Topic 7: Foreign Exchange Risk

Exposure and Management – Part 1

 Lesson Objectives

• Explain the need for hedging

• Identify how to assess the three types of exposure - transaction exposure,

economic exposure and translation exposure

• Explain different hedging techniques applicable to hedge these exposures

• Identify the limitations of hedging

• Apply the knowledge to real world scenarios

 Forex risk

• FX risk arises because of uncertainty about the future spot exchange rate.
• It refers to the variability of the domestic currency value of certain items
resulting from the variability of the exchange rate.
• When an MNC is exposed to exchange rate risk, its cash flows could be
adversely affected by exchange rate movements.
• By reducing exchange rate exposure, MNC’s may able to stabilize their
earnings and cash flows.
 Forex risk - relevant or not?

Forex risk is irrelevant – Forex risk is relevant –

• If an MNC operates in different countries and • Exchange rate effects of currencies will not
transact in different currencies, adverse exactly offset against each other.
effect of one currency will be offset by the • MNCs are similarly affected by forex risk. It
changes in other currencies. would be difficult for shareholders to create
• If creditors and/or shareholders of the MNC a diversified portfolio.
has invested in a diversified portfolio, they • Investors who invest in MNCs do not have
can reduce the currency risk. adequate knowledge to hedge their risk
• Investors investing in MNCs can hedge their using currency derivatives.
own forex risk using currency derivatives.
 Three Types of Exposure

It is conventional to classify foreign currency exposures into three types:

1. Transaction exposure is the potential change in the value of financial

positions due to changes in the exchange rate between the inception of
a contract and the settlement of the contract

2. Economic exposure is the possibility that cash flows and the value of
the firm may be affected by unanticipated changes in the exchange
rates

3. Translation exposure is the effect of an unanticipated change in the

exchange rates on the consolidated financial reports of an MNC
Transaction Exposure

• Firm is subject to transaction exposure when it faces contractual

cash flows that are fixed in foreign currencies
• Example
o Suppose a U.S. firm sold its product to a German client on three-month
credit terms and invoiced €1 million
o When the U.S. firm received €1m in three months, it will have to convert
(unless it hedges) the euros into dollars at the spot exchange rate prevailing
on the maturity date, which cannot be known in advance
Hedging Transaction Exposure

• This chapter focuses on alternative ways of hedging transaction exposure

using various financial contracts and operational techniques.

• Financial contracts
o Forward contracts, money market instruments, options contracts, and
swap contracts
• Operational techniques
o Choice of the invoice currency, lead/lag strategy, and exposure netting
 Should the Firm Hedge?

• No consensus on the question of whether a firm should hedge; Most

arguments suggesting corporate exposure management will not add value to
the firm hold in the case of a “perfect” capital market
• One can make a case for corporate risk management based on various
market imperfections:
1. Information asymmetry
2. Differential transaction costs
3. Default costs
4. Progressive corporate taxes
Hedging Foreign Currency Receivables

• Suppose Boeing Corporation exported a landing gear of Boeing 737 aircraft

to British Airways and billed £10 million payable in one year, with money
market interest rates and foreign exchange rates given as follows:
o U.S. interest rate: 6.10% per annum
o U.K. interest rate: 9% per annum
o Spot exchange rate: $1.50/£
o Forward exchange rate: $1.46/£ (1-year maturity)
• When Boeing receives £10m in one year, it will convert the pounds into
dollars at the spot exchange rate prevailing at the time
 Forward Market Hedge
• Most direct and popular way of hedging transaction exposure is by currency forward
contracts

• Sell (buy) foreign currency receivables (payables) forward to eliminate exchange risk
exposure
o Boeing may sell forward its pounds receivables, £10m, for delivery in one year, in
exchange for a given amount of U.S. dollars
o On the maturity date of the contract, Boeing will have to deliver £10m to the bank, which
is the counterparty of the contract, and, in return, take delivery of $14.6m ($1.46/£ *
£10m), regardless of the spot exchange rate that may prevail on the maturity date
Dollar Proceeds from the British Sale: Forward
Hedge versus Unhedged Position
 Forward Market Hedge (Continued)

• Suppose that on the maturity date of the forward contract, the spot rate
turns out to be $1.40/£, which is less than the forward rate, $1.46/£
o Boeing would have received $14m instead of $14.6m had it not entered
the forward contract
• What if the spot rate had been $1.50/£ at maturity?
o Boeing would have received $15m by remaining unhedged
o Ex post, forward hedging would have cost Boeing $0.4m
• Gains and losses are computed by the following:
Gains/Losses from Forward Hedge
Illustration of Gains and Losses from Forward Hedging
Forward Market Hedge (Concluded)
• Firm must make decision whether to hedge ex ante

• Consider the following scenarios:

1. T ≈ F
• Expected gains or losses are approximately zero, but forward hedging
eliminates exchange exposure
• Firm will be inclined to hedge if it is averse to risk
2. T < F
• Firm expects a positive gain from forward hedging and would be even more
includes to hedge than in Scenario 1
3. T > F
• Firm would be less inclined to hedge under this scenario, other things being
equal
Currency Futures versus Forwards
• A firm could use a currency futures contract, rather than a forward contract, for hedging
purposes
• A futures contract is not as suitable as a forward contract for hedging purposes for two
reasons:
1. Unlike forward contracts that are tailor-made to the firm’s specific needs, futures
contracts are standardized instruments in terms of contract size, delivery date, etc.
• Thus, in most cases, the firm can only hedge approximately
2. Due to the marking-to-market property, there are interim cash flows prior to the
maturity date of the futures contract that may have to be invested at uncertain interest
rates
• Again, this makes exact hedging difficult
 Money Market Hedge

• A firm may borrow (lend) in foreign currency to hedge its foreign currency receivables
(payables), thereby matching its assets and liabilities in the same currency
o Boeing can eliminate the exchange exposure arising from the British sale by first
borrowing in pounds, then converting the loan proceeds into dollars, which then can
be invested at the dollar interest rate
o On the maturity date of the loan, Boeing is going to use the pound receivable to pay
off the pound loan
o If Boeing borrows a particular pound amount so that the maturity value of this loan
becomes exactly equal to the pound receivable from the British sale, Boeing’s net
pound exposure is reduced to zero
Money Market Hedge (Continued)
• What amount of pounds should Boeing borrow?
o Amount to borrow may be computer as the discounted present value of the pound
receivable
o £10m / (1.09) = £9,174,312
• Step-by-step procedure of money market hedging:
1. Borrow £9,174,312
2. Convert £9,174,312 into $13,761,468 at the current spot exchange rate of $1.50/£
3. Invest $13,761,468 in the U.S.
4. After one year, collect £10m from British Airways and use it to repay the pound loan
5. Receive the maturity value of the dollar investment, that is, $14,600,918 = ($13,761,468)
(1.061)
Cash Flow Analysis of a Money
Market Hedge
 Options Market Hedge

• One possible shortcoming of both forward and money market hedges is that
these methods completely eliminate exchange risk exposure
o Ideally, Boeing would like to protect itself only if the pound weakens,
while retaining the opportunity to benefit if the pound strengthens

• Currency options provide a flexible “optional” hedge against exchange

exposure
o Firm may buy a foreign currency call (put) option to hedge its foreign
currency payables (receivables)
 Options Market Hedge (Continued)

• Suppose that in the OTC market, Boeing purchased a put option on £10m with an exercise
price of $1.46/£ and a one-year expiration, and assume the option premium (price) was
$0.02 per pound
o Boeing paid $200,000 (= $0.02 * 10 million) for the option
o Provides Boeing with the right, but not the obligation, to sell up to £10m for $1.46/£,
regardless of the future spot rate
• Assume the spot exchange rate turns out to be $1.30 on the expiration date
o Upfront cost is equivalent to $212,200 = ($200,000 * 1.061)
o Net dollar proceeds are $14,387,800 = $14.6m - $212,200
o Boeing is assured of “minimum” dollar receipt of $14,387,800
 Options Market Hedge (Concluded)
• Consider an alternative scenario where the pound appreciates against the
dollar, and assume the spot rate turns out to be $1.60 per pound at
expiration
o Boeing will have no incentive to exercise the option
o Rather, it would let the option expire and convert £10m into $16m at the
spot rate
o Subtracting $212,200 for the option cost, the net dollar proceeds will
become $15,787,800 under the option hedge
• Options hedge allows the firm to limit downside risk while preserving the
upside potential, but firm must pay for this flexibility in terms of the option
premium
 Comparison of Hedging Strategies
• Money market hedge versus forward hedge
o Money market hedge dominates since the guaranteed dollar proceeds from the British
sale with the money market hedge exceeds guaranteed proceeds with forward hedge
• Money market hedge versus options hedge
o Options hedge dominates money market hedge for future spot rates greater than
$1.4813/£, but money market hedge dominates options hedge for spot rates lower than
$1.4813/£
• Options hedge versus forward hedge
o Options hedge dominates the forward hedge for future spot rates greater than $1.48
per pound, whereas the opposite holds for spot rates lower than $1.48 per pound
Boeing’s Alternative Hedging Strategies for a
Foreign Currency Receivable
 Hedging Foreign Currency Payables
• Suppose Boeing imported a Rolls-Royce jet engine for £5 million payable in
one year
• Market condition is summarized as follows:
o The U.S. interest rate: 6.00% per annum
o The U.K. interest rate: 6.50% per annum
o The spot exchange rate: $1.80/£
o The forward exchange rate: $1.75/£ (1-year maturity)
o Exercise price of a call option: $1.80/£ (1-year maturity) and premium
$0.018/£
• Boeing is concerned about the future dollar cost of this purchase, and they
will try to minimize the dollar cost of paying off the payable
 Foreign Currency Payables: Alternatives
• Forward market hedge
o $8,750,000 = (£5,000,000) ($1.75/£)

• Money market hedge

o PV of foreign currency payable: £4,694,836 = £5m / 1.065
o Outlay of dollars today: $8,450,704 = (£4,694,836) ($1.80/£)
o Future value: $8,957,747 = ($8,450,705) (1.06)

• Options market hedge - Purchase a “call” on £5m

o Premium paid: 5,000,000 * $0.018/£ = $90,000
o Assuming the spot rate at expiry > $1.80/£, Boeing will exercise the option
o 5,000,000* ($1.80/£) + (90,000*1.06) = $9,095,400
Boeing’s Alternative Hedging Strategies for a
Foreign Currency Payable
Dollar Costs of Securing the Pound Payable:
Alternative Hedging Strategies
 Cross-Hedging Minor Currency Exposure

• If a firm has positions in major currencies (e.g., British pound, euro, and
Japanese yen), it can easily use forward, money market, or options contracts
to manage its exchange risk exposure
• However, if the firm has positions in less liquid currencies (e.g., Indonesian
rupiah, Thai bhat, and Czech koruna), it may be either very costly or
impossible to use financial contracts in these currencies
o In this situation, firms may use cross-hedging, which involves hedging a
position in one asset by taking position in another asset
Hedging Contingent Exposure

• Options contract can also provide an effective hedge against what might be called
contingent exposure
o Contingent exposure is the risk due to uncertain situations in which a firm does not
know if it will face exchange risk exposure in the future
o Example: Suppose GE is bidding on a hydroelectric project in Canada. If the bid is
accepted, which will be known in three months, GE is going to receive C$100m to
initiate the project. Since GE may or may not face exchange exposure, it faces a
typical contingent exposure situation
o Difficult to manage contingent exposure using traditional hedging tools like forward
contracts, but an alternative is for GE to buy a put option on C$100m
Hedging Recurrent Exposure with Swap
Contracts
• Firms often must deal with a “sequence” of accounts payable or
receivable in terms of a foreign currency, and these recurrent cash flows
can be best hedged using a currency swap contract
o Currency swap contracts are agreements to exchange one currency
for another at a predetermined exchange rate, that is, the swap rate,
on a sequence of future dates
o Similar to a portfolio of forward contracts with different maturities
o Very flexible in terms of amount and maturity, with maturity ranging
from a few months to 20 years
Hedging through Invoice Currency
• Hedging through invoice currency is an operational technique that allows the firm to shift,
share, or diversify exchange risk by appropriately choosing the currency of invoice
o Example: If Boeing invoices $150m rather than £100m for the sale of aircraft, it does not
face exchange exposure anymore. Though the exchange exposure has not
disappeared, it has been shifted to the British importer.
o Another option would be for Boeing to invoice half of the bill in U.S. dollars and the
remaining half in British pounds, thereby sharing the exchange exposure
o Finally, the firm can diversify exchange exposure to some extent by using currency
basket units, such as the SDR, as the invoice currency
 Hedging via Lead and Lag
• The lead/lag strategy reduces transaction exposure by paying or collecting foreign
financial obligations early (lead) or late (lag) depending on whether the currency is hard or
soft
o Challenges associated with this strategy:
• If we assume Boeing would like BA to prepay £100m, we can also assume BA
would have no incentive to do so unless they received a substantial discount to
compensate for prepayment
• Pushing BA to prepay may hurt future sales efforts by Boeing
• To the extent the original invoice price incorporated the expected depreciation of
the pound, Boeing is already partially protected against depreciation of the pound
o Strategy can be employed more effectively to deal with intrafirm payables and
receivables among subsidiaries
Exposure Netting

• Realistically, typical multinational corporations are likely to have a portfolio of currency

positions
o In this case, firms should hedge residual exposure rather than hedge each currency
position separately
• Exposure netting is hedging only the net exposure by firms that have both payable and
receivables in foreign currencies
o For firms that would like to apply this approach aggressively, it helps to centralize the
firm’s exchange exposure management function in one location
o Many MNCs are using a reinvoice center, a financial subsidiary, as a mechanism for
centralizing exposure management functions