FX Derivatives

1
FX Derivatives

• 3. Hedging Exposure

2
FX Risk Management

• ? Exposure
• At the firm level, currency risk is called
  exposure.
• Three areas
• (1) Transaction exposure Risk of transactions
  denominated in FX with a payment date or
  maturity.
• (2) Economic exposure Degree to which a firm's
  expected cash flows are affected by unexpected
  changes in St.
• (3) Translation exposure Accounting-based
  changes in a firm's consolidated statements that
  result from a change in St. Translation rules are
  complicated not all items are translated using
  the same St. These rules create accounting
  gains/losses due to changes in St.
• We will say a firm is exposed or has exposure
  if it faces currency risk.

3

• Q How can FX changes affect the firm?
• - Transaction Exposure
• - Short-term CFs Existing contract obligations.
• - Economic Exposure
• - Future CFs Erosion of competitive position.
• - Translation Exposure
• - Revaluation of balance sheet (Book Value vs
  Market Value).

4

• Example Exposure.
• A. Transaction exposure.
• Swiss Cruises, a Swiss firm, sells cruise
  packages priced in USD to a broker. Payment in 30
  days.
• B. Economic exposure.
• Swiss Cruises has 50 of its revenue denominated
  in USD and only 20 of its cost denominated in
  USD. A depreciation of the USD will affect future
  CHF cash flows.
• C. Translation exposure.
• Swiss Cruises obtains a USD loan from a U.S.
  bank. This liability has to be translated into
  CHF.

5
Measuring Transaction Exposure

• Transaction exposure (TE) is very easy to
  identify and measure
• TE Value of a fixed future transaction in FC
  x St
• For a MNC ? TE consolidation of contractually
  fixed future currency inflows and outflows for
  all subsidiaries, by currency. (Net TE!)
• Example Swiss Cruises.
• Sold cruise packages for USD 2.5 million.
  Payment 30 days.
• Bought fuel oil for USD 1.5 million. Payment 30
  days.
• St 1.45 CHF/USD.
• Thus, the net transaction exposure in USD is
• Net TE (USD 2.5M -USD 1.5M) x 1.45 CHF/USD CHF
  1,450,000.

6

• ? Netting
• MNC take into account the correlations among the
  major currencies to calculate Net TE ? Portfolio
  Approach.
• A U.S. MNC Subsidiary A with CF(in EUR) gt 0
• Subsidiary B with CF(in GBP) lt 0
• ?GBP,EUR is very high and positive.
• Net TE might be very low for this MNC.
• Hedging decisions are usually not made
  transaction by transaction. Rather, they are made
  based on the exposure of the portfolio.

7

• Example Swiss Cruises.
• Net TE (in USD) USD 1 million. Due 30 days.
• Loan repayment CAD 1.50 million. Due 30 days.
• St 1.47 CAD/USD.
• ?CAD,USD .924 (from 1990 to 2001)
• Swiss Cruises considers the Net TE (overall) to
  be close to zero.
• Note 1 Correlations vary a lot across
  currencies. In general, regional currencies are
  highly correlated. From 2000-2007, the GBP and
  EUR had an average correlation of .71, while the
  GBP and the MXN had an average correlation of
  -.01.
• Note 2 Correlations also vary over time.

8
Currencies from developed countries tend to move
together... But, not always!
9
(No Transcript)
10

• Q How does TE affect a firm in the future?
• MNCs are interested in how TE will change in the
  future (T days). After all, it is in the future
  that the transaction will be settled.
• - MNCs do not know the future StT, they need to
  forecast StT.
• - EtStT has an associated standard error,
  which produces a range for (or an interval
  around ) StT and, thus, TE.
• - From a risk management perspective, it is
  important to know how much will be received from
  a FC inflow or how much will be needed to cover
  a FC outflow.

11
Range Estimates of TE

• Exchange rates are very difficult to forecast.
  Thus, a range estimate of the Net TE will provide
  a more useful number for risk managers.
• The smaller the range, the lower the sensitivity
  of the Net TE.
• Three popular methods for estimating a range for
  transaction exposure
• (1) Ad-hoc rule (10)
• (2) Sensitivity Analysis (or simulating exchange
  rates)
• (3) Assuming a statistical distribution for
  exchange rates.

12
? Ad-hoc Rule Instead of using a specific
confidence interval (C.I.), which requires
(complicated calculations and/or unrealistic
assumptions) many firms use an ad-hoc rule to get
a range 10 rule Its a simple and easy to
understand Get TE and add/subtract 10 .
Example Swiss Cruises has a Net TE CHF 1.45 M
due in 30 days gt if St changes by 10, Net TE
changes by CHF 145,000. Note This example
gives a range for NTE NTE ? CHF 1.305M CHF
1.595 M gt the wider the range, the riskier an
exposure is. Risk Management Interpretation If
SC is counting on the USD 1M to pay CHF expenses,
these expenses should not exceed CHF 1.305M.
13
? Sensitivity Analysis Goal Measure the
sensitivity of TE to different exchange rates.
Examples Sensitivity of TE to extreme
forecasts of St. Sensitivity of TE to
randomly simulate thousands of St. Data
5-years of monthly CHF/USD percentage changes
1-mo Changes in CHF/USD 1-mo Changes in CHF/USD
Mean 0.0004005
Standard Error 0.0027497
Median -0.0022862
Mode N/A
Standard Deviation 0.0329961
Sample Variance 0.0010887
Kurtosis 0.4632713
Skewness 0.4298708
Range 0.2070586
Minimum -0.0893638
Maximum 0.1176948
Sum 0.0576765
Count 144
14
Example Sensitivity analysis of Swiss Cruises
Net TE (CHF/USD) Empirical distribution (ED) of
St monthly changes over the past 12 years.
Extremes 11.77 (on November 92) and 8.94
(on April 95). (A) Best case scenario. Net TE
USD 1M x 1.45 CHF/USD x (1 0.1177) CHF
1,620,665. (B) Worst case scenario. Net TE USD
1M x 1.45 CHF/USD x (1 - 0.0894) CHF
1,320,370. Note If Swiss Cruises is counting on
the USD 1M to cover CHF expenses, from a risk
management perspective, the expenses to cover
should not exceed CHF 1,320,370.
15
Note Some managers may consider the range, based
on extremes, too conservative NTE ? CHF
1,320,370 CHF 1,620,665. gt The probability
of the worst case scenario to happen is very low
(only once in 144 months!) Under more likely
scenarios, we may be able to cover more expenses
with the lower bound. A different range can be
constructed through sampling from the
ED. Example Simulation for SCs Net TE
(CHF/USD) over one month. (i) Randomly pick 1,000
monthly st30s from the empirical
distribution. (ii) Calculate St30 for each st30
selected in (i). (Recall St30 1.45 CHF/USD x
(1 st30)) (iii) Calculate TE for each St30.
(Recall TE USD 1M x St30) (iv) Plot the 1,000
TEs in a histogram. (Simulated TE distribution.)
16
Based on this simulated distribution, we can
estimate a 95 range (leaving 2.5 observations
to the left and 2.5 observations to the
right) gt N TE ? CHF 1.3661 M CHF 1.5443
M Practical Application If SC expects to cover
expenses with this USD inflow, the maximum amount
in CHF to cover, using this 95 CI, should be CHF
1,366,100.
17
? Assuming a Distribution Confidence intervals
(CI) based on an assumed distribution provide a
range for TE. For example, a firm can assume
that St changes, st, follow a normal distribution
and based on this distribution construct a 95
CI. Recall that a 95 confidence interval is
given by ? ? 1.96 ?.
18
Example CI range based on a Normal
distribution. Assume Swiss Cruises believes that
CHF/USD monthly changes follow a normal
distribution. Swiss Cruises estimates the mean
and the variance. ? Monthly mean 0 ?2
Monthly variance 0.00107 gt ? 0.03271
(3.27) st N(0,0.00107). st CHF/USD monthly
changes. Swiss Cruises constructs a 95 CI for
CHF/USD monthly changes. Recall that a 95
confidence interval is given by ? ? 1.96 ?.
Thus, st will be between -0.0641 and 0.0641
(with 95 confidence). Based on this range for
st, we derive bounds for the net TE (A) Upper
bound Net TE USD 1M x 1.45 CHF/USD x (1
0.0641) CHF 1,542,945. (B) Lower bound Net
TE USD 1M x 1.45 CHF/USD x (1 - 0.0641) CHF
1,357,055.
19

• gt TE ? CHF 1,357,055 CHF 1,542,945
• The lower bound, for a receivable, represents
  the worst case scenario within the confidence
  interval.
• There is a Value-at-Risk (VaR) interpretation
• VaR Maximum expected loss in a given time
  interval within a (one-sided) confidence
  interval.
• Going back to the previous example.
• CHF 1,357,055 is the minimum revenue to be
  received by Swiss Cruises in the next 30 days,
  within a 97.5 CI.
• If Swiss Cruises expects to cover expenses with
  this USD inflow, the maximum amount in CHF to
  cover, within a 97.5 CI, should be CHF
  1,357,055.

20
? Summary NTE for Swiss francs - NTE CHF
1.45M - NTE Range - Ad-hoc NTE ? CHF
1.305M CHF 1.595 M. - Simulation -
Extremes NTE ? CHF 1,320,370 CHF
1,620,665 - Simulation NTE ? CHF 1.3661 M
CHF 1.5443 M - Statistical Distribution
(normal) NTE ? CHF 1,357,055 CHF
1,542,945
21
? Approximating returns In general, we use
arithmetic returns st St/St-1-1. Changing the
frequency is not straightforward. But, if we use
logarithmic returns i.e., stlog(St)-log(St-1)-,
changing the frequency of the mean return (?)
and return variance (?2) is simple. Let ? and ?2
be measured in a given base frequency. Then, ?f
? T, ?2f ?2 T, Example From Table VII.1 ?m
0.0004 and ?m.0329961. (These are arithmetic
returns.) We want to calculate the daily and
annual percentage mean change and standard
deviation for the CHF/USD exchange rate. We
will approximate them using the logarithmic
rule. (1) Daily (i.e., fddaily and T1/5) ?d
(0.0004005) x (1/30) .000013 (0.0013) ?d
(0.0329961) x (1/30)1/2 .00602 (0.60)
22
? Approximating returns (2) Annual (i.e.,
faannual and T 52) ?a (0.0004005) x (12)
.004806 (0.48) ?a (0.0329961) x (12)1/2
.11430 (11.43) The annual compounded
arithmetic return is .004817 (1.0004005)12-1.
When the arithmetic returns are low, these
approximations work well. Note I Using these
annualized numbers, we can approximate an
annualized VaR(97.5), if needed USD 1M x 1.45
CHF/USD x 1 (.004806-1.96 0.1143) CHF
1,132,128.1. Note II Using logarithmic
returns rules, we can approximate USD/CHF monthly
changes by changing the sign of the CHF/USD. The
variance remains the same. Then, annual USD/CHF
mean percentage change is approximately -0.48,
with an 11.43 annualized volatility.
23
? Sensitivity Analysis for portfolio approach Do
a simulation assume different scenarios --
attention to correlations! Example IBM has the
following CFs in the next 90 days Outflows
Inflows St Net Inflows GBP 100,000 25,000 1.60
USD/GBP (75,000) EUR 80,000 200,000 1.05
USD/EUR 120,000 NTE (USD) EUR 120K1.05
USD/EUR(GBP 75K)1.60 USD/GBP USD
6,000 (this is our baseline case) Situation 1
Assume ?GBP,EUR 1. (EUR and GBP correlation is
high.) Scenario (i) EUR appreciates by 10
against the USD Since ?GBP,EUR 1, St 1.05
USD/EUR (1.10) 1.155 USD/EUR St 1.60
USD/GBP (1.10) 1.76 USD/GBP NTE (USD) EUR
120K1.155 USD/EUR(GBP 75K)1.76 USD/GBP
USD 6,600. (10 change)
24
Example (continuation) Scenario (ii) EUR
depreciates by 10 against the USD Since ?GBP,EUR
1, St 1.05 USD/EUR (1-.10) 0.945
USD/EUR St 1.60 USD/GBP (1-.10) 1.44
USD/GBP NTE (USD)EUR 120K0.945 USD/EUR(GBP
75K)1.44 USD/GBP USD 5,400. (-10
change) Now, we can specify a range for
NTE ?NTE ? USD 5,400, USD 6,600 Note The
NTE change is exactly the same as the change in
St. If a firm has matching inflows and outflows
in highly positively correlated currencies i.e.,
the NTE is equal to zero-, then changes in St do
not affect NTE. Thats very good.
25
Example (continuation) Situation 2 Suppose the
?GBP,EUR -1 (NOT a realistic assumption!) Scenar
io (i) EUR appreciates by 10 against the
USD Since ?GBP,EUR -1, St 1.05 USD/EUR
(1.10) 1.155 USD/EUR St 1.60 USD/GBP
(1-.10) 1.44 USD/GBP NTE (USD) EUR 120K1.155
USD/EUR(GBP 75K)1.44 USD/GBP USD
30,600. (410 change) Scenario (ii) EUR
depreciates by 10 against the USD Since ?GBP,EUR
-1, St 1.05 USD/EUR (1-.10) 0.945
USD/EUR St 1.60 USD/GBP (1.10) 1.76
USD/GBP NTE (USD)EUR 120K0.945 USD/EUR(GBP
75K)1.76 USD/GBP (USD 18,600). (-410
change) Now, we can specify a range for NTE ?
NTE ? (USD 18,600), USD 30,600
26
Example (continuation) Note The NTE has
ballooned. A 10 change in exchange rates
produces a dramatic increase in the NTE range.
? Having non-matching exposures in different
currencies with negative correlation is
very dangerous. IBM will assume a correlation
(estimated from the data) and, then, draw many
scenarios for St to generate an empirical
distribution for the NTE. From this ED, IBM will
get a range and a VaR- for the NTE.
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Managing TE

• A Comparison of External Hedging Tools
• Transaction exposure Risk from the settlement of
  transactions denominated in foreign currency.
• Example Imports, exports, acquisition of foreign
  assets.
• Tools Futures/forwards (FH)
• Options (OH)
• Money market (MMH)
• Q Which hedging tool is better?

28

• New tool MMH
• A money market hedge is based on a replication of
  IRPT arbitrage.
• Lets take the case of receivables denominated in
  FC
• 1) Borrow FC
• 2) Convert to DC
• 3) Deposit DC in domestic bank
• 4) Transfer FC receivable to cover loan from (1).
• Under IRPT, step 4) involves buying FC forward,
  to repay loan in (1)
• gt This step is not needed, instead, we just
  transfer the FC receivable.
• Q Why MMH instead of FH?
• - under perfect market conditions ? MMH FH
• - under less than perfect conditions ? MMH ? FH

29
Example Iris Oil Inc., a Houston-based energy
company, has a large foreign currency exposure in
the form of a CAD cash flow from its Canadian
operations. The exchange rate risk to Iris is
that the CAD may depreciate against the USD. In
this case, Iris CAD revenues, transferred to its
USD account will diminish and its total USD
revenues will fall. Situation Iris will have
to transfer CAD 300M into its USD account in 90
days. Data St 0.8451 USD/CAD Ft,90-day
0.8493 USD/CAD iUSD 3.92 iCAD 2.03
30
Example (continuation) Date Spot
market Forward market Money market t St .8451
USD/CAD Ft,90-day .8493 USD/CAD iUSD3.92
iCAD2.03 t90 Receive CAD 300M and transfer
into USD. Hedging Strategies 1. Do Nothing Do
not hedge and exchange the CAD 300M at St90. 2.
Forward Market At t, sell the CAD 300M forward
and at time t90 guarantee (CAD 300M) x (.8493
USD/CAD) USD 254,790,000
31
Example (continuation) 3. Money Market At t,
Iris Oil takes the following three steps,
simultaneously 1) Borrow from Canadian bank at
2.03 for 90 days CAD 300M /
1.0203x(90/360) CAD 298,485,188. 2) Convert
to USD at St CAD 298,485,188 x 0.8451 USD/CAD
USD 252,249,832 3) Deposit in US bank at 3.92
for 90 days to guarantee at time t90 USD
252,249,832 x 1 .0392x(90/360) USD
254,721,880. Note Both the FH and the MMH
guarantee certainty at time t90 FH delivers to
Iris Oil USD 254,790,000 MMH delivers to Iris
Oil USD 254,721,880 gt Iris Oil will select the
FH.
32
Example (continuation) 4. Option Market At
t, buy a put. Use the options market. Available
90-day options X Calls Puts .82
USD/CAD ---- 0.21 .84 USD/CAD 1.58 0.68 .88
USD/CAD 0.23 ---- Buy the .84 USD/CAD put gt
Total premium cost of USD 2.04M. St90 lt .84
USD/CAD St90 gt .84 USD/CAD In 90 days, the CF
is (.84 St90) CAD 300M
0 Plus St90 CAD 300M St90 CAD
300M Total USD 252M St90 CAD 300M Net CF at
t90 USD 249,960,000 for all St90 lt .84
USD/CAD or St90 CAD 300M USD 2.04M for all
St90 gt .84 USD/CAD
33
Example (continuation) 5. Collar At time
t, buy a put and sell a call. Buy the .84 put at
USD 0.0068 and finance it by selling the .88 call
at USD 0.0023. Thus, initial cost is reduced to
USD 0.0045 per put gt Total cost USD 1.35M
St90 lt .84 USD/CAD .84 lt St90 lt .88 St90
gt .88 USD/CAD Put (.84) (.84 St90 ) CAD
300M 0 0 Call (.88) 0
0 (.88 St90) CAD 300M Plus St90 CAD
300M St90 CAD 300M St90 CAD 300M Total USD 252
M St90 CAD 300M USD 264M Net CF at t90 USD
250.65M for all St90 lt .84 USD/CAD or St90
CAD 300M USD 1.35M for all .84 lt St90 lt .88 or
USD 262.65M for all St90 gt .88
USD/CAD Note This collar reduces the upside
establishes a floor and a cap.
34
Example (continuation) 6. Alternative Zero
cost insurance At time t, buy puts and sell
calls with overall (or almost) matching premium.
Buy the .84 put and finance it buy selling 3,
.88 calls. Thus, no initial cost (actually, its
a small profit, which well ignore). In 90
days St90 lt .84 USD/CAD .84 lt St90
lt .88 St90 gt .88 USD/CAD Put (.84) (.84
St90) CAD 300M 0 0 3 Calls (.88) 0
0 3 (.88St90) CAD 300M Plus
St90 CAD 300M St90 CAD 300M St90 CAD
300M Total USD 252 M St90 CAD 300M USD
792M2St90CAD 300M Net CF at t90 USD 252M
for all St90 lt .84 USD/CAD or St90 CAD
300M for all .84 lt St90 lt .88 or USD 792
M 2 St90 CAD 300M for all St90 gt .88 USD/CAD
35
Lets plot all strategies
Amount Received in t90
Do Nothing
Put
USD 264M USD 262.65M
Collar
Forward
USD 254.79M USD 252M USD 250.65M USD 249.96M
Zero-cost Collar
St90
.84 .8562 .88
36

• In order to make a decision regarding a hedging
  strategy, we need to say something about St90.
  For example, we can assume a distribution.
• We can use the ED to say something about future
  changes in St.
• Example Distribution for monthly USD/SGD changes
  from 1981-2009. Then, we get the distribution for
  St30 (USD/SGD).

37

• Example (continuation) Distribution for monthly
  USD/SGD changes from 1981-2009. Raw data, and
  relative frequency for St30 (USD/SGD).

st (SGD/USD) Frequency Rel frequency St 1/.65(1st) St 1/.65(1st)
-0.0494 or less 2 0.0058 1.462 0.6838
-0.0431 2 0.0058 1.472 0.6793
-0.0369 1 0.0029 1.482 0.6749
-0.0306 3 0.0087 1.491 0.6705
-0.0243 6 0.0174 1.501 0.6662
-0.0181 20 0.0580 1.511 0.6620
-0.0118 36 0.1043 1.520 0.6578
-0.0056 49 0.1420 1.530 0.6536
0.0007 86 0.2493 1.540 0.6495
0.0070 52 0.1507 1.549 0.6455
0.0132 41 0.1188 1.559 0.6415
0.0195 29 0.0841 1.568 0.6376
0.0258 5 0.0145 1.578 0.6337
0.0320 7 0.0203 1.588 0.6298
0.0383 5 0.0145 1.597 0.6260
0.0446 0 0.0000 1.607 0.6223
0.0508 or 3 0.0058 1.617 0.6186
S(t)1/.65(1s(t)
38

• Examples assuming an explicit distribution for
  StT
• ExampleReceivables Evaluate (1) FH, (2) MMH,
  (3) OH and (4) NH.
• Cud Corp will receive SGD 500,000 in 30 days.
  (SGD Receivable.)
• Data
• St .6500 - .6507 USD/SGD.
• Ft,30 .6510 - .6519 USD/SGD.
• 30-day interest rates iSGD 2.65 - 2.75
  iUSD 3.20 - 3.25
• A 30-day put option on SGD X .65 USD/SGD and
  Pt USD.01.
• Forecasted St30
• Possible Outcomes Probability
• USD .63 18
• USD .64 24
• USD .65 34
• USD .66 21
• USD .68 3

39
(1) FH Sell SGD 30 days forward USD received
in 30 days Receivables in SGD x Ft,30 SGD
500,000 x .651 USD/SGD USD 325,500. (2) MMH
Borrow SGD for 30 days, Convert to USD, Deposit
USD, Repay SGD loan in 30 days with SGD
payable Amount to borrow SGD 500,000/(1
.0275x30/360) SGD 498,856.79 Convert to
USD (Amount to deposit in U.S. bank) SGD
498,856.79 x .65 USD/SGD USD 324256.91 Amount
received in 30 days from U.S. bank deposit
USD 324256.91 x (1 .032x30/360) USD
325,121.60
40
(3) OH Purchase put option. X .65
USD/CHF Pt premium USD .01
Note In the Total Amount Received (in USD) we
have subtracted the opportunity cost involved in
the upfront payment of a premium USD .01 x .032
x 30/360 USD .000027 (Total USD 13.50) gt
Total Premium Cost USD 5,013.50 EAmount
Received in USD 319,986.5 x .76 324,986.50 x
.21 329,986.50 x .03 USD 321,336.5
41
(4) No Hedge Sell SGD 500,000 in the spot market
in 30 days.
Note When we compare (1) to (4), its not clear
which one is better. Preferences will matter. We
can calculate and expected value EAmount
Received in USD 315K x .18 320K x .24 325K
x .34 330K x .21 335K x . 03 USD 323,350
Conclusion Cud Corporation is likely to choose
the FH. But, risk preferences matter.
42

• ExamplePayables Evaluate (1) FH, (2) MMH, (3)
  OH, (4) No Hedge
• Situation Cud Corp needs CHF 100,000 in 180
  days. (CHF Payable.)
• Data
• St .675-.680 USD/CHF.
• Ft,180 .695-.700 USD/CHF.
• 180-day interest rates are as follows iCHF
  9-10 iUSD 13-14.0
• A 180-day call option on CHF X.70 USD/CHF and
  PtUSD.02.
• Cud forecasted St180
• Possible Outcomes Probability
• USD .67 30
• USD .70 50
• USD .75 20

43
(1) FH Purchase CHF 180 days forward USD
needed in 180 days Payables in CHF x Ft,180
CHF 100,000 x .70 USD/CHF USD 70,000. (2) MMH
Borrow USD for 180 days, Convert to CHF, Invest
CHF, Repay USD loan in 180 days Amount in CHF
to be invested CHF 100,000/(1 .09x180/360)
CHF 95,693.78 Amount in USD needed to
convert into CHF for deposit CHF 95,693.78
x .680 USD/CHF USD 65,071.77 Interest and
principal owed on USD loan after 180 days
USD 65,071.77 x (1 .14x180/360) USD 69,626.79
44
(3) OH Purchase call option. X .70 USD/CHF Ct
premium USD .02.
Note In the Total USD Cost we have included the
opportunity cost involved in the upfront payment
of a premium USD 130. Preferences matter A
risk taker may like the 30 chance of doing
better with the OH than with the MMH.
45
(4) Remain Unhedged Purchase CHF 100,000 in 180
days.
Preferences matter Again, a risk taker may like
the 30 chance of doing better with the NH than
with the MMH. (Actually, there is also an
additional 50 chance of being very close to the
MMH.) EAmount to Pay in USD USD
70,100 Conclusion Cud Corporation is likely to
choose the MMH.
46
Internal Methods

• These are hedging methods that do not involve
  financial instruments.
• Risk Shifting
• Q Can firms completely avoid exposure to
  exchange rate movements?
• A Yes! By pricing all foreign transactions in
  the domestic currency.
• Example Bossio Co., a U.S. firm, sells naturally
  colored cotton. Asuni, a Japanese company, buys
  Bossio's cotton. Bossio Co. prices all exports in
  USD.
• gt Currency risk is not eliminated. The foreign
  company bears it.
• Problem with risk-shifting Reduces firm
  flexibility.

47

• Currency Risk Sharing
• Two parties can agree -using a customized hedge
  contract- to share the FX risk involved in the
  transaction.
• Example Asuni buys cotton for USD 1 million from
  Bossio Co.
• Risk Sharing agreement
• If St ? 98 JPY/USD, 140 JPY/USD ?
  transaction unchanged. (Asuni pays USD 1 M to
  Bossio Co.)
• The range where the transaction is unchanged is
  called neutral zone.
• If St lt 98 JPY/USD or St gt 140 JPY/USD ? both
  companies share the risk equally.
• Suppose that when Asuni has to pay Bossio Co., St
  180 JPY/USD.
• The St used in settling the transaction is 160
  JPY/USD (180 - 40/2).
• Asuni's final cost JPY 160 million USD
  888,889 lt USD 1M.

48

• Leading and Lagging (LL)
• Firms can reduce FX exposure by accelerating or
  decelerating the timing of payments that must be
  made in different currencies
• ? leading or lagging the movement of funds.
• LL is done between the parent company and its
  subsidiaries or between two subsidiaries.
• Example Parent company HAL (U.S. company).
• Subsidiaries Mexico, Brazil, and Hong Kong.
• HAL Hong Kong's exposure is too large.
• HAL orders HAL Mexico and HAL Brazil to
  accelerate (lead) its payments to HAL Hong Kong.
  
• LL changes the assets or liabilities in one
  firm, with the reverse effect on the other firm.
• ? LL changes balance sheet positions.
• Might be a good tool for achieving a hedged
  balance sheet position.

49
Funds Adjustments Key to hedging Match
inflows and outflows denominated in the foreign
currency. Chinese subsidiary in U.S. Italian
subsidiary in U.S. has positive CFs in USD has
negative CFs in USD Increase USD
purchases Decrease USD purchases Decrease CNY
purchases Increase EUR purchases Decrease USD
sales Increase USD sales Increase CNY
sales Decrease EUR sales Increase USD
borrowing Reduce USD borrowing Reduce CNY
borrowing Increase EUR borrowing Example
Japanese and German carmakers have plants in the
U.S.
50
Translation Exposure

• Translation exposure Risk from consolidating
  assets and liabilities measured in foreign
  currencies with those in the reporting currency.
• Assets and liabilities in a FC must be restated
  in terms of a DC.
• This translation follows rules set up by a parent
  firm's government, an accounting association, or
  by the firm itself.
• Problem The translation involves complex rules
  that sometimes reflect a compromise between
  historical and current exchange rates.
• gt The translation might not end up with
  AssetsLiabilities.

51

• Examples of exchange rates used for translation
• - Historical rates may be used for some equity
  accounts, fixed assets,
• inventories.
• - Current exchange rates are used for current
  assets, liabilities, expenses and income.
• - Different exchange rates are used, imbalances
  will occur.
• Key issue what to do with the resulting
  imbalance? It is taken to either current income
  or equity reserves.
• Note Translation exposure does not directly
  affect cash flows, but some firms are concerned
  about it because of its potential impact on
  reported consolidated earnings.

52
Measuring Translation Exposure

• There are several methods to translate foreign
  currency accounts into the reporting currency.
  Two methods that predominate
• - Temporal method (monetary/nonmonetary method)
• - Current rate method
• Useful Terminology
• Monetary there is a date (maturity) attached to
  the asset or liability.
• Nonmonetary items with no maturity (fixed
  assets, inventory).
• Three exchange rates can be used
• S0 Historical exchange rate.
• St Current exchange rate at the date of
  balance.
• SAVERAGE Average exchange rate for the period.

53

• FASB 8 - Temporal Method (U.S. used from
  1976-1982)
• Premise Historical-cost accounting
• - Translate nonmonetary assets at S0, assets and
  liabilities use St
• - Translate most income statements items at the
  SAVERAGE
• - Translate shareholder equity at S0
• - Bookkeeping exchange gains or losses are
  passed to the Income statement

54

• FASB 52 - Current Rate Method (U.S. used since
  12/15/1982)
• - Translate most amounts at St
• - Income statement items are translated at S0 or
  SAVERAGE
• - Translate shareholder equity at S0
• - Exchange gains or losses are not reflected in
  income statement rather accumulate in an
  adjustment account in stockholders' equity
  Cumulative translation adjustment (CTA).
• - Distinguished between functional currency
  (usually local currency) and reporting currency
  (currency in which the parent firm prepares its
  own financial statements)
• - Exceptions to FASB 52
• 1. Accounts of subsidiaries whose operations are
  mostly with the parent use parents currency as
  functional currency, translate using temporal
  method.
• 2. Accounts of subsidiaries operating in
  hyperinflationary countries (over 100 over a
  three year period), functional currency must be
  the USD.

55

• Summary of U.S. accounting standards
• 1975-81 1981-today
• FASB 8 FASB 52
• Temporal Method Current Rate Method
• Monetary St St
• (Assets, debt, etc)
• Fixed
• (PE, inventory) S0 St
• Gains/losses
• reported Income statement Separate equity
  account

56
Managing Translation Exposure

• Most popular method balance sheet hedge.
• Perfect balance sheet hedge have an equal amount
  of exposed foreign currency assets and
  liabilities on a firm's consolidated balance
  sheet.
• ? net translation exposure will be zero.
• Translation exposure is measured by currency
  equality of exposed balance sheet's items can be
  achieved on a worldwide basis.

57

• Example HAL HK has the following balance sheet
  (in HKD M).
• Balance CR M/NM
• accounts exposures
• Assets
• Cash 300 300 300
• Accounts receivable 850 850 850
• Inventory 400 400 N.ex.
• Net fixed plant and equip. 1,000 1,000 N.ex.
  
• Total assets 2,550
• Total exposed assets 2,550 1,150
• Liabilities and Capital
• Accounts payable 200 200 200
• Notes payable 300 300 300
• Long-term debt 900 900 900
• Shareholder's equity 1,150 N.ex. N.ex.
• Total liabilities and capitsl 2,550
• Total exposed liabilities 1,400 1,400
• Net exposed assets 1,150 -250

58

• Example (Continuation)
• Net exposed assets 1,150 -250
• St.128 USD/HKD.
• Exposure in USD - CR method
• HKD 1,150,000,000 x .128 USD/HKD USD
  147,200,000.
• Exposure in USD - M/NM method
• HKD -250,000,000 x .128 USD/HKD USD
  -32,000,000.
• Management believes the HKD will depreciate 10
  against the USD.
• If St ? ? HAL will have
• (1) Translation loss USD 14.72 million under
  the CR Method.
• (2) Translation gain USD 3.2 million under the
  M/NM Method.

59

• Example (Continuation)
• Note Under the CR Method the loss will go to
  the CTA.
• Under the Temporal Method the gain will go to
  the income
• statement and increase earnings.
• HAL HK's functional currency is the HKD, HAL uses
  the CR Method.
• HAL wants to avoid translation exposure in HKD
• HAL HK should borrow HKD 1,150,000,000, and then
• (1) HAL HK could exchange the HKD for USD, or
• (2) HAL HK could transfer the borrowed HKD to
  HAL.

60
Economic Exposure

• Economic exposure (EE) Risk associated with a
  change in the NPV of a firm's expected cash
  flows, due to an unexpected change in St.
• Economic exposure is Subjective.
• Difficult to measure.
• We can use accounting data (changes in EAT) or
  financial/economic data (returns) to measure EE.
  Economists tend to like more economic data
  measures.
• Note Since St is very difficult to forecast, the
  actual change in St can be considered
  unexpected.

61
Measuring Economic Exposure

• An Easy Measure of EE Based on Financial Data
• We can easily measure how ?CF and ?St move
  together correlation.
• Example Kelloggs and IBMs EE.
• Using monthly stock returns for Kelloggs (Krett)
  and monthly changes in St (USD/EUR) from
  1/1994-2/2008, we estimate ?K,s (correlation
  between Krett and st) 0.154.
• It looks small, but away from zero. We do the
  same exercise for IBM, obtaining ?IBM,s0.056,
  small and close to zero.
• Better measure 1) Run a regression on ?CF
  against (unexpected) ?St. 2) Check statistical
  significance of regression coeffs.

62

• Testing and Evaluating EE with a regression
• Steps
• (1) Collect data on CF and St (available from
  the firm's past)
• (2) Estimate the regression ?CFt ? ß ?St
  ?t,
• ? ß measures the sensitivity of ?CF to changes
  in ?St.
• ? the higher ß, the greater the impact of ?St
  on CF.
• (3) Test for EE ? H0 (no EE) ß 0
• H1 (EE) ß ? 0
• (4) Evaluation of this regression t-statistic
  of ß and R2.
• Rule tß ß/SE(ß) gt 1.96 gt ß is
  significantly different than zero at 5
  level.

63

• Example Kelloggs EE.
• Now, using the data from the previous example, we
  run the regression Krett ? ß st ?t
• R2 0.023717
• Standard Error 0.05944
• Observations 169
• Coefficients Standard Error t-Stat P-value
• Intercept (a) 0.003991 0.004637 0.860756 0.390607
• Changes in St (ß) 0.551059 0.273589 2.014185 0.045
  595
• Analysis
• We reject H0, since tß 2.01 gt 1.96
  (significantly different than zero).
• Note, however, that the R2 is very low! (The
  variability of st explains less than 2.4 of the
  variability of Kelloggs returns.)

64

• Example IBMs EE.
• Now, using the IBM data, we run the regression
• IBMrett ? ß st ?t
• R2 0.003102
• Standard Error 0.09462
• Observations 169
•   Coefficients Standard Error t-Stat P-value
• Intercept (a) 0.016283 0.007297 2.231439 0.026983
• Changes in St (ß) -0.20322 0.2819 -0.72089 0.47
  1986
• Analysis
• We cannot reject H0, since tß -0.72 lt 1.96
  (not significantly different than zero).
• Again, the R2 is very low. (The variability of st
  explains less than 0.3 of the variability of
  IBMs returns.)

65

• Sometimes the impact of ?St is not felt
  immediately by a firm.
• ? contracts and short-run costs (short-term
  adjustment difficult).
• Example For an exporting U.S. company a sudden
  appreciation of the USD increases CF in the short
  term.
• Run a modified regression
• ?CFt ? ß0 ?St ß1 ?St-1 ß2 ?St-2 ß3
  ?St-3 ... ?t.
• The sum of the ßs measures the sensitivity of CF
  to ?St.
• Practical issue number of lags?
• Usual practice include at most two years of
  information.

66

• Example HAL runs the following regression.
• ?CFt .456 .421 ?St .251 ?St-1 .052
  ?St-2. R2 .168.
• (.89) (2.79) (2.01) (0.77)
• HAL's HKD CF (in USD) sensitivity to ?St is 0.672
  (.421.251). ? a 1 appreciation of the HKD will
  increase HKD CF (translated into USD) by 0.672.
  
• Evidence For large companies (MNCs, Fortune
  500), ? is not significantly different than zero.
  We cannot reject Ho No EE.

67

• A Measure Based on Accounting Data
• It requires to estimate the net cash flows of the
  firm (EAT or EBT) under several FX scenarios.
  (Easy with an excel spreadsheet.)
• Example IBM HK provides the following info
• Sales and cost of goods are dependent on St
• St 7 HKD/USD St 7.70 HKD/USD
• Sales (in HKD) 300M 400M
• Cost of goods (in HKD) 150M 200M
• Gross profits (in HKD) 150M 200M
• Interest expense (in HKD) 20M 20M
• EBT (in HKD) 130M 180M
• EBT (in USD at St7) HKD 130M/7 HKD/USD USD
  18.57M
• EBT (in USD at St 7.7) HKD 180M/7.70 HKD/USD
  USD 23.38M

68

• Example (continuation)
• A 10 depreciation of the HKD, increases the HKD
  cash flows from HKD 130M to HKD 180M, and the USD
  cash flows from USD 18.57M to USD 23.38.
• Q Is EE significant?
• A We can calculate the elasticity of CF to
  changes in St.
• For example, in USD, a 10 depreciation of the
  HKD produces a change of 25.9 in EBT. Quite
  significant. But you should note that the change
  in exposure is USD 4.81M.
• This amount might not be significant for IBM!
  (Judgment call needed.)
• Note Obviously, firms will simulate many
  scenarios to gauge the sensitivity of EBT to
  changes in exchange rates.

69
Managing Economic Exposure

• If EE is significant gt a firm should try to
  manage it.
• Ideal Situation A firm would like to have
  constant CFs at different exchange rates. If this
  is possible, there will not be EE.
• Matching Inflows and Outflows
• Severe problems show up when there is a currency
  gap ( inflows in FC - ouflows in FC).
• A very simple approach Avoid currency gaps
  between inflows denominated in FC and ouflows
  denominated in FC
• gt match inflows in FC and outflows in FC

70

• Case Study Laker Airways (Skytrain) (1977-1982)
• After a long legal battle in the U.S. and the
  U.K, Sir Freddie Laker was allow to let his low
  cost carrier, no-frills
• airline to fly from LON to NY (1977). Big
• success. Rapid expansion, financed with debt.
• Situation Rapid expansion Laker buys planes
• from MD, financed in USD.
• Cost
• (i) fuel, typically paid for in USD
• (ii) operating costs incurred in GBP, but with a
  small USD cost component (advertising and booking
  in the U.S.)
• (iii) financing costs from the purchase of
  aircraft, denominated in USD.
• Revenue
• Sale of airfare (probably, evenly divided between
  GBP and USD), plus other GBP revenue.

71

• Currency mismatch (gap)
• Revenues Payables
• mainly GBP, USD mainly USD, GBP
• What happened to St?
• 1977-1981 Big USD depreciation.
• 1981-1982 Big USD appreciation.
• 1982 Laker Airlines bankrupt.
• Solutions to Laker Airlines problem (economic
  exposure)
• - Sales in US
• - Borrow in GBP
• - Diversification
• - Transfer cost out to GBP/Shift expenses to GBP

72

• The Laker case study presents a very simple
  approach to managing EE Avoid currency gaps
  between inflows and ouflows.
• gt match inflows in FC and outflows in FC as
  much as possible.
• European and Japanese car makers have been
  matching inflows and outflows by moving
  production to the U.S.
• But, not all companies can have a very good
  match between inflows and outflows. Importing and
  Exporting companies will always be operationally
  exposed.

73

• Example A U.S. firm exports to the European
  Union. Two different FX scenarios
• (1) St 1.00 USD/EUR
• Sales in US USD 10M
• in EU EUR 15M
• Cost of goods in US USD 5M
• in EU EUR 8M
• (2) St 1.10 USD/EUR
• Sales in US USD 11M
• in EU EUR 20M
• Cost of goods in US USD 5.5M
• in EU EUR 10M
• Taxes US 30
• EU 40
• Interest US USD 4M
• EU EUR 1M

74

• Example (continuation)
• CFs under the Different Scenarios (in USD)
• St1 USD/EUR St1.1 USD/EUR
• Sales 10M15M25M 11M22M33M
• CGS 5M8M 13M 5.5M11M16.5M
• Gross profit 5M7M12M 5.5M11M16.5M
• Int 4M1M5M 4M1.1M5.1M
• EBT 7M 11.4M
• Tax 0.3M2.4M2.7M 0.45M3.96M4.41M
• EAT 4.3M 6.99M
• Q Is the change in EAT significant?
• Elasticity For a 10 depreciation of the USD,
  EAT increases by 63 (probably very
  significant!). That is, this company benefits by
  an appreciation of the Euro against the USD. The
  firm faces economic exposure.

75

• Example (continuation)
• Q How can the US exporting firm avoid economic
  exposure? (match!)
• - Increase US sales
• - Borrow more in Euros (increase outflows in EUR)
• - Increase purchases of inputs from Europe
  (increase CGS in EUR)
• (A) US firm increases US sales by 25
  (unrealistic!)
• EAT (St1 USD/EUR) USD 6.05M
• EAT (St1.1 USD/EUR) USD 8.915M
• gt a 10 depreciation of the USD, EAT increases
  by only 47.
• (B) US firm borrows only in EUR EUR 5M
• EAT (St1 USD/EUR) USD 4.7M
• EAT (St1.1 USD/EUR) USD 7.15M
• gt a 10 depreciation of the USD, EAT increases
  by 52.

76

• Example (continuation)
• (C) US firm increases EU purchases by 30
  (decreasing US purchases by 30)
• EAT (St1 USD/EUR) USD 3.91M
• EAT (St1.1 USD/EUR) USD 6.165M
• gt a 10 depreciation of the USD, EAT increases
  by 58.
• (D) US firm does (A), (B) and (C) together
• EAT (St1 USD/EUR) USD 6.06M
• EAT (St1.1 USD/EUR) USD 8.25M
• gt a 10 depreciation of the USD, EAT increases
  by 36.
• Note Some firms will always be exposed!

77

• International Diversification
• For the firms that cannot do matching. They still
  have a very good FX risk management tool
  Diversifying internationally the firm. (Portfolio
  approach.)
• True international diversification means to
  diversify
• location of production, sales, input sources,
  borrowing of funds, etc.
• In general, the variability of CF is reduced by
  diversification
• ?St is likely to increase the firm's
  competitiveness in some markets while reducing it
  in others.
• ? EE should be low.
• Not surprisingly big MNF do not have EE.

78

• Observation taken from Bloomberg.com (November
  20, 2007)
• (Dollar Will Weather the Whines, Jeers and Jokes
  John M. Berry)
• ... As for jokes, one attempt really wasn't
  very funny. A cartoon by Mike Luckovich of the
  Atlanta Journal-Constitution reprinted in the
  Nov. 18 New York Times showed Treasury Secretary
  Henry Paulson, in the Oval Office with President
  George W. Bush, asking, Can I get paid in
  euros?'
• Paying in Euros
• Actually, Zodiac SA, Europe's biggest maker of
  airplane seats, would like to get paid in euros.
• Zodiac sells both to Boeing Co. and its European
  competitor Airbus SAS, the world's two largest
  manufacturers of commercial aircraft. It's hardly
  surprising that Boeing insists on paying its
  suppliers in dollars. However, so does Airbus
  because so many of its own sales are priced in
  dollars.

79
Should a Firm Hedge?

• Fundamental question Does hedging add value to
  a firm?
• There are two views
• (1) Modigliani-Miller Theorem (MMT) ? hedging
  adds no value.
• (2) MMT assumptions are violated ? hedging adds
  value.
• The MMT depends on a set of assumptions
• MM requires that a firm operates in perfect
  markets.

80

• Hedging is Irrelevant The MMT
• Intuition What is the value of your car?
• Example You bought a last year car using a bank
  loan.
• Q Is the value of your car affected by the loan
  you took to pay for it?
• MMT provides a similar story to value a firm.
• - Firms make money if they make good
  investments.
• - The financing source of those good investments
  is irrelevant.
• - Different mechanisms of financing will
  determine how the cash flows are divided among
  shareholders or bondholders.
• MMT's hedging implications.
• If the methods of financing and the character of
  financial risks do not matter, managing them is
  not important
• ? hedging should not add any value to a firm.

81

• On the contrary, since hedging is not free,
  hedging might reduce the value of a firm.
• MM also say that investors can diversify their
  portfolio of holding.
• Example Ms. Sternin holds shares of a U.S.
  exporting firm and shares of a U.S. importing
  firm. Ms. Sternin's portfolio is hedged.
• A USD depreciation will negatively affect the
  importing firm and will positively affect the
  exporting firm.
• Hedging at the firm level -since it is expensive-
  will negatively affect the value of Ms. Sternin
  portfolio.

82

• Hedging Adds Value
• Key MMT assumptions are violated in the
  "real-world.
• (1) Investors might not be able to replicate an
  optimal hedge
• Sometimes firms can do a better job at hedging
  than individuals.
• Example Investors might not be big enough
• have enough information
• (2) Hedging as a tool to reduce the risk of
  bankruptcy
• If cash flows are very volatile, a firm might be
  faced with the problem of needing cash to meet
  its debt obligations.
• Conclusion Firms with little debt or with good
  access to credit have no need to hedge.
• Note Under this view, large corporations may be
  wasting their capital.

83

• (3) Hedging as a tool to reduce investment
  uncertainty
• Firms should hedge to ensure they always have
  sufficient cash flow to fund their planned
  investment plan.
• For example, an exporting firm might have cash
  flows problems in periods when the USD
  appreciates.
• Example Merk, a U.S. pharmaceutical firm, has
  used derivatives to ensure that investment (RD)
  plans can always be financed.
• (4) Stable CFs to get bank financing.
• (5) Herding Everybody else is hedging. I should
  hedge too otherwise, I may not look good.

84

• Do U.S. Firms Hedge?
• From a survey of the largest 250 U.S. MNCs, taken
  in (2001)
• (1) Most of the MNCs in the survey understood
• translation, transactions, and economic exposure
• completely or substantially.
• (2) A large percentage (32 - 44) hedged
• themselves substantially or partially. However, a
• larger percentage did not cover themselves at all
  
• against transactions and economic exposure.
• (3) A significant percentage of the firms'
  hedging decisions depended on future FX
  fluctuations.
• (4) Over 25 of firms indicated that they used
  the forward hedge.
• (5) The majority of the firms surveyed have a
  better understanding of transactions and
  translation exposure than of economic exposure.

85

• Canadian Evidence
• The Bank of Canada conducts an annual survey
• of FX hedging. The main findings from the 2011
• survey are
• Companies hedge approximately 50 of their FX
  risk.
• Usually, hedging is for maturities of six
  months or less.
• Use of FX options is relatively low, mainly
  because of accounting rules and restrictions
  imposed by treasury mandate, rules or policies.
• Growing tendency for banks to pass down the
  cost of credit (credit valuation adjustment) to
  their clients.
• Exporters were reluctant to hedge because they
  were anticipating that the CAD would depreciate.
  On the other hand, importers increased both
  their hedging ratio and duration. 

86

• Joke Talking About Accounting
• Never trust your Accountant or Stockbroker - The
  Franciscan
• The Godfather, accompanied by his stockbroker,
  walks into a room to meet with his accountant.
  The Godfather asks the accountant, Wheres the
  three million bucks you embezzled from me? The
  accountant doesnt answer. The Godfather asks
  again, Wheres the three million bucks you
  embezzled from me?
• The stockbroker interrupts, Sir, the man is a
  deaf-mute and cannot understand you, but I can
  interpret for you. The Godfather says, Well,
  ask him where the _at_! money is.
• The stockbroker, using sign language, asks the
  accountant where the three million dollars is.
  The accountant signs back, I dont know what
  youre talking about. The stockbroker interprets
  to the Godfather, He doesnt know what youre
  talking about.
• The Godfather pulls out a pistol, puts it to the
  temple of the accountant, cocks the trigger and
  says, Ask him again where the _at_! money is!
• The stockbroker signs to the accountant, He
  wants to know where it is! The accountant signs
  back, Okay! Okay! The moneys hidden in a
  suitcase behind the shed in my backyard!
• The Godfather says, Well, what did he say? The
  stockbroker interprets to the Godfather, He says
  that you dont have the guts to pull the trigger.