Transaction Exposure (Hedging and Foreign Exchange Risk Management)

Contents

1. Alternative Ways of Hedging Against Exchange Risk on Transaction

2. Hedging Through Options

Learning Objectives:

1. Identify transaction exposure,. Which assets or liabilities and cash flows are exposed to changes in exchange rates?

2. Strategies to hedge or not to hedge against the exchange rate risk. How to manage transaction exposure?

3. How to conduct hedging through a forward contract? 4. How to conduct a spot hedge or a money-market hedge? 5. How to conduct hedging through an option? 6. Evaluate various strategies and make a decision in favor of a certain strategy.

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Hedging and Foreign Exchange Risk Management Various currency derivatives such as forward, futures, and options may be used to

hedge against the exchange risk. An example presented here illustrates various

hedging strategies to protect transaction exposure against exchange rate changes.

1.0 ALTERNATIVE WAYS OF HEDGING AGAINST EXCHANGE

RISK IN TRANSACTIONS

Example:

General Dynamics, Inc., a US MNC, sells a gas turbine for power generation, to a

British firm in March for £1 million. Payment is due in June.

The following quotes are observed:

Spot exchange rate $1.400/£ 3-month forward rate $1.4175/£ UK 3-month interest rate 8% p.a. US 3-month interest rate 10% p.a. June Put option on Philadelphia Options Exchange for £12,500: Strike price 140:2.50 cents/£. Brokerage cost $25 per contract. June put option in the OTC market at strike price of 140:2% premium. Forecast of future spot rate: 3-month spot rate $1.4350/£.

Four alternatives will be considered:

1. Speculate or remain un-hedged 2. Forward market hedge 3. Money market hedge 4. Option market hedge

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2.0 Objective:

To hedge the transaction exposure on current asset of accounts receivable that

comes in existence in March, and to maximize dollar receipt against the accounts

receivable denominated in pounds.

The main concern is that pound will depreciate against dollar (or dollar will appreciate

against pound) so that dollar receipt against pound receivables will be adversely

affected.

2.1 Remain un-hedged

GD may be just happy with the transaction risk. If the managers of GD place a very

high trust in the Foreign Exchange Advisory’s forecast of $1.4350/£, they may decide

not to hedge. In this case they are exposed to risk,and their expected receipt is

£1,000,000($1.4350/£)=$1,435,000 in 3 months. (This amount, however, is at risk).

Suppose, if the pound falls to $1.3800/£ in June, GD would receive only $1,380,000

($1,435,000- $1,380,000= $55,000 less). However, if the transaction were left

uncovered and pound strengthened even more than the forecast, GD could receive

more than $1,435,000. Thus, depending upon the future spot rate, there will be

transaction gain or loss.

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2.2 Forward Market Hedge

This hedge involves a forward contract and a source of funds to fulfill that contract.

The forward contract is entered into at the time the transaction exposure is created. In

the case of GD, the transaction exposure is created in March, when the sale to the

British firm was booked as an account receivable. If the funds to fulfill the contract are

either in hand or due because of business operation, the hedge is considered "covered",

"perfect" or "square" because no residual foreign exchange risk is left. Funds on hand

or to be received are matched by funds to be paid.

If the funds to fulfill the forward exchange contract are not already available or

due later, but must be purchased in the spot market at some future date, then such a

hedge is "open" or "uncovered".

The dollar value of receivables through forward hedge = £1,000,000 x$1.4175/£

= $1.4175 million.

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2.3 Money Market Hedge or Spot market Hedge

Like a forward market hedge, a money market hedge or Spot market Hedge also

involves a contract and a source of funds to fulfill that contract. In this instance, the

contract is a loan agreement. The firm seeking the money market hedge borrows in

one currency and exchanges the proceeds for another currency. Funds to fulfill the

contract to repay the loan may be generated from business operations.

Note: The cost of money market hedge is determined by interest rate differential. If

the markets are efficient, such that the interest rate parity (IRP) holds, the cost of

forward market hedge and money market hedge will be identical.

How the money market hedge is conducted

Note that funds in £ are generated due to business operations in the form of £-

receivables. One can borrow (enter into a loan agreement) against the current asset of

accounts receivables, which serves as a collateral.

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1. Borrow pounds. How much? Of course the present value of £1,000,000. GD

will need to borrow just enough to repay both principal and interest with the sale

proceeds (£1,000,000). The interest is 8% per annum (or 2% for 3 months)

PV=£1,000,000/1.02=£980,393.

The firm should borrow £980,392 and after 3 months repay that amount plus the

interest of £19,608.

2. Exchange £980,392 for $ at the current spot rate of $1.40/£ and receive

$1,372,549.

3. Invest in $ money market at the 3-month rate of 2.50% (10% per annum) to

receive in June:

FV=$1,372,549 (1+0.025)=$1,406,862.73

Note that the above cash flow is less than that obtained through the forward market

hedge because quarterly forward rate differential is not equal to the quarterly interest

rate differential (you may like to verify this proposition by calculating the forward and

interest rate differentials and checking whether the IRP holds). Since the IRP does not

hold, under the given conditions, the forward hedge is superior to the money market

hedge.

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2.4 Options Market Hedge

2.41 PHLX Options

GD could cover its £1,000,000 exposure by purchasing a put option on £. The idea is

to take advantage on the upside potential on the value of £ while limiting the downside

risk to a known amount.

1. GD can buy a put option on PHLX with a June expiration date, a strike of 140,

a premium cost of 2.50 cents per pound, and a contract size of £12,500.

2. Through the put options, GD can lock in the minimum price of £ in dollars.

Put options on £ means option to sell £. Accounts receivables are the source of £, but

the put option enables to hedge against the depreciation of £.

3. Premium Cost $0.025/£.(£12,500)=$312.50 per one option contract.

Brokerage Cost =25.00 per one option contract

Total Cost =$337.50 per one option contract

Option Cost per £ =$337.50/$12500=$0.027/£

Number of options needed=£1,000,000/£12500=80

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Total Cost for 80 options=80.($337.50)=$27,000.

2.42 OTC Options

Alternatively GD could also buy a similar put from a participating international bank

over-the-counter (OTC) for a 2% premium.

1. Up-front premium cost = size of option * premium.

= £1,000,000x$1.40/£x$0.02/£ = $28,000.

Therefore, GD should choose OTC put option, which costs $1000 less.

2. When a sum of £1,000,000 is received in June, the value in dollars will depend

upon the spot rate in June.

Consider the following two scenarios:

A. £ depreciates against dollar (for example $1.35/£).

B. £ appreciates against dollar. At any exchange rate above $1.400 (the exercise

price), GD would allow its option to expire unexercised and would exchange

the pounds for dollars at the spot rate. That rate could be $1.4175 (the forward

rate), $1.4350 (the expected forecast rate), or any other higher rate.

For instance, if the expected rate of $1.4350 is realized in June, then GD will receive

£1,000,000=$1,435,000 in the future spot market.

Net proceeds=1,4365,000-27,000 (ignoring the interest cost on $27,000 from March to

June)

=$1,408,000

The downside risk is limited with an option. If the pound depreciated below $1.4000,

GD would exercise its option to sell (put) £1,000,000 at $1.4000/£ receiving

$1,400,000 gross, and a net of the $1,373,000 after the premium cost. Although this

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downside result is worse than the downside of the forward or money market hedges,

the upside potential is not limited. Thus the superiority of the option strategy over

other hedges depends upon the degree to which the management is riskaverse.

The break even upside spot price of £ must be

1.4175+0.0270=1.4445.

If the pound has a considerable volatility, there is good chance that it may appreciate

against dollar above $1.4455/£, then the option would be a better strategy.

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3.0 Graphical Presentation of Various Hedging Alternatives

Spot at maturity $/£ (X) Unhedged (Y1) Forward Hedge (Y2)

Money market Hedge (Y3)

Option Market Hedge (Y4)

Total Recepts

$ million

Recept Per unit $/£

Total Recepts

$ million

Recept Per unit

$/£

Total Recepts $ million

Recept Per unit $/£

Total Recepts

$ million

Receipt Per unit

$/£

1.35 1.35 $ 1.35/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.3730 $ 1.3730/₤ ITM

1.36 1.3 $ 1.36/₤ 1.41 5 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.3730 $ 1.3730/₤ ITM

1.37 1.37 $ 1.37/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.3730 $ 1.3730/₤ ITM 1.38

1.38 $ 1.38/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.373 $ 1.3730/₤ ITM 1. 9

1.39 $ 1.39/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤ =

1.3730 $ 1.3730/₤ ITM

1.40 1.40 $ 1.40/₤ 1.4175 $ 1.4175/₤ $ 1.40682/₤

1.3730 $ 1.3730/₤ ATM

1.41 1.41 $ 1.41/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.3830 $ 1.3830/₤ OT 1.4175*

1. 175 $ 1.4175/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.3905 $ 1.3905/₤ OTM

1.42 1.42 $ 1.42/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.3930 $ 1.3930/₤ OTM

1.43 1.43 $ 1.43/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4030 $ 1.4030/₤ OTM 1.4350** 1.4 50 $ 1.4350/₤

1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4080 $ 1.4080/₤ OTM

1.44 1.44 $ 1.44/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4130 $ 1.4130/₤ OTM

1.45 1.45 $ 1.45/₤ 1.4175 $ 1.4175/₤ 1.4068 $ 1.40682/₤

1.4230 $ 1.4230/₤ OTM

1.46 1.46 $ 1.46/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4330 $ 1.4330/₤ OTM

1.47 1.47 $ 1.47/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4430 $ 1.4430/₤ OTM

1.48 1.48 $ 1.48/₤ 1.4175 $ 1.4175/₤ 1 40682 $ 1.40682/₤

1. 530 $ 1.4530/₤ TM

1.49 1.49 $ 1.49/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4630 $ 1.4630/₤ OTM

1.50 1.50 $ 1.50/₤ 1.4175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4730 $ 1.4730/₤ OTM

1.51 1.51 $ 1.51/₤ 1. 175 $ 1.4175/₤ 1.40682 $ 1.40682/₤

1.4830 $ 1.4830/₤ OTM

* Forward Rate

** Forecast Rate

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3.1 Interpretation of the Graph

Following the graph of alternative hedges we can conclude:

1. If St ($/₤) < $ 1.400/₤ (put is ITM), the put option will be exercised at the

exercise price of x = 1.4. The portfolio value (underlying current assets of accounts

receivable + the put option ) is:

$ 1.4000/₤ * ₤1,000,000 – 27,000 = 1,373,000

So if ₤ depreciates unduly below the exercise price, the dollar value of accounts

receivable is protected and a guaranteed sum of $ 1,373,000 will be received.

2. If St = 1.435 ( The forecast of exchange rate is realized, put is OTM)

The put option will not be exercised because it is more profitable to sell ₤ in the spot

market at the exchange rate of $ 1.435/₤.

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3. Suppose we want to compare the forward and option hedges. What is the spot

rate at which the two hedges are equivalent?

F * (₤1m) = St (₤/m) – P (₤1m)

F = St – P

1.4175 = St – 0.027

St = 1.4445

If the spot rate exceeds $1.44$/₤, then option is a better choice.

3.2 Conclusion

If you expect that the spot exchange rate will be realized in the range 1.373 –

1.4450, then both remaining unhedged and the forward hedge are superior to

the put option hedge

If you expect that S will be realized above 1.4450, then put option hedge is a

better choice.

If S < 1.3730, then forward hedge may be a good choice.

If exchange rates are highly volatile (large variability), so that there is a high

probability that the spot rate will shoot above 1.4445, then put option hedge is

quite desirable.

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4.0 Summary of Hedging Actions

GOAL: Receive ____ maximum $ from sale

ALTERNATIVES

RESULTS

Unhedged Wait 3 months, then sell £ 1m for $ in the spot market.

Receive in 3 months 1. An unlimited Max. 2. An Exp. $1,435,000. 3. A Min of zero.

FWD, MKT, HEDGESell £ 1m forward for $ @ ST =$1.4175/£ to get $1,417,500 three months later.

Receive $1,417,500 in 3 months (certain)

MONEY MKT, HEDGE borrow £980,392 in U.K. (PV of £ 1m)@8% p.a. Buy spot $@$1.4/£ to get $1,372,549 which can be invested in US for 3 months.

Receive $1,372,549 in March. Future value after 3 months depends on US Int rate. i s . with

i s =10% receive

$1,406,862.73

OPTION MKT, HEDGE buy 3-month PUT of £ 1m Exercise price S=$1.40/£ p=$27,000

1. Receive in 3 months (unlimited Max -27,000) 2. An expected amount of 1,408,000 3. A Min 1,373,000

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HEDGING THROUGH AMERICAN OPTIONS: THE CASE OF GENERAL

DYNAMICS (The payment date is not certain)

Example:

General Dynamics, a U.S. importer will have a net cash outflow of £250,000 in

payment for goods bought. The payment date is not known with certainty, but should

occur around October 31. On September 16 the importer looks in a ceiling purchase

for pounds by buying eight PHLX calls on the pound, with a strike price of $1.5/£ and

an expiration date in December. The option premium on that date is $0.0220/£. There

is a brokerage commission of $4 per option contract for each transaction of buy or sell.

The opportunity cost on funds is 9% p.a. (Assume 360 days in a year).

1. What is the initial total cost of eight options contracts?

2. What is the ceiling price of £ in dollars that the importer has assured though the

options?

3. Consider two possible scenarios on Nov. 30:

a) spot exchange rate is $1.46/£:

b) spot exchange rate is $1.55/£

In each scenario, determine whether the importer should exercise the options, and find

the cost of £ in terms of $. On October 30, the call premium has increased to $0.055/£

for the same options that mature in December.

We will answer the above questions as follows:

The total cost of the eight contracts is:

8(£ 31,250)($0.0220)+8($4)=$5,532

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If opportunity cost for about 45 days (Sept 16 to October 30) is also considered, then

the total cost is:

5,532(1+0.01125)=5594.235

Or, $5594.235/250,000 = $0.022377/£

Measured from today’s viewpoint, the importer has essentially assured that the

purchase price for pounds will not be greater than

$1.50/£ + $0.022377/£ = $1.522377/£

Notice here that the add factor $0.022377/£ is larger than the option premium of

$0.0220/£ by $0.000377/£, which represents the dollar brokerage cost and opportunity

cost for 45 days.

The number $1.52237 is the importer’s ceiling price (the maximum price). The

importer is assured he will not pay more than this, but he could pay less. The price the

importer will actually pay will depend on the spot price on the October payment date.

To illustrate this, we consider two possible scenarios for the spot rate on October 30 .

Suppose the spot rate on October 30 payment date is $1.46/£. The importer would

not use the options but would buy pounds spot for the cheaper rate of $1.46/£. He or

she would then sell the eight calls for whatever market value they hold. Given the

brokerage fee of $4 per contract for the sale, the options would be sold as long as their

market value was greater than $4 per option. The total cost per pound will be:

=$1.46/ £ + $0.022377/£ - 0.055 + [(8x4)/250,000] = $1.427/£

Suppose the spot rate on October 30 is $1.55/£.

Here, we are required to find the alternative, whether to exercise or not to exercise,

that gives lower cost.

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a. If GD does not exercise the option.

The cost of £

= spot price + (call premium paid initially + interest foregone) - (call premium

received from sale of unexercised option) + brokerage cost of setting options

= $1.55/£ + $0.022377/£ - 0.055 + [(8x4)/250,000] = $1.49537/£

b. If GD exercises the options, the cost of £ in $ is:

= strike price + call premium paid initially + brokerage fee + interest

foregone

=$1.50/£ + $0.022377/£

=$1.52377/£ (greater than $1.49537/£ in a. above)

Hence, the US importer is better of by not exercising the options even though the spot

rate is above exercise price.