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10-1
Chapter 10Chapter 10Managing Transaction ExposureManaging Transaction Exposure
to Currency Riskto Currency RiskLearning objectives Transaction exposure
– An example Internal hedges
– Multinational netting and leading/lagging
Financial market (external) hedges– Currency forwards, futures, options, swaps, and money market hedges
Treasury management – best practicesButler, Multinational Finance, 4e
10-2
Exposures to currency riskExposures to currency riskChange in firm value due to unexpected changes in foreign exchange rates- Transaction exposure
change in the value of contractual cash flows arising from the firm’s monetary assets and liabilities
- Operating exposure change in the value of noncontractual cash flows
arising from the firm’s real assets
Realassets
Monetaryassets
Commonequity
Monetaryliabilities
Transaction exposure
10-3
A forward currency hedgeA forward currency hedgeUnderlying pound exposure
Short £ forward position
Net position
Net exposureV$/£
S$/£
shortpound
+£1,000,000
-£1,000,000+
$1,500,000
+$1,500,000
longpound
Transaction exposure
10-4
Managing transaction exposureManaging transaction exposure
Managing transaction exposure internally- multinational netting (currency diversification) - leading and lagging
Managing transaction exposure in the financial markets- currency forwards- money market hedges- futures- options- swaps
Transaction exposure
10-5
Multinational nettingMultinational netting
Germansubsidiary
U.S.subsidiary
U.K.parent
£100m
Cross rates €1.5000/£$1.2500/£$0.8333/€
£200m
$75m
$125m€150m
€60m
Internal hedges: Multinational netting
10-6
Cash flows before nettingCash flows before netting
Germansubsidiary
U.S.subsidiary
U.K.parent
£100m
£200m
£60m
£100m£100m
£40m
Internal hedges: Multinational netting
10-7
Cash flows after nettingCash flows after netting
Germansubsidiary
U.S.subsidiary
U.K.parent
£60m £140m
Internal hedges: Multinational netting
10-8
Leading and laggingLeading and lagging Leading and lagging refers to altering
the timing of cash flows within the firm to offset foreign exchange exposuresFor example:- Leading - If a parent firm is short
euros, it can accelerate euro payments from its subsidiaries
- Lagging - If a parent firm is long euros, it can delay euro payments from its subsidiaries
Internal hedges: Leading and lagging
10-9
Leading and laggingLeading and lagging Underlying cash flows
Leading
Lagging
-€10 million
+€7.5 million +€7.5 million +€7.5 million
-€10 million -€10 million
Jan Feb Mar Apr June May July Aug Internal hedges: Leading and lagging
10-10
Currency forward contractsCurrency forward contracts
Advantages- Forwards can provide a perfect hedge of
transactions of known size and timing Disadvantages
- Bid-ask spreads can be large on small transactions, long-dated contracts, or infrequently traded currencies
- Forwards are a pure credit instrument, so forward contracts have credit risk
External hedges: Forwards
10-11
Currency futures contractsCurrency futures contracts
The futures contract solution to the default risk of forward contracts- An exchange clearinghouse takes one side
of every transaction- Futures contracts are marked-to-market on
a daily basis- Initial and maintenance margins are
required on futures contracts
External hedges: Futures
10-12
FX forwards versus futures contractsFX forwards versus futures contracts
Forwards FuturesCounterparty Bank Futures exchange
clearinghouseMaturity Negotiated StandardizedAmount Negotiated StandardizedFees Bid-ask CommissionsCollateral Negotiated Margin account
External hedges: Futures
10-13
Currency futures contractsCurrency futures contracts
Advantages- Low cost if the size, currency and maturity
match the underlying exposure - Low credit risk with daily marking-to-
market Disadvantages
- Costs increase with transaction size- Exchange-traded futures come in limited
currencies and maturities- Daily marking-to-market can cause a cash
flow mismatchExternal hedges: Futures
10-14
Money market hedgesMoney market hedges
Advantages- Synthetic forward positions can be
built in currencies for which there are no forward currency markets
Disadvantages- Relatively expensive hedge- Might not be feasible if there are
constraints on borrowing or lending
External hedges: Money market hedges
10-15
Currency option hedgesCurrency option hedges
Advantages- Disaster hedge insures against
unfavorable currency movementsDisadvantages
- Option premiums reflect option values, so option hedges can be expensive in volatile currencies and at distant expiration dates
External hedges: Options
10-16
A pound call is an option to buy pounds- the option holder gains if pound sterling
rises- the option holder does not lose if pound falls
Long pound callan option to buypounds sterling at a contractualexercise price
S$/£
V$/£
Option premium = $0.30/£
Exerciseprice
$1.50/£
-$0.30/£
External hedges: Options
A currency call optionA currency call option
10-17
A call option hedgeA call option hedge
S$/£
V$/£
$1.50/£
-$1.50/£
Short exposureExternal hedges: Options
10-18
A call option hedgeA call option hedge
S$/£
V$/£ Call option hedge
-$0.30/£
$1.50/£
-$1.50/£
Short exposureExternal hedges: Options
10-19
A call option hedgeA call option hedge
S$/£
V$/£ Call option hedge
Optionhedged position
-$0.30/£
$1.50/£
-$1.50/£-$1.80/£
Short exposureExternal hedges: Options
10-20
A pound put is an option to sell pounds- the option holder gains if pound sterling falls- the option holder does not lose if pound
risesLong pound putan option to sellpounds sterling at a contractualexercise price
S$/£
V$/£
Option premium = $0.30/£
Exerciseprice
$1.50/£
-$0.30/£
External hedges: Options
A currency put optionA currency put option
10-21
A put option hedgeA put option hedge
S$/£
V$/£
Long exposure
+$1.50/£
$1.50/£
External hedges: Options
10-22
A put option hedgeA put option hedge
S$/£
V$/£
Put option hedge
Long exposure
-$0.30/£
+$1.50/£+$1.20/£
$1.50/£
External hedges: Options
10-23
A put option hedgeA put option hedge
S$/£
V$/£
Put option hedge
Long exposure
Optionhedged position
-$0.30/£
+$1.50/£+$1.20/£
$1.50/£
External hedges: Options
10-24
Currency swaps…Currency swaps…“I’ll pay yours if you pay mine”“I’ll pay yours if you pay mine”
Currency swap- An agreement to exchange a principal
amount of two currencies and, after a pre-arranged length of time, re-exchange the original principal
- Interest payments are also usually swapped during the life of the contract
External hedges: Swaps
10-25
Currency swap contractsCurrency swap contracts Advantages
- Quickly transforms the firm’s liabilities into other currencies or payout structures
- Low cost for plain vanilla swaps in actively traded currencies
- Swaps can be used to to hedge long-term exposures
Disadvantages- Not the best choice for near-term
exposures- Innovative or exotic swaps can be
expensiveExternal hedges: Swaps
10-26
Financial market hedgesFinancial market hedgesVehicles Advantages DisadvantagesForward Exact hedge; Large bid-ask spreads on
Small bid-ask spread small or long-dated deals & for large deals thinly traded currencies
Future Low cost for small Only a few currencies &deals; low risk maturities; mark-to-market with mark-to-market can cause a CF mismatch
Money market Synthetic forward Relatively expensive; not hedge always possibleSwap Quick & low-cost Innovative swaps costly;
switch of payoff may not be best for structures near-term exposures
Option Disaster hedge Option premiums provides insurance can be expensive
External hedges
10-27
10%
51%
10%
49%
6%
26%
Alter the size ofa hedge
Alter the timingof a hedge
Actively takepositions
Sometimes
Frequently
Active management of fx riskActive management of fx risk
Bodnar, Hayt, and Marston, “1998 Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms,” Financial Management (1998).
Financial management
10-28
42%
24%17% 17%
Beginning-of-period forward
rates
Beginning-of-period spot
rates
Baselinepercenthedgedstrategy
Otherbenchmark
Risk management benchmarksRisk management benchmarks
Bodnar, Hayt, and Marston, “1998 Wharton Survey.”Financial management
10-29
40%
21% 22%18%
Reducedvolatility
relative to abenchmark
Risk-adjustedperformance
Absolute profitor loss
Increasedprofit relative
to abenchmark
Performance evaluationPerformance evaluation
Bodnar, Hayt, and Marston, “1998 Wharton Survey.”Financial management
10-30
Active treasuriesActive treasuries
Tend to be large firms with centralized risk management
Use sophisticated valuation methodologies such as value-at-risk for managing their exposures
Frequently mark their derivatives positions to marketGéczy, Minton, and Schrand, “Taking a View: Corporate Speculation, Governance, and Compensation” Journal of Finance (2007)
Financial management
10-31
Active treasuriesActive treasuriesmanage their managersmanage their managers
Managers’ actions are closely monitored Firms use compensation contracts to
align managers’ objectives with those of other stakeholders
Firms use derivatives-specific controls such as performance benchmarks to manage potential abuses Géczy, Minton, and Schrand, “Taking a View”
Financial management
10-32
Corporate use of derivativesCorporate use of derivativesUsed Total
Type of product often usageCurrency forwards 72.3%
93.1%Currency swaps 16.4 52.6OTC currency options 18.8 48.8Cylinder options 7.0 28.7Synthetic forwards 3.0 22.0Currency futures 4.1 20.1Exchange-traded (spot) options 3.6 17.3Exchange-traded futures options 1.8 8.9
Jesswein, Kwok & Folks, “What New Currency Risk Products Are Companies Using and Why?” Journal of Applied Corporate Finance (1995)
Financial management