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Topic7 Management of Transaction Exposure (1)
- Forward Market Hedge
- Money Market Hedge
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Opponents of hedging (1)
Stockholders are much more capable ofdiversifying currency risk than management of thefirm.
Currency risk management does not add value tothe firm. It does, however, use precious resourcesof the firm, which leads too a net reduction in value.
Management often conducts hedging activity thatbenefits management at the expenses of thestockholder.
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Opponents of Hedging (2)
• Managers can’t outguess the market. If and whenmarkets are in equilibrium with respect to parityconditions, the expected net present value of thehedging is zero.
• Management’s motivation to reduce variability issometimes driven by accounting reasons.
• Efficient market theorists believe that investors cansee through the accounting veil and thereforealready factored the foreign exchange effect into afirm’s market valuation.
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Proponents of Hedging
Reduction of risk in future cash flows improves the planningcapability of the firm.
Reduction of risk in future cash flows reduces the likelihoodthat firm’s cash flows will fall below a necessary minimum.
Management has a comparative advantage over the individualstockholder in knowing the actual currency risk of the firm.
Management is in a better position than stockholders torecognize disequilibrium conditions and to take advantage ofone time opportunities to enhance firm value from selectivehedging.
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When transaction exposure exists, the firm faces three major 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.
Mgt of Transaction Exposure
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Identifying Net Transaction Exposure
Centralized Approach - A centralized group consolidates subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency for the upcoming period(s).
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Transaction Exposure Information System (1)
Information system should be forward looking.
Frequency of reporting needs to be adequate.
- Monthly reporting
The flow of information should be direct to the treasury rather than being routed via other departments, such as accounting departments,which can create delays.
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Transaction Exposure Information System (2)
The need for information must be sold to management in subsidiary companies
Information system should be timely, succinct and oriented to decision and control.
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Use of Hedging Instruments
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Forward Market Hedge
Foreign currency receipt
- Sell forward to lock in home currency receipt
Foreign currency payment
- Buy forward to lock in home currency cost
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Real cost of hedging payables (RCHp) =+ nominal cost of payables with hedging– nominal cost of payables without hedging
Real cost of hedging receivables (RCHr) =+ nominal home currency revenues received
without hedging– nominal home currency revenues received
with hedging
Techniques to Eliminate Transaction Exposure
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If the real cost of hedging is negative, then hedging is more favorable than not hedging.
To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate, and then use it to develop a probability distribution for the real cost of hedging.
Techniques to Eliminate Transaction Exposure
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Nominal Cost Nominal Cost Real CostProbability With Hedging Without Hedging of Hedging
5 % $1.40 $1.30 $0.10
10 $1.40 $1.32 $0.08
15 $1.40 $1.34 $0.06
20 $1.40 $1.36 $0.04
20 $1.40 $1.38 $0.02
15 $1.40 $1.40 $0.00
10 $1.40 $1.42 - $0.02
5 $1.40 $1.45 - $0.05
Expected RCHp = PiRCHi = $0.0295
The Real Cost of Hedging for Each £in Payables
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There is a 15% chance that the real cost of hedging will be negative.
The Real Cost of Hedging for Each £in Payables
0%
5%
10%
15%
20%
25%
-$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10
Pro
bab
ilit
y
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If the forward rate is an accurate predictor of the future spot rate, the real cost of hedging will be zero.
If the forward rate is an unbiased predictor of the future spot rate, the real cost of hedging will be zero on average.
Techniques to Eliminate Transaction Exposure
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The Real Cost of Hedging British Pounds Over Time
-0.3
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0.3
0.4
1975 1980 1985 1990 1995 2000
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0
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0.3
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Limitations of Hedging
In the long run, the continual hedging of repeated transactions may have limited effectiveness.
For example, the forward rate often moves in tandem with the spot rate. Thus, an importer who uses one-period forward contracts continually will have to pay increasingly higher prices during a strong-foreign-currency cycle.
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Limitations of Hedging
Time
ForwardRateSpotRate
Repeated Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Costs areincreasing …
although there are savings
from hedging.
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Non-Deliverable Forward Contracts- Principle
Doesn’t result in actual exchange of the
currencies at the future date
- No delivery
One party to the agreement makes a payment to the other party based on the exchange rate at the future date.
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Non-Deliverable Forward Contracts- Example
US importer buys €100m
Settlement date: Jan.22 ( 90days from now)
Reference index: €’s closing rate(in dollars) in London Forex market in 90 days.
Reference index now: $1.23/€
90 days later:
- $1.3/ €, the bank will pay $7m to the US importer.
- $1.1/ €, the US importer will pay $13m to the bank.
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Use of Option forward
Uncertain settlement date
Continuing stream of foreign currency cash flow
Bank’s pricing principle
- To choose the least favorable price to the customer, or
- To choose the most favorable price to itself
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Use of Option Forward
( Uncertain settlement date)
Suppose it is Sep, 28, 2003.A UK exporter exports
to a French company.The French company will pay
€5m before Dec, 28, 2003.The UK exporter enters a
forward option contract with a bank to sell €.
In London market:
Spot rate €2.2210 - 2.2310
1 month forward 2.2197 - 2.2272
2 months forward 2.2140 - 2.2186
3 months forward 2.2110 - 2.2135
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Use of Option Forward(Continuing stream of fc cash flow)
A UK exporter will probably receive $1m in the next year.
London:
SR: £1= $1.6234-1.6255
1 month FR £1 = $1.6340-1.6369
2 months FR £1……
12months FR £1 = $1.6780-1.6800
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Use of Forex Swap(Uncertain settlement date)
A UK exporter exports to France. The expected settlement date is
uncertain(maybe because delivery date is equally uncertain).The UK
exporter takes out a forward contract on 1May,2002 for an arbitrary
period of 2 months. So, he sells €5m forward for delivery on 1July,2002.
On 20 June ,2002, the UK exporter and the French importer agree that
the settlement will take place on 1 Aug,2002.On 1 May,2002,the outright exchange rates quote:
Spot Rate: 1.423/4 -- 1.431/2
1 month forward: 1.387/8 –1.3920
2 month forward: 1.36 -- 1.373/8
3 month forward: 1.331/8 -- 1.345/8
On 20,June,2002, the outright exchange rate quote:
Spot rate: 1.34--1.35
11 days forward: 1/4c--1/2c discount
1 month forward: 1/2c-3/4c discount
42 days forward: 3/4c-1c discount
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Solutions
May 1st :
- Sell 2 months € 5m
June 20:rollover
- Buy 11days €5m
- Sell 42 days €5m
July 1st
- Delivery of two previous forward transactions
Aug, 1st :
- Take delivery
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A money market hedge involves taking one or more money market position to cover a transaction exposure.
Often, two positions are required. Payables: Borrow in the home currency, and invest in the foreign currency.
Receivables: borrow in the foreign currency, and invest in the home currency.
Techniques to Eliminate Transaction Exposure
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Money Market Hedge- Foreign Currency Receivable
A US firm expects to receive S$400,000 in 90
days.
US dollar interest rate: 7.20% / 7.50%pa
Singapore Dollar interest rate : 7.65% / 8.00%pa
Spot rate now: $0.5500/S$
If the US firm chooses to use money market
hedge, how is the final result?
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Realexchange rate
$0.5489/S$
2. Holds $215,686
Exchange at $0.5500/S$
1. Borrows S$392,157
Borrows at 8.00%for 90 days
3. Pays S$400,000
3. Receives $219,568
Deposits at 7.20% for 90
days
Solution
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Money Market Hedge- Foreign Currency Payable
A US firm needs to pay NZ$1,000,000 in 30 days.
US dollar interest rate :8.10%/8.40%pa
NZ$ interest rate: 6.00%/6.30%pa
Spot rate now: $0.6500/NZ$
If the US firm chooses to use money market hedge,how
is the final result?
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Solution
Realexchange rate$0.6513/NZ$
2. Holds NZ$995,025
Exchange at $0.6500/NZ$
1. Borrows $646,766
Borrows at 8.40%for 30 days 3. Pays
$651,293
3. Receives NZ$1,000,000
Deposits at 6.00% for 30
days
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Note that taking just one money market position may be sufficient.
A firm that has excess cash need not borrow in the home currency when hedging payables.
Similarly, a firm that is in need of cash need not invest in the home currency money market when hedging receivables.
Techniques to Eliminate Transaction Exposure
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For the two examples shown, the known results of money market hedging can be compared with the known results of forward or futures hedging to determine which the type of hedging that is preferable.
Techniques to Eliminate Transaction Exposure
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If interest rate parity (IRP) holds, and transaction costs do not exist, a money market hedge will yield the same result as a forward hedge.
This is so because the forward premium on a forward rate reflects the interest rate differential between the two currencies.
Techniques to Eliminate Transaction Exposure
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Prerequisites
Developed money market
No control in the financial markets