International Financial Management - Exchange Rate Risk Management

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Exchange Rate Risk Management: Transaction Exposure © Tzvetomir Tzanov, Ph.D., © T.Tzanov, Ph.D, UNWE ...

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Exchange Rate Risk Management: Transaction Exposure © Tzvetomir Tzanov, Ph.D., © T.Tzanov, Ph.D, UNWE  International Financial Management Exchange rate risk management Exchange rate (ER) risk occurs because of ER fluctuations in the currencies’ value. This affects companies’ performance (financial result, value of assets). ER risk management – what we can do to reduce the impact of that risk. Thus, managing exposures to ER risk. Companies are closely monitoring their operations in order to determine their exposure to ER fluctuations. The concept of ER exposure refers to the degree to which a company is affected by ER changes (Shapiro). Identification and measurement of exposures. Decisions on how to reduce potential negative impacts. References: Madura, J., International Financial Management, 12e © Shapiro, A.C., Multinational Financial Management, 9e © © T.Tzanov, Ph.D, UNWE  International Financial Management Managing exposures Three types of exposure: Transaction Operating Accounting Transaction exposure – the sensitivity of the firm to contractually binding future foreign-currency denominated cash inflows or outflows Operating exposure – measures the extent to which ER fluctuations can alter future operating cash flows Translation – arises from the need, for purposes of reporting and consolidation of converting fin. statements of foreign operations from local to home currency © T.Tzanov, Ph.D, UNWE  International Financial Management Outline: Transaction exposure Managing transaction exposure: Identifying transaction exposure Explaining commonly used techniques for hedging transaction exposure Advantages and disadvantages of the identified hedging techniques Other methods of reducing ER risk when hedging techniques are not available © T.Tzanov, Ph.D, UNWE  International Financial Management Transaction exposure Transaction exposure exists when the upcoming cash transactions (receivables & payables already in the pipeline!) are affected by exchange rate fluctuations. When transaction exposure exists, the firm faces three major tasks:  Identify its degree of transaction exposure  Decide whether to hedge its exposure, and  Choose among the available hedging techniques if it decides on hedging © T.Tzanov, Ph.D, UNWE  International Financial Management Identifying net Transaction exposure Centralized vs. Decentralized Approach Centralized - a centralized group consolidates subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency for the upcoming period(s). Fiat – applied centralized system for over 420 subsidiaries in 55 countries, reporting system - track of cash flows in each currency, and HQ does any necessary hedging. Note: A firm may be able to reduce its transaction exposure by pricing some of its exports in the same currency as that needed to pay for its imports. Eliminating TE on subsidiary level: Eastman Kodak Co. invoiced in the same currency. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure Hedging – action to mitigate risk through establishing an offsetting currency position, so losses or gains on original currency exposures are offset by gains/losses on the currency hedge. Hedging techniques include: Futures hedge Forward hedge Money market hedge, and Currency option hedge MNCs will normally compare the cash flows that could be expected from each hedging technique before determining which technique to apply. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure A futures hedge involves the use of currency futures. Specific quantities of given currencies, the ER is fixed at the time the contract is entered into, delivery dates set by an exchange (International Monetary Market - CME). To hedge future payables, the firm may purchase a currency futures contract for the currency that it will be needing. To hedge future receivables, the firm may sell a currency futures contract for the currency that it will be receiving. http://www.cmegroup.com/ – financial info, incl. on futures, indexes, etc. © T.Tzanov, Ph.D, UNWE  International Financial Management Futures contracts infrastructure Chicago Mercantile Exchange (CME) – dominant trader and biggest outlet for currency speculators. Contracts patterned after those for grain and other commodity futures contracts. Other important outlets: London Financial Futures Exchange (LIFFE), the New York Mercantile Exchange, the Philadelphia Stock Exchange (PHLX), the Singapore International Monetary Exchange (SIMEX), Deutsche Termin Borse (DTB) in Frankfurt, the Hong Kong Futures Exchange (HKFE), the Marché à Termes des Instruments Financiers (MATIF) in Paris, the Tokyo International Financial Futures Exchange (TIFFE). © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure A forward hedge differs from a futures hedge in that forward contracts are used instead of futures contract to lock in the future exchange rate at which the firm will buy or sell a currency. Recall that forward contracts are common for large transactions, while the standardized futures contracts involve smaller amounts. Ex.: DuPont Co. – often the equivalent of $300 to $500 million in forward contracts at any one time to cover open currency positions. © T.Tzanov, Ph.D, UNWE  International Financial Management Forward hedge example Suppose a company XYZ Inc., whose functional currency is the Euro, is awarded a contract to supply products to ABC Ltd. In 6 months upon delivery XYZ will receive payment of $ 1 million for those products. Hedging the above-mentioned receivables: Selling a $ 1 M forward contract for delivery in 6 months. Assume a current spot price for the EUR of $ 1.15/ €, and a 6-months forward rate of $ 1.10/ €. Then, a forward sale of $ 1 M will yield € 0.909 M in 6 months. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure A money market hedge involves taking one or more money market position to cover a transaction exposure. Often, two positions are required. Payables: Borrow in the home currency, and invest in the foreign currency (ST deposit). Receivables: borrow in the foreign currency, and invest in the home currency. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure Note that taking just one money market position may be sufficient. A firm that has excess cash need not to borrow in the home currency when hedging payables. Similarly, a firm that is in need of cash need not invest in the home currency money market when hedging receivables. The known results of money market hedging can be compared with the known results of forward or futures hedging. In order to determine which type of hedging is preferable. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to Eliminate Transaction Exposure If interest rate parity (IRP) holds, and transaction costs do not exist, a money market hedge will yield the same result as a forward hedge. This is so because the forward premium on a forward rate reflects the interest rate differential between the two currencies. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to Eliminate Transaction Exposure A currency option hedge involves the use of currency call or put options to hedge transaction exposure. First exchange-traded currency options offered in 1983 by the Philadelphia Stock Exchange (PHLX). Since options need not be exercised, firms will be insulated from adverse exchange rate movements, and may still benefit from favorable movements. However, the firm must assess whether the premium paid is worthwhile. Hedging: Receivables with purchasing currency put options. Buying a put – buying the right to sell currency. Payables – purchasing currency call options. © T.Tzanov, Ph.D, UNWE  International Financial Management Currency Option hedge Assume XYZ Inc., whose functional currency is $, has payables of ₤ 100 000, 90 days from now. There is a call option available with an exercise price of $1.40 per ₤. The option premium is $0.04 per unit (thus for all 100 000 units, total premium of $4 000). Scenarios when the payables are due: (1) Spot rate of the pound $1.36. (2) Spot rate of the pound $1.44. (3) Spot rate of the pound $1.48. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure Hedging Payables Hedging Receivables Futures Purchase currency Sell currency hedge futures contract(s). futures contract(s). Forward Negotiate forward Negotiate forward hedge contract to buy contract to sell foreign currency. foreign currency. Money Borrow local Borrow foreign market currency. Convert currency. Convert hedge to and then invest to and then invest in foreign currency. in local currency. Currency Purchase currency Purchase currency option call option(s). put option(s). © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure A comparison of hedging techniques should focus on minimizing payables, or maximizing receivables. In general, hedging policies vary with the MNC management’s degree of risk aversion and exchange rate forecasts. The hedging policy of an MNC may be to hedge most of its exposure, none of its exposure, or to selectively hedge its exposure. © T.Tzanov, Ph.D, UNWE  International Financial Management Techniques to eliminate Transaction exposure Note: An exposure to exchange rate movements need not necessarily be hedged, despite the ease of futures, forwards and options hedging. Note that the cash flows associated with currency option hedging and remaining unhedged cannot be determined with certainty. Based on the firm’s degree of risk aversion, the hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged. Scenarios… © T.Tzanov, Ph.D, UNWE  International Financial Management Real cost of hedging Real cost of hedging payables (RCHp) = + nominal cost of payables with hedging – nominal cost of payables without hedging Real cost of hedging receivables (RCHr) = + nominal home currency revenues received without hedging – nominal home currency revenues received with hedging © T.Tzanov, Ph.D, UNWE  International Financial Management Real cost of hedging If the real cost of hedging is negative, then hedging is more favorable than not hedging. To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate, and then use it to develop a probability distribution for the real cost of hedging. MNC practice – conservative ERR management – often hedging when RCH is positive. © T.Tzanov, Ph.D, UNWE  International Financial Management Limitations of Hedging Some international transactions involve an uncertain amount of foreign currency, such that overhedging may result. One way of avoiding overhedging is to hedge only the minimum known amount in the future transaction(s). In the long run, the continual hedging of repeated transactions may have limited effectiveness. For example, the forward rate often moves in tandem with the spot rate. Thus, an importer who uses one- period forward contracts continually will have to pay increasingly higher prices during a strong-foreign- currency cycle. © T.Tzanov, Ph.D, UNWE  International Financial Management Hedging long-term Transaction exposure Long-term forward contracts, or long forwards, with maturities of ten years or more, can be set up for very creditworthy customers. Currency swaps can take many forms. In one form, two parties, with the aid of brokers, agree to exchange specified amounts of currencies on specified dates in the future. A parallel loan, or back-to-back loan, involves an exchange of currencies between two parties, with a promise to re-exchange the currencies at a specified exchange rate and future date. © T.Tzanov, Ph.D, UNWE  International Financial Management Alternative hedging techniques Sometimes, a perfect hedge is not available (or is too expensive) to eliminate transaction exposure. To reduce exposure under such a condition, the firm can consider: Leading and lagging (internal technique), Cross-hedging, or Currency diversification. © T.Tzanov, Ph.D, UNWE  International Financial Management Alternative hedging techniques The act of leading and lagging refers to an adjustment in the timing of payment request or disbursement to reflect expectations about future currency movements. Expediting a payment is referred to as leading, while deferring a payment is termed lagging. MNC practice – as per contractual obligations and local legislation. Example: GE. © T.Tzanov, Ph.D, UNWE  International Financial Management Alternative hedging techniques When a currency cannot be hedged, a currency that is highly correlated with the currency of concern may be hedged instead. Example: $ and €, instead of $ and BGN The stronger the positive correlation between the two currencies, the more effective this cross- hedging strategy will be. With currency diversification, the firm diversifies its business among numerous countries whose currencies are not highly positively correlated. Examples: Coca-Cola Co., PepsiCo, Altria. © T.Tzanov, Ph.D, UNWE  International Financial Management Nontraditional hedging techniques Currency Straddle – compound option that consists of a long call and a long put with the same strike price and expiration date on the same currency. Strangle – holding a position in both call and put with different strike prices. Bull spread – option strategy, maximum profit attained if the underlying asset rises in price. Bear spread – option strategy seeking maximum profit when the price of the underlying security declines. © T.Tzanov, Ph.D, UNWE  International Financial Management Impact of hedging Transaction exposure on an MNC’s enterprise value Hedging decisions on Transaction exposure  n  n  E (CFj, t ) E (ER j, t )  j =1  Value =    t =1  (1 + k ) t    E (CFj,t ) = expected cash flows in currency j to be received by the parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent © T.Tzanov, Ph.D, UNWE  International Financial Management THANK YOU FOR YOUR ATTENTION! © T.Tzanov, Ph.D, UNWE