INTERNATIONAL

FINANCIAL
MANAGEMENT

Fourth Edition

EUN / RESNICK

8-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Management of
Transaction Exposure 8
Chapter Eight
INTERNATIONAL
Chapter Objective: FINANCIAL
MANAGEMENT
This chapter discusses various methods available
for the management of transaction exposure facing
Fourth Edition
multinational firms.
EUN / RESNICK

8-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Chapter Outline
 Forward Market Hedge
 Money Market Hedge

 Options Market Hedge

 Cross-Hedging Minor Currency Exposure

 Hedging Contingent Exposure

 Hedging Recurrent Exposure with Swap Contracts

8-3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Chapter Outline (continued)
 Hedging Through Invoice Currency
 Hedging via Lead and Lag

 Exposure Netting

 Should the Firm Hedge?

 What Risk Management Products do Firms Use?

8-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Forward Market Hedge
 If you are going to owe foreign currency in the
future, agree to buy the foreign currency now by
entering into long position in a forward contract.
 If you are going to receive foreign currency in the

future, agree to sell the foreign currency now by

entering into short position in a forward contract.

8-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Forward Market Hedge: an Example
You are a U.S. 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—a long
forward contract on the pound.
8-6 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Forward Market Hedge
Suppose the The importer will be better off
forward exchange if the pound depreciates: he still
rate is $1.50/£. buys £100m but at an exchange
$30m rate of only $1.20/£ he saves
If he does not $30 million relative to $1.50/£
hedge the £100m
$0
payable, in one Value of £1 in $
year his gain $1.20/£ $1.50/£ $1.80/£ in one year
(loss) on the –$30m
unhedged position But he will be worse off if Unhedged
is shown in green. the pound appreciates. payable
8-7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Forward Market Hedge
If you agree to buy £100 Long
If he agrees
million at a price of forward
to buy £100m $1.50 per pound, you
in one year at will make $30 million if
$30m
$1.50/£ his the price of a pound
gain (loss) on reaches $1.80.
the forward $0
Value of £1 in $
are shown in $1.20/£ $1.50/£ $1.80/£ in one year
blue.
–$30m If you agree to buy £100 million at a
price of $1.50 per pound, you will lose
$30 million if the price of a pound is
only $1.20.
8-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Forward Market Hedge
The red line Long
forward
shows the
payoff of the
$30 m
hedged
payable. Note Hedged payable
that gains on $0
Value of £1 in $
one position are $1.20/£ $1.50/£ $1.80/£ in one year
offset by losses
–$30 m
on the other
position. Unhedged
payable
8-9 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Money Market Hedge
 This is the same idea as covered interest arbitrage.
 To hedge a foreign currency payable, buy a bunch

of that foreign currency today and sit on it.

 Buy the present value of the foreign currency payable
today.
 Invest that amount at the foreign rate.
 At maturity your investment will have grown enough to
cover your foreign currency payable.

8-10 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Money Market Hedge
A U.S.–based importer of Italian bicycles
 In one year owes €100,000 to an Italian supplier.
 The spot exchange rate is $1.25 = €1.00
 The one-year interest rate in Italy is i€ = 4%
€100,000
Can hedge this payable by buying €96,153.85 = 1.04
today and investing €96,153.85 at 4% in Italy for one year.
At maturity, he will have €100,000 = €96,153.85 × (1.04)

Dollar cost today = $120,192.31 = €96,153.85 × $1.25

€1.00
8-11 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Money Market Hedge
 With this money market hedge, we have
redenominated a one-year €100,000 payable into a
$120,192.31 payable due today.
 If the U.S. interest rate is i = 3% we could borrow
$

the $120,192.31 today and owe in one year

$123,798.08 = $120,192.31 ×(1.03)

€100,000
$123,798.08 = S($/€)× T × (1+ i$)
T
(1+ i€)
8-12 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Money Market Hedge: Step One
Suppose you want to hedge a payable in the amount
of £y with a maturity of T:
i. Borrow $x at t = 0 on a loan at a rate of i$ per year.
£y
$x = S($/£)× (1+ i )T
£

Repay the loan in T years

$x –$x(1 + i$)T

0 T
8-13 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Money Market Hedge: Step Two
£y
ii. Exchange the borrowed $x for
(1+ i£)T
at the prevailing spot rate.
£y
Invest at i£ for the maturity of the payable.
(1+ i£) T

At maturity, you will owe a $x(1 + i$)T.

Your British investments will have grown to £y. This
amount will service your payable and you will have no
exposure to the pound.
8-14 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Money Market Hedge
£y
1. Calculate the present value of £y at i£
(1+ i£)T
2. Borrow the U.S. dollar value of receivable at the spot rate.
£y £y
3. Exchange $x = S($/£)× for
(1+ i£)T (1+ i£)T
4. Invest £y 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.
8-15 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Market Hedge
 Options provide a flexible hedge against the
downside, while preserving the upside 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 exercise price of the call.
 To hedge a foreign currency receivable buy puts
on the currency.
 If the currency depreciates, your put option lets you sell
the currency for the exercise price.
8-16 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Market Hedge
Suppose the
The importer will be better off
forward exchange
if the pound depreciates: he still
rate is $1.50/£.
buys £100m but at an exchange
If an importer who $30m rate of only $1.20/£ he saves
owes £100m does $30 million relative to $1.50/£
not hedge the
payable, in one $0
Value of £1 in $
year his gain (loss) $1.20/£ $1.50/£ $1.80/£ in one year
on the unhedged
position is shown –$30m
in green. But he will be worse off if Unhedged
the pound appreciates. payable
8-17 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Markets Hedge
Profit Long call on
Suppose our £100m
importer buys a
call option on
£100m with an
exercise price
of $1.50 per –$5m Value of £1 in $
pound. $1.55/£ in one year
$1.50/£
He pays $.05
per pound for
loss
the call.
8-18 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Markets Hedge
Profit Long call on
The payoff of the
portfolio of a call £100m
and a payable is
shown in red. $25m
He can still profit
from decreases in
the exchange rate –$5m Value of £1 in $
below $1.45/£ but $1.20/£ in one year
has a hedge against $1.45 /£
unfavorable
increases in the $1.50/£ Unhedged
exchange rate. loss payable
8-19 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Markets Hedge
If the exchange Profit Long call on
rate increases to £100m
$1.80/£ the
importer makes
$25 m
$25 m on the call
but loses $30 m on
the payable for a
maximum loss of –$5 m Value of £1 in $
$5 million. $1.80/£ in one year
$1.45/£
This can be –$30 m
thought of as an $1.50/£ Unhedged
insurance loss payable
premium.
8-20 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Markets Hedge
IMPORTERS who OWE EXPORTERS with accounts
foreign currency in the receivable denominated in
future should BUY foreign currency should BUY
CALL OPTIONS. PUT OPTIONS.
 If the price of the currency
goes up, his call will lock in
 If the price of the currency goes
an upper limit on the dollar down, puts will lock in a lower
cost of his imports. limit on the dollar value of his
 If the price of the currency exports.
goes down, he will have the  If the price of the currency goes
option to buy the foreign up, he will have the option to sell
currency at a lower price. the foreign currency at a higher
price.
8-21 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Hedging Exports with Put Options
 Show the portfolio payoff of an exporter who
is owed £1 million in one year.
 The current one-year forward rate is £1 = $2.

 Instead of entering into a short forward

contract, he buys a put option written on £1

million with a maturity of one year and a
strike price of £1 = $2.
 The cost of this option is $0.05 per pound.

8-22 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Market Hedge:
Exporter buys a put option to protect the dollar
value of his receivable.
$1,950,000

e
bl
va
ei
c
re
d
ge
ed
H
S($/£)360
–$50k
Long put
le
ab

$2 $2.05
iv
ce
re
ng
Lo

–$2m

8-23 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 The exporter who buys a put option to protect
the dollar value of his receivable
has essentially purchased a call.

e
bl
va
ei
c
re
d
ge
ed
H
S($/£)360
–$50k

$2 $2.05

8-24 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Hedging Imports with Call
Options
 Show the portfolio payoff of an importer who owes
£1 million in one year.
 The current one-year forward rate is £1 = $1.80; but
instead of entering into a short forward contract,
 He buys a call option written on £1 million with an
expiry of one year and a strike of £1 = $1.80 The
cost of this option is $0.08 per pound.

8-25 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Forward Market Hedge:
GAIN
(TOTAL)
Importer buys £1m forward.
Long
currency
forward

This forward hedge

fixes the dollar value S($/£)360
of the payable at
$1.80m.
$1.80

Accounts Payable =
LOSS
Short Currency position
(TOTAL)
8-26 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options Market Hedge:
$1.8m Importer buys call option on £1m.
$1,720,000
Call
Call option limits
the potential cost of
servicing the payable.

S($/£)360
–$80k
$1.80
$1.72 $1.88

U
nh
ed
ge
d
ob
li g
at
8-27 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res

io
n
 Our importer who buys a call to protect himself
from increases in the value of the pound creates a
$1,720,000 synthetic put option on the pound.
He makes money if the pound falls in value.

S($/£)360
–$80k
$1.80
$1.72

The cost of this “insurance policy” is $80,000

8-28 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Taking it to the Next Level
 Suppose our importer can absorb “small” amounts
of exchange rate risk, but his competitive position
will suffer with big movements in the exchange
rate.
 Large dollar depreciations increase the cost of his
imports
 Large dollar appreciations increase the foreign currency
cost of his competitors exports, costing him customers
as his competitors renew their focus on the domestic
market.
8-29 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
Our Importer Buys a Second Call Option
This position is called a straddle
$1,720,000
2nd
$1,640,000 Call

S($/£)360
–$80k Importers synthetic put
$1.64 $1.80 $1.96
–$160k
$1.72 $1.88

8-30 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Suppose instead that our importer is willing to
risk large exchange rate changes but wants to
profit from small changes in the exchange rate,
$1,720,000 he could lay on a butterfly spread.

Sell 2 puts $1.90 strike.

butterfly spread

S($/£)360
–$80k Importers synthetic put
$1.80 $1.90
$1.72 $2 buy a put $2 strike

A butterfly spread is analogous to an interest rate collar; indeed

it’s sometimes called a zero-cost collar. Selling the 2 puts comes
close to offsetting the
8-31
cost of buying the other 2 puts.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Options
 A motivated financial engineer can create almost
any risk-return profile that a company might wish
to consider.
 Straddles and butterfly spreads are quite common.

 Notice that the butterfly spread costs our importer

quite a bit less than a naïve strategy of buying call

options.

8-32 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Cross-Hedging
Minor Currency Exposure
 The major 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 Thai

bhat.
 It is difficult, expensive, or impossible to use

financial contracts to hedge exposure to minor

currencies.

8-33 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Cross-Hedging
Minor Currency Exposure
 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
Swedish krona hedging with long or short forward
contracts on the euro. If the krona is expensive when
the euro is expensive, or even if the krona is cheap
when the euro is expensive it can be a good hedge. But
they need to co-vary in a predictable way.
8-34 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Hedging Contingent Exposure
 If only certain contingencies give rise to exposure,
then options can be effective insurance.
 For example, if your firm is bidding on a

hydroelectric dam project in Canada, you will

need to hedge the Canadian-U.S. dollar exchange
rate only if your bid wins the contract. Your firm
can hedge this contingent risk with options.

8-35 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Hedging Recurrent Exposure
with Swaps
 Recall that swap contracts can be viewed as a
portfolio of forward contracts.
 Firms that have recurrent exposure can very likely

hedge their exchange risk at a lower cost with

swaps than with a program of hedging each
exposure as it comes along.
 It is also the case that swaps are available in

longer-terms than futures and forwards.

8-36 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Hedging through
Invoice Currency
 The firm can shift, share, or diversify:
 shift exchange rate risk
 by invoicing foreign sales in home currency
 share exchange rate risk
 by
pro-rating the currency of the invoice between foreign and
home currencies
 diversify exchange rate risk
 by using a market basket index

8-37 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Hedging via Lead and Lag
 If a currency is appreciating, pay those bills
denominated in that currency early; let customers
in that country pay late as long as they are paying
in that currency.
 If a currency is depreciating, give incentives to

customers who owe you in that currency to pay

early; pay your obligations denominated in that
currency as late as your contracts will allow.

8-38 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 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 won receivables and Japanese yen
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 due and just buy yen
with won.
 Even if it’s not a perfect hedge, it may be too expensive
or impractical to hedge each currency separately.
8-39 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Exposure Netting
 Many multinational firms use a reinvoice center.
Which is a financial subsidiary that nets out the
intrafirm transactions.
 Once the residual exposure is determined, then the

firm implements hedging.

8-40 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:

$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30

8-41 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Exposure Netting: an Example
Bilateral Netting would reduce the number of
foreign exchange transactions by half:
$20
$10
$30
$40
$20 $15 $10
$10$25$35 $30$10$40
$25
$60
$20
$10
$30

8-42 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Multilateral Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:

$10
$15

$20
$30
$40
$40 $15
$15$25
$15 $10 $10
$10
$10

8-43 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Should the Firm Hedge?
 Not everyone agrees that a firm should hedge:
 Hedging by the firm may not add to shareholder wealth
if the shareholders can manage exposure themselves.
 Hedging may not reduce the non-diversifiable risk of
the firm. Therefore shareholders who hold a diversified
portfolio are not helped when management hedges.

8-44 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Should the Firm Hedge?
 In the presence of market imperfections, the firm
should hedge.
 Information Asymmetry
 Themanagers may have better information than the
shareholders.
 Differential Transactions Costs
 Thefirm may be able to hedge at better prices than the
shareholders.
 Default Costs
 Hedging may reduce the firms cost of capital if it reduces the
probability of default.

8-45 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Should the Firm Hedge?
 Taxes can be a large market imperfection.
 Corporations that face progressive tax rates may find
that they pay less in taxes if they can manage earnings
by hedging than if they have “boom and bust” cycles in
their earnings stream.

8-46 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 What Risk Management Products do
Firms Use?
 Most U.S. firms meet their exchange risk
management needs with forward, swap, and
options contracts.
 The greater the degree of international

involvement, the greater the firm’s use of foreign

exchange risk management.

8-47 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 End Chapter Eight

8-48 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res