International Financial Management (Chapter 8) PDF

PART THREE Page 231 Copyright © 2023. McGraw-Hill US Higher Ed I...

PART THREE Page 231 Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  OUTLINE 8 Management of Transaction Exposure 9 Management of Economic Exposure 10 Management of Translation Exposure Foreign Exchange Exposure and Management Page 232 PART THREE is composed of three chapters covering the topics of transaction, economic, and translation exposure management, respectively. CHAPTER 8 covers the management of transaction exposure that arises from contractual obligations denominated in a foreign currency. Several methods for hedging this exposure are compared and contrasted. The chapter also includes a discussion of why a MNC should hedge, a debatable subject in the minds of both academics and practitioners. CHAPTER 9 covers economic exposure, that is, the extent to which the value of the firm will be affected by unexpected changes in exchange rates. The chapter provides a way to measure economic exposure, discusses its determinants, and presents methods for managing and hedging economic exposure. CHAPTER 10 covers translation exposure or, as it is sometimes called, accounting exposure. Translation exposure refers to the effect that changes in exchange rates will have on the consolidated financial reports of a MNC. The chapter discusses, compares, and contrasts the various methods for translating financial statements denominated in foreign currencies, and includes a discussion of managing translation exposure using funds adjustment and the pros and cons of using balance sheet and derivatives hedges. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  CHAPTER 8 Management of Transaction Exposure Page 233 Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  CHAPTER OUTLINE Three Types of Exposure Should the Firm Hedge? Hedging Foreign Currency Receivables Forward Market Hedge Money Market Hedge Options Market Hedge Comparison of Hedging Strategies Hedging Foreign Currency Payables Forward Market Hedge Money Market Hedge Options Market Hedge Comparison of Hedging Strategies Cross-Hedging Minor Currency Exposure Hedging Contingent Exposure Hedging Recurrent Exposure with Swap Contracts Hedging through Invoice Currency Hedging via Lead and Lag Exposure Netting What Risk Management Products Do Firms Use? Summary Key Words Questions Problems Internet Exercises Mini Case: Airbus’ Dollar Exposure Case: Richard May’s Options References & Suggested Readings Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. AS THE NATURE of business becomes international, many firms are exposed to the risk of fluctuating exchange rates. Changes in exchange rates may affect the settlement of contracts, cash flows, and the firm valuation. It is thus important for financial managers to know the firm’s foreign currency exposure (i.e., what is at risk) and properly manage the exposure. By doing so, managers can stabilize the firm’s cash flows and enhance the firm’s value. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Three Types of Exposure Before we get into the important issue of how to manage transaction exposure, let us briefly discuss different types of exposure. It is conventional to classify foreign currency exposures into three types: Transaction exposure Economic exposure Translation exposure Transaction exposure, a subject to be discussed in this chapter, can be defined as the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Hence, it is about how the amount of money the firm owes in foreign currency or expects to receive in foreign currency in the future changes due to exchange rate movements. This is a significant risk that MNCs, especially exporters and importers, face. Since settlements of these contractual cash flows affect the firm’s domestic currency cash flows, transaction exposure is sometimes regarded as a short-term economic exposure. Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly. Economic exposure, a subject to be discussed in Chapter 9, can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been already discounted and reflected in the firm’s value. As we will discuss later, changes in exchange rates can have a profound effect on the firm’s competitive position in the world market and thus on its cash flows and market value. On the other hand, translation exposure, which will be discussed in Chapter 10, refers to Page 234 the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries’ financial statements from local currencies to the home currency. Consider a U.S. multinational firm that has subsidiaries in the United Kingdom and Japan. Each subsidiary will produce financial statements in local currency. To consolidate financial statements worldwide, the firm must translate the subsidiaries’ financial statements in local currencies into the U.S. dollar, the home currency. As we will see later, translation involves many controversial issues. Resultant translation gains and losses represent the accounting system’s attempt to measure economic exposure ex post. It does not provide a good measure of ex ante economic exposure. In the remainder of this chapter, we will focus on how to manage transaction Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. exposure. As discussed before, the firm is subject to transaction exposure when it faces contractual cash flows that are fixed in foreign currencies. Suppose that a U.S. firm sold its product to a German client on three-month credit terms and invoiced €1 million. When the U.S. firm receives €1 million in three months, it will have to convert (unless it hedges) the euros into dollars at the spot exchange rate prevailing on the maturity date, which cannot be known in advance. As a result, the dollar receipt from this foreign sale becomes uncertain; should the euro appreciate (depreciate) against the dollar, the dollar receipt will be higher (lower). This situation implies that if the firm does nothing about the exposure, it is effectively speculating on the future course of the exchange rate. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  For another example of transaction exposure, consider a Japanese firm entering into a loan contract with a Swiss bank that calls for the payment of SF100 million for principal and interest in one year. To the extent that the yen/Swiss franc exchange rate is uncertain, the Japanese firm does not know how much yen it will take to buy SF100 million spot in one year’s time. If the yen appreciates (depreciates) against the Swiss franc, a smaller (larger) yen amount will be needed to pay off the SF-denominated loan. These examples suggest that whenever a firm has foreign-currency-denominated receivables or payables, it is subject to transaction exposure, and their settlements are likely to affect the firm’s cash flow position. Furthermore, in view of the fact that firms are now more frequently entering into commercial and financial contracts denominated in foreign currencies, judicious management of transaction exposure has become an important function of international financial management. Unlike economic exposure, transaction exposure is well defined: The magnitude of transaction exposure is the same as the amount of foreign currency that is receivable or payable. This chapter will thus focus on alternative ways of hedging transaction exposure using various financial contracts and operational techniques: Financial contracts Forward contracts Money market instruments Options contracts Swap contracts Operational techniques Choice of the invoice currency Lead/lag strategy Exposure netting Before we discuss how a firm can hedge exchange exposure using these contracts and techniques, let us first discuss whether the firm should try to hedge to begin with. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Should the Firm Hedge? There hardly exists a consensus on whether the firm should hedge. Some would argue that Page 235 exchange exposure management at the corporate level is redundant when stockholders can manage the exposure themselves. Others would argue that what matters in the firm valuation is only systematic risk; corporate risk management may only reduce the total risk. These arguments suggest that corporate exposure management would not necessarily add to the value of the firm. www.sec.gov/info/edgar.shtml Company files with SEC show how companies deal with exchange risk exposure. While the above arguments against corporate risk management may be valid in a “perfect” capital market, one can make a case for it based on various market imperfections: 1. Information asymmetry: Management knows about the firm’s exposure position much better than stockholders. Thus, the management of the firm, not its stockholders, should manage exchange exposure. 2. Differential transaction costs: The firm is in a position to acquire low-cost hedges; transaction costs for individual stockholders can be substantial. Also, the firm has hedging tools like the reinvoice center that are not available to stockholders. 3. Default costs: If default costs are significant, corporate hedging would be justifiable because it will reduce the probability of default. Perception of a reduced default risk, in turn, can lead to a better credit rating and lower financing costs. 4. Progressive corporate taxes: Under progressive corporate tax rates, stable before-tax earnings lead to lower corporate taxes than volatile earnings with the same average value. This happens because under progressive tax rates, the firm pays more taxes in high-earning periods than it saves in low- earning periods. The last point merits elaboration. Suppose the country’s corporate income tax system is such that a tax rate of 20 percent applies to the first $10 million of corporate earnings and a 40 percent rate applies to any earnings exceeding $10 million. Firms thus face a simple progressive tax structure. Now consider an exporting firm that expects to earn $15 million if the dollar depreciates, but only $5 million if the dollar appreciates. Let’s assume that the dollar may appreciate or depreciate with equal Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. chances. In this case, the firm’s expected tax will be $2.5 million: Expected tax = 1/2[(.20)($, 5,000,000)] + 1/2[(.20)($, 10,000,000) + (.40)($, 5,000,000)] = $2,500,000 Now consider another firm, B, that is identical to firm A in every respect except that, unlike firm A, firm B aggressively and successfully hedges its risk exposure and, as a result, it can expect to realize certain earnings of $10,000,000, the same as firm A’s expected earnings. Firm B, however, expects to pay only $2 million for taxes. Obviously, hedging results in a $500,000 tax saving. Exhibit 8.1 illustrates this situation. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  EXHIBIT 8.1 Tax Savings from Hedging Exchange Risk Exposure While not every firm is hedging exchange exposure, many firms are engaged in hedging activities, suggesting that corporate risk management is relevant to maximizing the firm’s value. To the extent that for various reasons, stockholders themselves cannot properly manage exchange risk, the firm’s managers can do it for them, contributing to the firm’s value. Some corporate hedging activities, however, might be motivated by managerial objectives; managers may want to stabilize cash flows so that the risk to their human capital can be reduced. A study by Allayannis and Weston (2001) provides direct evidence on the important issue of Page 236 whether hedging actually adds to the value of the firm. Specifically, they examine whether Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. firms with currency exposure that use foreign currency derivative contracts, such as currency forward and options, increase their valuation. The authors find that U.S. firms that face currency risk and use currency derivatives for hedging have, on average, about 5 percent higher value than firms that do not use currency derivatives. For firms that have no direct foreign involvement but may be exposed to exchange rate movements via export/import competition, they find a small hedging valuation premium. In addition, they find that firms that stop hedging experience a decrease in firm valuation compared with those firms that continue to hedge. Mackay and Moeller (2007) show that hedging in general can add value equivalent to 2–3 percent of firm value if revenues are concave in product prices or if costs are convex in factor prices. Their study thus clearly suggests that corporate hedging contributes to firm value. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Hedging Foreign Currency Receivables When we discuss how to manage transaction exposure, it is useful to introduce a particular business situation that gives rise to exposure. Suppose that Boeing Corporation exported a landing gear of a Boeing 737 aircraft to British Airways and billed £10 million payable in one year. The money market interest rates and foreign exchange rates are given as follows: The U.S. interest rate: 6.10% per annum The U.K. interest rate: 9.00% per annum The spot exchange rate: $1.50/£ The forward exchange rate: $1.46/£ (1-year maturity) When Boeing receives £10 million in one year, it will convert the pounds into dollars at the spot exchange rate prevailing at the time. Since the future spot rate is unknown today, the dollar proceeds from this foreign sale is uncertain unless Boeing hedges. Let us now look at the various techniques for managing this transaction exposure. Forward Market Hedge Perhaps the most direct and popular way of hedging transaction exposure is by currency Page 237 forward contracts. Generally speaking, the firm may sell (buy) its foreign currency receivables (payables) forward to eliminate its exchange risk exposure. In the earlier example, in order to hedge foreign exchange exposure, Boeing may simply sell forward its pounds receivable, £10 million for delivery in one year, in exchange for a given amount of U.S. dollars. On the maturity date of the contract, Boeing will have to deliver £10 million to the bank, which is the counterparty of the contract, and, in return, take delivery of $14.6 million ($1.46/£×£10 million), regardless of the spot exchange rate that may prevail on the maturity date. Boeing will, of course, use the £10 million that it is going to receive from British Airways to fulfill the forward contract. Since Boeing’s pound receivable is exactly offset by the pound payable (created by the forward contract), the company’s net pound exposure becomes zero. Since Boeing is assured of receiving a given dollar amount, $14.6 million, from the counterparty of the forward contract, the dollar proceeds from this British sale will not be affected at all by future changes Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. in the exchange rate. This point is illustrated in Exhibit 8.2. Once Boeing enters into the forward contract, exchange rate uncertainty becomes irrelevant for Boeing. Exhibit 8.2 also illustrates how the dollar proceeds from the British sale will be affected by the future spot exchange rate when exchange exposure is not hedged. The exhibit shows that the dollar proceeds under the forward hedge will be higher than those under the unhedged position if the future spot exchange rate turns out to be less than the forward rate, that is, F = $1.46/£, and the opposite will hold if the future spot rate becomes higher than the forward rate. In the latter case, Boeing forgoes an opportunity to benefit from a strong pound. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  EXHIBIT 8.2 Dollar Proceeds from the British Sale: Forward Hedge versus Unhedged Position Suppose that on the maturity date of the forward contract, the spot rate turns out to be $1.40/£, which is less than the forward rate, $1.40/£, In this case, Boeing would have received $14.0 million, rather than $14.6 million, had it not entered into the forward contract. Thus, one can say that Boeing gained $0.6 million from forward hedging. Needless to say, Boeing will not always gain in this manner. If the spot rate is, say, $1.50/£ on the maturity date, then Boeing could have received $15.0 million by remaining unhedged. Thus, one can say ex post that forward hedging cost Boeing $0.40 million. The gains and losses from forward hedging can be illustrated as in Exhibits 8.3 and 8.4. The Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. gain/loss is computed as follows: Gain = (F − S T ) × £10 million (8.1) EXHIBIT 8.3 Gains/Losses from Forward Hedge Spot Exchange Rate on the Maturity Date (S T ) Receipts from the British Sale Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Spot Exchange Rate on the Maturity Date (S T ) Unhedged Receipts Position from the Forward British Sale Hedge Gains/Losses from Hedgeb Unhedged Position Forward Hedge Gains/Losses from Hedgeb $1.30 $13,000,000 $14,600,000 $1,600,000 $1.40 $14,000,000 $14,600,000 $600,000 $1.46a $14,600,000 $14,600,000 0 $1.50 $15,000,000 $14,600,000 −$400,000 $1.60 $16,000,000 $14,600,000 −$1,400,000 aThe forward exchange rate (F) is $1.46/£ in this example. bThe gains/losses are computed as the proceeds under the forward hedge minus the proceeds from the unhedged position at the various spot exchange rates on the maturity date. EXHIBIT 8.4 Illustration of Gains and Losses from Forward Hedging Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Obviously, the gain will be positive as long as the forward exchange rate (F) is greater than the spot rate on the maturity date (S ), that is, F > S , and the gain will be negative (i.e., a loss will result) if T T the opposite holds. As Exhibit 8.4 shows, the firm theoretically can gain as much as $14.6 million when the pound becomes worthless, which, of course, is unlikely, whereas there is no limit to possible losses. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  It is important, however, to note that the above analysis is ex post in nature, and that no one Page 238 can know for sure what the future spot rate will be beforehand. The firm must decide whether to hedge or not ex ante. To help the firm decide, it is useful to consider the following three alternative scenarios: 1. S T ≈ F 2. S T < F 3. S T > F where S denotes the firm’s expected spot exchange rate for the maturity date. T Under the first scenario, where the firm’s expected future spot exchange rate, S , is about the same as T the forward rate, F, the “expected” gains or losses are approximately zero. But forward hedging eliminates exchange exposure. In other words, the firm can eliminate foreign exchange exposure without sacrificing any expected dollar proceeds from the foreign sale. Under this scenario the firm would be inclined to hedge as long as it is averse to risk. Note that this scenario becomes valid when the forward exchange rate is an unbiased predictor of the future spot rate.1 Under the second scenario, where the firm’s expected future spot exchange rate is less than Page 239 the forward rate, the firm expects a positive gain from forward hedging. Since the firm expects to increase the dollar proceeds while eliminating exchange exposure, it would be even more inclined to hedge under this scenario than under the first scenario. The second scenario, however, implies that the firm’s management dissents from the market’s consensus forecast of the future spot exchange rate as reflected in the forward rate. Under the third scenario, on the other hand, where the firm’s expected future spot exchange rate is more than the forward rate, the firm can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds from the foreign sale. Thus, the firm would be less inclined to hedge under this scenario, other things being equal. Despite lower expected dollar proceeds, however, the firm may still end up hedging. Whether the firm actually hedges or not depends on the degree of risk aversion; the more risk averse the firm is, the more likely it is to hedge. From the perspective of a hedging firm, the reduction in the expected dollar proceeds can be viewed implicitly as an “insurance premium” paid for avoiding the hazard of exchange risk. To summarize, in this example, the dollar proceeds from the British sale becomes guaranteed $14,600,000 for Boeing regardless of exchange rate movements when forward hedge is used. There is no upfront cost. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. The firm can use a currency futures contract, rather than a forward contract, to hedge. However, a futures contract is not as suitable as a forward contract for hedging purposes for two reasons. First, unlike forward contracts that are tailor-made to the firm’s specific needs, futures contracts are standardized instruments in terms of contract size, delivery date, and so forth. In most cases, therefore, the firm can only hedge approximately. Second, due to the marking-to-market property, there are interim cash flows prior to the maturity date of the futures contract that may have to be invested at uncertain interest rates. As a result, exact hedging again would be difficult. Money Market Hedge Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money markets. Generally speaking, the firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency. Again using the same example presented above, Boeing can eliminate the exchange exposure arising from the British sale by first borrowing in pounds, then converting the loan proceeds into dollars, which then can be invested at the dollar interest rate. On the maturity date of the loan, Boeing is going to use the pound receivable to pay off the pound loan. If Boeing borrows a particular pound amount so that the maturity value of this loan becomes exactly equal to the pound receivable from the British sale, Boeing’s net pound exposure is reduced to zero, and Boeing will receive the future maturity value of the dollar investment. The first important step in money market hedging is to determine the amount of pounds to borrow. Since the maturity value of borrowing should be the same as the pound receivable, the amount to borrow can be computed as the discounted present value of the pound receivable, that is, £10 million/(1.09) = £9,174,312. When Boeing borrows £9,174,312, it then has to repay £10 million in one year, which is equivalent to its pound receivable. The step-by-step procedure of money market hedging can be illustrated as follows: Step 1: Borrow £9,174,312. Step 2: Convert £9,174,312 into $13,761,468 at the current spot exchange rate of $1.50/£. Step 3: Invest $13,761,468 in the United States. Step 4: After one year, collect £10 million from British Airways and use it to repay the pound loan. Step 5: Receive the maturity value of the dollar investment, that is, $14,600,918 = ($, 13,761,468)(1.061) which is the guaranteed dollar proceeds from the British sale. Exhibit 8.5 provides a cash flow analysis of money market hedging. The table shows that Page 240 the net cash flow is zero at the present time, implying that, apart from possible transaction costs, the money market hedge is fully self-financing. The table also clearly shows how the £10 million receivable is exactly offset by the £10 million payable (created by borrowing), leaving a net cash flow of $14,600,918 on the maturity date. EXHIBIT 8.5 Cash Flow Analysis of a Money Market Hedge Transaction Current Cash Flow Cash Flow at Maturity 1. Borrow pounds £9,174,312 −£10,000,000 Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. 2. Buy dollar spot with pounds $13,761,468 −£9,174,312 3. Invest in the United States −$13,761,468 $14,600,918 Collect pound receivable £10,000,000 4. Net cash f low 0 $14,600,918 The maturity value of the dollar investment from the money market hedge turns out to be nearly identical to the dollar proceeds from forward hedging. This result is no coincidence. Rather, this is due to the fact that the interest rate parity (IRP) condition is approximately holding in our example. If the IRP is not holding, the dollar proceeds from money market hedging will not be the same as those from Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  forward hedging. As a result, one hedging method will dominate another. In a competitive and efficient world financial market, however, any deviations from IRP are not likely to persist. Options Market Hedge One possible shortcoming of both forward and money market hedges is that these methods completely eliminate exchange risk exposure. Consequently, the firm has to forgo the opportunity to benefit from favorable exchange rate changes. To elaborate on this point, let us assume that the spot exchange rate turns out to be $1.60 per pound on the maturity date of the forward contract. In this instance, forward hedging would cost the firm $1.4 million in terms of forgone dollar receipts (see Exhibit 8.3). If Boeing had indeed entered into a forward contract, it would regret its decision to do so. With its pound receivable, Boeing ideally would like to protect itself only if the pound weakens, while retaining the opportunity to benefit if the pound strengthens. Currency options provide such a flexible “optional” hedge against exchange exposure. Generally speaking, the firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables). As discussed in Chapter 7, a currency call option gives the holder the right, but not the obligation, to buy a certain amount of a foreign currency at a specific exchange rate up to or at the maturity date. On the other hand, a currency put option gives the holder the right, but not the obligation, to sell a certain amount of a foreign currency at a specific exchange rate again up to or at the maturity date. Price of call or put options that option buyers have to pay is called premium. To show how the options hedge works, suppose that in the over-the-counter market Boeing purchased a put option on £10 million with an exercise price of $1.46/£ and a one-year expiration. Assume that the option premium (price) was $0.02 per pound. Boeing thus paid $200, 000 (= $0. 02 × 10 million) for the option. This transaction provides Boeing with the right, but not the obligation, to sell up to £10 million for $1.46/£, regardless of the future spot rate. Now assume that the spot exchange rate turns out to be $1.30 on the expiration date. Since Page 241 Boeing has the right to sell each pound for $1.46, it will certainly exercise its put option on the pound and convert £10 million into $14.6 million. The main advantage of options hedging is that the firm can decide whether to exercise the option based on the realized spot exchange rate on the expiration date. Recall that Boeing paid $200,000 upfront for the option. Considering the time value of money, this upfront cost is equivalent to $212, 200 (= $200, 000 × 1. 061) as of the expiration date. This means that under the options hedge, the net dollar proceeds from the British sale become $14,387,800: Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. $14,387,800 = $14,600,000 − $212,200 Since Boeing is going to exercise its put option on the pound whenever the future spot exchange rate falls below the exercise rate of $1.46, it is assured of a “minimum” dollar receipt of $14,387,800 from the British sale. Next, consider an alternative scenario where the pound appreciates against the dollar. Assume that the spot rate turns out to be $1.60 per pound on the expiration date. In this event, Boeing would have no incentive to exercise the option. It will rather let the option expire and convert £10 million into $16 million at the spot rate. Subtracting $212,200 for the option cost, the net dollar proceeds will become Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  $15,787,800 under the option hedge. As suggested by these scenarios, the options hedge allows the firm to limit the downside risk while preserving the upside potential. The firm, however, has to pay for this flexibility in terms of the option premium. There rarely exist free lunches in finance! Note that neither the forward nor the money market hedge involves any upfront cost. Exhibit 8.6 provides the net dollar proceeds from the British sale under options hedging for a range of future spot exchange rates. The same results are illustrated in Exhibit 8.7. As Page 242 Exhibit 8.7 shows, the options hedge sets a “floor” for the dollar proceeds. The future dollar proceeds will be at least $14,387,800 under the option hedge. Boeing thus can be said to have an insurance policy against the exchange risk hazard; the upfront option cost of $200,000 that Boeing incurred can be explicitly regarded as an insurance premium. When a firm has an account payable rather than a receivable, in terms of a foreign currency, the firm can set a “ceiling” for the future dollar cost of buying the foreign currency amount by buying a call option on the foreign currency amount as we will see in the next section. EXHIBIT 8.6 Dollar Proceeds from Options Hedge Future Spot Exchange Rate (S T ) Exercise Decision Gross Dollar Proceeds Option Cost Net Dollar Proceeds $1.30 Exercise $14,600,000 $212,200 $14,387,800 $1.40 Exercise $14,600,000 $212,200 $14,387,800 $1.46 Neutral $14,600,000 $212,200 $14,387,800 $1.50 Not exercise $15,000,000 $212,200 $14,787,800 $1.60 Not exercise $16,000,000 $212,200 $15,787,800 Note: The exercise exchange rate (E) is $1.46 in this example. EXHIBIT 8.7 Dollar Proceeds from the British Sale: Alternative Hedging Strategies Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Comparison of Hedging Strategies The three alternative hedging strategies are summarized in Exhibit 8.8, and Exhibit 8.7 compares the dollar proceeds from these strategies. As indicated in Exhibit 8.7, the money market hedge dominates the forward hedge since the guaranteed dollar proceeds from the British sale with the money market hedge ($14,600,918) exceeds the guaranteed proceeds with the forward hedge ($14,600,000). As an exporter, Boeing would want to maximize dollar proceeds from foreign sales. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. EXHIBIT 8.8 Boeing’s Alternative Hedging Strategies for a Foreign Currency Receivable: A Summary Strategy Transactions Outcomes Forward market hedge 1. Sell £10,000,000 forward for Assured of receiving $14,600,000 in one year; future spot U.S. dollars now. exchange rate becomes irrelevant. 2. In one year, receive £10,000,000 from the British client and deliver it to the counterparty of the forward contract. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Strategy Transactions Outcomes Money market hedge 1. Borrow £9,174,312, buy Assured of receiving $13,761,468 now or $14,600,918 in one $13,761,468 spot, and invest in year; future spot exchange rate becomes irrelevant. the U.S. now. 2. In one year, collect £10,000,000 from the British client and pay off the pound loan using the amount. Options market hedge 1. Buy a put option on Assured of receiving at least $14,387,800 or more if the £10,000,000 for an upfront cost future spot exchange rate exceeds the exercise exchange of $200,000. rate; Boeing controls the downside risk while retaining the upside potential. 2. In one year, decide whether to exercise the option upon observing the prevailing spot exchange rate. When we compare the money market hedge and the options hedge, the options hedge dominates the money market hedge for future spot rates greater than $1.4813/£ because the dollar proceeds from the options hedge will be greater than the dollar proceeds from the money market hedge when the future spot rate is greater than $1.4813/£. On the contrary, the money market hedge will dominate the options hedge for future spot rates lower than $1.4813/£. Boeing will be indifferent between the two hedging methods at the “break-even” spot rate of $1.4813/£ because the dollar proceeds from both hedging methods will be the same. The break-even spot rate, which is useful for choosing a hedging method, can be determined by setting the proceeds from two hedging methods equal to each other. The dollar proceeds from the options hedge when the option gets exercised (with the option premium accounted for) appears on the left side of the equation, and the dollar proceeds from the money market hedge is on the right side of the equation as shown below: $(10,000,000)S T − $212,000 = $14,600,918 ∗ By solving the equation for S , we obtain the break-even spot rate, S = $1.4813. The break-even T T Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. analysis suggests that if the firm’s expected future spot rate is greater (less) than the break-even rate, then the options (money market) hedge may be preferred. If we compare the options hedge and the forward hedge, the options hedge dominates the Page 243 forward hedge for future spot rates greater than $1.48 per pound, whereas the opposite holds for spot rates lower than $1.48 per pound. Boeing will be indifferent between the two hedging methods at the “break-even” spot rate of $1.48 per pound. The break-even spot rate can be determined as follows: $(10,000,000)S T − $212,200 = $14,600,000 Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  ∗ From the equation, we obtain the break-even spot rate, S = $1.48. It suggests that if the firm’s T expected future spot rate is greater (less) than the break-even rate, then the options (forward) hedge may be preferred. Unlike the forward contract, which has only one forward rate for a given maturity, there are multiple exercise exchange rates (prices) for the options contract. In the preceding discussion, we worked with an option with an exercise price of $1.46. Considering that Boeing has a pound receivable, it is tempting to think that it would be a good idea for Boeing to buy a put option with a higher exercise price, thereby increasing the minimum dollar receipt from the British sale. But it becomes immediately clear that the firm has to pay for it in terms of a higher option premium. Again, there is no free lunch. Choice of the exercise price for the options contract ultimately depends on the extent to which the firm is willing to bear exchange risk. For instance, if the firm’s objective is only to avoid very unfavorable exchange rate changes (i.e., a major depreciation of the pound in Boeing’s example), then it should consider buying an out-of-money put option with a low exercise price, saving option costs. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  Hedging Foreign Currency Payables So far, we have discussed how to hedge foreign currency transaction exposure using Boeing’s receivable as an example. In this section, we are going to discuss how to hedge foreign currency “payables.” Suppose Boeing imported a Rolls-Royce jet engine for £5 million payable in one year. The market condition is summarized as follows: The U.S. interest rate: 6.00% per annum The U.K. interest rate: 6.50% per annum The spot exchange rate: $1.80/£ The forward exchange rate: $1.75/£ (1-year maturity) Given exchange rate fluctuations, Boeing is concerned about the future dollar cost of this purchase. Facing an account payable, Boeing will have to try to minimize the dollar cost of paying off the payable. We examine alternative ways of hedging this foreign currency payable using (i) forward contracts, (ii) money market instruments, and (iii) currency options contracts. Forward Market Hedge If Boeing decides to hedge this payable exposure using a forward contract, it only needs to buy £5 million forward in exchange for the following dollar amount: $8,750,000 = (£, 5,000,000)($, 1.75, /, £) On the maturity date of the forward contract, Boeing will receive £5,000,000 from the counterparty of the contract in exchange for $8,750,000. Boeing then can use £5,000,000 to make payment to Rolls- Royce. Since Boeing will have £5,000,000 for sure in exchange for a given dollar amount, that is, $8,750,000, regardless of the spot exchange rate that may prevail in one year, Boeing’s foreign currency payable is fully hedged. As a result, the guaranteed dollar cost of this purchase from Rolls-Royce with forward hedge is $8,750,000. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Money Market Hedge In the case where the firm has an account payable denominated in pounds, the money market Page 244 hedge calls for borrowing in dollars, buying pounds spot, and investing at the pound interest rate. If Boeing first computes the present value of its foreign currency payable, that is, £4,694,836 = £5,000,000/1.065, and immediately invests exactly the same pound amount at the British interest rate of 6.5 percent per annum, it is assured of having £5,000,000 in one year. Boeing then can use the maturity value of this Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  investment to pay off its pound payable. Under this money market hedging, Boeing has to outlay a certain dollar amount today in order to buy spot the pound amount that needs to be invested: $8,450,705 = (£, 4,694,836)($, 1.80, /, £) The future value of this dollar cost of buying the necessary pound amount is computed as follows: $8,957,747 = ($, 8,450,705)(1.06) Hence, the guaranteed dollar cost of the foreign purchase with the money market hedge is $8,957,747, regardless of future spot rate. Options Market Hedge If Boeing decides to use a currency options contract to hedge its pound payable, it needs to buy “call” options on £5,000,000 because Boeing needs to acquire pounds in order to deliver them to Rolls- Royce. Boeing also will have to decide on the exercise or strike price for the call options. We assume that Boeing chooses the exercise price at $1.80/£ with the premium of $0.018 per pound. The total cost of options as of the maturity date (considering the time value of money) then can be computed as follows: $95,400 = ($, 0.018, /, £)(£, 5,000,000)(1.06) If the British pound appreciates against the dollar beyond $1.80/£, the strike price of the options contract, Boeing will choose to exercise its options and purchase £5,000,000 for $9,000,000 = (£, 5,000,000)($, 1.80, /, £). If the spot rate on the maturity date turns out to be below the strike price, on the other hand, Boeing will let the option expire and purchase the pound amount in the spot market. Thus, Boeing will be able to secure £5,000,000 for a maximum of $9,095,400(=, $, 9,000,000, +, $, 95,400), or less. Note that we add the cost of the options to compute the total dollar cost of paying off the foreign currency payable here. In the previous example with the foreign currency receivable, we subtracted the cost of the options to compute the total dollar proceeds from the foreign sale. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Comparison of Hedging Strategies The three alternative hedging strategies for the foreign currency payable are summarized in Exhibit 8.9. Exhibit 8.10 illustrates the dollar costs of securing £5,000,000 under the three alternative hedging approaches for different levels of spot exchange rate on the maturity date. The exhibit shows that the dollar cost of purchasing a jet engine from Rolls-Royce using the money market hedge exceeds the dollar cost of securing £5,000,000 under forward hedging. Since Boeing will have to try to minimize the dollar cost of securing the pound amount, forward hedge would be preferable to money market hedge. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  EXHIBIT 8.9 Boeing’s Alternative Hedging Strategies for a Foreign Currency Payable: A Summary Strategy Transactions Outcomes Forward market hedge 1. Agree today to buy £5,000,000 and Assured of paying $8,750,000 in one year; future spot sell U.S. dollars forward in one year. exchange rate becomes irrelevant. 2. In one year, pay $8,750,000 and receive £5,000,000 from the counterparty of the forward contract and deliver the pounds to Rolls- Royce. Money market hedge 1. Borrow $8,450,705 and use the Assured of paying $8,957,747 in one year; future spot dollars to buy £4,694,836 now. Invest exchange rate becomes irrelevant. the pounds at the British interest rate. 2. In one year, collect £5,000,000 and deliver the pounds to Rolls-Royce. Pay off the dollar loan with $8,957,747. Options market hedge 1. Buy a call option on £5,000,000 for Assured of paying at most $9,095,400 or less if the an upfront cost of $90,000. future spot exchange rate falls below the exercise exchange rate; Boeing controls the downside risk while 2. In one year, decide whether to retaining the upside potential. exercise the option upon observing the prevailing spot exchange rate. EXHIBIT 8.10 Dollar Costs of Securing the Pound Payable: Alternative Hedging Strategies Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/rmit/detail.action?docID=7235286. Created from rmit on 2024-10-07 05:04:01.  It would be useful then to compare the forward hedge and options hedge. As can be seen from