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  1. Hedging Risk and Exposure International Corporate Finance P.V. Viswanath

  2. Learning Objectives • Should firms hedge forex risk? • How do firms hedge transactions exposure using forwards, futures and options? • How can firms hedge operating exposure? P.V. Viswanath

  3. Why firms should hedge • Reasons why a firm should hedge, rather than its shareholders • Progressive corporate income tax • Scale economies in hedging transactions • Marketing and employment benefits • Lower expected bankruptcy costs • Better internal information P.V. Viswanath

  4. Hedging with forwards • An importer or exporter faces exposure and risk because of delay between agreeing on a foreign-currency price and settling the transaction. • Suppose WalMart has placed an order with a European manufacturer for €1m worth of fabric; delivery in 3 months. • This exposes WMT to fluctuations in the $/€ rate. • WMT could buy the euros forward. • The 3-mth forward rate on euros (6/21/06) is 1.27347 bid/ 1.27513 ask. Hence WMT could lock in its obligations at $1.27513m. • The expected cost of hedging would be $1m.x[1.2753-E(e)] • If speculators do not need a risk premium, then this = zero. P.V. Viswanath

  5. Hedging using forwards • If there is a risk premium, then the expected cost of hedging provides the benefit of not having to bear the risk. • Hence the existence of a risk premium does not affect the decision to hedge or not, unless shareholders are of less than average risk. • If there are transactions costs, the forward ask will be greater than the expected future spot ask, while the forward bid will be lower than the expected future spot bid. • fask-eask > 0 and fbid-ebid < 0 • Assume fask-eask = -(fbid-ebid) • Then fask-eask = ½[fask-eask-(fbid-ebid)] = ½[fask-fask-(eask-ebid)] P.V. Viswanath

  6. Hedging using forwards • This can be interpreted as follows: • Suppose we buy and sell forward, the transaction cost is fask-fbid; • the transaction cost from buying and selling spot is eask-ebid. • The difference is fask-fbid-(eask-ebid). • This > 0 because the spread is generally larger in forward markets. • Hence the cost of hedging is half the difference between the forward bid-ask spread and the spot bid-ask spread. • The spot bid-ask spread for the euro is 0.0005; the 3-mth forward bid-ask spread is 0.00147; hence the estimated cost of hedging is 0.000485/€ or $485 for €1m. P.V. Viswanath

  7. Futures Market Hedging • Futures-market hedging achieves essentially the same result as forward hedging. • However, with futures the foreign exchange is bought or sold at the spot rate matmaturity, and the balance of receipts from selling a foreign currency or cost of buying a foreign currency is reflected in the margin account. • Because interest rates vary, the exact receipt or payment with currency futures is uncertain. P.V. Viswanath

  8. Hedging using options • Foreign currency accounts payable can be hedged by buying a call option on the foreign currency, and account receivable can be hedged by buying a put option on the foreign currency. • Options set a limit on the worst that can happen from unfavorable exchange rate movements without preventing enjoyment of gains from favorable exchange rate movements. P.V. Viswanath

  9. Hedging Using Swaps • An importer can hedge with a swap by borrowing in the home currency, buying the foreign currency spot, and investing in the foreign currency. • Exporters can hedge with a swap by borrowing in the foreign currency, buying the home currency spot, and investing in the home currency: the loan is repaid from the export proceeds. • Lets us compute the cost of this strategy for an importer. • Consider the case of WMT, which had to pay €1m. in 3 months. P.V. Viswanath

  10. Cost of using swaps • Assume 3-mth interest rates in euros are (2.88/2.92), and in dollars (4.45/4.52). The spot rate today is 1.2616/1.2621; the 3-mth forward rate 1.268590/1.270240. • Now, WMT needs €1m in 3 mths; it can invest in riskfree euro securities at the rate of 2.88%; so it will need 1/(1+0.0288/4) = €992,851 today; this can be obtained by buying spot with 992,851(1.2621) = $1,253,078. • Alternatively, WMT can buy the euros forward by committing to pay $1,270,240, which can be acquired by putting 1,270,240/(1+0.045/4) = $1,256,109 in riskfree dollar securities. • The cost of hedging using swaps over forward is 1,256,109 - 1,253,078 or $3031 in today’s dollars. P.V. Viswanath

  11. Hedging through currency of invoicing • Forex exposure can be eliminated by invoicing in domestic currency. • Exposure can also be reduced by invoicing in a mixture of currencies or by buying inputs in the currency of exports. P.V. Viswanath

  12. Risk Sharing • Risk-Sharing is a contractual arrangement in which the buyer and seller agree to share or split currency movement impacts on payments that pass between them. • This is worthwhile if the relationship between the two firms is long-term. • For example, Ford and Mazda may agree that all purchases by Ford will be made in Japanese yen at the current rate, as long as it is between 115 and 125 yen/$. • If the rate falls outside this range, they may agree to share the difference equally. • Of course, if the equilibrium rate level changes drastically, the agreement will have to be changed. P.V. Viswanath

  13. Reinvoicing Centers • A reinvoicing center is a separate corporate subsidiary that manages in one location all transaction exposure from intracompany trade. • Effectively, the reinvoicing center centralizes transaction exposure risk, and diversifies the exposure of the parent company to transaction exposure. It need only hedge residual exposure risk. • This method releases individual company subsidiaries from having to worry about transaction exposure for intracompany trades. • The reinvoicing center can manage intra-affiliate cash flows, including leads and lags of payments. P.V. Viswanath

  14. Reinvoicing Centers P.V. Viswanath

  15. Managing Operating Exposure Strategically – Diversifying Operations • The key to operating exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows. • Management can diversify the firm’s operating and financing base. • Diversifying operations means diversifying sales, location of production facilities and raw material sources. • Diversifying financing means raising funds in more than one capital market and in more than one currency. • It can change the firm’s operating and financing policies. P.V. Viswanath

  16. Strategic Diversification of Operations • There might be a change in comparative costs in the firms’ own plants located in different countries. • Management can make marginal shifts in sourcing raw materials, components, or finished products. If spare capacity exists, production runs can be lengthened in one country and reduced in another. • There might be a change in profit margins or sales volume in one area compared to another, depending on price and income elasticities of demand and competitor’s reactions. • Marketing efforts can be strengthened in export markets where the firms’ products have become more price-competitive. P.V. Viswanath

  17. Managing Operating Exposure – Diversifying Financing • Interest rates differentials might not adjust fully to expected changes in interest rates. • In this case, provided the firm is established and known in different markets, it can change the source of its short and long-term financing. • Diversifying financing per se can also help diversify risks of restrictive capital market policies or government borrowing competition in the capital market • It can help diversify political risks – expropriation, war, blocked funds, or unfavorable changes in laws. P.V. Viswanath

  18. Modifying Financing Policies – Natural Hedges • Suppose we have a US firm selling to a Canadian client. One way to offset an anticipate continuous long exposure to a particular currency is to acquire debt denominated in that currency; in this case, the Canadian dollar. • If stable (in foreign currency) and continuing receipts from sales are expected, debt in the foreign currency could be issued; the sales receipts would be used to make interest payments on the debt. This is a form of matching. • The firm could also seek raw material suppliers in Canada, so that sales receipts could be used to pay for purchases. • The firm could arrange to pay raw material suppliers from a third country using the foreign currency of the sales receipts. P.V. Viswanath

  19. Natural Hedges – An Example P.V. Viswanath

  20. Currency Swaps P.V. Viswanath

  21. Currency Risk Sharing • Suppose GE expects to receive €10m. from Lufthansa from the sale of turbines in 1 year. • Suppose the current spot price is $1.00/€ and the forward price is $0.957/€. • GE can avoid the transaction exposure to euros if Lufthansa, its customer would allow it to bill in dollars. • However, since Lufthansa is aware of the forward rate and the alternative available to GE, it would be willing to accept such billing only if it receives a discount of $0.43m, for a total bill of $9.57m as before. • If Lufthansa uses the spot rate of $1/€ and accepted a quote of $10m, it would be forgoing $0.43m. P.V. Viswanath

  22. Currency Risk Sharing • Lufthansa and GE can agree to share the currency risks associated with their turbine contract. This can be done by developing a customized hedge contract embedded in the underlying trade transaction. • Possible agreement: • A neutral zone ($0.98-$1.02/€) within which there will be no price adjustment. In this zone, Lufthansa will pay GE, the dollar equivalent of €10m at the base rate of $1/€. • If the euro depreciates from $1 to, say, $0.90, the actual rate wil have moved $0.08 beyond the lower boundary of the neutral zone ($0.98/€). This amount is shared equally. The actual rate used, here is $0.96€ ($1.00-0.08/2) • If the euro appreciates to, say, $1.1, the actual rate will have moved $0.08 beyond the upper boundary ($1.02/€)/ The actual rate used will be $1.04/€. GE collects $10.4m and Lufthansa pays €9.45 (10.4/1.1) P.V. Viswanath

  23. Protection with Currency Risk Sharing P.V. Viswanath

  24. Currency Collars/ Range Forwards • A currency collar is a contract that provides protection against currency moves outside an agreed-upon price range. • Suppose GE is willing to accept variations in the value of its euro receivable associated with fluctuations in the euro in the range of $0.95 to $1.05, but not more. • With a currency collar purchased from a bank, GE can obtain the following forward euro rate: • If e1 < $0.95, then RF = $0.95 • If $0.95 < e1 < $$1.05, then RF = e1 • If e1 > $1.05, then RF = $1.05 • If e1 < $0.95, GE will be shielded from losses on its receivable. • If e1 > $1.05, the bank will make a profit. • By forgoing the profit, the cost, for GE, of the downside protection will be lower. P.V. Viswanath

  25. Protection with Currency Collars P.V. Viswanath

  26. Cross Hedging • Hedging with futures is similar to hedging with forwards. • However, it is very difficult to find a futures contract that matches the needs of the hedger in currency, maturity and amount simultaneously. • As long as the futures price on the futures contract that is available is positively correlated with the exposure being hedged, the company can obtain some protection. Such use of futures contracts is called cross-hedging. • Suppose a US firm has a Danish Krone receivable, but it wants to use euro futures to hedge. Then, the slope coefficient from the regression of changes in the DK/$ rate against changes in the €/$ rate is the number of euros it should sell forward per DK. P.V. Viswanath

  27. Foreign Currency Options • Using forwards/futures or currency collars makes sense if the extent of the exposure is known. However, at times, a firm might want to hedge against a future exposure that might or might not materialize. • In this case, using forwards might not be a good idea. If the exposure does materialize, well and good. However, if the exposure does not materialize, then the firm would end up with an unwanted exposure, once again. • One way around this would be to buy an option. This is more like insurance. P.V. Viswanath

  28. Foreign Currency Options • Suppose GE bids on a contract worth €10m. to be paid in 3 months. However, GE will only know in 2 months if the bid has been accepted. • If GE sells a forward contract maturing in 3 months at a price of $0.98/€, it will receive $9.8b. if the bid is accepted, no matter what the euro rate in 3 months. • If the bid is not accepted, then GE will be contractually obligated to sell euros at $0.98/€ in 3 months time, no matter what the euro rate. • If GE buys an option allowing it to sell €10m. for dollars in 3 months at a rate of $0.98/€, it can use the option if its bid is accepted. If not, it can let the option lapse – unless the euro depreciates by then to less than $0.98/€. The cost to GE will be the cost of the option. P.V. Viswanath

  29. Options versus Forwards • Options are more useful than forwards when the amount of the exposure is uncertain. • However, if there is some part of the exposure that is known for sure, such as that the exposure will be at least €5b., the firm can hedge the €5b. in the forward market and the rest of the potential exposure in the options market. • This assumes that the objective of the manager is to reduce risk, and that both forwards and options are priced fairly. Obviously, if these conditions do not hold, then the optimal policy might be different. P.V. Viswanath

  30. Contractual Hedging and Long-term Exposure • Normally, firms take contractual positions like forward contracts and options in order to hedge positions that do not have quantity risk (but only exchange rate risk), such as hedging transaction exposure. • However, firms that have relatively predictable cash flows might use contractual strategies to hedge operating exposure as well. This is usually difficult because it is necessary for the firm to be able to predict competitor response as well. • Another question with contractual hedging to protect against changes in strategic position is that it is purely a short-term hedge. A change in strategic posture would be a longer-term response. • Hence contractual hedging would be effective only if the “strategic” impacts are temporary. P.V. Viswanath