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Transaction Exposure

Transaction Exposure

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Transaction Exposure

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  1. Transaction Exposure Risk due to lags in payments Hedging strategies Transaction Exposure

  2. Exposure • Transaction exposure • changes in the value of outstanding contracts • Operating exposure (economic exposure) • change in the PV of the firm (real exchange rates) • Translation exposure (accounting exposure) • change in value of owner equity • Tax exposure Transaction Exposure

  3. Transaction exposure sources • lending or receivables denominated in foreign currency • borrowing or payables denominated in foreign currency • holding a defaulted forward contract Transaction Exposure

  4. Lags and transaction exposure • t0 - order placed • Forward contract agreed to • t1 - order shipped (10 days) • t2 - order delivered (24 days) • t3 - order settled (90 days) Transaction Exposure

  5. Balance sheet perspective • Contract: price, quantity, due date (today) • Forward contract purchased (today) • Input inventories purchased (today) • Inventories increase • (Payables increase) • May also be funded by LT debt • Output inventories created (8days) • Input inventories decrease • Output inventories increase • (Accruals increase) • May also be funded by LT debt • Goods shipped (no change) (10 days) Transaction Exposure

  6. Balance sheet perspective (cont) • Goods received (24 days) • Inventories decrease • Receivables increase • Contract paid (90 days) • Receivables decrease • Take delivery on forward contract • Cash increases • During this process • Payables paid • Accruals paid Transaction Exposure

  7. To Hedge • Reduce the volatility of future cash flows • Eliminate one source of risk • Exchange rate volatility • Cost of the hedge • Does not change default risk • Management either hedges or speculates ?? • Does not have expertise in exchange rate risk Transaction Exposure

  8. To not Hedge • Shareholders better able to diversify risk than firm • If parity holds NPV of hedging negative • Costs of hedging • Efficient markets have already impounded the risk into share price • Agency problem • Management is risk averse relative to their jobs not to stockholder value Transaction Exposure

  9. Accounting practices non-hedged position • Balance sheet • Input inventories at cost • Output inventories at COGS • Receivable denominated in cd • Spot in effect at time of delivery • Income statement • At payment • Gain or loss realized • Counted on income statement Transaction Exposure

  10. Types of hedges • contractual hedges • forwards, futures, option, • money market hedges • operating & financial hedges • risk-sharing • leads & lags • swaps Transaction Exposure

  11. Forward hedge - 90 day • short goods (delivered) • selling goods for 154,000 usd • long bill of exchange (bankers accept) • payment 154,000 usd promised forward • long a forward contract • forward contract set for delivery of 229,460 cd • delivery of 154,000 usd • delivery of 229,460 cd • discounted value 225,796.28 Transaction Exposure

  12. Forward hedge - Sources of risk • delivery on bill • bank backing the bill could default • delivery on forward contract • bank delivering cd forward could defaulat • risk of default is low • the hedge reduces transaction exposure Transaction Exposure

  13. Accounting practicesHedged position • Contract values • 231,000 receivable @ spot = 1.50 • 229,460 payable @ forward = 1.49 • Balance sheet • Input inventories at cost • Output inventories at COGS • Receivable denominated • Denominated at spot in effect at time of delivery • Forward contract as payable • Denominated at forward rate Transaction Exposure

  14. Money market hedge - 90 day • short goods (delivered) • 154,000 usd • long bill for 154,000 usd • short loan 154,000/(1.0765) .25 = 151,188 • exchange for 225,270 cd • delivery of 154,000 usd • pay off loan of 154,000 Transaction Exposure

  15. Money market hedge - Sources of risk • delivery on bill • bank backing the bill could default • no forward contract • risk of default is lower • the hedge reduces transaction exposure Transaction Exposure

  16. One can also discount the bill - 90 day • short goods • 154,000 usd • long bill of exchange • sell bill at discount to bank @ 8.65% • 150,839 usd • exchange for 224,750 cd Transaction Exposure

  17. Discounting bill of exchange - Sources of risk • no risk delivery on bill • bill sold at discount to another party • no forward contract • risk of default is eliminated • the hedge eliminates transaction exposure Transaction Exposure

  18. OTC option contract - 90 day • short goods • 154,000 usd • long bill of exchange • long call option to buy 229,508 cd • @0.0025 usd/cd cost = 573.77 usd • exercise price = 6710 • delivery of 154,000 • if e > x, exercise option • get 229,508 cd net of cost of hedge Transaction Exposure

  19. Option contract - Sources of risk • risk of bank default on delivery on bill • risk of default by bank on option contract • the hedge reduces transaction exposure Transaction Exposure

  20. Present value of the hedges • forward hedge = 225,796 cd • money market hedge = 225,270 • discounting = 224,750 • option contract = 229,508 cd / (1.0667).25 - (573.77 usd * 1.49cd/usd) = 224,989 cd Transaction Exposure

  21. Accounting for unhedged positions • Payables and receivables are booked at current spot • income statements • balance sheets • at settlement - changes to book value must be counted • losses • gains Transaction Exposure

  22. Accounting hedged positions • Payables and receivables are booked at current spot • Use your forward rate as best estimator of future expected spot • foreign exchange gain/loss = forward - spot • forward contract loss = 0 • Gains/losses will be the difference between • contract evaluated at forward and • contract evaluated at spot Transaction Exposure

  23. Risk management • Hedging costs money • Hedging exposure • As contracts are anticipated • Contracts may not be signed • If contracts signed unanticipated exchange rate changes • As contracts are signed • Risk that contract may be refused • Risk that goods may not clear customs • As contracts are delivered • Default by the importer • Out goods • Must deliver on forward contract Transaction Exposure

  24. Other hedge practices • Proportional hedges • Forward contracts hedge percentage of exposure • Percentage cover directly related to term to maturity • Forward points (using Interest Rate Parity) • The usd sells forward at discount • May not hedge this transaction because they may get a better exchange rate in the future Transaction Exposure