International Finance Lecture 9 Page 1 International

International Finance Lecture 9 Page 1

International Finance • Course topics – Foundations of International Financial Management – World Financial Markets and Institutions – Foreign Exchange Exposure – Financial Management for a Multinational Firm 2

Foreign Exchange Exposure • Economic Exposure • Translation Exposure • Transaction Exposure 3

Transaction Exposure • Risk exposure that arises from _____ obligations to pay in foreign currency, or from ______ foreign currency-denominated payments. Exposure management tools Forward market hedge Money market hedge Options hedge Cross-hedging currency Hedging contingent exposure • Hedging recurrent exposure with swaps • • • 4 • Hedging through invoice • • currency Lead and lag Exposure netting Should firms always hedge? Popular risk management products.

Example Consider a situation when Boeing sells five 747 s to Garuda, the Indonesian airline, in rupiahs. The rupiah price of the deal is Rp 140 billion. To help reduce the impact on Indonesia’s balance of payments, Boeing agrees to buy parts from various Indonesian companies worth Rp 55 billion. • If the spot rate is $0. 004, what is Boeing’s net rupiah transaction exposure? • • If the rupiah depreciates to $0. 0035, what is Boeing’s transaction loss? 5

Forward Market Hedge • If you are going to owe foreign currency in the future, you should buy the foreign currency now by entering into long position in a forward contract. – Idea: remove _______ with respect to the price of the foreign ______ in the future • If you are going to receive foreign currency in the future, you should sell the foreign currency now by entering into short position in a forward contract. – Idea: remove uncertainty with respect to the domestic currency ______ related to the future foreign currency ______ • Same way to hedge with futures, except futures offer more flexibility. 6

Forward Market Hedge • You are a Canadian importer of British woolens and have just ordered next year’s inventory. Payment of £ 100 M is due in one year. • Question: How can you fix the cash outflow in dollars? • Answer: One way is to put yourself in a position that delivers £ 100 M in one year is – _________________ 7

Forward Market Hedge $0 8 Value of £ 1 in $ in one year

Forward Market Hedge $0 9 Value of £ 1 in $ in one year

Forward Market Hedge Long forward $30 m $0 $1. 20/£ $1. 50/£ Value of £ 1 in $ in one year –$30 m Unhedged payable 10

Example • A US exporter has been promised a JPY 125 million payment in 7 months. What would be the perfect way to remove all uncertainty with respect to the $ value of the JPY payment? Be specific. • • The OTC forward contracts are not available, the US company decides to use futures market. CME lists JPY 12, 500, 000 maturing in 9 months. What is the hedging plan? Be specific. • 11

Example (continued) The current conditions are as follows. Interest rate in USD is 6%, in JPY it is 5%, spot JPY/USD=125. 00 and futures JPY/USD=124. 07. • Seven months later the conditions are: interest rate in USD is 6%, in JPY it is 2%, spot JPY/USD=150. 00 and futures JPY/USD=149. 00. • What is the $ gain or loss on the (i) unhedged position in JPY, (ii) futures position and (iii) the hedged position? • 12

Money Market Hedge • To hedge a foreign currency payable, ______ that foreign currency today and sit on it. – It’s more efficient to buy the ______ of the foreign currency payable today. – Invest that amount at the foreign rate. – At maturity your investment will have _____ enough to cover your foreign currency payable. 13

Money Market Hedge The importer of British woolens can hedge his £ 100 million payable with a money market hedge: 1. Borrow $112. 05 million in Canada. 2. Translate $112. 05 million into pounds at the spot rate S($/£) = $1. 25/£ 3. Invest £ 89. 64 million in the UK at i£ = 11. 56% for one year. In one year the investment will have grown to £ 100 million. Spot exchange rate 360 -day forward rate S($/£) = $1. 25/£ F 360($/£) = $1. 20/£ Canadian discount rate i$ = 7. 10% British discount rate i£ = 14 11. 56%

Money Market Hedge Where do the numbers come from? We owe our supplier £ 100 million in one year—so we know that we need to have an investment with a future value of £ 100 million. Since i£ = 11. 56% we need to invest £ 89. 64 million at the start of the year: How many dollars will it take to acquire £ 89. 64 million at the start of the year if the spot rate S($/£) = $1. 25/£? 15

Money Market Hedge If we borrow $112. 05 today we will owe $120 in one year to the Canadian lender: With this money market hedge, we have redenominated our future £ 100 payable into a future $120 payable. 16

Money Market Hedge 1. Calculate the present value of £y at i£ £y (1+ i£)T 2. Borrow the CAN $ value of receivable $x at the spot rate. £y £y 3. Exchange $x = S($/£)× for (1+ i£)T £y 4. Invest at i£ for T years. (1+ i£)T 5. At maturity your pound sterling investment pays your receivable. 6. Repay your dollar-denominated loan with $x(1 + i$)T. 17

Example • Pepsi. Co would like to hedge its CAN$ 40 million payable to Alcan, a Canadian aluminum producer, which is due in 90 days. It faces the following conditions: Spot rate: US$0. 7307 -12, 90 -day forward rate: US$0. 7320 -41, interest rates (p. a. ) in the US 5. 35 -5. 50%, in Canada 4. 64%-4. 71%. Should Pepsi. Co use forward or money market hedge? Use 30 days/month and 360/year interest conversion. 18

Example (continued) 19

Options Market Hedge • Options provide a flexible hedge against the _______, while preserving the _____ potential. • To hedge a foreign currency payable buy calls on the currency. – If the currency appreciates, your call option lets you buy the currency at the ________ of the call. • To hedge a foreign currency receivable buy puts on the currency. – If the currency ________, your put option lets you sell the currency for the exercise price. 20

Options Markets Hedge Profit –$5 m loss 21 Value of £ 1 in $1. 55 /£ one year $1. 50/£

Options Markets Hedge Profit Long call on £ 100 m –$5 m $1. 45 /£ Value of £ 1 in $ in one year Unhedged loss 22 $1. 50/£ payable

Options Markets Hedge Profit Long call on £ 100 m –$5 m $1. 45 /£ loss 23 Value of £ 1 in $1. 80/£ one year $1. 50/£ Unhedged payable

Example • You are a British exporter and it is December now. You know you will receive US$15, 000 in 3 months (March). The current spot rate is USD/GBP $1. 5, and the March forward rate is also $1. 5. Calls on GBP are quoted by your bank for the exact amount that you need as follows: March Sterling Options (prices in USD per GBP) Strike 1. 50 • Call price 0. 030 What will be your cash flow in 3 months if rate is $1. 7 Consider the following scenarios: (i) you do no hedging, (ii) you hedge with forward contracts, (iii) you hedge with calls 150. 24

Example 25

Cross-Hedging Minor Currency Exposure • The _____ currencies are the: U. S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. • Everything else is a minor currency, like the Polish zloty. • It is difficult, expensive, or impossible to use financial contracts to hedge exposure to _____ currencies. 26

Cross-Hedging • Cross-Hedging involves hedging a position in one asset by taking a position in another asset. • The effectiveness of cross-hedging depends upon how well the assets are correlated. – An example would be a U. S. importer with liabilities in ______ hedging with long or short forward contracts on the _____. If the koruna is expensive when the euro is expensive, or even if the koruna is cheap when the euro is expensive it can be a good hedge. But they need to ______in a predictable way. 27

Hedging Contingent Exposure • If only certain __________ give rise to exposure, then options can be effective insurance. • For example, if your firm is bidding on a hydroelectric dam project in China, you will need to hedge the Canadian dollar-Renminbi exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with _________. 28

Recurrent Exposure and Swaps • Recall that _____ contracts can be viewed as a portfolio of _______ contracts. • Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with ____ than with a program of hedging _______ exposure as it comes along. • It is also the case that swaps are available in longer-terms than futures and forwards. 29

Invoice Currency • The firm can shift, share, or diversify: – shift exchange rate risk • – share exchange rate risk • – diversify exchange rate risk • 30

Hedging via Lead and Lag • If a currency is _______, pay bills denominated in that currency _______; let customers in that country pay _____ as long as they are paying in that currency. • If a currency is _______, give incentives to customers who owe you in that currency to pay _____; pay your obligations denominated in that currency as ____ as your contracts will allow. 31

Exposure Netting • A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions. – As an example, consider a U. S. -based multinational with Korean _____ receivables and Japanese _____ payables. Since the won and the yen tend to move in similar directions against the U. S. dollar, the firm can just wait until these accounts come _____ and just buy yen with won. – Even if it’s not a perfect hedge, it may be too ______ or impractical to hedge each currency separately. 32

Exposure Netting • Many multinational firms use a reinvoice center. Which is a financial subsidiary that ____ out the intrafirm transactions. • Once the _____ exposure is determined, then the firm implements hedging. 33

Should the Firm Hedge? • Not everyone agrees that a firm should hedge: – Hedging by the firm may not ______ to shareholder wealth if the shareholders can manage exposure themselves. – Hedging may not reduce the _______ risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges. 34

Should the Firm Hedge? • In the presence of market imperfections, the firm should hedge. – Information Asymmetry • The managers may have _____ information than the shareholders. – Differential Transactions Costs • The firm may be able to hedge at _____ than the shareholders. – Default Costs • Hedging may reduce the firms _______ if it reduces the probability of default. 35

Should the Firm Hedge? • Taxes can be a large market imperfection. – Corporations that face _______ tax rates may find that they pay less in taxes if they can manage ______ by hedging than if they have “boom and bust” cycles in their earnings stream. 36

What Risk Management Products do Firms Use? • Most firms meet their exchange risk management needs with _____, and _______ contracts. • The greater the degree of international involvement the greater the firm’s use of foreign exchange risk management. 37