International Finance
Lecture 9
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International Finance
• Course topics
– Foundations of International Financial
Management
– World Financial Markets and Institutions
– Foreign Exchange Exposure
– Financial Management for a Multinational
Firm
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Foreign Exchange Exposure
• Economic Exposure
• Translation Exposure
• Transaction Exposure
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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
•
•
•
•
•
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• 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 747s 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?
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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.
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Forward Market Hedge
• You are a Canadian importer of British woolens
and have just ordered next year’s inventory.
Payment of £100M 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 £100M in one year is
– __________________________________
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Forward Market Hedge
$0
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Value of £1
in $ in one
year
Forward Market Hedge
$0
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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
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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.
•
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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?
•
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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.
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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 $112.05 million into pounds at the spot rate
S($/£) = $1.25/£
3.
Invest £89.64 million in the UK at i£ = 11.56% for one
year.
In one year the investment will have grown to £100 million.
Spot exchange rate
360-day forward rate
S($/£) = $1.25/£
F360($/£) = $1.20/£
Canadian discount rate
i$ = 7.10%
British discount rate
i£ =
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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/£?
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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.
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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
(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.
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Example
•
PepsiCo 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 PepsiCo use forward or money
market hedge? Use 30 days/month and 360/year interest
conversion.
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Example (continued)
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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.
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Options Markets Hedge
Profit
–$5 m
loss
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Value of £1 in
$1.55 /£ one year
$1.50/£
Options Markets Hedge
Profit
Long call on £100m
–$5 m
$1.45 /£
Value of £1 in $ in
one year
Unhedged
$1.50/£
loss
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payable
Options Markets Hedge
Profit
Long call on £100m
–$5 m
$1.45 /£
Value of £1 in $ in
$1.80/£
one year
$1.50/£ Unhedged payable
loss
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Example
•
You are a British exporter and it is December now. You know you
will receive US$15,000,000 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
Call price
1.50
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.
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Example
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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.
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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.
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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
_________________.
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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.
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Invoice Currency
• The firm can shift, share, or diversify:
– shift exchange rate risk
•
– share exchange rate risk
•
– diversify exchange rate risk
•
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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