Tài chính doanh nghiệp - Management of transaction exposure

1MANAGEMENT OF TRANSACTION EXPOSURE CHAPTER TEN TYPES OF FOREIGN EXCHANGE EXPOSURE There are three types of exposures: 1. Transaction exposure 2. Translation exposure 3. Operation exposure COMPARISON OF OCCURRENCE TIME OF THE THREE FOREIGN EXCHANGE EXPOSURES ON THE TIME LINE Time point when the exchange rate changes Translation exposure Transaction exposure Operating exposure Time Changes in reported owners’ equity in consolidated financial statements caused by a change in exchange rates Change in expected future cash flows for following years arising from an unexpected change in exchange rates Impact of settling existing obligations, which entered into before changes in exchange rates but to be settled after changes in exchange rates SHOULD THE FIRM HEDGE? • Not everyone agrees that a firm should hedge: – Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves. – Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges. 2SHOULD THE FIRM HEDGE? • In the presence of market imperfections, the firm should hedge. – Information Asymmetry • The managers may have better information than the shareholders. – Differential Transactions Costs • The firm may be able to hedge at better prices than the shareholders. – Default Costs • Hedging may reduce the firms cost of capital if it reduces the probability of default. • Taxes can be a large market imperfection. – Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have “boom and bust” cycles in their earnings stream. WHAT RISK MANAGEMENT PRODUCTS DO FIRMS USE? • Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts. • The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management. WHY HEDGE? • What is to be gained by the firm from hedging? – The major motive for firms to hedge is to increase the present value of firms – The value of a firm, according to financial theories, is the present value of all expected future cash flows in the future – For expected cash flows with higher uncertainty (or risk), a higher discount rate should be applied to calculating the present value and thus a lower present value for these cash flows is generated – A firm that hedges these foreign exchange exposures reduces the variance (or risk) in the value of future expected cash flows (see Exhibit 10.1 on the next slide) – Thus, a lower discount rate is employed to calculate the present value of expected future cash flows, which implies the increase of the present value of the firm EXHIBIT 10.1 IMPACT OF HEDGING ON THE EXPECTED CASH FLOWS OF THE FIRM ※ Hedging will not increase the expected value for a cash flow. Actually, if taking the hedging cost into account, hedge transactions will decrease the expected cash flow ※ Hedging reduces the variability of future cash flows about the expected value of the distribution. This reduction of distribution variance is a reduction of risk 3MANAGEMENT OF TRANSACTION EXPOSURE Various methods available for the management of transaction exposure facing multinational firms. • Forward Market Hedge • Money Market Hedge • Options Market Hedge • Cross-Hedging Minor Currency Exposure • Hedging Contingent Exposure • Hedging Recurrent Exposure with Swap Contracts • Hedging Through Invoice Currency • Hedging via Lead and Lag • Exposure Netting MANAGEMENT OF TRANSACTION EXPOSURE • Transaction exposure can be managed by operating, financial, and contractual hedges • The term operating hedge refers to an off-setting operating cash flow arising form the conduct of business – For example, the payments in a foreign currency could be offset by the foreign currency cash inflow generated from operating activities, e.g., from sales. This kind of hedge for the transaction exposure is also termed natural hedge – Operating hedge could also employ the use of risk-sharing agreements, leads and lags in payment terms, and other strategies MANAGEMENT OF TRANSACTION EXPOSURE • A financial hedge refers to either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap – To eliminate the transaction exposure, firms can borrow foreign currencies today to prepare for the settlement of A/Rs in foreign currencies in the future – Due to the borrowing activities, this kind of hedge is classified as financial hedge • Contractual hedges employ the forward, futures, and options contracts to hedge transaction exposures • The Trident case as follows illustrates how contractual and financial hedging techniques may be used to protect against transaction exposure FORWARD MARKET HEDGE • If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract. • If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract. 4FORWARD MARKET HEDGE: AN EXAMPLE You are a U.S. importer of Italian shoes and have just ordered next year’s inventory. Payment of €100M is due in one year. Question: How can you fix the cash outflow in dollars? 14 FORWARD MARKET HEDGE $1.50/€ Value of €1 in $ in one year Suppose the forward exchange rate is $1.50/€. If he does not hedge the €100m payable, in one year his gain (loss) on the unhedged position is shown in green. $0 $1.20/€ $1.80/€ –$30m $30m Unhedged payable The importer will be better off if the euro depreciates: he still buys €100m but at an exchange rate of only $1.20/€ he saves $30 million relative to $1.50/€ But he will be worse off if the pound appreciates. 15 FORWARD MARKET HEDGE $1.50/€ Value of €1 in $ in one year$1.80/€ If he agrees to buy €100m in one year at $1.50/€ his gain (loss) on the forward are shown in blue. $0 $30m $1.20/€ –$30m Long forward If you agree to buy €100 million at a price of $1.50 per pound, you will lose $30 million if the price of the euro falls to $1.20/€. If you agree to buy €100 million at a price of $1.50/€, you will make $30 million if the price of the euro reaches $1.80. FORWARD MARKET HEDGE $1.50/€ Value of €1 in $ in one year$1.80/€ The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position. $0 $30 m $1.20/€ –$30 m Long forward Unhedged payable Hedged payable 5FUTURES MARKET CROSS-CURRENCY HEDGE Your firm is a U.K.-based exporter of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer. Payment (in euro) is due in six months. Your firm wants to hedge the receivable into pounds. Sizes of contracts are shown. Country U.S. $ equiv. Currency per U.S. $ Britain (£62,500) $2.0000 £0.5000 1 Month Forward $1.9900 £0.5025 3 Months Forward $1.9800 £0.5051 6 Months Forward $2.0000 £0.5000 12 Months Forward $2.1000 £0.4762 Euro (€125,000) $1.4700 €0.6803 1 Month Forward $1.4800 €0.6757 3 Months Forward $1.4900 €0.6711 6 Months Forward $1.5000 €0.6667 12 Months Forward $1.5100 €0.6623 FUTURES MARKET CROSS-CURRENCY HEDGE: STEP ONE • You have to convert the €750,000 receivable first into dollars and then into pounds. • If we sell the €750,000 receivable forward at the six- month forward rate of $1.50/€. Or we can do this with a SHORT position in 6 six-month euro futures contracts. 6 contracts = €750,000 €125,000/contract FUTURES MARKET CROSS-CURRENCY HEDGE: STEP TWO • Selling the €750,000 forward at the six-month forward rate of $1.50/€ generates $1,125,000: 9 contracts = £562,500 £62,500/contract $1,125,000 = €750,000 × $1.50 o At the six-month forward exchange rate of $2/£, $1,125,000 will buy £562,500. o Or we can secure this trade with a LONG position in 9 six- month pound futures contracts: MONEY MARKET HEDGE • This is the same idea as covered interest arbitrage. • To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. – Buy the present value of the foreign currency payable today. – Invest that amount at the foreign rate. – At maturity your investment will have grown enough to cover your foreign currency payable. 6MONEY MARKET HEDGE A U.S.–based importer of Italian bicycles – In one year owes €100,000 to an Italian supplier. – The spot exchange rate is $1.50 = €1.00 – The one-year interest rate in Italy is i€ = 4% $1.50 €1.00 Dollar cost today = $144,230.77 = €96,153.85 × €100,000 1.04 €96,153.85 = Can hedge this payable by buying today and investing €96,153.85 at 4% in Italy for one year. At maturity, he will have €100,000 = €96,153.85 × (1.04) MONEY MARKET HEDGE 0t yeart1 Receive €100,000 €100,000 1.04 Investing €96,153.85 = Dollar cost today $144,230.77 = €96,153.85 × $1.50 Paying $148,557.69 = $144,230.77 × (1.03) MONEY MARKET HEDGE 1. Calculate the present value of £y at i£ £y (1+ i£) T 2. Borrow the U.S. dollar value of receivable at the spot rate. $x = S($/£)× £y (1+ i£) T 3. Exchange for £y (1+ i£) T 4. Invest at i£ for T years. £y (1+ i£) T 5. At maturity your pound sterling investment pays your receivable. 6. Repay your dollar-denominated loan with $x(1 + i$) T. MONEY MARKET CROSS-CURRENCY HEDGE •Your firm is a U.K.-based importer of bicycles. You have bought €750,000 worth of bicycles from an Italian firm. Payment (in euro) is due in one year. Your firm wants to hedge the payable into pounds. – Spot exchange rates are $2/£ and $1.55/€ – The interest rates are 3% in €, 6% in $ and 4% in £, •What should you do to redenominate this 1-year €-denominated payable into a £-denominated payable with a 1-year maturity? 7MONEY MARKET CROSS-CURRENCY HEDGE 0t Borrow £564,320.39 at i£ = 4%, Invest in the euro zone for 1 year at 3% Receive €750,000 Sell pounds for dollars, receive $1,128,640.78 yeart1 Paying £586,893.20 Buy euro with the dollars, receive €728,155.34 OPTIONS MARKET HEDGE • Options provide a flexible hedge against the downside, while preserving the upside potential. • To hedge a foreign currency payable buy calls on the currency. – If the currency appreciates, your call option lets you buy the currency at the exercise price of the call. • To hedge a foreign currency receivable buy puts on the currency. – If the currency depreciates, your put option lets you sell the currency for the exercise price. Value of €1 in $ in one year OPTIONS MARKETS HEDGE Profit loss –$5m $1.45 /€ Long call on €100m The payoff of the portfolio of a call and a payable is shown in red. $1.50/€ Unhedged payable $1.20/€ $25m –$30 m $1.80/€ Value of €1 in $ in one year OPTIONS MARKETS HEDGE Profit loss –$5 m $1.45/€ Long call on €100m If the exchange rate increases to $1.80/€ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of $5 million. This can be thought of as an insurance premium. $1.50/€ Unhedged payable $25 m 8OPTIONS MARKETS HEDGE IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS. – If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports. – If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price. EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS. – If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports. – If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price. With an exercise price denominated in local currency HEDGING EXPORTS WITH PUT OPTIONS • Show the portfolio payoff of an exporter who receive £1 million in one year. • The current one-year forward rate is £1 = $2. • Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2. – The cost of this option is $0.05 per pound. 31 S($/£)360 –$2m $2 Long put $1,950,000 –$50k OPTIONS MARKET HEDGE Exporter buys a put option to protect the dollar value of his receivable. $2.05 HEDGING IMPORTS WITH CALL OPTIONS • Show the portfolio payoff of an importer who owes £1 million in one year. • The current one-year forward rate is £1 = $1.80; but instead of entering into a long forward contract, • He buys a call option written on £1 million with an expiry of one year and a strike of £1 = $1.80 The cost of this option is $0.08 per pound. 933 $1.8m S($/£)360 $1.80 Call –$80k $1.88 $1,720,000 $1.72 Call option limits the potential cost of servicing the payable. OPTIONS MARKET HEDGE Importer buys call option on £1m. The cost of this “insurance policy” is $80,000 TAKING IT TO THE NEXT LEVEL • Suppose our importer can absorb “small” amounts of exchange rate risk, but his competitive position will suffer with big movements in the exchange rate. – Large dollar depreciations increase the cost of his imports – Large dollar appreciations increase the foreign currency cost of his competitors exports, costing him customers as his competitors renew their focus on the domestic market. 35 IMPORTER BUYS A SECOND CALL OPTION S($/£)360 $1.80 $1,720,000 $1.72 –$80k This position is called a straddle $1.64 $1.96 $1,640,000 –$160k 2nd Call $1.88 Importers synthetic put 36 S($/£)360 $1.80 $1,720,000 $1.72 Suppose instead that our importer is willing to risk large exchange rate changes but wants to profit from small changes in the exchange rate, he could lay on a butterfly spread. –$80k A butterfly spread is analogous to an interest rate collar; indeed it’s sometimes called a zero-cost collar. Selling the 2 puts comes close to offsetting the cost of buying the other 2 puts. $2 buy a put $2 strike butterfly spread Sell 2 puts $1.90 strike. $1.90 Importers synthetic put IMPORTER BUYS A SECOND OPTION 10 CROSS-HEDGING MINOR CURRENCY EXPOSURE • The major currencies are the U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. • Everything else is a minor currency, like the Thai baht, Vietnam Dong. • It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies. 8-37 CROSS-HEDGING MINOR CURRENCY EXPOSURE • Cross-Hedging involves hedging a position in one asset by taking a position in another asset. • The effectiveness of cross-hedging depends upon how well the assets are correlated. – An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way. HEDGING CONTINGENT EXPOSURE • If only certain contingencies give rise to exposure, then options can be effective insurance. • For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options. HEDGING THROUGH INVOICE CURRENCY • The firm can shift, share, or diversify: – shift exchange rate risk • by invoicing foreign sales in home currency – share exchange rate risk • by pro-rating the currency of the invoice between foreign and home currencies – diversify exchange rate risk • by using a market basket index 11 HEDGING VIA LEAD AND LAG • If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. • If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow. EXPOSURE NETTING • A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. – As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. – Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately. EXPOSURE NETTING • A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. – As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won. – Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately. 43 EXPOSURE NETTING • Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. • Once the residual exposure is determined, then the firm implements hedging. 44 12 11/15/2015 45 EXPOSURE NETTING: AN EXAMPLE $10 $35 $40$30 $20 $25 $60 $40 $10 $30 $20 $30 Bilateral Netting would reduce the number of foreign exchange transactions by half: 11/15/2015 46 EXPOSURE NETTING: AN EXAMPLE Clearly, multilateral netting can simplify things greatly. $15 $40 11/15/2015 47 EXPOSURE NETTING: AN EXAMPLE With this: $15 $40 TRIDENT’S TRANSACTION EXPOSURE • Trident company just concludes negotiations for the sale of telecommunication equipments to Regency, a British firm, for ￡1,000,000 – The sale is made in March with payment due three months later in June – The financial and market information is as follows • Spot exchange rate: $1.7640/￡ • Three-month forward rate: $1.7540/￡ • Cost of capital for Trident company: 12% • U.K. three-month deposit (borrowing) interest rate: 8% (10%) • U.S. three-month deposit (borrowing) interest rate: 6% (8%) • Put option expired in June for ￡1,000,000 with the strike price $1.75/￡ ($1.71/￡) is quoted as 1.5% (1.0%) premium – Trident’s foreign exchange advisory service forecasts that the spot rate after three months will be $1.76/￡ 13 TRIDENT’S TRANSACTION EXPOSURE • Trident’s minimum acceptable margin is at a sales price of $1,700,000, which implies the budget rate, the lowest acceptable dollar per pound exchange rate, is at $1.70/￡ • Trident company has four alternatives to deal with the transaction exposure: – Remain unhedged – Hedge in the forward market – Hedge in the money market – Hedge in the options market • These choices can be applied to both an account receivable (in this case) and an account payable TRIDENT’S TRANSACTION EXPOSURE • Unhedged position • Forward Market Hedge – A forward hedge involves a forward contract and a source of funds to fulfill the contract in the future – If funds to fulfill the forward contract are on hand or are due because of a business operation, the hedge is considered “covered,” since no residual foreign exchange risk exists TRIDENT’S TRANSACTION EXPOSURE – It would be recorded on Trident’s income statement as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled) – Different from the above case, if funds to fulfill the forward exchange contract are not already available or due to be received later, funds to fulfill the forward contract must be purchased in the spot market at some future time points – This type of hedge is “open” or “uncovered” and involves considerable risk because of the uncertain future spot rate to obtain funds to fulfill the forward contract – In this chapter, only the covered hedge is considered TRIDENT’S TRANSACTION EXPOSURE • Money Market Hedge – A money market hedge also involves a contract and a source of funds to fulfill that contract – In this instance, the contract is a loan agreement, so the money market hedge is a kind of financial hedge – The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency – Funds to fulfill the contract–to repay the loan–may be generated from business operations, in which case the money market hedge is covered ※￡975,610 =￡1,000,000 / (1+10%×90/360) 14 TRIDENT’S TRANSACTION EXPOSURE – The money-market hedge actually creates a pound-denominated liability (the pound loan) to offset the pound-denominated asset (the account receivable) – So, the money-market hedge is also a kind of balance sheet hedge – Money market hedge vs. forward market hedge ※ A break-even investment rate can be calculated that would make Trident indifferent between the forward market hedge and the money market hedge ※ If Trident can invest the loan proceeds at a rate higher than 7.68% per annum, it would prefer the money market hedge Received today Invested in Rate (annual) FV after 3 months $1,720,976 Deposit 6% $1,746,791 $1,720,976 Dollar loans 8% $1,755,396 $1,720,976 Operations of the firm 12% $1,772,605 $1,720,976 (1 ) $1,754,000 1.92% (7.68% annually)r r    TRIDENT’S TRANSACTION EXPOSURE • Option Market Hedge – Trident could also cover ￡1,000,000 exposure by purchasing a put option to acquire the right to sell British pounds forward at the strike price – Hedging with purchasing options allows for participation in any upside potential associated with the position while limiting downside risk – The choice of option strike prices is an important aspect of utilizing options for hedging because option premiums and payoff patterns will differ accordingly – Trident consider (1) a nearly ATM put with the strike price of $1.75/￡ and the premium of 1.5%, or (2) an OTM put with the strike price of $1.71/￡ and the premium of 1% TRIDENT’S TRANSACTION EXPOSURE – For the ATM put, the cost of put is ￡1,000,000 × 1.5% = ￡15,000 = $26,460 (=￡15,000 × $1.7640/￡) – The minimal dollar receipts in June is $1,750,000 – $26,460×(1 + 12%×90/360) = $1,750,000 – $27,254 = $1,722,746 when the spot exchange rate is below $1.75/￡ (The opportunity cost of $26,460 is the cost of capital of Trident, i.e., 12%) – The maximal dollar receipts in June is unlimited and increasing with the appreciation of the pounds TRIDENT’S TRANSACTION EXPOSURE – Compare the ATM put and the OTM put ※ The option premium for the OTM put is ￡1,000,000 × 1% = ￡10,000 = $17,640 (= ￡10,000 × $1.7640/￡) ※ The minimal dollar receipts in June is $1,710,000 – $17,640×(1 + 12%×90/360) = $1,710,000 – $18,169 = $1,691,831 when the spot exchange rate is below $1.71/￡ ※ The OTM put is much cheaper today, but the minimum net proceeds of the OTM put is smaller than those of the ATM put, i.e., the OTM put provides a lower level of protection ※ In the Trident’s case, the OTM put cannot meet its budgeted exchange rate of $1.70/￡ after taking the premium expenses into consideration Put option with strike price ATM put at $1.75/￡ OTM put at $1.71/￡ Option cost (FV in June) $27,254 $18,169 Proceeds if exercised $1,750,000 $1,710,000 Minimum net proceeds $1,722,746 $1,691,831 Maximum net proceeds Unlimited Unlimited 15 COMPARISON OF ALTERNATIVE HEDGING STRATEGIES FOR TRIDENT Unhedged position Wait three months then sell the received ￡1,000,000 for dollars in the spot market Result Receipt in US$ in June 1.An unlimited maximum 2.An expected $1,760,000 3.A zero minimum Forward market hedge Sell ￡1,000,000 forward for dollars Result Certain receipts of $1,754,000 in June Money market hedge 1.Borrow ￡975,610 at the interest rate of 10% 2.Exchange for $1,720,976 at the spot exchange rate 3.Invest $1,720,976 in US markets for three months Result 1.The received ￡1,000,000 is for the repayment of the interest and principal of the borrowed amount of ￡975,610 2.The FV of $1,720,976 in June depends on the US$ investment rate (The break-even rate of 7.68% generates the same payment as the forward contract, i.e., $1,754,000) Options market hedge Purchase a three-month put option of ￡1,000,000 with the strike price of $1.75/￡ and premium cost of $27,254 (FV after 3 months) Result Receipt in US$ in June 1.An unlimited maximum less $27,254 2.An expected $1,760,000 less $27,254 3.A minimum of $1,750,000 less $27,254 TRIDENT’S TRANSACTION EXPOSURE • The final choice among hedges depends on the firm’s risk tolerance, its view of the future exchange rate, and its confidence in its view – Thus, transaction exposure management with contractual or financial hedges requires managerial judgment • For an account payable, where the firm would be required to make a foreign currency payment at a future date, it is possible to apply similar techniques to hedging this transaction exposure • Suppose that Trident had a ￡1,000,000 account payable which will be settled in 90 days, the possible hedge alternative are summarized in the table on the next slide TRIDENT’S TRANSACTION EXPOSURE Unhedged position Wait 90 days, exchange dollars for ￡1,000,000 at that time, and make its payment Result Total payment for ￡1,000,000 in June 1.Unlimited US$ 2.Expected amount of $1,760,000 3.Minimal zero US$ payment Forward market hedge Buy ￡1,000,000 forward for dollars Result Certain payments of $1,754,000 in June Money market hedge 1.Borrow $1,729,411.77 at the interest rate of 8% 2.Exchange for ￡980,392.16 at the spot exchange rate of $1.764/￡ 3.Deposit ￡980,392.16 in the British pound money market at the interest rate of 8% for 90 days Result 1.The interest and principal of ￡980,392.16 is ￡1,000,000, which is just enough for the payment after 90 days 2.The repayment amount of $1,729,411.77 in 90 days is $1,764,000 (This cost is higher than the forward hedge and therefore unattractive) Options market hedge Purchase a three-month call option of ￡1,000,000 with a nearly at-the-money strike price of $1.75/￡ and premium is assumed to be 1.5%, which implies a cost of $27,254 (FV after 3 months) Result Total payment for ￡1,000,000 in June 1.A limited maximum of $1,750,000 + $27,254 = $1,777,254 2.A minimum of $0 plus $27,254