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Transaction Exposure (Note 11; Ch 8)

1. Transaction Exposure 2. Hedging

Foreign exchange exposure is a measure of the potential for a firms profitability, net cash flow, and market value to change because of a change in exchange rates These three components (profits, cash flow and market value) are the key financial elements of how we evaluate the relative success or failure of a firm 1. Transaction Exposure: measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are in a foreign currency. The situations include Purchasing or selling on credit goods or services when prices are stated in foreign currencies Borrowing or lending funds when repayment is to be made in a foreign currency Being a party to an unperformed forward contract Acquiring assets or incurring liabilities denominated in foreign currencies

Example (purchasing or selling): Leo Srivastava is the director of finance for Pixel Manufacturing, a U.S.-based manufacturer of hand-held computer systems for inventory management. Pixel has completed the sale of a barcode system to a British firm, Grand Metropolitan (UK), for a total payment of 1,000,000. The following exchange rates were available to Pixel on the following dates corresponding to the events of this specific export sale. Assume each month is 30 days.

(a) Assume Leo decides not to hedge the transaction exposure. What is the value of the sale as booked? What is the foreign exchange gain (loss) on the sale? The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met, and the shipment is categorized as an account receivable (A/R). Value as settled = 1,000,000* $1.7290/ = $1,729,000 Value as booked = 1,000,000* $1.7689/ = $1,768,900 Foreign exchange loss = ($1,729,000 - $1,768,900) = -$39,900 (b) Assume Leo decides to hedge the transaction exposure using a forward contract when the product is shipped. What is the value of the sale as booked? What is the foreign exchange gain (loss) on the sale if hedged with a forward contract? The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met. Value as forward settlement = 1,000,000* $1.7602/ = $1,760,200 Value as booked = 1,000,000* $1.7689/ = $1,768,900 Foreign exchange loss = ($1,760,200 - $1,768,900) = -$8,700

Reminder: Problem 19 of Ch 8

Example (purchasing or selling): Suppose Trident Corporation sells products to a Belgian buyer for 1,800,000 payable in 60 days. The current spot rate is $1.20/ and Trident expects to exchange the euros for 1,800,000*$1.20/ = $2,160,000 when payment is received. Transaction exposure arises because of the risk that Trident will receive something other than $2,160,000 expected If the euro weakens to $1.10/, then Trident will receive $1,980,000 If the euro strengthens to $1.30/, then Trident will receive $2,340,000 Example (borrowing and lending): Problem 22 of Ch 8 PepsiCos largest bottler outside the U.S. is located in Mexico (Grupo Embotellador de Mexico; Gemex) In mid 12/94, Gemex had US dollar denominated debt of $264 million. The Mexican peso (Ps) was pegged at Ps$3.45/US$. On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$5.50/US$ in mid-January, 1995. Gemexs peso obligation: Dollar debt mid-December, 1994 US$264m*Ps$3.45/US$=Ps$910.8m Dollar debt in mid-January, 1995 US$264m*Ps$5.50/US$ = Ps$1,452m Dollar debt increase measured in % (1452-910.8)/910.8 = 59.4% Gemexs dollar obligation increases by 59% due to transaction exposure. Note: US$ appreciates by 59.4%, which is (5.50-3.45)/3.45. Example (forward contract): When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure. A U.S. firm wants to offset transaction exposure of 100 million to pay for an import from Japan in 90 days. The firm can purchase 100 million in forward market to cover payment in 90 days. Example (acquiring foreign assets): Problem 12 of Ch 8 Worldwide Travel, a 100% privately owned travel firm based in Honolulu, has signed an agreement to acquire a 50% ownership share of Taipei Travel, a privately owned travel agency based in Taiwan specializing in servicing inbound customers from the United States and Canada. The acquisition price is 7 million Taiwan dollars (NT$7,000,000) payable in cash in three months.

2. Hedging (1) What constitutes a hedge? Acquiring a cash flow, asset, or contract that will rise in value to offset a decrease in value of an underlying (existing) position

2. Why hedge? Hedging protects the owner of an asset (future stream of cash flows) from loss. However, it also eliminates any gain from an increase in the value of the asset hedged against. Since the value of a firm is the net present value of all expected future cash flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against. Example: Suppose there is a company drilling oil and it plans on selling 2 million barrels of oil in 60 days. How can the firm hedge the exposure to changes in oil prices? - sell a futures contract on oil deliverable in 60 days

Example 1 (managing account receivable; A/R): Maria Gonzalez, CFO of Trident, has just concluded a sale to Regency, a British firm, for 1,000,000. The sale is made in March with payment due in June (3 months). Assumptions for Marias currency exposure problem are: - Spot rate is $1.7640/ - 3-month forward rate is $1.7540/ - Tridents cost of capital is 12.0% - UK 3 month borrowing rate is 10.0% p.a. (per annum) - UK 3 month investing rate is 8.0% p.a. - US 3 month borrowing rate is 8.0% p.a. - US 3 month investing rate is 6.0% p.a. - June put option in the OTC market (bank) for 1,000,000; strike price $1.75; 1.5% for option premium - Tridents foreign exchange advisory service forecasts future spot rate in 3 months to be $1.76/ Trident operates on narrow margins and Maria wants to secure the most amount of US dollars; her budget rate (lowest acceptable amount) is $1.70/, below which Trident actually lose money on the transaction. Maria faces four possibilities: Remain un-hedged Hedge in the forward market Hedge in the money market Hedge in the options market (1) Un-hedged position Maria may decide to accept the transaction risk. If she believes that the future spot rate will be $1.76/, then Trident will receive 1,000,000*$1.76/ = $1,760,000 in 3 months. However, if the future spot rate is $1.65/, Trident will receive only $1,650,000 well below the budget rate. (2) Forward market hedge - A forward hedge involves a currency forward or futures contract and a source of funds to fulfill the contract - The forward contract is entered at the time when the A/R (account receivable) is created, in this case in March. - When this sale is booked, it is recorded at the spot rate. - In this case the A/R is recorded at a spot rate of $1.7640/, thus $1,764,000 is recorded as a sale for Trident.

- If Trident does not have an offsetting A/P (account payable) in the same amount, then the firm is considered uncovered. - If Maria wants to cover this exposure with a forward contract, then she will sell 1,000,000 forward today at the 3-month forward rate of $1.7540/ - She is now covered and Trident no longer has any transaction exposure - In 3 months, Trident will receive 1,000,000 and exchange those pounds at $1.7540/ receiving $1,754,000. - This would be recorded in Tridents books as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled) Reminder: Problems 1, 2, 10, 13, 17, 21 of Ch 8 (3) Money market hedge - A money market hedge also includes a contract and a source of funds, similar to a forward contract - In this case, the contract is a loan agreement - The firm borrows in one currency and exchanges the proceeds for another currency - Hedges can be left open (i.e., no investment) or closed (i.e., investment). - To hedge in the money market, Maria will borrow pounds in London, convert the pounds to dollars and repay the pound loan with the proceeds from the sale - To calculate how much to borrow, Maria needs to discount the PV of the 1,000,000 to today 1,000,000/(1+10%*1/4) = 975,610 - Maria should borrow 975,610 today and in 3 months repay this amount plus 24,390 in interest from the proceeds of the sale (1,000,000). - Trident would exchange the 975,610 at the spot rate of $1.7640/ and receive $1,720,976 immediately. - This hedge creates a pound denominated liability (bank loan) that is offset with a pound denominated asset (the sale of goods; A/R) thus creating a balance sheet hedge In order to compare the forward hedge with the money market hedge, Maria must analyze the use of the loan proceeds - Remember that the loan proceeds may be used today, but the funds for the forward contract may not - Three logical choices exist for an assumed investment rate for the next 3 months

- First, if Trident is cash rich, the loan proceeds might be invested at the US rate of 6.0% p.a. - Second, Maria could use the loan proceeds to substitute an equal dollar loan that Trident would have otherwise taken for working capital needs at a rate of 8.0% p.a. - Third, Maria might invest the loan proceeds in the firm itself in which case the cost of capital is 12.0% p.a.

- Because the proceeds in 3 months from the forward hedge will be $1,754,000, the money market hedge is superior to the forward hedge if Maria used the proceeds to replace a dollar loan (8%) or conduct general business operations (12%) - The forward hedge would be preferable if Maria were to just invest the loan proceeds (6%) - We assume that she uses the cost of capital as the reinvestment rate - A breakeven investment rate can be calculated and help Maria in her decision

- Conclusion: If Maria can invest the loan proceeds at a rate equal to or greater than 7.68% p.a., then the money market hedge will be superior to the forward hedge. Reminder: Problem 4 of Ch 8 (4) Options market hedge: - Maria could also cover the 1,000,000 exposure by purchasing a put option (insurance). This allows her to speculate on the upside potential for appreciation of the pound while limiting her downside risk.

- Given the quote earlier, Maria could purchase 3-month put option at an ATM (at-the-money) strike price of $1.75/ and a premium of 1.5% The cost of this option = (size of option)*(premium)*(spot rate) = 1,000,000*0.015*$1.7640/ = $26,460 - Because we are using future value to compare the various hedging alternatives, it is necessary to project the cost of the option in 3 months. Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium of the option as of June $26,460*1.03 = $27,254 - Since the upside potential is unlimited, Trident would not exercise its option at any rate above $1.75/ and would sell pounds on the spot market - For example, the spot rate of $1.76/ materializes, Trident would exchange pounds on the spot market to receive 1,000,000*$1.76/ = $1,760,000 less the premium of the option ($27,254) netting $1,732,746. (Out-of-themoney) - If the pound depreciates below $1.75/, Maria would exercise her option and exchange her 1,000,000 at $1.75/ receiving $1,750,000. Less the premium of the option, Maria nets $1,722,746. - Comparing with the forward hedge and un-hedge, Maria can also calculate her breakeven price on the option - The upper bound of the range is determined by comparison of the forward rate Option hedge is better (just let it expire) if the pound appreciates above $1.7813/ =$1.7540/ (forward rate) + $0.0273/ (27,254/1,000,000) - The lower bound of the range is determined by comparison of the unhedged strategy If the pound depreciates below $1.75/, the net proceeds would be $1.75/ - $0.0273/ = $1.7227/ If the future spot falls below $1.7227/, option hedge is better by exercising the put option. Reminder: Problems 5, 7, 8, 9, 16, 18, 20 of Ch 8 Conclusion: Trident, like all firms, must decide on a strategy to undertake before the exchange rate changes. But, how will Maria choose among the strategies? Risk tolerance of the firm, as expressed in its stated policies Viewpoint - Marias own view on the expected direction and distance of the exchange rate movement


Example 2 (managing account payable; A/P): Now, assume that the 1,000,000 was an account payable in 90 days. (1) remain unhedged: Trident could wait 90 days and at that time exchange dollars for pounds to pay the obligation. If the spot rate is $1.76/, then Trident would pay $1,760,000 but this amount is not certain. (2) forward market hedge: Trident could purchase a forward contract locking in the exchange rate of $1.7540/ ensuring that their obligation will not be more than $1,754,000. (3) money market hedge: This hedge is quite different for a payable than a receivable. Trident would exchange US dollars spot and invest them for 90 days in pounds. The pound obligation for Trident is now offset by a pound asset for Trident with matching maturity To ensure that exactly 1,000,000 will be received in 90 days time, Maria discounts the principal by 8% p.a. 1,000,000/{1+0.08*(90/360)} = 980,392.16 (needed today) 980,392.16*$1.7640/ = $1,729,411.77 Finally, carry the cost forward 90 days in order to compare the payout from the money market hedge $1,729,411.77*{1+0.12*(90/360)} = $1,781,294.12 This is higher than the forward hedge of $1,754,000, thus money market hedge is unattractive in this example. Reminder: Problem 3, 11, 12 of Ch 8 (4) option hedge: Maria would want to purchase a call option to cover the payable. The terms of an ATM call option with a strike price of $1,75/ would be a 1.5% premium. 1,000,000*0.015*$1.7640/ = $26,460 Carried forward 90 days the premium = $26,460*{1+0.12*(90/360)} = $27,254 (a) If the spot rate is less than $1.75/, then the option would be allowed to expire and the 1,000,000 would be purchased on the spot market.


(b) If the spot rate rises above $1.75/, then the option would be exercised and Trident would exchange the 1,000,000 at $1.75/ plus the option premium. $1,750,000 + $27,254 = $1,777,254 (better than money market hedge) Reminder: Problems 6, 14, 15 of Ch 8 Forward Manage A/R
Sell forward

Money Market
(1) borrow FC (2) convert PV of FC @ spot rate (3) invest using (2) (1) discount A/P (FC) (2) convert (1) @ spot rate (3) calculate FV of (2)

* Buy put option * Calculate FV of premium * Exercise? * Buy call option * Calculate FV of premium * Exercise?

Manage A/P

Buy forward


Example 3: General Electrics Transaction Exposure to euros GE sells turbine blades to Lufthansa, the German Airline. GE will receive a payment of 25 million in one year for the blades. (A/R problem) Current spot rate = S0 = $0.9901/ One-year forward rate = Ft = 1yr. = $0.9842/ German borrowing interest rate = 15% per annum German investment interest rate = 13% per annum U.S. borrowing interest rate = 10% per annum U.S. investment interest rate = 8% per annum One-year put on strike price of $0.9850/ = 1.5% One-year put on strike price of $0.9800/ = 1.0% GEs cost of capital = 12% (1) No hedge no reduction in transaction exposure GE takes no action now, collects 25 million in one year, converts into $ at the existing spot rate in one year
$s received (Mil) 24.875
24.75 24.625

0.9850 0.9900 0.9950

(2) Forward Market Hedge reduce exposure by entering into forward contract at the forward rate Today: GE sells forward 25 million at $0.9842/ One Year: GE collects 25 million from Lufthansa and then delivers 25 million and receives $24,605,000 (at $0.9842/) $s at the existing spot rate in 1 year
$s received (Mil) 24.875
24.75 24.605

0.9842 0.9900 0.9950 14

(3) Money Market Hedge reduce exposure by borrowing and lending currency (a similar idea to covered interest arbitrage) The objective is to match the contractual FC cash inflows/outflows by currency and maturity If a future FC inflow is expected (long), borrow FC today (short) If a future FC outflow is expected (short), invest in FC today (long) GE Money Market Hedge Today: Borrow discounted value of 25 million = 21,739,130.43; (25M/ (1+15%)) Exchange at S0 = $0.9901/, receiving $21,523,913.04 One Year: Collect 25 million from Lufthansa, and use the amount to pay off loan To compare with other options, we need to consider time value of money, and discount rate Investment rate (8%) = $23,245,826.08 = $21,523,913.04*(1+8%) Reduce borrowing (10%) = $23,676,304.34 = $21,523,913.04*(1+10%) Fund projects (12%) = $24,106,782.60 = $21,523,913.04*(1+12%) All are realistic rates, but borrowing rate might be more reasonable Break-even reinvestment rate (r) for money market hedge vs. forward contract (only valid for A/R exposure) Initial Proceeds from Money market hedge * (1 + r) = Forward Proceeds $21,523,913.04*(1 + r) = $24,605,000 r = 14.3% breakeven investment rate (Anything greater than r money market hedge dominates)


(4) Option Hedge can reduce exposure by retaining upside potential while providing downside protection For a future cash inflow (receivable), buy a put option (insurance) on the FC (Example 1) For a future cash outflow (payable), buy a call option (hope or upside potential) on the FC (Example 2) GE: Today, GE purchases a put option on 25 million at a strike price of $0.9850/ & a premium of 1.5% Option premium is 25 million*$0.9850/*1.5% = $369,375 To compare against other hedging techniques, convert put option premium using cost of capital: $369,375*(1+0.12) = $413,700 If spot rate in one year is:

less than $0.9850/, exercise the put option to sell 25 million at a strike price of $0.9850/. Receiving a net: $24,625,000 - $413,700 = $24,211,300 greater than or equal to $0.9850/, let put option expire. Convert at the spot rate in one year. Receiving a net: (25 million*So) - $413,700 >= $24,211,300 Minimum amount received is $24,211,300


Comparisons of Hedging Alternatives: Money market vs. Forward contract - compare proceeds at a reasonable r; in the above example, forward contract is better because r needs to be > 14.3%. Forward contract vs. Option hedge: need to calculate breakeven spot: 25 million * future spot rate - $413,700 = $24,605,000 Future spot rate = $1.00075/ (greater than this rate option hedge dominates)


Example (A/R): Tek (US) wishes to hedge a 1,000,000 account receivable arising from a sale to Olivetti (Italy). Payment is due in three months. Citibank has offered Tek the following quotes: Spot rate: $1.54/; Threemonth forward rate: $1.56/; Three-month euro borrowing rate and deposit rate are 4% and 3% per year, respectively; US 3-month borrowing rate and deposit rate are 3% and 2% per year, respectively; Tek's weighted average cost of capital: 10% (a) To hedge the account receivable of 1,000,000, should Tek buy or sell forward contracts @ the forward rate $1.56/? In doing so, what is the amount of US dollar proceeds in three months? (b) To use the money market hedge, Tek will borrow and then have some amount of dollars to invest in the companys projects @ WACC of 10%, what is the future value of this investment in three months? (c) If the forward hedge is equivalent to the money market hedge, what is the breakeven investment rate? Solutions: (a) Sell forward contracts to hedge the account receivable of 1,000,000. The dollar proceeds = 1,000,000* $1.56/ = $1,560,000 (b) Borrow 1,000,000/(1+4%*90/360) = 990,099 At the spot rate of $1.54/, Tek receives 990,099*$1.54/ = $1,524,752 immediately. The future value of investment in three months = $1,524,752*(1+10%*90/360) = $1,562,871 (c) $1,524,752*(1+r*90/360) = $1,560,000 r = 9.25%


Example (A/P): Tek has imported components from its joint venture in Japan, Sony-Tek, with payment of 2,000,000 due in six months. Tek's weighted average cost of capital = 10% per year. Citibank has offered Tek the following quotes: Spot rate = 105/$; Six-month forward rate = 110/$; Six-month yen deposit rate = 1.25% per year; Six-month dollar deposit rate = 4.00% per year. Option premium for six-month put and call option on at the strike rate of 106/$ are 2% and 1.5%, respectively (the option premium is on the position hedged in terms of US $). (a) What is the dollar cost (in terms of future value in 6 months) of using money market hedge? (b) To hedge the account payable of 2,000,000, should Tek buy call option or put option on ? (c) If the future spot rate in six months is exactly 110/$, what is the total amount of US dollar proceeds in six months plus the future value of option premium if Tek uses the option strategy to hedge the account payable (A/P) of 2,000,000? Solutions: (a) Yen deposit needed now = 2,000,000/(1+0.0125*180/360) = 1,987,578; Dollar deposit needed now = 1,987,578/(105/$) = $18,929.31 Carry-forward cost @ WACC = $18,929.31*(1+0.10*180/360) = $19875.78 (b) To hedge the account payable of 2,000,000, Tek should buy call option on (Call option on provides Tek with the right to buy @ $(1/106 = 0.009434)/) (c) The future value of call option premium = 2,000,000/(105/$)*0.015*{1+0.10*(180/360)} = $300 110/$ equivalent to $0.009091/ dont exercise the call option and let it expire since the strike rate is $0.009434/, which is larger than $0.009091/. Buy 2,000,000 at the spot market Tek needs 2,000,000/(110/$) = $18,181.82 $18,181.82 + $300 = $18,481.82 (note: better than money market hedge in this scenario)