Chapter 11 - Managing Transaction Exposure PDF

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Summary

Policies for hedging transaction exposure: Hedging most of the exposure: Doing this allows MNCs to more accurately forecast future cash flows (in home currency), so that they can make better decisions regarding the amount of financing they will need Selective hedging: MNC must identify its degree ...

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Chapter 11: Managing Transaction Exposure Policies for hedging transaction exposure: 

Hedging most of the exposure: Doing this allows MNCs to more accurately forecast future cash flows (in home currency), so that they can make better decisions regarding the amount of financing they will need

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Selective hedging: MNC must identify its degree of transaction exposure MNC must consider the various techniques to hedge the exposure so that it can decide which hedging technique is optimal and whether to hedge its transaction exposure

Hedging Exposure to Payables: A MNC can decide to hedge part or all of its known payables transactions using: 1. Forward or Futures hedge  Allows a MNC to lock in a specific exchange rate at which it can purchase a currency and hedge their payables  Forward contract is negotiated between the firm and a financial institution  Contract will specify: - Currency the firm will pay - Currency the firm will receive - Amount of currency to be received by the firm - Rate at which the MNC will exchange currencies (forward rate) - Future date at which the exchange will occur 2. Money Market hedge  Involves taking a money market position to cover a future payables position  Involves borrowing local currency and converting it to the currency denominating payables. Invest these funds until they are needed to cover the payables 3. Currency Option hedge Currency Call:  A currency call option provides the right to buy a specified amount of a particular - Borrow funds in the home currency - Invest in the foreign currency  currency at a specified strike/exercise price within a given period of time  Currency call option does not obligate its owner to buy the currency at this price. MNC has the flexibility to let the option expire and obtain the currency at existing spot rate  The cost of call options are based on a contingency graph - This provides an effective hedge - A premium must be paid  Cost of call options are based on currency forecasts  When deciding what type of call option to purchase, you compare it to the other hedging techniques to see what is the most desirable for hedging a particular payables position

Chapter 11: Managing Transaction Exposure Comparing techniques to hedge payables: 

Cost of forward hedge or money market hedge can be determined with certainty, the currency call option hedge has different outcomes depending on the future spot rate

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Money Market v Forward hedge…  Since results of both are known beforehand, the firm can implement the one which is more feasible. If IRP holds and there are no transaction costs, the money market hedge will yield the same results as the forward hedge

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Select optimal hedging technique by:  Consider whether future or forward are preferred  Consider desirability of money market hedge versus futures/forwards based on cost  Assess the feasibility of a currency call option based on estimated cash outflows

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Choose optimal hedge versus no hedge for payables – even when a MNC knows what its future payables will be, it may decide not to hedge in some cases

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Evaluate the hedge decision by estimating the real cost of hedging versus the cost if not hedged

EG. Deciding whether to hedge or not… Firm’s estimates of its cost of payables when unhedged: So

the expected value of the payables when not hedged is estimated as: (116,000 x 20%) + (122,000 x 70%) + (124,000 x 10%) = $121,000  expected value is $1,000 more than if the firm uses a forward hedge & probability distribution suggests an 80% probability that the cost of payables when unhedged will exceed the cost of hedging with a forward contract SO the firm should hedge using forwards

Real cost of hedging:

Chapter 11: Managing Transaction Exposure Hedging Exposure to Receivables: 1. Forward or Future hedge on receivables  Allows the MNC to lock in the exchange rate at which it can sell a specific currency. 2. Money Market hedge on receivables  Involves borrowing the currency denominating the receivables, converting it to the local currency and investing it. Then pay off the loan with cash inflows from the receivables 3. Put option hedge:  Provides the right to sell a specified amount of a particular currency at a specified strike price by a specified expiration date  Cost of put options based on a contingency graph: - Provides an effective hedge - Premium must be paid  A MNC can use currency forecasts to more accurately estimate the dollar cash inflows to be received when hedging with put options

Comparing Techniques for Hedging Receivables: 

Select optimal hedging technique by:  Consider whether future or forward are preferred  Consider desirability of money market hedge versus futures/forwards based on cost  Assess the feasibility of a currency put option based on estimated cash outflows

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Choose optimal hedge versus no hedge for receivables – even when a MNC knows what its future receivables will be, it may decide not to hedge in some cases

Limitations of Hedging: 

Limitation of hedging an uncertain payment  some transactions can involve an uncertain amount of foreign currency, leading to over hedging

Alternative Hedging Techniques: 

Leading and Lagging = adjusting the timing of a payment or disbursement to reflect expectations about future currency movements

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Cross-Hedging = hedging by using a currency that serves as a proxy for the currency in which the MNC is exposed

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Currency Diversification = reduce exposures by diversifying business among numerous countries...