International Banking

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International Banking and Trade Finance
Chpt 11
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Managing Transaction Exposure

• Chapter 11

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Overview

• Identify techniques for hedging transaction
  exposure
• Describe how each technique hedges an MNCs
  payables and receivables
• Compare the different hedging techniques
• Observe other methods that reduce exchange rate
  risk

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Exchange Rate Exposure

• There are 3 forms by which a MNC is exposed to
  exchange rate fluctuations
• 1. Transaction exposure
• 2. Economic Exposure
• 3. Translation Exposure

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Transaction Exposure
Exposure exists when future cash transactions
are affected by exchange rate fluctuations

• Affects future cash flows
• e.g., MNC from US has payables denominated in
  German marks
• 1. identify degree of exposure
• 2. decide whether to hedge and if so, then what
  percent of payables to hedge
• 3. select the hedging technique

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Before Hedging

• Before making any decisions about hedging
• you should identify the net transaction exposure
  on a currency-by-currency basis
• Net means all inflows and outflows

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Before Hedging

• If it turns out that the inflows and outflows,
  across all the subsidiaries offset each other,
  then you do not need to hedge !!!
• Problem is, individual managers do not like to be
  exposed because they think it looks bad on their
  record
• So they may hedge

Page 335
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Before Hedging

• If the individual managers hedge, they might
  erode some of the offset advantages that the
  whole firm has
• It must be kept in mind that the goal of the MNC
  is to be profitable as a whole - not just each
  subsidiary
• remember when hedging there are transaction costs
  - its not free

Page 335
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Transaction Exposure
Identifying Net Transaction Exposure

• Conduct analysis by currency
• calculate the net exposure for each currency
• make hedging decisions on MNC-wide basis
• consolidates all subsidiaries

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Transaction Exposure

• Hedging within MNC and agency theory
• MNC should hedge at the corporate level
• subsidiary managers may try to protect their own
  cash flows
• redundant hedging may occur within MNC

MNC X
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Transaction Exposure

• Corporate level hedging practices may
• 1. create unhedged positions of subsidiary
• 2. may increase riskiness of subsidiarys cash
  flow
• Subsidiary hedging without MNC approval
• may leave MNC exposed

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Texts example of Eastman Kodak Companys
Example of Kodaks centralized currency
management approach

• Irrelevant to us in Canada
• we just dont have that many companies who are so
  large and have manufacturing and business in so
  many places that such questions of hedging would
  be relevant

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Is Hedging Worthwhile ?

• on the average it will not reduce the MNCs
  costs it could be argued that hedging is not
  worthwhiletext page 336

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Canadian companies that might use hedging

• Magna
• BCE / Nortel
• Noranda
• Air Canada
• Celestica
• Xerox

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Canadian companies that use hedging

• Bombardier
• Alcan
• Canadian Airlines
• McCains

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Top companies in Canada that might need to do
centralized foreign currency management

• from the class

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Transaction ExposureApproaches to Hedging

• 1) Hedge only when currency expected to move in
  direction that makes hedging feasible eg.
  approach of Black Decker
• if MNC expects the DM to depreciate in value
• hedge only inflow exposure (receivables)
• if MNC expects the DM to appreciate in value
• hedge only outflow exposure (payables)

Page 336
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Transaction Exposure Approaches to Hedging

• 2) Hedge 100 percent of net exposures in foreign
  currency (Seagram Company)
• eliminates uncertainty when valuing expected cash
  flows
• - they dont do it to make any money, but rather
  to prevent losing a lot of money, which then
  helps a lot with planning

100
100
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• Most MNCs do not perceive their foreign exchange
  management as a profit center
• that is they do not do hedging to make money
  -they do it to

Page 337
1. Measure exposure in order to assess risk 2.
Determine whether the exposure should be
hedged 3. Determine HOW the exposure should be
hedged
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Adjusting the Invoice Policy to Manage Exposure

• Sometimes a large company will have to pay for
  things in x from X country
• It might also sell stuff to X country
  denominated in dollars
• One of the things you can do is denominate it in
  x so you balance your exposure
• textbook example uses paying in Swiss francs

Page 337
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Transaction Exposure Hedging Techniques

• 1) Futures hedge
• 2) Forward hedge
• 3) Money market hedge
• 4) Currency option hedge

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1. Futures Hedge (Currency Futures)

• Characteristics of contract
• buyer of futures contracts
• depends if your purpose is payables or
  receivables
• entitled to receive a specified amount in a
  specified currency for a stated price on a
  specified date
• expects the currency to appreciate in value
• if it appreciates, then they will have saved
  money because in the future, they will not have
  had to pay at the higher price
• sometimes they can backfire

Page 338
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2. Forward Hedge (Forward Contract)
Page 339

• Used heavily by large corporations
• usually because they have to pay for a large
  amount of material, supplies or component parts
• contract specifies the exchange rate at which
  currencies will be exchanges
• if you dont know the amount, then you have to
  lock in the rate
• if you know the amount, then you could do a
  currency futures hedge

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2. Forward Hedge

• Hedging vs not hedging on payables
• MNC compares possible outcomes
• hedging produces known results
• not hedging permits range of possibilities to
  exist

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2. Forward Hedge

• Hedging vs not hedging on receivables
• MNC compares possible outcomes
• hedging produces known results
• not hedging permits range of possibilities to
  exist

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3. Money Market Hedge
Page 344

• Hedge on payables
• basically, if you have the money available, you
  can but it in the bank, in the denomination of
  the currency you will need, and the small amount
  of interest you will earn might cover the
  possible drop if you did not take this action

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3. Money Market Hedge
Page 344

• Hedge on payables
• If you take this action, it requires you do 2
  things
• 1. Borrow funds in the particular currency
• 2. Make a short term investment in that currency

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3. Money Market Hedge on Receivables
Page 345

• Hedging on receivables
• If you expect some large amount of money coming
  in (say, 2M Pounds)
• Maybe you expect the Pound to drop in the next
  few weeks so that incoming money will be less in
  value
• What you can do is borrow the 2 million pounds now

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3. Money Market Hedge on Receivables
Page 345

• Hedging on receivables, continued,,,
• Now, for a short period of time you will have to
  pay interest in the 2 million pounds, but when
  you payment comes in from the person you are
  doing business with, you can take that 2 million
  pounds, and use it to pay back the other 2
  million pounds you borrowed

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3. Money Market Hedge on Receivables
Page 345

• Hedging on receivables, continued,,,
• The reason you would want to do this is just in
  case Pounds dropped very low, the incoming Pounds
  may not mean much in dollars, but they would
  still be OK to pay off a short term loan
  denominated in Pounds !

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4. Currency Option Hedge

• Unhedged strategies
• may outperform hedging strategies
• when a payables currency depreciates
• when a receivables currency appreciates

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4. Currency Option Hedge
Page 346

• Sometimes using a Forward Hedge (Forward
  Contract) and a Currency Hedge (Currency Futures
  Contract) can backfire,
• therefore, people use currency options - only
  problem is you have to pay a premium for them,
  which sometimes could negate any small advantages

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4. Currency Option Hedge

• Hedging payables with call option (buying)
• provides right to buy a specified amount of a
  currency at a specific price with a specified
  time period
• does not obligate the owner to buy the currency

Page 346
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4. Currency Option Hedge

• Hedging receivables with currency put options
• provides right to sell a specified amount of a
  currency at a specific price within a specified
  time period
• does not obligate the owner to sell the currency

Page 347
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4. Currency Option Hedge

• Hedging receivables with currency put options
• if the existing spot rate of the foreign currency
  is above the exercise (strike) price when the
  firm receives the foreign currency, the firm can
  sell the currency received at the spot rate and
  let the put option expire

Page 347
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Comparison of
Hedging Techniques
Page 348
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Comparison of
Hedging Techniques
In the textbook, they spend some pages explaining
the different hedge techniques on pages 349, 350
and 351, only to conclude on page 352 that
Fresno Corporation is likely to perform best if
it remains unhedged While the hedging
techniques described in this chapter can be
useful, they have limited effectiveness for the
long term
Page 352
Page 355
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(No Transcript)
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Limitation of RepeatedShort-term Hedging

• Long-term hedging
• may be more effective than a series of short-term
  hedges
• when a currency enters a long cycle of strength
  or weakness
• e.g., Deutsche mark strengthened against most
  currencies in the early 1990s
• long term hedges would have been more effective

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Long-term Transaction Exposure

• Hedging methods
• long-term forward contract
• currency swap
• parallel loan

Reducing Uncertainty
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Long-term Transaction Exposure Hedging

• Long-term forward contract
• time horizon up to five years
• long-term payables (outflow) exposure
• long-term receivables (inflow) exposure
• commonly used for major currencies
• MNCs that benefit most from this hedging
• have established fixed-price contracts

Page 357
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Long-term Transaction Exposure Hedging
Page 357

• Currency swap
• works well for two companies that have long term
  expectations of being exposed to a currency, so
  they get their bankers to swap the exposure for
  a better currency, or their own

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Long-term Transaction Exposure Hedging
Page 357

• Currency swap
• see handout given to class from WWW
• http//www.finpipe.com/currswaps.htm
• Currency swaps give companies extra flexibility
  to exploit their comparative advantage in their
  respective borrowing markets

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Long-term Transaction Exposure Hedging
Page 357

• Currency swap
• from http//www.finpipe.com/currswaps.htm
• Currency swaps allow companies to exploit
  advantages across a matrix of currencies and
  maturities
• Because of the exchange and re-exchange of
  notional principal amounts, the currency swap
  generates a larger credit exposure than the
  interest rate swap

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Long-term Transaction Exposure Hedging

• Currency swap
• from http//www.finpipe.com/currswaps.htm
• Companies have to come up with the funds to
  deliver the notional at the end of the contract.
  They are obliged to exchange one currency's
  notional against the other currency's notional at
  a fixed rate. The more actual market rates have
  deviated from this contracted rate, the greater
  the potential loss or gain. This potential
  exposure is magnified with time. Volatility
  increases with time. The longer the contract, the
  more room for the currency to move to one side or
  other of the agreed upon contracted rate of
  principal exchange. This explains why currency
  swaps tie up greater credit lines than regular
  interest rate swaps.

Page 357
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Long-term Transaction Exposure Hedging

• Example of a swap serving two MNCs
• MNC A is a French firm
• committed to a four year contract in the US
• expects to receive 6,000,000 at end of fourth
  year
• MNC B is a US firm with a contract in France
• will receive FF35,000,000 in four years
• MNCs A and B, with a banks help, arrange swap
• permits the exchange of US for FF at an agreed
  price

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Long-term Transaction Exposure Hedging

• Parallel loan
• a two-step currency exchange agreement
• two MNCs agree to
• 1) exchange FF for US
• 2) re-exchange US for FF at a specified exchange
  rate and a specified time
• requires two currency swaps
• at inception of loan and at the second exchange

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Alternative Hedging Techniques

• Three common methods
• leading and lagging
• cross hedging
• currency diversification
• Reduce exposures formed from poor forecasts
• standard hedging works best when MNCs accurately
  forecast future exchange rates

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Alternative Hedging Techniques

• Leading and lagging
• adjust the timing of payments or receipts
• expects currency change to affect receivables or
  payables
• leading, moves up transaction
• lagging, postpones transaction

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Alternative Hedging Techniques

• Cross hedging
• reduces transaction exposure in a currency that
  cannot be hedged directly
• hedges with a currency that is highly correlated
  with the desired currency

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Alternative Hedging Techniques

• Currency diversification
• takes a portfolio approach to currencies
• MNC with transactions in many currencies benefit
  most
• Coca Cola

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Summary

• Techniques to hedge transaction exposures
• futures hedge
• forward hedge
• money market hedge
• currency option hedge
• Alternative methods
• used to hedge payables and receivables exposures