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Transaction Exposure Chapter 11
Transaction Exposure Chapter 11
Types of exposure:
2. Transaction Exposure in FE rate in outstanding contracts (asset or liabilities) giving rise to gains or losses.
Transaction Exposure
Transaction exposure exists when outstanding transactions (liabilities or assets) incurred in foreign currency are not yet settled and are exposed to exchange rate fluctuations. Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely
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.
Suppose Trident Corporation sells merchandise on open account to a European buyer for 1,800,000 payable in 60 days Further assume that the spot rate is $0.9000/ and Trident expects to exchange the euros for 1,800,000 x $0.9000/ = $1,620,000 when payment is received (assuming no expected change in exchange rate) Transaction exposure arises because of the risk that Trident will receive something other than $1,620,000 expected If the euro weakens to $0.8500/, then Trident will receive $1,530,000 If the euro strengthens to $0.9600/, then Trident will receive $1,728,000
t1
Seller quotes a price to buyer
t2
Buyer places order at offered price
t3
Seller ships product and bills buyer
t4
Buyer settles A/R with cash in amount of currency quoted at t1
Quotation Exposure
Work In Progress Exposure Time it takes between order is placed and goods are ready to be shipped
Billing Exposure
Time it takes from the goods are shipped to to get paid in cash after A/R is issued
when funds are loaned or borrowed Example: PepsiCos largest bottler outside the US is located in Mexico, [Grupo Embotellador de Mexico
(Gemex)]
How could the MNC use forward contracts to hedge against its transaction exposure to s?
Should London and Toronto subsidiariessell s forward and Munich subsidiary buy s forward?
OR
2)
What could the MNC do about its transaction exposure to the ? It may decide it has no transaction exposure to the
Should net exposure be viewed from the subsidiary level or be centralized (from the view of the entire MNC)?
But goal of financial decision maker is to maximize the value of the overall MNC, not the value of individual subsidiaries
But local creditors may look unfavorably toward subsidiarys exposure if it doesnt handle its own exposure
And, subsidiarys management may feel more comfortable handling their own exposure so they will not be hurt by adverse movements in exchange rates which make them look bad on their job record
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Real World
In the past Kodak would bill its subsidiaries in $s for supplies it provided so each subsidiary had to deal with its own transaction exposure
Now Kodak bills its subsidiaries in their local currencies and Kodaks main headquarters handles any transaction exposure
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Also, 1-year call options with a strike price of $0.51/ have a premium of 6 / and put options with a strike price of $0.58/ have a premium of 5 /.
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Lufthansa may disagree and award the contract to a firm pricing their blades in s
Today
G.E. sells 25,000,000 125,000 = 200 contracts at $0.54/
Case #1
Suppose GE needs to borrow $15,000,000 to build a new plant in the U.S. GE can borrow s today instead of $s with the idea of using the 25,000,000 it receives from Lufthansa to repay this loan
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25,000,000 = 23,148,148 1 + 8%
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Today
1. GE borrows 23,148,148 from German bank at 8% for 1 year 2. Convert s to $s at spot rate 23,148,148($0.55) = $12,731,481 3. Deposit $s in U.S. bank for 1 year at 5%
Case # 1
GE has excess $s it does not need during the next 90 days
Today
Today
1. GE borrows the right amount of $s for 90 days at 1.75% from U.S. bank
24,630,541.87 (0.55) = $ 13,546,798.03 2. Convert $ 13,546,798.03 to 24,630,541.87 3. GE deposits 24,630,541.87 in German bank for 90 days at 1.5%
1. G.E. buys
That one year from today the spot rate will be BELOW $0.54/ (the Futures rate today) i.e. that the will depreciate below the current futures rate
Should GE use a Put or a Call? Put Option Should GE buy or sell a Put? BUY
GE is now guaranteed that the minimum they will receive for the turbine blades is (25,000,000)($0.58 - 5) = $13,250,000
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If spot < $0.58 GE should exercise the Put GE receives 25,000,000($0.58) = $14,500,000 GE clears $14,500,000 - $1,250,000 = $13,250,000
If spot > $0.58 GE should not exercise the Put GE sells the s in the spot market GE receives 25,000,000(spot rate) clears 25,000,000(spot rate) - $1,250,000
Depends on what the spot rate is expected to be one year from today
Put premium
EXAMPLE
French firm ships supplies to its subsidiary in Switzerland and will be paid in SFs What should the French firm do if it thinks the SF will depreciate against the ? Speed up the payment
Leading
What should the French firm do if it thinks the SF will appreciate against the ? Slow down the payment
Lagging
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Cross-Hedging
Suppose a firm has transaction exposure against a currency where a hedge does not exist Identify another foreign currency which is highly positively correlated with the currency needed (relative to movements against the home currency) and for which a hedge does exist
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Cross-Hedging
Suppose a firm has transaction exposure against a currency where a hedge does not exist Identify another foreign currency which is highly positively correlated with the currency needed (relative to movements against the home currency) and for which a hedge does exist
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To Hedge or not?
Is the reduction of variability in cash flows then sufficient reason for currency risk management?
This question is actually a continuing debate in multinational financial management and corporate finance. There are several schools of thought.
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To Hedge or not?
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Opponents of Hedging
Opponents of currency hedging commonly make the following arguments:
Stockholders are much more capable of diversifying currency risk than the management of the firm. Currency risk management does not add value to the firm and it incurs costs. Hedging might benefit corporate management more than shareholders.
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Proponents of Hedging
Proponents of hedging cite:
Reduction in risk in future cash flows improves the planning capability of the firm. Reduction of risk in future cash flows reduces the likelihood that the firms cash flows will fall below a necessary minimum (the point of financial distress). Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Individuals and corporations do not have same access to hedging instruments or same cost.
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To Hedge or not?
Should the firms hedging strategy be to use forward contracts for all of its future foreign exchange transactions?
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To Hedge or not?
Should the firm hedge a future foreign exchange transaction if it feels the exchange rate will move in an unfavorable direction?
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To Hedge or not?
The MNCs level of risk aversion, and its ability (and desire) to forecast exchange rates determine: