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11_0725 Intl finance ch8-10 student

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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
Belgian buyer for Bf700,000, payment to be received in 60 days.
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.
                                                                1
  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.




                                                              2
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.




                                                                      3
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.

                                                                     4
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£/€?




                                                                          5
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 £/€




                                                                      6
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
          cover your foreign currency payable.

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 £/€




                                                                        7
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.




                                                                        8
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.




                                                         9
 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?




                                                         10
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.




                                                         11
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.




                                                              12
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.




                                                               13
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
             basket index


   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.

                                                               14
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.




                                                             15
Chapter 9 – Economic Exposure


Economic Exposure – How do exchange rates affect a
business’s competitiveness vis-à-vis their competition.


 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.


                                                                16
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.




                                                             17
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.


                                                                  18
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.
                                                              19
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.




                                                              20
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.




                                                                21
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.




                                                              22
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




                                                             23

				
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