C09 Transaction Exposure

Chapter9,TransactionExposure,LearningObjectives,DistinguishbetweenthethreemajorforeignexchangeexposuresexperiencedbyfirmsAnalyzetheprosandconsofhedgingforeignexchangetransactionexposureIdentifyforeignexchangetransactionexposureIdentifythealternativesavailabletoafirmformanagingalargeandsignificanttransactionexposure,9-2,ForeignExchangeExposure,Foreignexchangeexposureisameasureofthepotentialforafirmsprofitability,netcashflow,andmarketvaluetochangebecauseofachangeinexchangeratesTheprofits,cashflowandmarketvaluearethekeyfinancialelementsofhowweviewtherelativesuccessorfailureofafirmTypesofforeignexchangeexposureTransactionExposuremeasureschangesinthevalueofoutstandingfinancialobligationsincurredpriortoachangeinexchangeratesbutnotduetobesettleduntilaftertheexchangeratechangesOperatingExposurealsocalledeconomicexposure,measuresthechangeinthepresentvalueofthefirmresultingfromanychangeinexpectedfutureoperatingcashflowscTranslationExposurealsocalledaccountingexposure,isthepotentialforaccountingderivedchangesinownersequitytooccurbecauseoftheneedto“translate”financialstatementsofforeignsubsidiariesintoasinglereportingcurrencyforconsolidatedfinancialstatementscausedbyanunexpectedchangeinexchangerates,9-3,Exhibit9.1ConceptualComparisonofTransaction,Operating,andTranslationForeignExchangeExposure,9-4,MeasurementofTransactionExposure,Transactionexposuremeasuresgainsorlossesthatarisefromthesettlementofexistingfinancialobligations.,9-5,1)_exposuredealswithcashflowsthatresultfromexistingcontractualobligations.A)OperatingB)TransactionC)TranslationD)EconomicAnswer:B,9-6,MeasurementofTransactionExposure,Transactionexposure:PurchasingorsellingoncreditgoodsorserviceswhenpricesarestatedinforeigncurrenciesBorrowingorlendingfundswhenrepaymentistobemadeinaforeigncurrencyBeingapartytoanunperformedforwardcontractandOtherwiseacquiringassetsorincurringliabilitiesdenominatedinforeigncurrencies,9-7,TransactionExposure:PurchasingorSellingonOpenAccount,SupposeTridentCorporationsellsmerchandiseonopenaccounttoaBelgianbuyerfor1,800,000payablein60daysFurtherassumethatthespotrateis$1.2000/andTridentexpectstoexchangetheeurosfor1,800,000 x$1.2000/=$2,160,000whenpaymentisreceivedTransactionexposurearisesbecauseoftheriskthatTridentwillsomethingotherthan$2,160,000expectedIftheeuroweakensto$.1000/,thenTridentwillreceive$1,980,000Iftheeurostrengthensto$1.3000/,thenTridentwillreceive$2,340,000,9-8,Exhibit9.3TheLifeSpanofaTransactionExposure,9-9,HedgingTransactionExposure,Transactionexposurecanbemanagedbycontractualandnaturalhedge.AnaturalhedgeisonethatresultsfrommatchingforeigncurrencycashflowsthatcomeaboutfromthenormaloperationsofaMNE.AnexamplewouldbeforaMNEthathadeurooperatinginflowsfromsalestoborrowanequivalentamountofeurostofinanceworkingcapital.Acontractualhedgeisacontractspecificallyenteredintoasafinancialratherthanoperatinghedge.Examplesareforwardandfutureforeignexchangeagreements,moneymarkethedges,andpurchaseofoptions.,10,ContractualHedgingTechniques,HedgingofReceivablesSellfuturesorforwardMoneymarkethedgeborrowforeigncurrencytobereceivedconverttodomesticcurrencyinvestforfutureuseBuyPutOption,11,HedgingofPayablesBuyfuturesorforwardMoneymarkethedgeborrowhomecurrencyconverttoforeigncurrencyinvestforfutureuseBuyCallOption,6)Lossesfrom_exposuregenerallyreducetaxableincomeintheyeartheyarerealized._exposurelossesmayreducetaxesoveraseriesofyears.A)accounting;OperatingB)operating;TransactionC)transaction;OperatingD)transaction;AccountingAnswer:C,9-12,TridentsTransactionExposure,MariaGonzalez,CFOofTrident,hasjustconcludedasaletoRegency,aBritishfirm,for1,000,000ThesaleismadeinMarchforsettlementdueinthreemonthstime,JuneAssumptionsSpotrateis$1.7640/3monthforwardrateis$1.7540/(a2.2676%discount)Interestrate:UK3monthborrowingrateis10.0%p.a.UK3monthinvestingrateis8.0%p.a.Tridentscostofcapitalis12.0%US3monthborrowingrateis8.0%p.a.US3monthinvestingrateis6.0%p.a.JuneputoptioninOTCmarketfor1,000,000;strikeprice$1.75;1.5%premiumTridentsforeignexchangeadvisoryserviceforecastsfuturespotratein3monthstobe$1.7600/TridentoperatesonthinmarginsandMariawantstosecurethemostamountofUSdollars;herbudgetrate(lowestacceptableamount)is$1.7000/,9-13,TridentsTransactionExposure,TridentmighthaveavoidedtransactionexposurebyinvoicingtheBelgianbuyerinUSdollars,butthismighthaveleadtoTridentnotbeingabletobookthesaleMariafacesfourpossibilities:RemainunhedgedHedgeintheforwardmarketHedgeinthemoneymarketHedgeintheoptionsmarket,9-14,TridentsTransactionExposure:Unhedgedposition,UnhedgedpositionMariamaydecidetoacceptthetransactionriskIfshebelievesthatthefuturespotratewillbe$1.76/,thenTridentwillreceive1,000,000 x$1.76/=$1,760,000in3monthstimeHowever,ifthefuturespotrateis$1.65/,Tridentwillreceiveonly$1,650,000wellbelowthebudgetrate,9-15,TridentsTransactionExposure,ForwardMarkethedgeAforwardhedgeinvolvesaforwardorfuturescontractandasourceoffundstofulfillthecontractTheforwardcontractisenteredatthetimetheA/Riscreated,inthiscaseinMarchWhenthissaleisbooked,itisrecordedatthespotrate.InthiscasetheA/Risrecordedataspotrateof$1.7640/,thus$1,764,000isrecordedasasaleforTridentIfTridentdoesnothaveanoffsettingA/Pinthesameamount,thenthefirmisconsidereduncovered,9-16,TridentsTransactionExposure,ForwardMarkethedgeShouldMariawanttocoverthisexposurewithaforwardcontract,thenshewillsell1,000,000forwardtodayatthe3monthrateof$1.7540/Sheisnow“covered”andTridentnolongerhasanytransactionexposureIn3months,Tridentwillreceived1,000,000andexchangethosepoundsat$1.7540/receiving$1,754,000Thissumis$6,000lessthantheuncertain$1,760,000expectedfromtheunhedgedpositionThiswouldberecordedinTridentsbooksasaforeignexchangelossof$10,000($1,764,000asbooked,$1,754,000assettled),9-17,TridentsTransactionExposure,MoneyMarkethedgeTohedgeinthemoneymarket,MariawillborrowpoundsinLondon,convertthepoundstodollarsandrepaythepoundloanwiththeproceedsfromthesaleTocalculatehowmuchtoborrow,MarianeedstodiscountthePVofthe1,000,000totoday1,000,000/1.025=975,610Mariashouldborrow975,610todayandin3monthstimerepaythisamountplus24,390ininterest(1,000,000)fromtheproceedsofthesale,9-18,TridentsTransactionExposure,MoneyMarkethedgeTridentwouldexchangethe975,610atthespotrateof$1.7640/andreceive$1,720,976atonceThishedgecreatesapounddenominatedliabilitythatisoffsetwithapounddenominatedassetthuscreatingabalancesheethedge,9-19,TridentsTransactionExposure,Inordertocomparetheforwardhedgewiththemoneymarkethedge,MariamustanalyzetheuseoftheloanproceedsRememberthattheloanproceedsmaybeusedtoday,butthefundsfortheforwardcontractmaynotBecausethefundsarerelativelycertain,comparisonispossibleinordertomakeadecisionThreelogicalchoicesexistforanassumedinvestmentrateforthenext3months,9-20,TridentsTransactionExposure,First,ifTridentiscashrichtheloanproceedsmightbeinvestedattheUSrateof6.0%p.a.Second,MariacouldusetheloanproceedstosubstituteanequaldollarloanthatTridentwouldhaveotherwisetakenforworkingcapitalneedsatarateof8.0%p.a.Third,Mariamightinvesttheloanproceedsinthefirmitselfinwhichcasethecostofcapitalis12.0%p.a.,9-21,$1,720,976Treasurybill6%p.a.or1.5%/quarter$1,746,791,$1,720,976Debtcost8%p.a.or2.0%/quarter$1,755,396,$1,720,976Costofcapital12%p.a.or3.0%/quarter$1,772,605,TridentsTransactionExposure,Becausetheproceedsin3monthsfromtheforwardhedgewillbe$1,754,000,themoneymarkethedgeissuperiortotheforwardhedgeifMariausedtheproceedstoreplaceadollarloan(8%)orconductgeneralbusinessoperations(12%)TheforwardhedgewouldbepreferableifMariaweretojustinvesttheloanproceeds(6%)Wewillassumesheusesthecostofcapitalasthereinvestmentrate,9-22,TridentsTransactionExposure,AbreakeveninvestmentratecanbecalculatedinordertoforgonumerouscalculationsandstillaidMariainherdecision,9-23,Toconvertthis3monthratetoanannualrate,TridentsTransactionExposure,Inotherwords,ifMariacaninvesttheloanproceedsatarateequaltoorgreaterthan7.68%p.a.thenthemoneymarkethedgewillbesuperiortotheforwardhedgeThefollowingchartshowsthevalueofTridentsA/Roverarangeofpossiblespotratesbothuncoveredandcoveredusingthepreviouslymentionedalternatives,9-24,Exhibit9.4ValuationofCashFlowsbyHedgingAlternativeforTrident,9-25,TridentsTransactionExposure,OptionmarkethedgeMariacouldalsocoverthe1,000,000exposurebypurchasingaputoption.ThisallowshertospeculateontheupsidepotentialforappreciationofthepoundwhilelimitingherdownsideriskGiventhequoteearlier,Mariacouldpurchase3monthputoptionatanATMstrikepriceof$1.75/andapremiumof1.5%Thecostofthisoptionwouldbe,9-26,TridentsTransactionExposure,Becauseweareusingfuturevaluetocomparethevarioushedgingalternatives,itisnecessarytoprojectthecostoftheoptionin3monthsforwardUsingacostofcapitalof12%p.a.or3.0%perquarter,thepremiumcostoftheoptionasofJunewouldbe$26,4601.03=$27,254Sincetheupsidepotentialisunlimited,Tridentwouldnotexerciseitsoptionatanyrateabove$1.75/andwouldsellpoundsonthespotmarketIfforexample,thespotrateof$1.76/materializes,Tridentwouldexchangepoundsonthespotmarkettoreceive1,000,000$1.76/=$1,760,000lessthepremiumoftheoption($27,254)netting$1,732,746,9-27,TridentsTransactionExposure,Unliketheunhedgedalternative,MariahaslimiteddownsidewiththeoptionShouldthepounddepreciatebelow$1.75/,Mariawouldexerciseheroptionandexchangeher1,000,000at$1.75/receiving$1,750,000Lessthepremiumoftheoption,Marianets$1,722,746Althoughthisdownsideislessthanthatoftheforwardormoneymarkethedge,theupsidepotentialisnotlimited,9-28,TridentsTransactionExposure,Aswiththeforwardandmoneymarkethedges,MariacanalsocalculateherbreakevenpriceontheoptionTheupperboundoftherangeisdeterminedbycomparisonoftheforwardrateThepoundmustappreciateabove$1.754/forwardrateplusthecostoftheoption,$0.0273/,to$1.7813/ThelowerboundoftherangeisdeterminedinasimilarmannerIfthepounddepreciatesbelow$1.75/,thenetproceedswouldbe$1.75/lessthecostof$0.0273/or$1.722/,9-29,Exhibit9.5TridentsHedgingAlternatives,IncludinganATMPutOption,9-30,TridentsTransactionExposure,9-31,Optioncost(futurecost)$27,254,Proceedsifexercised$1,750,000,Minimumnetproceeds$1,722,746,Maximumnetproceedsunlimited,Breakevenspotrate(upside)$1.7813/,Breakevenspotrate(downside)$1.7221/,StrategyChoiceandOutcome,Trident,likeallfirms,mustdecideonastrategytoundertakebeforetheexchangeratechangesbuthowwillMariachooseamongthestrategies?TwocriteriacanbeutilizedtohelpMariachooseherstrategyRisktolerance-ofthefirm,asexpressedinitsstatedpoliciesandViewpointMariasownviewontheexpecteddirectionanddistanceoftheexchangerateFinancialsituation,9-32,StrategyChoiceandOutcome,Afterallthestrategieshavebeenexplained,TridentnowneedstocomparethealternativesandtheiroutcomesinordertochooseastrategyTherewerefouralternativesavailabletomanagethisaccountreceivableandMariahasabudgetrateatwhichshecannotfallbelowonthistransaction,9-33,StrategyChoiceandOutcome,9-34,RemainuncoveredUnknown,ForwardContracthedge$1.754/$1,754,000,Moneymarkethedge8%p.a.$1,755,396,Moneymarkethedge12%p.a.$1,772,605,Putoptionhedgestrike$1.75/,Minimumifexercised$1,722,746,MaximumifnotexercisedUnlimited,RiskManagementinPractice,WhichContractualHedges?Transactionexposuremanagementprogramsaregenerallydividedalongan“option-line;”thosewhichuseoptionsandthosethatdonotAlso,theseprogramsvaryintheamountofriskcovered;theseproportionalhedgesarepoliciesthatstatewhichproportionandtypeofexposureistobehedgedbythetreasury,9-35,WhyHedge-theProsCurrencyriskmanagementdoesnotincreasetheexpectedcashflowsofafirm;currencyriskmanagementnormallyconsumesresourcesthusreducingcashflow