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10-1

Chapter 10Managing 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

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Exposures to currency risk

Change in firm value due to unexpectedchanges 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

Realassets

Monetaryassets

Commonequity

Monetaryliabilities

Transaction exposure

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A forward currency hedge

Underlying pound exposure

Short forward position

Net position

Net exposureDV$/

DS$/

shortpound

+1,000,000

-1,000,000

+$1,500,000

+$1,500,000

longpound

Transaction exposure

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Managing transaction exposure

Managing transaction exposure internally

- multinational netting (currency diversification)

- leading and lagging

Managing transaction exposure in the financialmarkets

- currency forwards

-

money market hedges- futures

- options

- swaps

Transaction exposure

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Multinational netting

Germansubsidiary

U.S.subsidiary

U.K.parent

100m

Cross rates 1.5000/$1.2500/

$0.8333/

200m$75m

$125m

150m

60m

Internal hedges: Multinational netting

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Cash flows before netting

Germansubsidiary

U.S.subsidiary

U.K.parent

100m200m60m

100m

100m

40m

Internal hedges: Multinational netting

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Cash flows after netting

Germansubsidiary

U.S.subsidiary

U.K.parent

60m 140m

Internal hedges: Multinational netting

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Leading and lagging

Leading and lagging refers to altering thetiming of cash flows within the firm to offsetforeign exchange exposures

For example:

- Leading - If a parent firm is short euros, itcan accelerate euro payments from itssubsidiaries

-Lagging - If a parent firm is long euros, itcan delay euro payments from itssubsidiaries

Internal hedges: Leading and lagging

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Leading and laggingUnderlying cash flows

Leading

Lagging

-10 million

+7.5 million+7.5 million +7.5 million

-10 million -10 million

Jan Feb Mar Apr JuneMay July Aug

Internal hedges: Leading and lagging

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Currency forward contracts

Advantages

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

Disadvantages

- Bid-ask spreads can be large on smalltransactions, long-dated contracts, or

infrequently traded currencies- Forwards are a pure credit instrument, so

forward contracts have credit risk

External hedges: Forwards

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Currency futures contracts

The futures contract solution to the defaultrisk of forward contracts

-An exchange clearinghouse takes one side ofevery transaction

- Futures contracts are marked-to-market on a dailybasis

-Initial and maintenance margins are required onfutures contracts

External hedges: Futures

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FX forwards versus futures contracts

Forwards Futures

Counterparty Bank Futures exchange

clearinghouse

Maturity Negotiated Standardized

Amount Negotiated Standardized

Fees Bid-ask Commissions

Collateral Negotiated Margin account

External hedges: Futures

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Currency futures contracts

Advantages

- Low cost if the size, currency and maturity matchthe underlying exposure

-

Low credit risk with daily marking-to-market

Disadvantages- Costs increase with transaction size

- Exchange-traded futures come in limitedcurrencies and maturities

- Daily marking-to-market can cause a cash flowmismatch

External hedges: Futures

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Money market hedges

Advantages

- Synthetic forward positions can be built incurrencies for which there are no forward

currency markets

Disadvantages

- Relatively expensive hedge

-

Might not be feasible if there areconstraints on borrowing or lending

External hedges: Money market hedges

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10-15

Currency option hedges

Advantages

- Disaster hedge insures againstunfavorable currency movements

Disadvantages

- Option premiums reflect option values, sooption hedges can be expensive involatile currencies and at distantexpiration dates

External hedges: Options

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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

Long pound callan option to buypounds sterlingat a contractual

exercise price

S$/

V$/

Option premium = $0.30/

Exerciseprice

$1.50/

-$0.30/

External hedges: Options

A currency call option

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A call option hedge

S$/

V$/

$1.50/

-$1.50/

Short exposure

External hedges: Options

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A call option hedge

S$/

V$/ Call option hedge

-$0.30/

$1.50/

-$1.50/

Short exposure

External hedges: Options

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A call option hedge

S$/

V$/ Call option hedge

Optionhedged position

-$0.30/

$1.50/

-$1.50/

-$1.80/

Short exposure

External hedges: Options

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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

Long pound putan option to sellpounds sterlingat a contractual

exercise price

S$/

V$/

Option premium = $0.30/

Exerciseprice

$1.50/

-$0.30/

External hedges: Options

A currency put option

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A put option hedge

S$/

V$/

Long exposure

+$1.50/

$1.50/

External hedges: Options

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A put option hedge

S$/

V$/

Put option hedge

Long exposure

-$0.30/

+$1.50/

+$1.20/

$1.50/

External hedges: Options

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A put option hedge

S$/

V$/

Put option hedge

Long exposure

Optionhedged position

-$0.30/

+$1.50/

+$1.20/

$1.50/

External hedges: Options

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Currency swapsIll pay yours if you pay mine

Currency swap

- An agreement to exchange a principal

amount of two currencies and, after a pre-arranged length of time, re-exchange theoriginal principal

-

Interest payments are also usuallyswapped during the life of the contract

External hedges: Swaps

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Currency swap contracts

Advantages

- Quickly transforms the firms liabilities into othercurrencies 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

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Financial market hedges

Vehicles Advantages Disadvantages

Forward Exact hedge; Large bid-ask spreads onSmall bid-ask spread small or long-dated deals &

for large deals thinly traded currencies

Future Low cost for small Only a few currencies &

deals; low risk maturities; mark-to-market

with mark-to-market can cause a CF mismatch

Money market Synthetic forward Relatively expensive; not

hedge always possible

Swap Quick & low-cost Innovative swaps costly;

switch of payoff may not be best for

structures near-term exposures

Option Disaster hedge Option premiums

provides insurance can be expensive

External hedges

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10%

51%

10%

49%

6%

26%

Alter the size ofa hedge

Alter the timingof a hedge

Actively takepositions

Sometimes

Frequently

Active management of fx risk

Bodnar, Hayt, and Marston, 1998 Wharton Survey of Derivatives

Usage by U.S. Non-Financial Firms, Financial Management(1998).

Financial management

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42%

24%

17% 17%

Beginning-of-

period forward

rates

Beginning-of-

period spot

rates

Baseline

percent

hedged

strategy

Other

benchmark

Risk management benchmarks

Bodnar, Hayt, and Marston, 1998 Wharton Survey.

Financial management

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40%

21% 22%18%

Reduced

volatility

relative to a

benchmark

Risk-adjusted

performance

Absolute profit

or loss

Increased

profit relative

to a

benchmark

Performance evaluation

Bodnar, Hayt, and Marston, 1998 Wharton Survey.

Financial management

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Active treasuries

Tend to be large firms with centralized riskmanagement

Use sophisticated valuation methodologiessuch as value-at-risk for managing theirexposures

Frequently mark their derivatives positions to

market

Gczy, Minton, and Schrand, Taking a View: Corporate Speculation,Governance, and Compensation Journal of Finance(2007)

Financial management

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Active treasuriesmanage their managers

Managers actions are closely monitored

Firms use compensation contracts to align

managers objectives with those of otherstakeholders

Firms use derivatives-specific controls such asperformance benchmarks to manage potential

abuses

Gczy, Minton, and Schrand, Taking a View

Financial management

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Corporate use of derivatives

Used TotalType of product often usage

Currency forwards 72.3% 93.1%

Currency swaps 16.4 52.6

OTC currency options 18.8 48.8Cylinder options 7.0 28.7

Synthetic forwards 3.0 22.0

Currency futures 4.1 20.1

Exchange-traded (spot) options 3.6 17.3Exchange-traded futures options 1.8 8.9

Jesswein, Kwok & Folks, What New Currency Risk Products AreCompanies Using and Why? Journal of Applied CorporateFinance(1995)

Fi i l t