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Transaction Exposure

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Title: Transaction Exposure


1
Transaction Exposure (or chapter 8)
2
Agenda
  • Types of forex exposures?
  • Causes of transaction exposure?
  • Pros cons of hedging transaction exposure?
  • How to manage transaction exposure?
  • Forward Market Hedge
  • Money Market Hedge
  • Option Market Hedge
  • Institutional practices of forex risk management.

3
Types of forex exposure
  • Forex exposure
  • potential change in profitability, net cash flow,
    market value due to change in forex rate.
  • Transaction Exposure
  • changes in value of outstanding financial
    obligations incurred prior to change in forex,
    not due to settle until after forex change.
  • Operating (Economic) Exposure
  • change in firm PV resulting from change in
    expected future operating cash flows due to
    unexpected forex change
  • Translation (Accounting) Exposure
  • accounting-derived changes in owner equity due
    to consolidation in single currency.
  • Tax Exposure
  • varies by country, general rule only realized
    foreign losses are deductible for calculating
    income taxes

4
Why Hedge? Pros Cons
  • Improves planning.
  • Reduces likelihood of bankruptcy.
  • Management better knows actual risks.
  • vs.
  • Currency risk management costly, may not increase
    expected cash flows.
  • Shareholders more capable diversifying risk.
  • Investors already factored forex exposure into
    valuation.
  • Conducts hedging to benefit management. ?
  • Managers cannot outguess efficient market .
  • Management criticized for forex losses but not
    for cost in avoiding forex losses.

5
Why Hedge?
  • Reduction of risk?
  • Increase/decrease in expected cash flow?
  • Increase in value?

Net Cash Flow (NCF)
NCF
Expected Cash Flow
6
What causes transaction exposure?
  • Purchasing or selling on credit.
  • Borrowing or lending in foreign currency.
  • Being party to unperformed forward contract.
  • Acquiring assets/ incurring liabilities in
    foreign currency.

7
Open Account Purchasing/ Selling
Anticipa-tion Exposure
8
Borrowing Lending
  • Grupo Embotellador de Mexico (Gemex)
  • Dollar debt mid-December, 1994
  • 264 m ? PS 3.45/ PS 910,800,000.
  • Dollar debt in mid-January, 1995
  • 264 m ? PS 5.50/ PS 1,452,000,000 (59 up!)

9
How to manage transaction exposure?
  • Contractual hedge
  • Operating hedges
  • Risk-sharing agreements.
  • Leads and lags in payment terms.
  • Swaps.
  • Natural hedge
  • Financial hedge
  • offsetting debt obligation.
  • financial derivative such as swap.

10
Hedging Account Receivable
  • Suppose October sale for 1,000,000, A/R January.
  • Spot 1.764/
  • 3m-forward 1.754/ (2.27 discount)
  • Cost of capital 12.0 annual
  • British 3m borrowing rate 10 annual
  • British 3m lending rate 8 annual
  • US 3m borrowing rate is 8 annual
  • US 3m lending rate is 6 annual
  • Jan. put on 1,000,000 w/ strike 1.75/ 1.5
    premium.
  • Forecasts 3m future spot 1.76/.
  • Budget rate (lowest acceptable amount) 1.70/

11
Hedging Account Receivable
  • Unhedged position 1,000,000 x 1.76/ 1.76
    m.
  • Forward hedge
  • Forward contract source of funds to fulfill the
    contract.
  • Forward entered _at_ time A/R created (October).
  • A/R recorded _at_ spot 1.764/, so 1,764,000.
  • Covered (perfect) vs. uncovered (open) forward
    hedge.
  • Money market hedge
  • creates liability offset w/ asset in balance
    sheet hedge.
  • borrow PV of 1,000,000 1,000,000/1.025
    975,610.
  • exchange 975,610 at spot 1.764/ for 1,720,976.

1,720,976 Treasury bill 6 annual or
1.5/qtr 1,746,791
1,720,976 Debt cost 8 annual or
2.0/qtr 1,755,396
1,720,976 Cost of capital 12 annual or
3.0/qtr 1,772,605
12
Option Market Hedge
  • Purchase put option.
  • 3 month put option _at_ ATM strike 1.75/, premium
    1.5
  • Premium as of Jan 26,460 ? 1.03 27,254.
  • Unlimited upside, limited downside.
  • Breakeven price, option hedge
  • Upper bound
  • If pound appreciate above 1.754/ 0.0273/
    1.7813/.
  • Lower bound
  • If pound depreciates below 1.75/ - 0.0273/
    1.722/.

13
A / R Hedges
14
Account Payable Hedge
  • Assume 1,000,000 A/P in 90 days
  • Unhedged position expected pay 1,760,000.
  • Forward market hedge purchase forward _at_
    1.754/, cost locked 1,754,000.
  • Money market hedge
  • Offset obligation by asset w/ matching
    maturity.
  • Exchange US spot invest for 90 days in .
  • Carry the cost forward 90 days

15
Account Payable Hedge
  • Option hedge
  • purchase call option on payable.
  • ATM call option w/ strike 1,75/ would be 1.5
    premium.
  • If spot less 1.75/ option expire 1,000,000
    purchased on spot market.
  • If spot above 1.75/ option exercised exchange
    1,000,000 _at_ 1.75/ less option premium
  • Carried forward 90 days _at_ 12 p.a. premium
    27,254.

Exercise call option (1,000,000 ?
1.75/ 1,750,000 Call premium (carried forward
90 days) 27,254 Total maximum expense of
call option hedge 1,777,254
16
A / P Hedges
Call option 1,777,254
17
Forex Risk Management for Real
  • Goals?
  • cost center vs. profit center.
  • Exposures?
  • backlog exposure?
  • selectively hedge backlog anticipated
    exposures?
  • Contractual Hedges?
  • Amount of risk covered, proportional hedges?
  • Currency options?

18
Things to remember
  • Types of forex exposures
  • Transaction
  • Operating
  • Translation
  • Tax
  • How to hedge A/R A/P transaction exposure?
  • Money market?
  • Forward market?
  • Option market?
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