put option receivables hedge on CAD with a strike price of USD 1.00 and a premium of USD 0.05.The firm forecasts that the CADUSD will be worth 0.85 (probability = 60%) or 1.10 (probability = 40%) in 270-days. Assume receivables of CAD 500,000. Assume that the USD-denominated LIBOR interest rate is 6% (actual/360 simple interest).
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| Put Option / Receivables Hedge | |||||||
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | |
| Scenario | Amount | S | FV(P) | Max(0, X-S) | CF / unit = (3)-(4)+(5) | CF = (1) × (6) | |
| I | 500,000 | 60% | 0.85 | 0.05225 | 0.15 | 0.94775 | 473,875 |
| II | 500,000 | 40% | 1.10 | 0.05225 | 0 | 1.04775 | 523,875 |
| 493,875 | |||||||
| 24,495 |
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G1. Operating Decisions to Mitigate Transaction Exposure
- Specifying the appropriate invoice currency: try to specify home currency as invoice currency.
- Leading and lagging contractual cash flows: try to synchronize cash inflows and outflows.
- Netting currency cash flows across corporate subsidiaries and affiliates
- Risk-sharing contracts with customers and suppliers
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G2. Risk-Sharing Contract
A US based MNC sourcing garments from the Dominican Republic has to pay DOP (the Dominican peso) 60,000 in 30 days. The DOP is currently trading at USDDOP = 30. If USDDOP decreases in value, the exporter gains and the US firm loses. Consider a scenario where in 30 days USDDOP = 23. Suppose the risk-sharing contract calls for equal sharing of the change in the USDDOP rate. Calculate the DOP payment for the US firm.
If there had been no risk-sharing clause, the US firm would have paid USD 2,608.70 ( =60,000/23).
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H. Operating Decisions to Mitigate Operating Exposure
- Geographical dispersion of suppliers: allows firms to move to suppliers operating in a lower value currency
- Geographical dispersion of customers: allows firms to switch to customers paying with a higher value currency
- Achieving product differentiation: allows the firm to adjust selling price to offset currency changes.
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Amount
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2,304.35
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