Taj Company Scandle

8/16/2019 Taj Company Scandle

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TRANSACTIONEXPOSURE

Presented by:

Umair Ahmed

Mohsin Shafque

i!a! "ameed

#u!rai$

Ansar

Presented to:

Sir imad-ud-din


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Transaction exposure refers to the change in the home currencvalue of an item whose foreign currency value is contractually fixed.

One obvious way in which most MNCs are exposed to exchange ratrisk is through contractual transactions that are invoiced in foreigcurrencies. The sensitivity of the firm’s contractual transactions in foreigcurrencies to exchange rate movements is referred to as TransactioExposure.

To assess transaction exposure an MNC needs to

• estimate its net cash flows in each currency and• measure the potential impact of the currency exposure.


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estimate its net %ash &o's in ea%h%urren%y

Consolidated Net Cash Flow Assessment

Currency Total Inflow Total

Outflow

Net Inflow or

Outflow

Expected

ExchangeRate

Net Inflow

Outflow

!ritish "ound £17,000,000

£7,000,000£10,000,00

0

$1.50 +$15,000,

0

Canadian#ollar

$%&&&&&& %&&&&&& $&&&&&&& '.(& )' (&&&&

*wedish+rona

%&&&&&&& $%&&&&&&& ,$&&&&&&& '.$- '$-&&&&

Mexicaneso

!"#"""#""" $"#"""#""" %"#"""#""" '.$& )' (&&&&

!i i ( d i i


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Po!i%ies (or "ed)in) Transa%tionE*+osure

"ed)in) E*+osure To Payab!es

/n MNC may decide to hedge part or all of its known payable

transactions so that it is insulated from possible appreciation of thcurrency. 0t may select from the following hedging techni1ues to hedge itpayables2

■ Futures hedge

■ Forward hedge

■ Money market hedge ■ Currency option hedge

!efore selecting a hedging techni1ue MNCs normally compare the casflows that would be expected when using each techni1ue. The selectioof the optimal hedging techni1ue can vary over time as the relativeadvantages of the various techni1ues may change over time.


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,or'ard hed)es on +ayab!es

/ 3orward Contract is negotiated between the firm and financial institution such as commercial banks and therefore can b

tailored to meet the specific needs of the firm. The contract will specifthe2

• Currency that the firm will pay

• Currency that the firm will receive

• /mount of currency to be received by the firm

• 4ate at which the Mnc will exchange currencies

• 3uture #ate at which the exchange of currencies will occur


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E*am+!e:

Coleman Co. is a 5.*.based MNC that will need $&&&&& euros in

year. 0t could obtain a forward contract to purchase the euros in $ year. Coleman purchases euros $ year forward its dollar cost in $ year is2

Cost in ' 6 "ayables x 3orward rate

6 $&&7&&& euros x '$2%&

6 &$'"#"""


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,uture %ontra%ts

The future rate is very similar to the forward rate only the maindifference would be that2

• The 3orward contracts are *tandardi8ed

• The forward contracts would be purchased on an 9xchange.


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Payab!es

/ money market hedge on payables involves taking a money markeposition to cover a future payables position. 0f a firm has excess cash ican create a simplified money market hedge. :owever many MNCs prefeto hedge payables without using their cash balances.

/ money market hedge re1uires two money market positions.

• borrowed funds in the home currency and

• a short term investment in the foreign currency


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E*am+!e:

0f Coleman Co. needs $&&&&& euros in $ year it could convert dollars teuros and deposit the euros in a bank today. /ssuming that it could earn percent on this deposit it would need to establish a deposit of !(#')euros in order to have $&&&&& euros in $ year as shown below2

#eposit amount to hedge payables 6 $&&&&& euros ;$ ) &.&- 6


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Money Mar-et "ed)e .ersus,or'ard "ed)e

*hould an MNC implement a forward contract hedge or a money markehedge? *ince the results of both hedges are known beforehand the firm

can implement the one that is more feasible. 0f interest rate parity @04"exists and transaction costs do not exist the money market hedge wiyield the same results as the forward hedge. This is so because thforward premium on the forward rate reflects the interest ratdifferential between the two currencies. The hedging of future payablewith a forward purchase will be similar to borrowing at the home interes

rate and investing at the foreign interest rate.


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Ca!! O+tion "ed)e on Payab!es

/ currency call option provides the right to buy a specified amount of particular currency at a specified price @called the strike price o

exercise priceA within a given period of time. Bet unlike a futures oforward contract the currency call option does not obligate its owner tbuy the currency at that price. The MNC has the flexibility to let thoption expire and obtain the currency at the existing spot rate whepayables are due.

C t f C ll O ti B d C


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Cost of Call Options Based on CurrencyForecasts

/n MNC may wish to incorporate its own forecasts of the spot rate at the time payableare due so that it can more accurately estimate the cost of hedging with call options.

Example

Coleman Co. considers hedging its payables of $&&&&& euros with a call option thahas an exercise price of '$.%& a premium of '.&= and an expiration date of $ year fromnow. /lso assume that Coleman’s forecast for the spot rate of the euro at the timpayables are due is as follows2

■ '$.$ @%& percent probabilityA

■ '$.%% @>& percent probabilityA

■ '$.%D @$& percent probabilityA


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+CENARIO +OT RATE,-EN

A.A/0E+ARE 12E

REMI2MER 2NITAI1 ON

CA00OTION+

AMO2NT AI1ER 2NIT

,-ENO,NIN3

CA00OTION+

TOTA0AMO2NT

AI1 ER 2NIT4INC021IN3

T-E REMI2M5,-EN

O,NIN3CA00 OTION+

&

FOE2O,

$ ' $.$ ' &.&= ' $.$ ' $.$< '

% ' $.%% ' &.&= ' $.%& ' $.%= '

= ' $.%D ' &.&= ' $.%& ' $.%= '


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0f *cenario % or = occurs Coleman will exercise the options antherefore purchase euros for '$.%& per unit and it will use the euros tmake its payment. Column - which is the sum of columns = and D showthe amount paid per unit when the '.&= premium paid on the call optio

is included. Column converts column - into a total dollar cost based othe $&&&&& euros hedged.

Comparison of Tecni!ues to "ed#e


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Comparison of Tecni!ues to "ed#eaya%les

The techni1ues that can be used to hedge payables are summari8ed ifollowing 9xhibit with an illustration of how the cost of each hedgintechni1ue was measured for Coleman Co. @based on the previouexamplesA. Notice that the cost of the forward hedge or money markehedge can be determined with certainty while the currency call optiohedge has different outcomes depending on the future spot rate at thtime payables are due.


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Forward Hedge

• "urchase euros $ year forward.

•

#ollars needed in $ year 6 payables in E x forward rate of euro6 $&&7&&& euros x '$2%&

6 '$%&7&&&

Money Market Hedge

!orrow ' convert to E invest E repay ' loan in $ year.

•

/mount in E to be invested 6 E$&&7&&& ;$.&-6 $


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Call Option

"urchase call option. @The following computations assume that the option is to beexercised on the day euros are needed or not at all. 9xercise price 6 '$.%& premium 6

'.&=.A

O++I/0E+OT

RATE IN $.EAR

REMI2MER 2NITAI1 FOR OTION

E6ERCI+EOTION7

TOTA0 RICE4INC021IN3

OTIONREMI2M5

AI1ER 2NIT

TOTA0 RICEAI1 FOR $""#"""E2RO+

RO/A/I0IT.

' $.$ ' &.&= No ' $.$< ' $$& F

' $.%D ' &.&= Bes ' $.%= ' $%=&&& $& F


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E.a!uatin) the "ed)e /e%ision

MNCs can evaluate hedging decisions that they made in the past bestimating the real cost of hedging payables which is measured as2

RCHp = Cost of hedging payales ! Cost of payales if not hedged

/fter the payables transaction has occurred an MNC may assess the outcome oits decision to hedge.

Example"

4ecall that Coleman Co. decided to hedge its payables with a forward contractresulting in a dollar cost of '$%&&&&. /ssume that on the day that it makes it

payment @$ year after it hedged its payablesA the spot rate of the euro is '$.$(Notice that this spot rate is different from any of the three possible spot ratethat Coleman Co. predicted. This is not unusual as it is difficult to predict thspot rate even when creating a distribution of possible outcomes. 0f ColemaCo. had not hedged its cost of the payables would have been '$$(&&@computed as $&&&&& euros G '$.$(A. Thus Coleman’s real cost of hedging is2


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RC-p 8 Cost of hedging paya9les : Cost of paya9les if not hedged

8 &$'"#""" :&$$%#"""

8 &'#"""

0n this example Coleman’s cost of hedging payables turned out to be '%&&more than if it had not hedged. :owever Coleman is not necessarildisappointed in its decision to hedge. That decision allowed it to know exactlhow many dollars it would need to cover its payables position and insulated thpayment from movements in the euro.


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RECEI0A1ES

/n MNC may decide to hedge part or all of its receivables transactidenominated in foreign currencies so that it is insulated from the possidepreciation of those currencies.

Forward or Futures Hedge on Recei#ales

3orward contracts and futures contracts allow an MNC to lock in a specexchange rate at which it can sell a specific currency and therefore allow ithedge receivables denominated in a foreign currency.

Example

Hiner Co. is a 5.*.based MNC that will receive %&&&&& *wiss francs in monthscould obtain a forward contract to sell *3%&&&&& in months. The ,moforward rate is '.>$ the same rate as currency futures contracts on *wiss francsHiner sells *wiss francs months forward it can estimate the amount of dollarsbe received in months2

Cash inflow in ' 6 4eceivables x 3orward rate

6 *3%&&7&&& x '2>$

6 '$D%7&&&


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Money Market Hedge on Recei#ales

/ money market hedge on receivables involves borrowing the currency thawill be received and using the receivables to pay off the loan.

E$%M&'E

Hiner Co. will receive *3%&&&&& in months. /ssume that it can borrow funddenominated in *wiss francs at a rate of = percent over a ,month period. Thamount that it should borrow so that it can use all of its receivables to repay thentire loan in months is2

/mount to borrow 6 *3%&&7&&& ;$.&=

*3 $-

0f Hiner Co. obtains a ,month loan of *3$- from a bank it will owe thbank *3%&&&&& in months. 0t can use its receivables to repay the loan. Thfunds that it borrowed can be converted to dollars and used to support existinoperations.


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Re%ei.ab!es

/ put option allows an MNC to sell a specific amount of currency at specified exercise price by a specified expiration date. /n MNC capurchase a put option on the currency denominating its receivables an

lock in the minimum amount that it would receive when converting threceivables into its home currency. :owever the put option differs from forward or futures contract in that it is an option and not an obligation. the currency denominating the receivables is higher than the exercisprice at the time of expiration the MNC can let the put option expire ancan sell the currency in the foreign exchange market at the prevailin

spot rate. The MNC must also consider the premium that it must pay fothe put option.

Cost o( Put O+tions ased on


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Cost o( Put O+tions ased onCurren%y ,ore%asts

/n MNC may wish to incorporate its own forecasts of the spot rate at the time receivablewill arrive so that it can more accurately estimate the dollar cash inflows to be receivewhen hedging with put options.

Example"

Hiner Co. considers purchasing a put option contract on *wiss francs with an exercisprice of '.>% and a premium of '.&%. 0t has developed the following probabilitdistribution for the spot rate of the *wiss franc in months2

■ '.>$ @=& percent probabilityA

■ '.>D @D& percent probabilityA

■ '.> @=& percent probabilityA

+CENARIO +OT RATE REMI2M ER AMO2NT NET AMO2NT 1O00AR


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,-ENA.MENT ONRECEI;A/0E+I+ RECEI;E1

2NIT ON 2TOTION+

RECEI;E1ER

2NIT ,-ENO,NIN3 2T

OTION+

RECEI;E1ER

2NIT 4AFTER ACCO2NTIN3

FORREMI2M

AI15

AMO2NTRECEI;E1

FROM-E13IN3

+F'""#""RECEI;A/0

,IT-2T OTIO

$ ' &.>$ ' &.&% ' &.>% ' &.>& ' $D&&&

% ' &.>D ' &.&% ' &.>D ' &.>% ' $DD&&

= ' &.> ' &.&% ' &.> ' &.>D ' $D(&&


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The expected dollar cash flows to be received from purchasing the puoptions on *wiss francs are shown in the above 9xhibit. The seconcolumn discloses the possible spot rates that may occur in month

according to Hiner’s expectations. The third column shows the optiopremium that is the same regardless of what happens to the spot rate ithe future. The fourth column shows the amount to be received per unias a result of owning the put options. 0f the spot rate is '.>$ in the future@see the first rowA the put option will be exercised at the exercise pricof '.>%. 0f the spot rate is more than '.>% in months @as reflected irows % and =A Hiner will not exercise the option and it will sell the *wisfrancs at the prevailing spot rate. Column - shows the cash received peunit which adIusts the figures in column D by subtracting the premiumpaid per unit for the put option. Column shows the amount of dollars tbe received which is e1ual to cash received per unit @shown in column -multiplied by the amount of unit @%&&&&& *wiss francsA.J

Com+arison o( Te%hniques (or


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Com+arison o( Te%hniques (or"ed)in) Re%ei.ab!es

The techni1ues that can be used to hedge receivables are summari8ed the following with anillustration of how the cash inflow from each hedging techni1ue was measured for Hiner Co.

Forward Hedge

*ell *wiss francs months forward.

#ollars to be received in months 6 receivables in *3 x forward rate of *3

6 *3%&&&&& x '&.>$

6 '$D%&&&

Money Market Hedge

!orrow *3 convert to ' invest ' use receivables to pay off loan in months.

/mount in *3 borrowed 6 *3%&&&&&;$.&=

6 *3$-

' received from converting *3 6 *3$- x '&.>& per *3

6 '$=-


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&ut Option Hedge

"urchase put option. @/ssume the options are to be exercised on the day *3 are to bereceived or not at all. 9xercise price 6 '.>% premium 6 '.&%.A

O++I/0E+OT RATE IN

< MONT-+

REMI2MER 2NITAI1 FOR OTION

E6ERCI+EOTION7

RECEI;E1ER

2NIT 4AFTER ACCO2NTIN3

FOR T-E

REMI2M5

TOTA01O00AR+RECEI;E1

FROMCON;ERTIN3+F'""#"""

RO/A/I0IT.

' &.>$ ' &.&% Bes ' &.>& ' $D&&&& =& F

' &.>D ' &.&% No ' &.>% ' $DD&&& D& F

' &.> ' &.&% No ' &.>D ' $D(&&& =& F

TEC"NI2UES


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TEC"NI2UES

Khen a perfect hedge is not available @or is too expensiveA to eliminattransaction exposure the firm should consider methods to at least reducexposure. *uch methods include the following2

■ Leading and lagging

■ Cross,hedging

■ Currency diversification

'eading and 'agging

Leading and lagging strategies involve adIusting the timing of a payment re1ues

or disbursement to reflect expectations about future currency movements.E$%M&'E Corvalis Co. is based in the 5nited *tates and has subsidiariedispersed around the world. The focus here will be on a subsidiary in the 5nite+ingdom that purchases some of its supplies from a subsidiary in :ungary. Thessupplies are denominated in :ungary’s currency @the forintA. 0f Corvalis Coexpects that the pound will soon depreciate against the forint it may attempt texpedite the payment to :ungary before the pound depreciates. This strategy

referred to as leading.

/ d i th t th ! iti h b idi t th d


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/s a second scenario assume that the !ritish subsidiary expects the poundappreciate against the forint soon. 0n this case the !ritish subsidiary may attempstall its payment until after the pound appreciates. 0n this way it could use fepounds to obtain the forint needed for payment. This strategy is referred to as laggi

Cross!HedgingCross,hedging is a common method of reducing transaction exposure when

currency cannot be hedged.

Example

reeley Co. a 5.*. firm has payables in 8loty @"oland’s currencyA


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Currency (i#ersification

/ third method for reducing transaction exposure is currency diversificationwhich can limit the potential effect of any single currency’s movements on thvalue of an MNC. *ome MNCs such as The Coca,Cola Co. "epsiCo and /ltria

claim that their exposure to exchange rate movements is significantly reducebecause they diversify their business among numerous countries.

The dollar value of future inflows in foreign currencies will be more stable ithe foreign currencies received are not highly positively correlated. The reason ithat lower positive correlations or negative correlations can reduce thvariability of the dollar value of all foreign currency inflows. 0f the foreigcurrencies were highly correlated with each other diversifying among themwould not be a very effective way to reduce risk. 0f one of the currenciesubstantially depreciated the others would do so as well given that all thescurrencies move in tandem.


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Taj Company Scandle