Summary Investments and International Finance by Razaul Kabir (Chapters 14-20)
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Course
International Finance
Institution
Universiteit Twente (UT)
This book was tailor-made for students of the University of Twente. The book contains parts of two different books, for two different courses; one being Investments and one being International Finance. The chapters 14 until 20 are concerned with International Finance. Subjects discussed are transac...
International Finance Daniek Scholte Lubberink FENSI
Chapter 8 Management of transaction exposure
Three types of exposure:
Transaction exposure = the sensitivity of “realized” domestic currency values of the firm
S contractual cash flows denominated in foreign currencies to unexpected exchange rate changes
Short-term economic exposure
→ arises from fixed-price contracting in a world with randomly changing exchange rates
Economic exposure = 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.
Where ‘consolidation’ involves translation of subsidiaries’ financial statements from local currencies
to the home currency
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
As discussed before the firm is subject to transaction exposure when it faces contractual cash flows
that are fixed in foreign currencies. Whenever 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.
Chapter 14 focuses on alternative ways of hedging transaction exposure using various financial
contracts and operational techniques.
Financial contracts Operational techniques
Forward market hedge Choice of the invoice currency
Money market hedge Lead/lag strategy
Option market hedge Exposure netting
Swap market hedge
For this chapter, given is the following:
Suppose that Boeing Corporation exported a Boeing 737 to British Airways and billed £10 million
payable in one year. The money market interest rates and foreign exchange rate are as follows:
The US interest rate 6.10% per annum
The UK interest rate 9.00% per annum
The spot exchange rate $1.50/£
The forward exchange rate $1.46/£ (1-year maturity)
Hedge = dekken, indekken
Forward market hedge
In this case the firm may sell (buy) its foreign currency receivables (payables) forward to eliminate its
exchange risk exposure
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 US dollars. On the maturity
date of the contract, Boeing will have to deliver £10 million to the bank, which in the counterparty of
the contract, and in return, take delivery of $14.6 million (1.46x10) regardless of the sport 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 fulfil 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 in the exchange rate.
Suppose that on the maturity date of the forward contract the spot rate turns out to be $1.40/£,
which is less than the estimated spot exchange rate. Boeing would have received $14 million instead
of $14.6 million, had it not entered the forward contract. Thus, one can say that Boeing gained $0,6
million from forward hedging.
Gain will be positive as long as the forward exchange rate (F) > spot rate on maturity (St)
If the spot rate is $1.50 on the maturity date, then Boeing could have earned $15 million by
remaining unhedged. One can say that ex post forward hedging cost Boeing $0,4 million.
Gain will be negative if the spot rate on maturity (St) > forward exchange rate (F)
3 scenarios
1. St ≈ F Expected gain/loss are approximately 0
Firms hedge here if they are averse to risk
2. St < F Positive gain from forward hedging
Management dissents from the market’s consensus of St and F
3. St > F Negative gain from forward hedging
Firms are less inclined to hedge in this scenario
Firms 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 purpose:
- Forward contracts are tailor-made. Futures contracts are standardized instruments → hedge approximately
- 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. → hedging = difficult
Money market hedge
Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign
markets. 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.
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. In the maturity 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 zero, and Boeing will receive the future maturity value of the dollar
investment.
The first 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, £10million/(1.09) = £9.174.312. When Boeing borrows that, it has to repay 10 million in one
year and thus the payables and receivables are equal.
Blz. 443 of the uTwente book
The maturity value of the dollar investment from money market hedge is nearly identical to the
forward hedging. 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 both will not be the same.
As a result, one hedging method will dominate the other.
Options market hedge
One shortcoming from both forward and money market hedges completely eliminate exchange risk
exposure. Consequently, the firm has to forgo the opportunity to benefit from favorable exchange
rate changes. Say that the spot exchange rate turns out to be $1.60 on 1 pound on the maturity date
of the forward contract. If Boeing had entered a forward contract, it would have regretted it. 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.
The firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables)
Suppose that in the over-the-counter market Boeing purchased a put option on 10 million British
pounds 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 x 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 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.
So, Boeing paid $200.000 upfront for the option. Considering the time value of money, this upfront
cost is equivalent to $212.000 (200.000 x 1.061) as of the expiration date. This means that under the
options hedge, the net dollar proceeds from the British sale become $14.600.000-212.000 =
$14.387.800
3
, International Finance Daniek Scholte Lubberink FENSI
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 that receipt from
the British sale.
An alternative scenario is when the pound appreciates against the dollar. Assume that the spot rate
turns out to be $1.60 per pound on the expiration date. 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 the option cost of $212.000, the net dollar proceeds become $15.787.800 under the
option hedge.
The option 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.
In option hedge a “floor” is set. A minimum future dollar proceed must be achieved.
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.
The break-even spot rate is useful for choosing a hedging method. By solving the equation for St, we
obtain the break-even spot rate, St*:
The break-even analysis suggests that if the firm’s expected future spot rate is greater (less) than the
break-even rate then the options (forward) may be preferred.
Hedging foreign currency payables
So far, we have discussed how to hedge foreign currency transaction exposure using the Boeing
receivables 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. Given is:
Strategy Transactions Outcomes
Forward market hedge 1. Sell £10.000.000 forward for US dollars Assured of receiving $14.600.000 in one year,
now future spot exchange becomes irrelevant
2. In one year, receive £10.000.000 from
the British client and deliver it to the
counterparty of the forward contract.
Money market hedge 1. Borrow £9.174.312 and buy $13.761.468 Assured of receiving $13.761.468 now or
spot now $14.600.918 in one year, future spot exchange
2. In one year collect £10.000.000 from the becomes irrelevant
British client and pay off the pound loan
using the amount
4
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