Risk due to lags in payments

1
Transaction Exposure

• Risk due to lags in payments
• Hedging strategies

2
Exposure

• Transaction exposure
• changes in the value of outstanding contracts
• Operating exposure (economic exposure)
• change in the PV of the firm (real exchange
  rates)
• Translation exposure (accounting exposure)
• change in value of owner equity
• Tax exposure

3
Transaction exposure sources

• lending or receivables denominated in foreign
  currency
• borrowing or payables denominated in foreign
  currency
• holding a defaulted forward contract

4
Lags and transaction exposure

• t0 - order placed
• Forward contract agreed to
• t1 - order shipped (10 days)
• t2 - order delivered (24 days)
• t3 - order settled (90 days)

5
Balance sheet perspective

• Contract price, quantity, due date (today)
• Forward contract purchased (today)
• Input inventories purchased (today)
• Inventories increase
• (Payables increase)
• May also be funded by LT debt
• Output inventories created (8days)
• Input inventories decrease
• Output inventories increase
• (Accruals increase)
• May also be funded by LT debt
• Goods shipped (no change) (10 days)

6
Balance sheet perspective (cont)

• Goods received (24 days)
• Inventories decrease
• Receivables increase
• Contract paid (90 days)
• Receivables decrease
• Take delivery on forward contract
• Cash increases
• During this process
• Payables paid
• Accruals paid

7
To Hedge

• Reduce the volatility of future cash flows
• Eliminate one source of risk
• Exchange rate volatility
• Cost of the hedge
• Does not change default risk
• Management either hedges or speculates ??
• Does not have expertise in exchange rate risk

8
To not Hedge

• Shareholders better able to diversify risk than
  firm
• If parity holds NPV of hedging negative
• Costs of hedging
• Efficient markets have already impounded the risk
  into share price
• Agency problem
• Management is risk averse relative to their jobs
  not to stockholder value

9
Accounting practices non-hedged position

• Balance sheet
• Input inventories at cost
• Output inventories at COGS
• Receivable denominated in cd
• Spot in effect at time of delivery
• Income statement
• At payment
• Gain or loss realized
• Counted on income statement

10
Types of hedges

• contractual hedges
• forwards, futures, option,
• money market hedges
• operating financial hedges
• risk-sharing
• leads lags
• swaps

11
Forward hedge - 90 day

• short goods (delivered)
• selling goods for 154,000 usd
• long bill of exchange (bankers accept)
• payment 154,000 usd promised forward
• long a forward contract
• forward contract set for delivery of 229,460 cd
• delivery of 154,000 usd
• delivery of 229,460 cd
• discounted value 225,796.28

12
Forward hedge - Sources of risk

• delivery on bill
• bank backing the bill could default
• delivery on forward contract
• bank delivering cd forward could defaulat
• risk of default is low
• the hedge reduces transaction exposure

13
Accounting practicesHedged position

• Contract values
• 231,000 receivable _at_ spot 1.50
• 229,460 payable _at_ forward 1.49
• Balance sheet
• Input inventories at cost
• Output inventories at COGS
• Receivable denominated
• Denominated at spot in effect at time of delivery
• Forward contract as payable
• Denominated at forward rate

14
Money market hedge - 90 day

• short goods (delivered)
• 154,000 usd
• long bill for 154,000 usd
• short loan 154,000/(1.0765) .25 151,188
• exchange for 225,270 cd
• delivery of 154,000 usd
• pay off loan of 154,000

15
Money market hedge - Sources of risk

• delivery on bill
• bank backing the bill could default
• no forward contract
• risk of default is lower
• the hedge reduces transaction exposure

16
One can also discount the bill - 90 day

• short goods
• 154,000 usd
• long bill of exchange
• sell bill at discount to bank _at_ 8.65
• 150,839 usd
• exchange for 224,750 cd

17
Discounting bill of exchange - Sources of risk

• no risk delivery on bill
• bill sold at discount to another party
• no forward contract
• risk of default is eliminated
• the hedge eliminates transaction exposure

18
OTC option contract - 90 day

• short goods
• 154,000 usd
• long bill of exchange
• long call option to buy 229,508 cd
• _at_0.0025 usd/cd cost 573.77 usd
• exercise price 6710
• delivery of 154,000
• if e gt x, exercise option
• get 229,508 cd net of cost of hedge

19
Option contract - Sources of risk

• risk of bank default on delivery on bill
• risk of default by bank on option contract
• the hedge reduces transaction exposure

20
Present value of the hedges

• forward hedge 225,796 cd
• money market hedge 225,270
• discounting 224,750
• option contract 229,508 cd / (1.0667).25 -
  (573.77 usd 1.49cd/usd) 224,989 cd

21
Accounting for unhedged positions

• Payables and receivables are booked at current
  spot
• income statements
• balance sheets
• at settlement - changes to book value must be
  counted
• losses
• gains

22
Accounting hedged positions

• Payables and receivables are booked at current
  spot
• Use your forward rate as best estimator of future
  expected spot
• foreign exchange gain/loss forward - spot
• forward contract loss 0
• Gains/losses will be the difference between
• contract evaluated at forward and
• contract evaluated at spot

23
Risk management

• Hedging costs money
• Hedging exposure
• As contracts are anticipated
• Contracts may not be signed
• If contracts signed unanticipated exchange rate
  changes
• As contracts are signed
• Risk that contract may be refused
• Risk that goods may not clear customs
• As contracts are delivered
• Default by the importer
• Out goods
• Must deliver on forward contract

24
Other hedge practices

• Proportional hedges
• Forward contracts hedge percentage of exposure
• Percentage cover directly related to term to
  maturity
• Forward points (using Interest Rate Parity)
• The usd sells forward at discount
• May not hedge this transaction because they may
  get a better exchange rate in the future