International Finance #5

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International Financial Management 13th Edition

by Jeff Madura

11 Managing Transaction Exposure

 Describe common policies for hedging transaction exposure.

 Compare the techniques commonly used to hedge payables.

 Compare the techniques commonly used to hedge receivables.

 Describe limitations of hedging.

 Suggest other methods of reducing exchange rate risk when hedging techniques are not available.

Chapter Objectives

Policies for Hedging Transaction Exposure

Hedging Most of the Exposure  Hedging most of the transaction exposure allows MNCs to

more accurately forecast future cash flows (in their home currency) so that they can make better decisions regarding the amount of financing they will need.

Selective Hedging  MNC must identify its degree of transaction exposure.  MNC must consider the various techniques to hedge the

exposure so that it can decide which hedging technique is optimal and whether to hedge its transaction exposure.

Hedging Exposure to Payables (1 of 11)

An MNC may decide to hedge part or all of its known payables transactions using:

 Forward or futures hedge  Money market hedge  Currency option hedge

Hedging Exposure to Payables (2 of 11)

Forward or Futures Hedge on Payables  Allows an MNC to lock in a specific exchange rate at which

it can purchase a currency and hedge payables. A forward contract is negotiated between the firm and a financial institution. The contract will specify the:  currency that the firm will pay.  currency that the firm will receive.  amount of currency to be received by the firm.  rate at which the MNC will exchange currencies (called the

forward rate).  future date at which the exchange of currencies will occur.

Hedging Exposure to Payables (3 of 11)

Money Market Hedge on Payables  Involves taking a money market position to cover a future

payables position.  If a firm prefers to hedge payables without using its cash

balances, then it must  Borrow funds in the home currency and  Invest in the foreign currency.

 Money market hedge versus forward hedge  Since the results of both hedges are known beforehand, the

firm can implement the one that is more feasible.

Hedging Exposure to Payables (4 of 11)

Call Option Hedge on Payables  A currency call option provides the right to buy a specified

amount of a particular currency at a specified strike price or exercise price within a given period of time.

 The currency call option does not obligate its owner to buy the currency at that price. The MNC has the flexibility to let the option expire and obtain the currency at the existing spot rate when payables are due.

Hedging Exposure to Payables (5 of 11)

Call Option Hedge on Payables (cont.)  Cost of call options based on contingency graph (Exhibit 11.1)  Advantage: provides an effective hedge  Disadvantage: premium must be paid

 Cost of call options based on currency forecasts (Exhibit 11.2)  MNC can incorporate forecasts of the spot rate to more accurately

estimate the cost of hedging with call options.  Consideration of Alternative Call Options  Several different types of call options may be available, with

different exercise prices and premiums for a given currency and expiration date.

 Whatever call option is perceived to be most desirable for hedging a particular payables position would be analyzed, so that it could then be compared to the other hedging techniques.

Exhibit 11.1 Contingency Graph for Hedging Payables With Call Options

Exhibit 11.2 Using Currency Call Options to Hedge Euro Payables (exercise price = $1.20, premium = $.03)

Hedging Exposure to Payables (6 of 11)

Comparison of Techniques to Hedge Payables (Exhibit 11.3)  The cost of the forward hedge or money market hedge

can be determined with certainty.  The currency call option hedge has different outcomes

depending on the future spot rate at the time payables are due.

Exhibit 11.3 Comparison of Hedging Alternatives for Coleman Co.

Hedging Exposure to Payables (7 of 11)

Comparison of Techniques to Hedge Payables  Optimal Technique for Hedging Payables (Exhibit 11.4)  Select optimal hedging technique by:  Considering whether futures or forwards are preferred.  Considering desirability of money market hedge versus

futures/forwards based on cost.  Assessing the feasibility of a currency call option based on estimated

cash outflows.

 Choose optimal hedge versus no hedge for payables.  Even when an MNC knows what its future payables will be, it

may decide not to hedge in some cases.

Evaluate the hedge decision by estimating the real cost of hedging versus the cost if not hedged.

Exhibit 11.4 Graphic Comparison of Techniques to Hedge Payables

Hedging Exposure to Receivables (8 of 11)

Forward or futures hedge on receivables allows the MNC to lock in the exchange rate at which it can sell a specific currency. Money market hedge on receivables involves borrowing the currency that will be received and using the receivables to pay off the loan.

Hedging Exposure to Receivables (9 of 11)

Put option hedge on receivables provides the right to sell a specified amount of a particular currency at a specified strike price by a specified expiration date.  Cost of Put Options Based on Contingency Graph (Exhibit 11.5)  Advantage: provides an effective hedge  Disadvantage: premium must be paid

 Cost of Put Options Based on Currency Forecasts (Exhibit 11.6)  MNC can use currency forecasts to more accurately estimate the

dollar cash inflows to be received when hedging with put options.  Consideration of Alternative Put Options  Several different types of put options may be available that feature

different exercise prices and premiums for a given currency and expiration date.

Exhibit 11.5 Contingency Graph for Hedging Receivables with Put Options

Exhibit 11.6 Use of Currency Put Options for Hedging Swiss Franc Receivables (exercise price = $.72; premium = $.02)

Hedging Exposure to Receivables (10 of 11)

Comparison of Techniques for Hedging Receivables (Exhibit 11.7)  Optimal Technique for Hedging Receivables: (Exhibit 11.8)  Consider whether futures or forwards are preferred.  Consider desirability of money market hedge versus

futures/forwards based on cost.  Assess the feasibility of a currency put option based on estimated

cash outflows.  Optimal hedge versus no hedge on receivables  An MNC may know what its future receivables will be yet still

decide not to hedge. In that case, the MNC needs to determine the probability distribution of its revenue from receivables when not hedging

Exhibit 11.7 Comparison of Hedging Alternatives for Viner Co.

Exhibit 11.8 Graph Comparison of Techniques to Hedge Receivables

Hedging Exposure to Receivables (11 of 11)

Evaluating the hedge decision by estimating the real cost of hedging receivables versus the cost of receivables if not hedged. Summary of Hedging Techniques (Exhibit 11.9)

Exhibit 11.9 Review of Techniques for Hedging Transaction Exposure

Limitations of Hedging

Limitation of Hedging an Uncertain Payment  Some international transactions involve an uncertain amount

of foreign currency, leading to overhedging. Limitation of Repeated Short-Term Hedging  The continual short-term hedging of repeated transactions

may have limited effectiveness. (Exhibits 11.10 and 11.11)  Long-term Hedging as a Solution  Some banks offer forward contracts for up to 5 years or 10

years on some commonly traded currencies.

Exhibit 11.10 Repeated Hedging of Foreign Payables When the Foreign Currency Is Appreciating

Exhibit 11.11 Long-Term Hedging of Payables When the Foreign Currency Is Appreciating

Alternative Hedging Techniques

Leading and Lagging: Adjusting the timing of a payment or disbursement to reflect expectations about future currency movements. Cross-Hedging: Hedging by using a currency that serves as a proxy for the currency in which the MNC is exposed. Currency Diversification: Reducing exposure by diversifying business among numerous countries.

SUMMARY (1 of 4)

 An MNC may choose to hedge most of its transaction exposure or to selectively hedge. Some MNCs hedge most of their transaction exposure so that they can more accurately predict their future cash inflows or outflows and make better decisions regarding the amount of financing they will need. Many MNCs use selective hedging, in which they consider each type of transaction separately.

 To hedge payables, a futures or forward contract on the foreign currency can be purchased. Alternatively, a money market hedge strategy can be used; in this case, the MNC borrows its home currency and converts the proceeds into the foreign currency that will be needed in the future. Finally, call options on the foreign currency can be purchased.

SUMMARY (2 of 4)

 To hedge receivables, a futures or forward contract on the foreign currency can be sold. Alternatively, a money market hedge strategy can be used. In this case, the MNC borrows the foreign currency to be received and converts the funds into its home currency; the loan is to be repaid by the receivables. Finally, put options on the foreign currency can be purchased. When hedging techniques like forward and currency option contracts are not available, there are still some methods of reducing transaction exposure, such as leading and lagging, cross-hedging, and currency diversification. The currency option hedge has an advantage over the other hedging techniques in that the options do not have to be exercised. However, a premium must be paid to purchase the currency option, so there is a cost for the flexibility they provide.

SUMMARY (3 of 4)

 One limitation of hedging is that if the actual payment on a transaction is less than the expected payment, the MNC overhedged and is partially exposed to exchange rate movements. Alternatively, if an MNC hedges only the minimum possible payment in the transaction, it will be partially exposed to exchange rate movements if the transaction involves a payment that exceeds the minimum. Another limitation of hedging is that a short-term hedge is only effective for the period in which it was applied. One potential solution to this limitation is for an MNC to use long- term hedging rather than repeated short-term hedging. This choice is more effective if the MNC can be sure that its transaction exposure will persist into the distant future.

SUMMARY (4 of 4)

 When hedging techniques like forward and currency option contracts are not available, there are still some methods of reducing transaction exposure, such as leading and lagging, cross-hedging, and currency diversification.

Slide Number 1
11
Policies for Hedging Transaction Exposure
Hedging Exposure to Payables (1 of 11)
Hedging Exposure to Payables (2 of 11)
Hedging Exposure to Payables (3 of 11)
Hedging Exposure to Payables (4 of 11)
Hedging Exposure to Payables (5 of 11)
Exhibit 11.1 Contingency Graph for Hedging Payables With Call Options
Exhibit 11.2 Using Currency Call Options to Hedge Euro Payables (exercise price = $1.20, premium = $.03)
Hedging Exposure to Payables (6 of 11)
Exhibit 11.3 Comparison of Hedging Alternatives for Coleman Co.
Hedging Exposure to Payables (7 of 11)
Exhibit 11.4 Graphic Comparison of Techniques to Hedge Payables
Hedging Exposure to Receivables (8 of 11)
Hedging Exposure to Receivables (9 of 11)
Exhibit 11.5 Contingency Graph for Hedging Receivables with Put Options
Exhibit 11.6 Use of Currency Put Options for Hedging Swiss Franc Receivables (exercise price = $.72; premium = $.02)
Hedging Exposure to Receivables (10 of 11)
Exhibit 11.7 Comparison of Hedging Alternatives for Viner Co.
Exhibit 11.8 Graph Comparison of Techniques to Hedge Receivables
Hedging Exposure to Receivables (11 of 11)
Exhibit 11.9 Review of Techniques for Hedging Transaction Exposure
Limitations of Hedging
Exhibit 11.10 Repeated Hedging of Foreign Payables When the Foreign Currency Is Appreciating
Exhibit 11.11 Long-Term Hedging of Payables When the Foreign Currency Is Appreciating
Alternative Hedging Techniques
SUMMARY (1 of 4)
SUMMARY (2 of 4)
SUMMARY (3 of 4)
SUMMARY (4 of 4)