11_0725 Intl finance ch8-10 student by tangshuming

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```									  Chapter 8 – Transaction Exposure
Companies conducting international business might supply
or receive goods in months when exchange rates are
changing. How can the manufacturer guarantee they receive
or pay a set amount of the proceeds in the future? Similar to
a farmer with a wheat forward.

Transaction exposure arises from:
Purchasing or selling on credit goods or services whose
prices are stated in foreign currencies or borrowing or
lending funds when repayment is to be made in a foreign
currency. If you didn’t have to pay/receive payment in the
foreign currency there wouldn’t be a problem.
Suppose a U.S. firm sells merchandise on open account to
S0 = 35 Bf/\$. The U.S. seller expects to exchange the Bf700,000
payment for \$20,000 when payment is received.
Transaction exposure arises because of the risk that the U.S.
seller will receive something other than \$20,000.
If S60 = 38 Bf/\$, U.S. seller receives only \$18,421 =
(Bf700,000) * (1\$/38 Bf). If S60 = 33 Bf/\$, U.S. seller
receives \$21,212 = (Bf700,000) * (1\$/33 Bf)
Thus, exposure is the chance of either a loss or a gain.
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In 1971, Great Britain’s Beecham Group borrowed SF100
million (equivalent to £10.13 million).
When the loan came due five years later, the cost of
repayment of principal was £22.73 million – more than
double the amount borrowed!

We will discuss three ways to hedge transaction exposure.
1. A forward hedge
2. A money market hedge
3. An option hedge.

Let’s begin.

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Forward Market Hedge – Exporter

An example: Suppose your company is Raleigh bicycle, a British firm,
and you sell 750,000 euros of bicycles to an Italian wholesaler,
Colnago, payable in six months.

UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€
How can you guarantee Raleigh will receive a set amount of pounds
in six months, and how much will Raleigh receive?

1. Sell forward 750,000€ in six months in exchange for pounds. In
six months your company will have to deliver (pay) 750,000€ and
will receive a set amount of pounds.

2. Use the 750,000€ receivable from Colnago to fulfill the 750,000€
forward contract.

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Money Market Hedge -- Exporter
An example: Suppose your company is Raleigh bicycle, a British firm,
and you sell 750,000 euros of bicycles to an Italian wholesaler,
Colnago, payable in six months.

UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€
1.    With a money market hedge, borrow an amount today in the
foreign currency that you can repay in the future with the
accounts receivable.
2.   Convert the euros to £ at the spot rate.
3.   Invest the converted amount at the UK interest rate.
4.   Use the 750,000 euro from the receivable to repay the loan.

Note: the forward hedge and money market hedge give the same
value. This is not coincidence, it is due to IRP.

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Options – One shortcoming for forward and money market hedges is
that the firm has to forgo the opportunity to benefit from favorable
exchange rate changes. Not so with options.

Options – Exporter

Suppose your company is Raleigh bicycle and you sell 750,000 euros of
bicycles to an Italian wholesaler, Colnago, payable in six months.

UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€
 The put option premium is 0.01 pounds per euro and the strike
price is 0.7143 £/€. The contract size is 125,000 euros. If the six
month spot is 0.735 £/€, how much will Colnago pay in total?
What if the spot is 0.7143 £/€, or 0.6950£/€?

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We just talked about exporting and have an accounts payable, i.e.
wanting to collect a certain amount from a foreign company given
that your receivable is designated in the foreign currency. The
same ideas apply for a payable, that is, you agree to pay a firm in
the foreign currency.

Forward Market Hedge -- Importer

If you expect to owe foreign currency in the future, you can hedge by
agreeing today to buy the foreign currency in the future at a set price
by entering into a long position in a forward contract.

Colnogo, an Italian company that normally deals in euros, must pay
Raleigh 10,000£ for bike parts in six months.

UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€

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Money Market Hedge -- Importer

 To hedge a foreign currency payable, buy the present value of
that foreign currency payable today and put it in the bank at
interest.

– Buy the present value of the foreign currency payable today
at the spot exchange rate.

– Invest that amount at the foreign rate.

– At maturity your investment will have grown enough to

Colnogo, an Italian company that normally deals in euros, must pay
Raleigh 10,000£ for bike parts in six months.

UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€

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Options – Importer

Suppose Colnogo must pay Raleigh 10,000£ for bike OEM parts in six
months.

UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€

 The call option premium is 0.02 euros per pound, the strike price
is 0.735 £/€, and there are 125,000 euros per contract.

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Summary -- Hedging Foreign Currency Payables

 Suppose the following:

US interest rate 6%/year
UK interest rate 6.5%/year
Spot exchange rate \$1.80/£
Forward exchange rate \$1.75/£
 Boeing decides to hedge a £5M payable due in 1 year.

 Using a forward contract.

 Using a Money Market Instrument.

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 For an option hedge assume X = \$1.80/£ and the premium is
\$0.018/£.

 Is the Forward MM or Option Hedge preferable in this
instance?

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A Future Contract isn’t as Suitable for Hedging.
 Futures contracts are standardized, not tailor made.
Issues with contract size, delivery, date, etc.
 Mark-to-market means there are interim CFs prior to
maturity that may have to be invested/borrowed.

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Cross-Hedging Minor Currency Exposure
 The major world currencies are the U.S. dollar, Canadian
dollar, British pound, euro, Swiss franc, Mexican peso, and
Japanese yen.
 Everything else is a minor currency (for example, the
Swedish krona).
 It is difficult, expensive, and sometimes even impossible to
use financial contracts to hedge exposure to minor
currencies.
 Cross-hedging involves hedging a position in one asset by
taking a position in another asset.
 The effectiveness of cross-hedging depends upon how well
the assets are correlated.
 An example would be a U.S. importer with liabilities
in Swedish krona hedging with long or short forward
contracts on the euro. If the krona is expensive when
the euro is expensive, or even if the krona is cheap
when the euro is expensive, it can be a good hedge.
But they need to co-vary in a predictable way.

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Hedging Recurrent Exposure with Swaps
 Swap contracts are an agreement to exchange one
currency for another at a predetermined exchange rate on
a sequence of future dates. It is a portfolio of forward
contracts with agreed upon exchange rates.
 E.G. Boeing is to receive £10 M from British Air for each of
the next five years in exchange for airplane parts. Boeing
finds a counterparty that agrees to a swap an exchange
rate of \$1.50/£ for each of the next five years. Boeing is
then guaranteed \$15 M /year for the next five years.
 Swaps are lower cost than hedging each exposure as it
comes along.
 Swaps are available in longer-terms than futures and
forwards.

Exposure Netting
 A multinational firm should not consider deals in isolation,
but should focus on hedging the firm as a portfolio of
currency positions.

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Other Hedging Strategies
 Hedging through invoice currency.
– The firm can shift, share, or diversify:
• Shift exchange rate risk by invoicing foreign sales
in home currency
• Share exchange rate risk by pro-rating the
currency of the invoice between foreign and
home currencies
• Diversify exchange rate risk by using a market

 Hedging via lead and lag.
– If a currency is appreciating, pay those bills
denominated in that currency early; let customers in
that country pay late as long as they are paying in
that currency.

– If a currency is depreciating, give incentives to
customers who owe you in that currency to pay early;
pay your obligations denominated in that currency as
late as your contracts will allow.

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Should the Firm Hedge?
 Not everyone agrees that a firm should hedge.
– Hedging by the firm may not add to shareholder
wealth if the shareholders can manage exposure
themselves.
– Hedging may not reduce the non-diversifiable risk of
the firm. Therefore, shareholders who hold a
diversified portfolio are not benefitting when
management hedges.

What Risk Management Products do Firms Use?
 Most U.S. firms use forward, swap, and options contracts.
 The greater the degree of international involvement, the
greater the firm’s use of foreign exchange risk
management.

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Chapter 9 – Economic Exposure

Economic Exposure – How do exchange rates affect a

 Changes in exchange rates can affect not only firms that
are directly engaged in international trade but also purely
domestic firms.

 If the domestic firm’s products compete with imported
goods, then their competitive position is affected by the
strength or weakness of the local currency.

 Consider a U.S. bicycle manufacturer who sources,
produces, and sells only in the U.S.

 Since the firm’s product competes against imported
bicycles, it is subject to foreign exchange exposure. Their
customers are comparing the cost and features of the
domestic bicycle against Japanese, British, and Italian
bicycles.

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The economic exposure we discuss is operating exposure.

 The extent to which the firm’s operating cash flows or
competitive position are affected by random changes in
exchange rates.

 Competitive effect – A pound depreciation can affect
operating CFs in pounds by altering the firm’s
competitive position in the marketplace.

 Conversion effect – A given operating CF in pounds
will be converted into a lower dollar amount after the
pound depreciation.

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An Illustration of Operating Exposure
 Case 1 – No variables change except the price of imported
inputs.
– Increased costs of raw material, leads to decreased
operating CF
– The degree to which the firm can pass the increased
costs along to customers depends on substitutes and
price elasticity.

 Case 2 – Selling price as well as the price of the imported
inputs changes, with no other changes.
– Since the firm can pass costs along to customers
(inelastic demand), this case shows that a pound
depreciation need not lead to a lower dollar
operating CF.

 Case 3 – All variables change, selling price, sales volume,
prices of both locally sourced and imported inputs change
following depreciation in the pound.
– Assume elastic demand – then increases in prices lead
to fewer units sold and CFs are reduced.

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Determinants of Operating Exposure
 The firm’s operating exposure is determined by:
– How competitive or how monopolistic the market
structure of inputs and products is.
– A firm is subject to a high degree of operating
exposure when either costs or price is sensitive to
exchange rate changes. When both cost and price
are sensitive or insensitive to exchange rate changes,
the firm has no major operating exposure. If the firm
can adjust its markets, product mix, and sourcing it
can mitigate the effect of exchange rate changes.
– (E.G. Ford Mexicano). Inflation US = 4%; Inflation
Mexico = 15%; Dollar appreciates by 11%.
Suppose the Peso price of Ford cars appreciates by
15%, reflecting a 4% increase in the \$ price of cars
and an 11% dollar appreciation. Since peso price of
both Ford and locally produced cars rises by the same
15%, the 11% appreciation of the dollar will not affect
the competitive position of Ford relative to local car
makers. Therefore, Ford does NOT have operating
exposure.
– Generally, companies pass through some but not all
price changes.
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Managing Operating Exposure – Objective is to Stabilize CFs in
Face of Fluctuating Exchange Rates.

 Strategies
 Selecting Low Cost Production Sites – Toyota
produces in US for US sales.

 Flexible Sourcing Policy – Low cost material inputs.

 Diversification of the Market – Sell in several markets and
if pricing becomes unfavorable in one market, hopefully it
will become more favorable in another market.

 R&D and Product Differentiation – Limit chance of
substitutes and focus on cutting costs through R&D.
Successful product differentiation gives the firm less
elastic demand—which may translate into less exchange
rate risk.

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Chapter 10 – Translation Exposure
This is frequently called accounting exposure as it refers to
the effect that an unanticipated change in exchange rates
will have on consolidated financial statements.
There are four methods of foreign currency translation
 Current/Noncurrent Method
 Monetary/Nonmonetary Method
 Temporal Method
 Current Rate Method

International Accounting Standards
 IAS 21, The Effects of Changes in Foreign Exchange Rates is
the European standard for handling foreign currency
translation.
 IAS 21 most closely resembles the monetary/nonmonetary
translation method.

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Monetary/Nonmonetary Method
 The underlying principle is that monetary accounts have a
similarity because their value represents a sum of money
whose value changes as the exchange rate changes.

 All monetary balance sheet accounts (cash, marketable
securities, accounts receivable, etc.) of a foreign subsidiary
are translated at the current exchange rate.

 All other (nonmonetary) balance sheet accounts (owners’
equity, land, etc.) are translated at the historical exchange
rate in effect when the account was first recorded.

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Example: All monetary balance sheet accounts are
translated at the current exchange rate. e.g. €2 = \$1. All
other balance sheet accounts are translated at historical
exchange rate in effect when the account was first
recorded. e.g. €3 = \$1

Balance Sheet         Local           Monetary/
Currency        Nonmonetary

Cash                        € 2,100           \$1,050
Inventory                   € 1,500             \$500
Net fixed assets            € 3,000           \$1,000
Total Assets        € 6,600           \$2,550
Current liabilities         € 1,200             \$600
Long-Term debt              € 1,800             \$900
Common stock                € 2,700             \$900
Retained earnings             € 900                \$0
CTA                          --------         --------
Total Liabilities       € 6,600           \$2,400
and Equity

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