Transaction_Exposure_Chapter_11.ppt

7/27/2019 Transaction_Exposure_Chapter_11.ppt

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FOREIGN EXCHANGE (FE) EXPOSURE

Impact of Exchange Rate Change

1. Translation or AccountingExposure

in FE rate in ownersequity in consolidated

financial statements

3. Economic Exposure

in FE rate in expectedcash flows impacting on firm valueor market price

2. Transaction Exposure

in FE rate in outstandingcontracts (asset or liabilities) giving

rise to gains or losses.

Types o f exposure:


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2

Transaction Exposure: Examples

A Taiwanese company has the following USD exposures:1. Owns a factory in Texas worth US$5 million.

2. Agreement to buy goods worth US$2 million.

3. Biggest competitor is a US company.

What happens if the New Taiwan dollar (NT$) appreciates?

1. NT$ value of US factory goes down (translation).

2. NT$ cost of buying goods goes down (transaction).

3. Global competitiveness of Taiwanese company

decreases (economic).


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Transaction exposure exists when outstandingtransactions (liabilities or assets) incurred in foreigncurrency are not yet settled and are exposed toexchange rate fluctuations.

Transaction exposure measures gains or losses thatarise from the settlement of existing financialobligations, namely

When transaction exposure exists, the firm faces threemajor tasks:

Identify its degree of transaction exposure, Decide whether to hedge its exposure, and Choose among the available hedging techniques if it

decides on hedging.

Transaction Exposure


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Transaction Exposure Sources: Example 1

In 1971, Great Britains Beecham Group borrowedSF100 million (equivalent to 10.13 million).

When the loan came due five years later, the cost of

repayment of principal was 22.73 millionmore than

double the amount borrowed!


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Purchasing or Sell ing on Account

Suppose Trident Corporation sells merchandise on openaccount to a European buyer for1,800,000 payable in 60

days

Further assume that the spot rate is $0.9000/ and Trident

expects to exchange the euros for1,800,000 x $0.9000/ =$1,620,000 when payment is received (assuming no expected

change in exchange rate)

Transaction exposure arises because of the risk that Trident

will receive something other than $1,620,000 expected If the euro weakens to $0.8500/, then Trident will receive

$1,530,000

If the euro strengthens to $0.9600/, then Trident will receive

$1,728,000



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Trident might have avoided transaction exposure by

invoicing the European buyer in US dollars, but this

might have caused Trident not being able to book the

sale Even if the European buyer agrees to pay in dollars,

however, Trident has not eliminated transaction

exposure, instead it has transferred it to European

buyer whose dollar account payablehas an unknowneuro value in 60 days




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Quotation Exposure

Time between quoting

a price and order is

placed

Work In Progress

Exposure

Time it takes between

order is placed and

goods are ready to be

shipped

Billing Exposure

Time it takes from the

goods are shipped to

to get paid in cash

after A/R is issued

Seller quotes aprice to buyer

t1

Buyer placesorder at offered

price

t2

Seller shipsproduct and

bills buyer

t3

Buyer settlesA/R with cash

in amount of

currency

quoted at t1

t4

Life Span of a Transaction Exposure




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A second example of transaction exposure arises

when funds are loaned or borrowed

Example: PepsiCos largest bottler outside the US is

located in Mexico, [Grupo Embotel lador de Mexico(Gemex)]

On 12/94, Gemex had US dollar denominated debt of$264 million

The Mexican peso (Ps) was pegged at Ps3.45/$

On 12/22/94, the government allowed the peso to floatdue to internal pressures and it sank to Ps4.65/$

Borrowing and Lending



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Gemexs debt obligation:

Dollar debt mid-December, 1994:$264,000,000 Ps3.45/$ = Ps910,800,000

Dollar debt in mid-January, 1995:$264,000,000 Ps5.50/$ = Ps1,452,000,000

Dollar debt increase measured in Ps

Ps541,200,000 Gemexs dollar obligation increased by 59% due to

transaction exposure

Borrowing and Lending



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When a firm buys a forward exchange contract, it

deliberately creates transaction exposure; this risk is

incurred to hedge an existing exposure

Example: US firm wants to offset transaction

exposure of 100 million to pay for an import from

Japan in 90 days

Firm can purchase 100 million in forward market to

cover payment in 90 days

Forward Contracts



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Do it on a currency-by-currency basis

Identifying Transaction

Exposure for MNC

Centralized or Non-Centralized Management?

BUT


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Some multinational corporations use non-centralized approach for exposuremanagement. Each subsidiary assesses and manages its individual exposureto exchange rate risk. This can cause redundancy in hedging.

Centralized exposure management requires the projection of consolidatednet amount of currency inflows and outflows for all subsidiaries categorizedby currency.

Consider two subsidiaries X & Y of a U.S. MNC:

Subsidiary X has net inflow of 500,000

Subsidiary Y has net outflows of 600,000

Then, the consolidated "net" outflow for this multinational corporation is100,000. If the pound decrease it will be unfavorable to X but favorable toY. If hedging is limited to net exposure, transaction cost savings are realized.

Centralized and Non-centralized Management

Identifying Transaction Exposure


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U.S. Based MNC(millions of $)

Subsidiary London + $100

Munich - $110Toronto + $30Consolidated + $20

Should London and Toronto subsidiariessell sforward and Munich subsidiary buy sforward?

How could the MNC use

forward contracts to hedge

against i ts transact ionexposure to s?

Should MNC could sell $20m worth of s forward?

OR1)

2)




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What could the MNC do about itstransaction exposure to the ?

C$ -$60 -$80 - $30-$80 +$120 + $80+$70 -$10 - $50-$70 +$30 + $0

Subsidiary London + $100Munich - $110Toronto + $30Consolidated + $20

It may decide it has no

transaction exposure to the

U.S. Based MNC(millions of $)




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Should net exposure be viewed from thesubsidiary level or be centralized (from the viewof the entire MNC)?

But goal of financial decision maker is to maximize the

value of the overall MNC, not the value of individualsubsidiaries




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If exposure of subsidiaries nets out no hedge isnecessary

Subsidiary London - $30Munich + $80Toronto - $50Consolidated + $0

If al l three sub sid iarieshedge, MNC

experiences

unnecessary

expenses

If a single subsidiary hedges, then the MNC overallbecomes exposed




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But local creditors may look unfavorably towardsubsidiarys exposure if it doesnt handle its own

exposure

And, subsidiarys management may feel more comfortablehandling their own exposure so they will not be hurt by

adverse movements in exchange rates which make themlook bad on their job record




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In the past Kodak would bill its

subsidiaries in $s for supplies itprovided so each subsidiary had to deal

with its own transaction exposure

Now Kodak bills its subsidiaries intheir local currencies and Kodaks

main headquarters handles anytransaction exposure



Real World


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Fiat (Italian auto maker) has a centralized system for 421subsidiaries in 55 countries, uses a comprehensive reporting

system to keep track of cash flows in each currency, and its mainheadquarters does any necessary hedging




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Billing in the foreign currency

Pricing in the domestic currency

Enter into futures (forward) contracts

Money Market Hedge

Options Hedge

Go Uncovered

Techniques for Managing

Transaction Exposure


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21

G.E. is awarded a contract to supply turbine blades to Lufthansa(German company).

The turbine will be delivered to Lufthansa one year from today andG.E. will receive25,000,000.

Currently the spot rate is $0.55/ and the 1-year futures rate is$0.54/. The size of a futures contract is125,000.

German annual interest rates are 6% on deposits and 8% on

borrowed funds and U.S. annual interest rates are 5% on depositsand 7% on borrowed funds.

Also, 1-year call options with a strike price of $0.51/ have apremium of 6 / and put options with a strike price of $0.58/ have apremium of 5 /.

Techniques for Managing Transaction

Exposure: CASE


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GE will receive25,000,000 in the future

0 1

+25,000,000

If G.E. decides it wants to offset this position, it will setup a situation which will require it to pay25,000,000one year from today. Thats HEDGING.

Techniques for Managing Transaction

Exposure: CASE


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If G.E. is buying parts from a Europeansupplier for payment in one year, it

could agree to pay for them ins and

not $

Billing in the foreigncurrency


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When negotiating the contract withLufthansa, G.E. could insist on being paidin U.S. $s rather than s

Could this cause problems for G.E.?

Lufthansa may disagree and award thecontract to a firm pricing their blades in

s

Pricing in the domestic

currency


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Futures Contract Hedge

Should G.E. hedge with a futures contract or maintain its currentposition ins?

That depends on what G.E. thinks the future spot rate will bebefore making the decision.

What bad could happen which would cause GE to beinterested in futures contract?

That one year from today the spot rate will be BELOW $0.54/ (thefutures rate today) i.e. that the will depreciate below the currentfutures rate.


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Spot Rates$0.53/$0.54/$0.55/

Develop a probability distribution for whatthe spot rate will be one year from today

Calculate the expected spot rate

E[spot] = (15%)($0.53) + (40%)($0.54) + (45%)($0.55) =$0.542/

Since E[spot] > Future Rate, do not hedge

Probability15%40%45%

Possible Future



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If GE doesnt hedge, what is the probability it made the correctchoice?

40% + 45% = 85%

What is GEs expected revenue without hedging?

(25,000,000)($0.542) = $13,550,000

Compare this to GEs revenue if it hedges

(25,000,000)($0.54) = $13,500,000

GE will have to decide if the extra expected revenue of $50,000 isworth the risk of going unhedged.



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Should G.E. buy or sell a futures contract?

Since it will receives in the future and wants toconvert them to $s, it should sell Futures Contracts

G.E. sells

Today

25,000,000

125,000= 200 contracts at $0.54/



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G.E. receives25,000,000 from Lufthansa

G.E. deliverss on Futures Contract

G.E. receives (25,000,000)(0.54) = $13,500,000

One Year from Today



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Take a money market position to offset a futureforeign currency payables or receivables position

GE can borrows today instead of $s with the ideaof using the25,000,000 it receives from Lufthansa torepay this loan

Money Market HedgeReceivables

Suppose GE needs to borrow $15,000,000 to builda new plant in the U.S.

Case #1


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Should GE borrow25,000,000?

It should borrow less than25,000,000

Borrowed(1 + iGer) =25,000,000

Borrowed = 148,148,238%1

000,000,25+



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1. GE borrows23,148,148 from

German bank at 8% for 1 year

2. Converts to $s at current spot rate

(23,148,148)($0.55) = $12,731,481

3. Use the $s to help build thenew plant in the U.S.

Today



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1. GE receives25,000,000 fromLufthansa

2. Use the25,000,000 to repayloan from the German bank

(23,148,148)(1 + 8%) =25,000,000

One Year from Today



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GE does not need to borrow $s to help financeconstruction of a new plant.

1. GE borrows23,148,148 from German bankat 8% for 1 year

2. Converts to $s at spot rate 23,148,148($0.55) = $12,731,481

3. Deposit $s in U.S. bank for 1 year at 5%

Today

Case # 2



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1. GE receives25,000,000 from Lufthansa

2. Use theses to repay loanfrom German bank

(23,148,148)(1 + 8%) =25,000,000

3. GE receives $s from U.S. bank(12,731,481)(1 + 5%) = $13,368,055

One Year from Today



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GE gets $13,500,000 with theFutures hedge compared to$13,368,055 with this

Money Market hedge

Which is better for GE, the MoneyMarket hedge or the Futures

hedge?

It depends on the spot rate at thematurity of the future contract.



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Now, suppose GE must pay25 million to a German companythree months from today. The 90-day interest rate on borrowedfunds in the U.S. is 1.75% and on deposits in Germany is 1.5%.Use a Money market hedge.

GE has excess $s it does not need during the next 90 days

How manys should GE deposit in a German bank?

Money Market HedgePayables

Case # 1

25,000,000

1.015

= 24,630,541.87


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1. GE converts appropriate amount of $s to s

2. GE deposits 24,630,541.87 in a German bank at1.5% for 90 days

2. GE uses theses to pay German company.

Today

Three Months from Today

24,630,541.87 (0.55) = $ 13,546,798.03

1. GE receivess from German bank

24,630,541.87 (1.015) =25,000,000



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GE does not have excess cash (or has excess but doesnt want touse it for this purpose)

2. Convert $ 13,546,798.03 to 24,630,541.87

3. GE deposits 24,630,541.87 in German bank for 90 days at 1.5%

Today

1. GE borrows the right amount of $s for 90 days at 1.75% from U.S.bank

24,630,541.87 (0.55) = $ 13,546,798.03

Case # 2



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Whats the implicit exchange rate?

Three Months from Today

2. GE uses theses to pay German company

1. GE receivess from German bank

24,630,541.87 (1.015) =25,000,000

3. GE repays loan

$ 13,546,798.030(1.0175) = $14,562,807.88



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Now, compare the amount repaid to the U.S. bank tothe cost of getting the neededs with a futurescontract to determine which is best.

1. G.E. buys

2. G.E. pays (25,000,000)(0.54) = $13,500,000

Which alternative is the best?

25,000,000

125,000= 200 contracts at $0.54/



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Currency Option Hedge

Should GE use a Put or a Call? Put Option

Should GE buy or sell a Put? BUY

Consider the 25 million GE will receive from Lufthansa. Whatbad could happen which would cause GE to be interested inbuying a Futures Contract?

That one year from today the spot rate will be BELOW $0.54/(the Futures rate today) i.e. that the will depreciatebelow the current futures rate


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Cost: (25,000,000)(5 /) = $1,250,000

GE is now guaranteed that the minimum they will receivefor the turbine blades is (25,000,000)($0.58 - 5) =$13,250,000

Today

GE buys 200 Put Options to sell 25,000,000 with astrike price of $0.58/ and a premium of 5/



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GE receives25,000,000 from Lufthansa

How does GE decide if it should exercise the Put?

GE should compare the spot rate to the strike price

GE should exercise the PutGE receives 25,000,000($0.58) = $14,500,000GE clears $14,500,000 - $1,250,000 = $13,250,000

If spot < $0.58

One Year from Today

If spot > $0.58GE should not exercise the PutGE sells thes in the spot marketGE receives 25,000,000(spot rate)clears 25,000,000(spot rate) - $1,250,000


C O ti H d


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Which would have been better for GE?

Depends on what the spot rate is expected to be one year fromtoday

Sell Futures Contract$0.54/

Buy Put Option strike $0.58/@ 5 cent/ premium

Put Optionis betterif spot > $0.59

Futures Contractis betterif spot < $0.59/ = $0.54/ + 5 /

Futures rate Put premium



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Alternative Hedging

Techniques

Adjust timing of payables andreceivables depending on expectation

of exchange rate movement

Leading & Lagging


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French firm ships supplies to its subsidiaryin Switzerland and will be paid in SFs

What should the French firm do if it thinks

the SF will depreciate against the?

What should the French firm do if it thinksthe SF will appreciate against the?

EXAMPLE

Speed up the paymentLeading

Slow down the paymentLagging


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Suppose a firm has transaction exposureagainst a currency where a hedge does

not exist

Identify another foreign currency whichis highly positively correlated with the

currency needed (relative to movements

against the home currency) and forwhich a hedge does exist

Cross-Hedging


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Suppose a firm has transaction exposureagainst a currency where a hedge does

not exist

Identify another foreign currency whichis highly positively correlated with the

currency needed (relative to movements

against the home currency) and forwhich a hedge does exist

Cross-Hedging

To Hedge or not?


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To Hedge or not?

Is the reduction of variability in cash flows then

sufficient reason for currency risk management?

This question is actually a continuing debate in

multinational financial management and corporate

finance.

There are several schools of thought.

T H d ?


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To Hedge or not?

Opponents of Hedging


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Opponents of Hedging

Opponents of currency hedging commonly make the

following arguments:

Stockholders are much more capable of diversifying

currency risk than the management of the firm.

Currency risk management does not add value to the firmand it incurs costs.

Hedging might benefit corporate management more than

shareholders.

Proponents of Hedging


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Proponents of Hedging

Proponents of hedging cite:

Reduction in risk in future cash flows improves the planning

capability of the firm.

Reduction of risk in future cash flows reduces the likelihood

that the firms cash flows will fall below a necessary

minimum (the point offinancial distress).

Management has a comparative advantage over the

individual shareholder in knowing the actual currency risk

of the firm.

Individuals and corporations do not have same access to

hedging instruments or same cost.

To Hedge or not?


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Should the firms hedging strategy be to useforward contracts for all of its future foreign

exchange transactions?

To Hedge or not?

To Hedge or not?


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Should the firm hedge a future foreignexchange transaction if it feels the exchangerate will move in an unfavorable direction?

If it is fairly good at forecastingexchange rate movements

To Hedge or not?

To Hedge or not?


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The MNCs level of risk aversion, and its

ability (and desire) to forecast

exchange rates determine:

If it will hedge

How much it will hedge

How it will hedge

To Hedge or not?


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2005 Financial Report, McDonalds Corporation, p 18http://www.mcdonalds.com/corp/invest/pub/2005_Financial_Report.RowPar.0002.ContentPar.0001.ColumnPar.0003.DownloadFiles.000

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Transaction_Exposure_Chapter_11.ppt