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Chapter 14 Transaction Exposure to Currency Risk

Chapter 14 Transaction Exposure to Currency Risk

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Chapter 14 Transaction Exposure to Currency Risk

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  1. Chapter 14Transaction Exposure to Currency Risk 14.1 An Example of Transaction Exposure to Currency Risk 14.2 Managing Transaction Exposure Internally Multinational netting Leading and lagging 14.3 Managing Transaction Exposure in the Financial Markets Currency forwards Currency futures Money market hedges Currency options Currency swaps 14.4 Summary

  2. Economic exposure to currency risk • Economic exposure Û change in firm value due to unexpected changes in exchange rates • Transaction exposure • change in the value of contractual cash flows • change in the value of monetary assets and liabilities • Operating exposure • change in the value of noncontractual cash flows • change in the value of real assets Monetary assets Monetary liabilities Real assets Common equity

  3. A survey of corporate treasurers Do you agree or disagree with the following statements? Mean score “Managing transaction exposure is important.” 1.4 “Managing economic exposure is important.” 1.8 “Managing translation exposure is important.” 2.4 Key: 1= strongly agree, ... 3=neutral, ... 5= strongly disagree Source: Kurt Jesswein, Chuck C.Y. Kwok, William R. Folks, Jr., “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics,” Journal of Applied Corporate Finance, Fall 1995. Transaction exposure is viewed as the most important currency risk exposure

  4. Currency risk versus currency risk exposure Rd/f Currency risk exposure sd/f Currency risk sd/f

  5. Exposure to foreign exchange risk(contract price FF40,000) +FF40,000 Û+$10,000 at $0.25/FF Expected receipt in francs at E[S1$/FF] = $0.25/FF Actual exchange S1$/FF = $0.20/FF Net loss from original position Risk (or payoff) profile of underlying exposure +FF40,000 Û+$8,000 at $0.20/FF -$2,000 DV$/FF -$0.05/FF DS$/FF -$0.05/FF

  6. Currency hedging with forwards(contract price FF40,000) Buy $10,000 forward +$10,000 at F1$/FF = $0.25/FF Sell FF40,000 forward -FF40,000 Market exchange of FF +$8,000 for $ at S1$/FF = $0.20/FF -FF40,000 Net gain on forward +$2,000 Risk (or payoff) profile of forward contract DV$/FF +$0.05/FF DS$/FF -$0.05/FF

  7. Net currency exposure +FF40,000 Underlying position (long francs) Sell francs forward (short francs and long dollars) Net position Net exposure +$10,000 -FF40,000 +$10,000 DV$/FF short francs long francs DS$/FF

  8. Managing transaction exposure Managing transaction exposure internally leading and lagging currency diversification and multinational netting Managing transaction exposure in financial markets currency forwards money market hedges futures options swaps

  9. Multinational netting

  10. Cash flows before multinational netting

  11. Cash flows after multinational netting

  12. Leading and lagging Timing of cash flows within the corporation to offset underlying currency exposures. Leading - If a U.S. parent is short euros, the parent can accelerate euro repatriations from its European affiliates. Lagging - If a U.S. parent is long euros, the parent can accelerate euro payments to its European affiliates. Like multinational netting, leading and lagging works best when the currency needs of the individual units within the corporation offset one another.

  13. Financial market instrumentsused to hedge currency risk Currency forward contracts Advantages Currency forwards can provide a perfect hedge of transactions of known size and timing Disadvantages Bid-ask spreads can be large on long-dated contracts or infrequently traded currencies A pure credit instrument, so currency forward contracts have credit risk

  14. Financial market instrumentsused to hedge currency risk Currency futures contracts Advantages Low cost if the currency and maturity match the underlying exposure Low credit risk because of daily marking-to-market Disadvantages Exchange-traded futures come in limited currencies and maturities Daily marking-to-market can cause a cash flow mismatch

  15. Financial market instrumentsused to hedge currency risk Money market hedges Advantages Forward positions can be built in currencies for which there are no forward currency markets Disadvantages Relatively expensive hedge Might not be feasible if there are contraints on borrowing or lending

  16. Financial market instrumentsused to hedge currency risk Currency option contracts Advantages Disaster hedge insures against unfavorable currency movements Disadvantages Option premiums reflect option values, so option hedges can be expensive in volatile currencies and at distant expiration dates

  17. Financial market instrumentsused to hedge currency risk Currency swap contracts Advantages Quickly transforms liabilities into other currencies or payout structures (e.g., fixed vs. floating) Low cost for plain vanilla swaps in actively traded currencies Able to hedge long-term exposures Disadvantages Not the best choice for near-term exposures Innovative or exotic swaps can be expensive

  18. Corporate use of currency risk management products Used Used Used once Never Type of productoftensometimesor twiceheard of Forward contracts 72.3% 17.9% 2.9% 0.0% Foreign currency swaps 16.4 17.0 19.3 1.2 OTC currency options 18.8 19.4 10.6 6.5 Currency futures contracts 4.1 10.7 5.3 1.2 Exchange-traded currency (spot) options 3.6 6.5 7.1 3.6 Exchange-traded futures options 1.8 3.0 4.2 4.2 Foreign currency warrants 1.8 1.2 1.2 22.3 Cylinder options 7.0 9.9 11.7 8.8 Synthetic forwards 3.0 8.9 10.1 12.5 Source: Jesswein, Kwok, and Folks, “What New Currency Risk Products Are Companies Using and Why?” Journal of Applied Corporate Finance 8, Fall 1995, pages 115-124.