Chapter 10

Managing Transaction Exposure to Currency Risk

Learning objectives Transaction exposure
An example

Internal hedges
Multinational netting and leading/lagging

Financial market (external) hedges

Currency forwards, futures, options, swaps, and money market hedges

Treasury management best practices

Butler, Multinational Finance, 4e 10-1

Exposures to currency risk

Change in firm value due to unexpected changes in foreign exchange rates
- Transaction exposure
change in the value of contractual cash flows arising from the firms monetary assets and liabilities

- Operating exposure
change in the value of noncontractual cash flows arising from the firms real assets

Monetary assets Real assets

Transaction exposure

Monetary liabilities

Common equity
10-2

A forward currency hedge

Underlying pound exposure
+1,000,000 +$1,500,000 -1,000,000

Short forward position

Net position Net exposure
short pound DV$/ long pound DS$/

+$1,500,000

Transaction exposure

10-3

Managing transaction exposure

Managing

transaction exposure internally

- multinational netting (currency diversification) - leading and lagging

Managing

transaction exposure in the financial

markets
currency forwards money market hedges futures options swaps
10-4

Transaction exposure

Multinational netting
100m $75m

60m

U.K. parent
150m
$125m

200m

German subsidiary
Cross rates

U.S. subsidiary

1.5000/ $1.2500/ $0.8333/

10-5

Internal hedges: Multinational netting

Cash flows before netting

100m 60m

40m

U.K. parent

200m

German subsidiary

100m
100m

U.S. subsidiary

Internal hedges: Multinational netting

10-6

Cash flows after netting

60m 140m

U.K. parent

German subsidiary

U.S. subsidiary

Internal hedges: Multinational netting

10-7

Leading and lagging

Leading and lagging refers to altering the timing of cash flows within the firm to offset foreign exchange exposures For example: - Leading - If a parent firm is short euros, it can accelerate euro payments from its subsidiaries - Lagging - If a parent firm is long euros, it can delay euro payments from its subsidiaries

Internal hedges: Leading and lagging

10-8

Leading and lagging

Underlying cash flows
+7.5 million +7.5 million +7.5 million

-10 million

-10 million

-10 million

Leading

Lagging

Jan

Feb

Mar

Apr

May

June

July

Aug

Internal hedges: Leading and lagging

10-9

Currency forward contracts

Advantages

- Forwards can provide a perfect hedge of transactions of known size and timing
Disadvantages

- Bid-ask spreads can be large on small transactions, long-dated contracts, or infrequently traded currencies - Forwards are a pure credit instrument, so forward contracts have credit risk

External hedges: Forwards

10-10

Currency futures contracts

The

futures contract solution to the default risk of forward contracts

- An exchange clearinghouse takes one side of every transaction - Futures contracts are marked-to-market on a daily basis - Initial and maintenance margins are required on futures contracts

External hedges: Futures

10-11

FX forwards versus futures contracts

Forwards Futures

Counterparty
Maturity Amount Fees

Bank
Negotiated Negotiated Bid-ask

Futures exchange clearinghouse

Standardized Standardized Commissions

Collateral
External hedges: Futures

Negotiated

Margin account
10-12

Currency futures contracts

Advantages

- Low cost if the size, currency and maturity match the underlying exposure - Low credit risk with daily marking-to-market
Disadvantages

- Costs increase with transaction size - Exchange-traded futures come in limited currencies and maturities - Daily marking-to-market can cause a cash flow mismatch
External hedges: Futures 10-13

Money market hedges

Advantages

- Synthetic forward positions can be built in currencies for which there are no forward currency markets
Disadvantages

- Relatively expensive hedge - Might not be feasible if there are constraints on borrowing or lending

External hedges: Money market hedges

10-14

Currency option hedges

Advantages

- Disaster hedge insures against unfavorable currency movements

Disadvantages

- Option premiums reflect option values, so option hedges can be expensive in volatile currencies and at distant expiration dates
External hedges: Options 10-15

A currency call option

A

pound call is an option to buy pounds

- the option holder gains if pound sterling rises - the option holder does not lose if pound falls V$/ Long pound call an option to buy pounds sterling at a contractual exercise price S$/

Exercise price
$1.50/ -$0.30/

Option premium = $0.30/

External hedges: Options 10-16

A call option hedge

V$/
$1.50/

S$/

-$1.50/

Short exposure
External hedges: Options 10-17

A call option hedge

V$/
$1.50/

Call option hedge S$/

-$0.30/

-$1.50/

Short exposure
External hedges: Options 10-18

A call option hedge

V$/
$1.50/

Call option hedge S$/

-$0.30/

-$1.50/ -$1.80/

Option hedged position

Short exposure
External hedges: Options 10-19

A currency put option

A

pound put is an option to sell pounds

- the option holder gains if pound sterling falls - the option holder does not lose if pound rises V$/ Long pound put an option to sell pounds sterling at a contractual exercise price S$/

Exercise price
$1.50/ -$0.30/

Option premium = $0.30/

External hedges: Options 10-20

A put option hedge

V$/ Long exposure

+$1.50/

$1.50/

S$/

External hedges: Options

10-21

A put option hedge

V$/ Long exposure

+$1.50/ +$1.20/

$1.50/ -$0.30/

S$/
Put option hedge

External hedges: Options

10-22

A put option hedge

V$/ Long exposure Option hedged position

+$1.50/ +$1.20/

$1.50/ -$0.30/

S$/
Put option hedge

External hedges: Options

10-23

Currency swaps Ill pay yours if you pay mine

Currency

swap

- An agreement to exchange a principal amount of two currencies and, after a prearranged length of time, re-exchange the original principal - Interest payments are also usually swapped during the life of the contract

External hedges: Swaps

10-24

Currency swap contracts

Advantages

- Quickly transforms the firms liabilities into other currencies or payout structures - Low cost for plain vanilla swaps in actively traded currencies - Swaps can be used to to hedge long-term exposures
Disadvantages

- Not the best choice for near-term exposures - Innovative or exotic swaps can be expensive
External hedges: Swaps 10-25

Financial market hedges

Vehicles Forward Advantages Exact hedge; Small bid-ask spread for large deals Low cost for small deals; low risk with mark-to-market Disadvantages Large bid-ask spreads on small or long-dated deals & thinly traded currencies Only a few currencies & maturities; mark-to-market can cause a CF mismatch

Future

Money market hedge

Swap

Synthetic forward
Quick & low-cost switch of payoff structures Disaster hedge provides insurance

Relatively expensive; not always possible

Innovative swaps costly; may not be best for near-term exposures Option premiums can be expensive
10-26

Option
External hedges

Active management of fx risk

Sometimes Frequently

51%

49%

26% 10% 10%

6%

Alter the size of Alter the timing a hedge of a hedge

Actively take positions

Bodnar, Hayt, and Marston, 1998 Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms, Financial Management (1998).
Financial management 10-27

Risk management benchmarks

42%

24% 17% 17%

Beginning-of- Beginning-ofperiod forward period spot rates rates

Baseline percent hedged strategy

Other benchmark

Bodnar, Hayt, and Marston, 1998 Wharton Survey.

Financial management 10-28

Performance evaluation

40%

21%

22%

18%

Reduced Risk-adjusted Absolute profit Increased volatility performance or loss profit relative relative to a to a benchmark benchmark

Bodnar, Hayt, and Marston, 1998 Wharton Survey.

Financial management 10-29

Active treasuries

Tend Use

to be large firms with centralized risk management

sophisticated valuation methodologies such as value-at-risk for managing their exposures mark their derivatives positions to market
Gczy, Minton, and Schrand, Taking a View: Corporate Speculation, Governance, and Compensation Journal of Finance (2007)

Frequently

Financial management

10-30

Active treasuries manage their managers

Managers Firms

actions are closely monitored

use compensation contracts to align managers objectives with those of other stakeholders use derivatives-specific controls such as performance benchmarks to manage potential abuses
Gczy, Minton, and Schrand, Taking a View

Firms

Financial management

10-31

Corporate use of derivatives

Type of product Currency forwards Currency swaps OTC currency options Cylinder options Synthetic forwards Currency futures Exchange-traded (spot) options Exchange-traded futures options Used often 72.3% 16.4 18.8 7.0 3.0 4.1 3.6 1.8 Total usage 93.1% 52.6 48.8 28.7 22.0 20.1 17.3 8.9

Jesswein, Kwok & Folks, What New Currency Risk Products Are Companies Using and Why? Journal of Applied Corporate Finance (1995)
Financial management 10-32