FIN 40500: International Finance Hedging Foreign Exchange Risk

FIN 40500: International Finance

Hedging Foreign Exchange Risk

To hedge or not to hedge….that is the question”

Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now.

Spot Rate: $1.88

90 Day Forward: $1.85 (-1.6%)

If you were to “lock in” your price with the forward/futures contract, you would pay $185,000 for the goods (with certainty)

Suppose you have the following forecast for the percentage change in the British pound over the upcoming 90 days

% Change in e ($/GBP)

Mean: -1.6%

Std. Dev: 2%

-1.6%[ -3.6% , 0.4%]

[ -5.6% ,2.4%]

[ -7.6%, 4.4%]

e%

pr

Given a standard deviation, we can approximate a distribution for the exchange rate in 90 days.

Standard Deviations

Percentage Change

Exchange Rate Probability

-3 -7.6% $1.74 1%

-2 -5.6% $1.77 4%

-1 -3.6% $1.81 25%

0 -1.6% $1.85 40%

1 .4% $1.89 25%

2 2.4% $1.93 4%

3 4.4% $1.96 1%

Current Spot Rate: $1.88

Given the distribution of exchange rates, we can estimate the expected cost of the hedge

Exchange Rate

Probability Cost w/out hedge

Cost w/hedge

Value of Hedge

$1.74 1% $174,000 $185,000 -$11,000

$1.77 4% $177,000 $185,000 -$8,000

$1.81 25% $181,000 $185,000 $-4,000

$1.85 40% $185,000 $185,000 $0

$1.89 25% $189,000 $185,000 $4,000

$1.93 4% $193,000 $185,000 $8,000

$1.96 1% $196,000 $185,000 $11,000


Expected Value: $0

From the previous table, we can show the distribution of gains from the hedge

0

5

10

15

20

25

30

35

40

Pro

bability

($11,000) ($8,000) ($4,000) $0 $4,000 $8,000 $11,000

Hedge Cost

If forward rates are unbiased, most of the weight will be at zero!

Money Market Hedges


Spot Rate = $1.88

British 90 Day Interest Rate = 2.6%

US 90 Day interest rate = 1%

Money Market Hedges

Spot Rate = $1.88

British 90 Day Interest Rate = 2.6%

US 90 Day interest rate = 1%

Today 90 Days

GBP 100,000

1.026

Present Value of 100,000 in 90 days

$1.88 = $183,236 (1.01) = $185,000

Borrow $183,236 @ 1% for 90 Days

Convert to GBP @ $1.88

Invest in 90 Day British Asset @ 2.6%

Collect GBP 100,000 to pay for imports

Pay of loan + interest = $185,000

Money Market Hedges VS.

Forward/Futures Hedge

Recall Covered Interest Parity

If covered interest parity holds (and it does!), then the forward rate reflects the interest differential and the money market hedge is identical to the forward/future hedge!

)1(1 * iie

F

Currency Options

With options, you have the right to buy/sell currency, but not the requirement Call: The right to buy at a specific “strike price” Put: The right to sell at a specific “strike price”

The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option.

The buyer must pay an up front price for the contract

Payout from a Call

0

0.05

0.1

0.15

0.20.9

5 1

1.0

5

1.1

1.1

5

1.2

1.2

5

1.3

1.3

5

1.4

Exchange Rate ($/ E)

Pro

fit per

Euro

Suppose you buy a 30 day call on 125,000 Euros at a strike price of $1.20

For spot rates less than $1.20, the option is worthless (“out of the money”)

If the spot rate is $1.25, your profit is

($.05)*($125,000) = $6,250

Payout from a Put

Suppose you buy a put on 125,000 Euros at a strike price of $1.20

For spot rates greater than $1.20, the option is worthless (“out of the money”)

For example, if the spot rate is $1.15, your profit is

($.05)*($125,000) = $6,250

0

0.05

0.1

0.15

0.2

0.25

0.9

5

1.0

5

1.1

5

1.2

5

1.3

5

Hedging with Options


Spot Rate: $1.88

3 Month Call w/strike price of $1.85 is selling at a premium of $.05 (GBP 100,000)

You pay $.05(100,000) = $5,000 today. Your cost of GBP in 90 days = MIN [ spot rate, $1.85]

Remember, you pay (.05)*100,000 = $5,000 Today!

Exchange Rate

Probability Cost w/out hedge

Cost w/hedge

Value of Hedge

$1.74 1% $174,000 $179,000 -$5,000

$1.77 4% $177,000 $182,000 -$5,000

$1.81 25% $181,000 $186,000 -$5,000

$1.85 40% $185,000 $190,000 -$5,000

$1.89 25% $189,000 $190,000 $1,000

$1.93 4% $193,000 $190,000 $3,000

$1.96 1% $196,000 $190,000 $6,000


Expected Value: -$3,070

0

10

20

30

40

50

60

70

Pro

bability

($5,000) $1,000 $3,000 $6,000

Hedge Value

The option hedge is more expensive on average, but protects you from large negative outcomes!

Hedging Techniques

Type of Exposure

Forward/Futures Money Market Options

Payables (Cash Outflow)

Long Position Borrow Domestically/Lend Abroad

Call Option

Receivables (Cash Inflow)

Short Position Lend Domestically/Borrow Abroad

Put Option

Cross Hedging

Suppose that you have entered an agreement to buy PLN 100,000 (Polish Zloty) worth of imports. ($1 = 3.17PLN). Zloty futures are not traded. What do you do?

You notice that the Zloty is highly correlated with the Euro (E 1 = 4.09 PLN)

Act as if you are hedging (100,000/4.09) = E 24,454

Some more advanced hedging strategies…

Suppose that you have signed an agreement to purchase GBP 100,000 worth of goods from England payable 90 days from now. You are in the process of negotiating a deal to sell GBP 200,000 worth of goods to Britain.

Case #1: The export deal falls through and you will need to buy GBP 100,000 in one 90 days

Case #2: The export deal succeeds and you will need to sell GBP 100,000 in one 90 days

How do you hedge this?

A currency straddle is a combination of a put (the right to sell) and a call (the right to buy)

e ($/L)

Value

1.85 e ($/L)

Value

1.85

e ($/L)

Value

1.85

Cost = $0.06/LCost = $0.06/L

Cost = $0.12/L(L 100,000) = $12,000

Currency Straddles: Four Possibilities

NCF = L100,000, e > $1.85

Let Put Expire

Buy $ in Spot Market

Buy GPB with Call

Sell GBP in Spot Market

NCF = L100,000, e < $1.85

Let Call Expire

Use Put to sell GBP

NCF = - L100,000, e > $1.85

Let Put Expire

Use Call to Buy GBP

NCF = - L100,000, e < $1.85

Let Call Expire

Buy GBP in Spot Market

Sell GBP with Put

e ($/L)

Value

1.89 e ($/L)

Value

1.84

e ($/L)

Value

1.84

Cost = $0.03/LCost = $0.04/L

Cost = $0.07/L(L 100,000) = $7,000

Straddles hedge your exposure under all circumstances, but are very expensive (in this case, $12,000

in premium costs) 1.89

Un-hedged Region

Another way to save money is to only hedge particular ranges (i.e. a 95% confidence interval!)


e ($/L)

Value

1.85 e ($/L)

Value

1.89

Cost = $0.05/LCost = $0.08/L

You could hedge the range from $1.85 to $1.89 by selling a call w/ a strike price of $1.89 and using the proceeds to buy a call with a strike price of $1.85

e ($/L)

Value

1.85 e ($/L)

Value

1.89

Cost = $0.05/LCost = $0.08/L

Value

1.85

Cost = $0.08 - $0.05 = $0.03

e ($/L)1.89

Hedging…the possibilities are endless!

There are many different types of hedges available. Each hedge has a cost and a level of protection. Its your choice to decide what coverage you need and how much you are willing to pay for it!!

Transaction Exposure vs. Economic Exposure

Profits = e (Price – Unit Costs) Q

Transaction exposure refers to changes in the $ value of costs/revenues due to exchange rate movements

Economic exposure refers to changes in the $ value of costs/revenues due to changes in demand (caused by exchange rate movements)

Example: Suppose that Pepsi has subsidiaries in both the US and Canada. Below is Pepsi’s income statement.

Sales

USCanadian

Total

Costs of Goods Sold

USCanadian

Total

Operating Expenses

US: FixedUS: Variable

Total

EBIT

$300C$4 * .75 = $3

$303

$50C$200 * .75 = $150

$200

$30$30

$60

$43

Canadian sales and costs are unaffected by exchange rate movements, but are subject to transaction exposure

US costs are independent of the Exchange rate, but US sales rise when the Canadian dollar strengthens (Canadian goods become more expensive)

If the Canadian Dollar Strengthens, both Costs and Sales are Affected.

Sales

USCanadian

Total

Costs of Goods Sold

USCanadian

Total

Operating Expenses


Total

EBIT

$300C$4 * .75 = $3

$303

$50C$200 * .75 = $150

$200

$30$30

$60

$43

Sales

USCanadian

Total

Costs of Goods Sold

USCanadian

Total

Operating Expenses


$310C$4 *. 80 = $3.20

$313.20

$55C$200 * . 80 = $160

$215

$30$33

1 CD = $.75 1 CD = $.80

EBIT $35.20

$63

Example: Suppose that Pepsi has subsidiaries in both the

US and Canada. Below is Pepsi’s income statement.

Sales

USCanadian

Total

Costs of Goods Sold

USCanadian

Total

Operating Expenses


Total

EBIT

$300C$4 * .75 = $3

$303

$50C$200 * .75 = $150

$200

$30$30

$60

$43

If Pepsi could raise its Canadian Sales and lower its Canadian costs, it would be better insulated from exchange rate changes

Increasing Canadian sales and lowering Canadian costs lowers exposure

Sales

USCanadian

Total

Costs of Goods Sold

USCanadian

Total

Operating Expenses


Total

EBIT

$300C$20 * .75 = $15

$315

$140C$100 * .75 = $75

$215

$30$30

$60

$40

Sales

USCanadian

Total

Costs of Goods Sold

USCanadian

Total

Operating Expenses


$310C$20 *. 80 = $16

$326

$145C$100 * . 80 = $80

$225

$30$33

1 CD = $.75 1 CD = $.80

EBIT $38

$63

Increasing Canadian sales and lowering Canadian costs lowers exposure

EBIT

E $/CD

Old Structure

New Structure

.75 .80

$43

$35.20

$40$38

Searching for economic exposure

Economic exposure is much more general than transaction exposure (it can come from many sources). Therefore, it can be much more difficult to find!

Exchange rates change market competition

Exchange rates are correlated with Macroeconomic conditions

Exchange rates change the value of foreign currency cash flows (transaction exposure)

Changes in currency prices can have all kinds of economic impacts. A general way to estimate economic exposure would be as follows:

ttt beaPCF

Percentage change in the exchange rate ($/F)

Percentage change in cash flows (measured in home currency)

Regression Results

Variable Coefficients Standard Error t Stat

Intercept .05 1.5 .03

% Change in Exchange Rate -3.35 .97 -3.45

Regression Statistics

R Squared .63

Standard Error 1.20

Observations 1,000

tt beaPCF

Every 1% depreciation in the dollar relative to the British pound lowers cash flows from England by 3.35%

Suppose you have three different facilities …

Regression Results

Variable Coefficients Standard Error t Stat

Intercept .001 2 .0005

% Change in e ($/Euro) -4.35 . 5 -8.70

You first run a regression using consolidated income statements

Plant A

Plant B

Plant C

Overall, your cash flows are negatively related to the value of the Euro

Now, try isolating the exact location …

Regression Results

Variable Plant A Plant B Plant C

Coefficient 1.50 -4.6 -.4

T-Stat 1.2 -6.50 -1.5

Now, run a regression using individual plant income statements

Plant A

Plant B

Plant C

Aha!!! Plant B is the culprit! (And they would’ve gotten away with it if it weren’t for those meddling kids!!!)

Now, try isolating the specific income statement items …

Regression Results

Variable SalesCost of

Goods Expenses

Coefficient -3.67 -2.23 0.02

T-Stat -5.59 -.65 4.0

Now, run a regression using individual plant income statements

Plant B

Ultimately, it looks like sales from plant B are the underlying currency problem

Sales

Costs of Goods Sold

Operating Expenses

Now, what do we do about it?Pricing Policy: If sales drop when the Euro appreciates, then consider lowering prices during strong Euro periods to maintain market share

Cash flow matching: If sales (and hence, cash inflows) are dropping during periods with a weak dollar, try adjusting production locations so that your costs will drop at the same time.

Futures, Forwards, and Options

Documents

FIN 40500: International Finance Hedging Foreign Exchange Risk