Transaction Exposure Forward Points

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					Transaction Exposure


         Risk due to lags in payments

         Hedging strategies



January 5, 2011      Transaction Exposure   1
Exposure
 Transaction exposure
      changes in the value of outstanding contracts
 Operating exposure (economic exposure)
      change in the PV of the firm (real exchange
       rates)
 Translation exposure (accounting exposure)
      change in value of owner equity
 Tax exposure



January 5, 2011        Transaction Exposure            2
Transaction exposure sources
 lending or receivables denominated in
  foreign currency

 borrowing or payables denominated
  in foreign currency

 holding a defaulted forward contract


January 5, 2011   Transaction Exposure   3
Lags and transaction exposure
 t0 - order placed
      Forward contract agreed to

 t1 - order shipped (10 days)

 t2 - order delivered (24 days)

 t3 - order settled (90 days)

January 5, 2011    Transaction Exposure   4
Balance sheet perspective
 Contract: price, quantity, due date (today)
 Forward contract purchased (today)
 Input inventories purchased (today)
      Inventories increase
      (Payables increase)
           May also be funded by LT debt
 Output inventories created (8days)
      Input inventories decrease
      Output inventories increase
      (Accruals increase)
           May also be funded by LT debt
 Goods shipped (no change) (10 days)

January 5, 2011           Transaction Exposure   5
Balance sheet perspective
(cont)
 Goods received (24 days)
      Inventories decrease
      Receivables increase
 Contract paid (90 days)
      Receivables decrease
      Take delivery on forward contract
      Cash increases
 During this process
      Payables paid
      Accruals paid


January 5, 2011        Transaction Exposure   6
To Hedge
 Reduce the volatility of future cash
  flows
      Eliminate one source of risk
           Exchange rate volatility
           Cost of the hedge
      Does not change default risk
 Management either hedges or
  speculates ??
      Does not have expertise in exchange
       rate risk
January 5, 2011         Transaction Exposure   7
To not Hedge
 Shareholders better able to diversify risk
  than firm
 If parity holds NPV of hedging negative
      Costs of hedging
 Efficient markets have already impounded
  the risk into share price
 Agency problem
      Management is risk averse relative to their jobs
       not to stockholder value


January 5, 2011        Transaction Exposure               8
Accounting practices
non-hedged position
 Balance sheet
      Input inventories at cost
      Output inventories at COGS
      Receivable denominated in cd
        Spot in effect at time of delivery
 Income statement
      At payment
        Gain or loss realized
        Counted on income statement


January 5, 2011         Transaction Exposure   9
Types of hedges
 contractual hedges
      forwards, futures, option,
      money market hedges
 operating & financial hedges
      risk-sharing
      leads & lags
      swaps



January 5, 2011       Transaction Exposure   10
Forward hedge - 90 day
 short goods (delivered)
   selling goods for 154,000 usd
 long bill of exchange (bankers accept)
      payment 154,000 usd promised forward
 long a forward contract
      forward contract set for delivery of 229,460 cd
 delivery of 154,000 usd
 delivery of 229,460 cd
      discounted value 225,796.28

January 5, 2011        Transaction Exposure              11
Forward hedge - Sources of
risk
 delivery on bill
      bank backing the bill could default
 delivery on forward contract
      bank delivering cd forward could defaulat
 risk of default is low
 the hedge reduces transaction
  exposure


January 5, 2011     Transaction Exposure      12
Accounting practices
Hedged position
 Contract values
      231,000 receivable @ spot = 1.50
      229,460 payable @ forward = 1.49
 Balance sheet
      Input inventories at cost
      Output inventories at COGS
      Receivable denominated
        Denominated at spot in effect at time of
          delivery
      Forward contract as payable
        Denominated at forward rate

January 5, 2011        Transaction Exposure         13
Money market hedge - 90 day
 short goods (delivered)
      154,000 usd
 long bill for 154,000 usd
 short loan 154,000/(1.0765)               .25   =
  151,188
 exchange for 225,270 cd
 delivery of 154,000 usd
 pay off loan of 154,000
January 5, 2011      Transaction Exposure             14
Money market hedge
- Sources of risk
 delivery on bill
      bank backing the bill could default
 no forward contract
 risk of default is lower
 the hedge reduces transaction
  exposure



January 5, 2011     Transaction Exposure     15
One can also discount the bill -
90 day
 short goods
      154,000 usd
 long bill of exchange
 sell bill at discount to bank @ 8.65%
      150,839 usd
 exchange for 224,750 cd



January 5, 2011      Transaction Exposure   16
Discounting bill of exchange
- Sources of risk
 no risk delivery on bill
      bill sold at discount to another party
 no forward contract
 risk of default is eliminated
 the hedge eliminates transaction
  exposure



January 5, 2011      Transaction Exposure       17
OTC option contract - 90 day
 short goods
      154,000 usd
 long bill of exchange
 long call option to buy 229,508 cd
      @0.0025 usd/cd cost = 573.77 usd
      exercise price = 6710
 delivery of 154,000
 if e > x, exercise option
      get 229,508 cd net of cost of hedge
January 5, 2011      Transaction Exposure   18
Option contract - Sources of
risk
 risk of bank default on delivery on bill

 risk of default by bank on option
  contract

 the hedge reduces transaction
  exposure


January 5, 2011   Transaction Exposure   19
Present value of the hedges
 forward hedge = 225,796 cd

 money market hedge = 225,270

 discounting = 224,750

 option contract = 229,508 cd /
  (1.0667).25 - (573.77 usd *
  1.49cd/usd) = 224,989 cd

January 5, 2011   Transaction Exposure   20
Accounting for unhedged
positions
 Payables and receivables are booked
  at current spot
      income statements
      balance sheets
 at settlement - changes to book value
  must be counted
      losses
      gains

January 5, 2011   Transaction Exposure   21
Accounting hedged positions
 Payables and receivables are booked at
  current spot
 Use your forward rate as best estimator of
  future expected spot
      foreign exchange gain/loss = forward - spot
      forward contract loss = 0
 Gains/losses will be the difference between
      contract evaluated at forward and
      contract evaluated at spot



January 5, 2011       Transaction Exposure           22
Risk management
 Hedging costs money
 Hedging exposure
   As contracts are anticipated
           Contracts may not be signed
           If contracts signed unanticipated exchange rate
            changes
      As contracts are signed
           Risk that contract may be refused
           Risk that goods may not clear customs
      As contracts are delivered
           Default by the importer
                     Out goods
                     Must deliver on forward contract


January 5, 2011                    Transaction Exposure       23
Other hedge practices
 Proportional hedges
      Forward contracts hedge percentage of exposure
        Percentage cover directly related to term to
          maturity
 Forward points (using Interest Rate Parity)
                                               90
                                1.0575       360
                  f 90  1.49                      1.4882
                                1.0625 

      The usd sells forward at discount
      May not hedge this transaction because they
       may get a better exchange rate in the future
January 5, 2011              Transaction Exposure               24