Firms that engage in international trade will be exposed to risk of fluctuations in exchange
rate → change in exchange rate will affect:
- settlement of a contract
- firm’s cash flow
- firm’s value (ultimately)
Transaction exposure → sensitivity of firm’s short-term cfs (as expressed in the domestic
currency) & contractual cfs to changes in the exchange rate
- OR changes in exchange rates btw time that an obligation is incurred & time that it’s
settled, affecting actual cfs
Transaction exposure = uncertainty of proceeds
Example (we are receiving euros)
Assume a SA construction company won a tender to construct a road in France. The
contract will take 9 months to complete. The contract price is € 1,000,000. Assume the rand
currently trades at R19.00/€.
What happens if the SA Rand strengthens to anything below R19.00/€?
- money coming in → protect against strengthening of the Euro
- we are worse off because will convert our euros into fewer rands than what was
previously possible
What happens if the SA Rand is weaker than R19.00/€?
- benefits us
,HEDGE
Typical policy options
No hedging policy:
- firm decides to carry foreign exchange risk → potentially a high-risk option
- lack of control of firm’s foreign currency cf can negatively impact its profitability
- if an insignificant portion of cf is in foreign currency, the policy may be wise
Selective hedging policy:
- firm decides on level of risk willing to adopt & hedge foreign currency cfs accordingly
- e.g. decide to carry the risk of exchange rate fluctuation on 30% of its foreign
currency cf & hedge the remaining 70%.
- policy may vary according to changing market perceptions
Systematic Hedging:
- firm decides to automatically hedge all foreign currency cfs
- few firms do this → could be costly
Why the firm and not the investor?
In a perfect capital market firms may not need to hedge exchange risk, but firms can add to
their value by hedging if markets are imperfect.
1. if management knows about firm’s exposure better than shareholders, the firm (not
its shareholders) should hedge
2. firms may be able to hedge at a lower cost
Note: financial managers are always risk averse
Advantages:
- improves planning
- reduces likelihood of bankruptcy
- management knows actual risks
Disadvantages:
- currency risk management costly → may not increase expected cfs
- shareholders more capable of diversifying risk
- investors already factored forex exposure into valuation
Hedged → narrower curve → lower std
deviation → less variation from mean →
exposed to less risk
FORWARD MARKET HEDGE
A forward market hedge is a contract which individuals & firms can enter into to either buy
or sell foreign currency at a forward exchange rate which is quoted today
- mitigates against risk associated with expected future spot rate of exchange
From perspective of the MNC the contract may be to:
- sell a foreign currency receivable at a forward rate
▪ i.e. USA buying something from SA so we receive money
• think debtors
• exporting
- buy a foreign currency payable at a forward rate
▪ i.e. SA buys something from UK so we will have to pay then in euros
• think creditors
• importing
This provides certainty with regard to positive and negative cf
Receivables
Example
Assume Stellenbosch Farmers Winery (SFW) won a contract to supply a consignment of
wine to a distributor in France. The wine will cost the French Distributor €1,000,000 and this
is payable within 3 months.
The money market interest rates and the foreign exchange rate are as follows:
- The French Interest Rate 6.0% per annum
- The SA Interest Rate 9.0% per annum
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