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Management of Transaction Exposure IoBM 1.pptx

  1. Management of Transaction Exposure Imran Siraj Khan
  2. Three Types of Exposure • Transaction exposure : 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. • Economic exposure : can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. • Translation exposure : refers to 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.
  3. • The 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. Alternative ways of hedging transaction exposure using various financial contracts and operational techniques: Financial Contracts • Forward market hedge • Money market hedge • Option market hedge • Swap market hedge Operational Techniques • Choice of the invoice currency • Lead/lag Strategy : "Leads and lags" is a strategy for ducking that problem. If you believe the euro is going up in value, pay your bills before it happens. Lagging takes the opposite approach: when you expect a currency to drop in value, delay the transfer so you're paying fewer dollars. • Exposure Netting
  4. Techniques to Eliminate Transaction Exposure Hedging techniques include: • Futures hedge, • Forward hedge, • Money market hedge • Currency option hedge MNCs will normally compare the cash flows that would be expected from each hedging technique before determining which technique to apply
  5. Futures and Forward Hedges • A futures hedge uses currency futures, while a forward hedge uses forward contracts, to lock in the future exchange rate • Recall that forward contracts are commonly negotiated for large transactions, while the standardized futures contracts tend to be used for smaller amounts. • To hedge future payables (receivables), a firm may purchase (sell) currency futures, or negotiate a forward contract to purchase (sell) the currency forward. • The hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged, and taking into consideration the firm’s degree of risk aversion. • The real cost of hedging measures the additional expenses beyond those incurred without hedging. • Real cost of hedging payables (RCH p) = nominal cost of payables with hedging – nominal cost of payables without hedging • Real cost of hedging receivables (RCH r) = nominal revenues received without hedging – nominal revenues received with 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. Then use it to develop a probability distribution for the real cost of hedging.
  6. Exposures ; defined • Exposure ------------------- Exposed to Risk Transactional Risk Economic Risk Translation Risk Difference in Payments due Exchange rate fluctuation Profit Loss Same
  7. Reducing Risk – Hedging • Hedging Exposure --------- Reducing risk Techniques of Hedging Exposure 1. Forward / Future Hedge 2. Money Market Hedge 3. Currency Option Hedge Hedging is discussed in following transaction 1. Payables (Importers) 2. Receivables (Exporters)
  8. Forward / Future Market hedge • Forward / Future Contracts allow the company to lock specific exchange rate for a currency. • The forward contract would be entered in with most probably with a bank and would include: • Currency the company will pay • Currency the company will get • Maturity or future date • Rate • Amount and volume
  9. Example of a forward market hedge • ABC Company a US based MNC will need 100,000/- euro in one year time. It obtains a forward contract to purchase to purchase euros one year from now . The rate is 1.2 . The future contracts also has the same rate on euros . • Solution : • Cost in USD= Payable X Forward Rate = 100,000 X 1.2 = 120,000
  10. Money Market Hedge Goods imported for 100,000 (Borrow in Europe and invests in USA) 2020 XYZ in ABC in USA Europe Good Exported 2019 XYZ Deposits or invests in US To be returned in 2020 as $100,000 Factors in decision making • Borrowing rate Europe • Deposit rate in USA • Spot rate
  11. • Step 1 • Deposit in US @ 5% to achieve 100,000 at the payment time • Deposit amount $ = 100,000/(1+.05) = 92,238 • Step 2 • Convert amount in Euro @ spot rate 1.18 • Deposit amount in Euro = 95,238 X 1.18 = 112,381 • Step 3 • Borrow at home country @ 8% • =112381 X (1+.08) = 121,371
  12. Call Option Hedge • A call option is a contract between 2 parties to exchange a stock at a strike price by a predetermined date. The buyer of the call has the right but no obligation to buy the commodity at the strike price by the future date while the seller of the call at the strike price but an option. The seller of the call has the obligation to sell to the buyer of the commodity at the strike price if the buyer exercises the option. The buyer gets this option by paying a premium / margin to seal the deal. • Currency call option ---- Right of buy Fcy if the contract is (Buy Option) ------ denominated in FCY (importers perspective ) • Difference between call option and Forward / Future • Right + no obligation Right + obligation • Advantage • Keeping the best of both world open Advantage • Disadvantage: • Cost of Premium / Margin as a cost of Hedging : 1.2 (Spot) + .05 (Premium / Margin) = 1.25
  13. Scenarios Scenario Spot rate at payment time Premium paid for call option Per unit amount Total amount paid including premium Amount paid without option Real Cost of Hedging (payable) = Cost of Hedging (payable) – Cost of payable if not hedged RCHp = CHp – Cp
  14. Other Strategies- 1 • Lead/lag Strategy : "Leads and lags" is a strategy for ducking that problem. If you believe the euro is going up in value, pay your bills before it happens. Lagging takes the opposite approach: when you expect a currency to drop in value, delay the transfer so you're paying fewer dollars. • If your business has substantial investments overseas, a change in currency rates can cost you. Suppose you're about to pay a bill to a French supplier. If the value of the euro compared to the dollar goes up right before you settle a debt to a French company, you're going to have to pay more dollars.
  15. Technique Payable Recivables Future Hedge Purchase of currency future contract representing the amount related to payable Sell a currency future contracts representing the amount related to recievables
  16. Other Strategies – 2 • Exposure Netting : Exposure Netting has the objective of reducing a company’s exposure to exchange rate (currency) risk. It is especially applicable in the case of a large multinational company, whose various currency exposures can be managed as a single portfolio; it is often challenging and costly to hedge each and every currency risk of a client individually when dealing with many international clients. • Exposure Netting Example Assume Widget Co., located in Canada, has imported machinery from the United States and regularly exports to Europe. The company must pay $10 million to its U.S. machinery supplier in three months, at which time it is also expecting a receipt of EUR 5 million and CHF 1 million for its exports. The spot rate is EUR 1 = USD 1.35, and CHF 1 = USD 1.10. How can Widget Co. use exposure netting to hedge itself? The company’s net currency exposure is USD $2.15 million (i.e., USD $10 million - [(5 x 1.35) + (1 x 1.10)]). If Widget Co. is confident that the Canadian dollar will appreciate over the next three months, it would do nothing, since a stronger Canadian dollar would result in U.S. dollars becoming cheaper in three months. On the other hand, if the company is concerned the Canadian dollar may depreciate against the U.S. dollar, it may elect to lock in its exchange rate in three months through a forward contract or a currency option. Exposure netting is thus a more efficient way of managing currency exposure by viewing it as a portfolio, rather than hedging each currency exposure separately. •