Hedging Risk and Exposure
International Corporate Finance
P.V. Viswanath
Learning Objectives
 Should firms hedge forex risk?
 How do firms hedge transactions exposure using
forwards, futures and options?
 How can firms hedge operating exposure?
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Why firms should hedge
 Reasons why a firm should hedge, rather than its
shareholders
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Progressive corporate income tax
Scale economies in hedging transactions
Marketing and employment benefits
Lower expected bankruptcy costs
Better internal information
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Hedging with forwards
 An importer or exporter faces exposure and risk because of
delay between agreeing on a foreign-currency price and
settling the transaction.
 Suppose WalMart has placed an order with a European
manufacturer for €1m worth of fabric; delivery in 3 months.
 This exposes WMT to fluctuations in the $/€ rate.
 WMT could buy the euros forward.
 The 3-mth forward rate on euros (6/21/06) is 1.27347 bid/
1.27513 ask. Hence WMT could lock in its obligations at
$1.27513m.
 The expected cost of hedging would be $1m.x[1.2753-E(e)]
 If speculators do not need a risk premium, then this = zero.
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Hedging using forwards
 If there is a risk premium, then the expected cost of hedging
provides the benefit of not having to bear the risk.
 Hence the existence of a risk premium does not affect the
decision to hedge or not, unless shareholders are of less than
average risk.
 If there are transactions costs, the forward ask will be
greater than the expected future spot ask, while the forward
bid will be lower than the expected future spot bid.
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fask-eask > 0 and fbid-ebid < 0
 Assume fask-eask = -(fbid-ebid)
 Then fask-eask = ½[fask-eask-(fbid-ebid)] = ½[fask-fask-(eask-ebid)]
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Hedging using forwards
 This can be interpreted as follows:
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Suppose we buy and sell forward, the transaction cost is fask-fbid;
the transaction cost from buying and selling spot is eask-ebid.
The difference is fask-fbid-(eask-ebid).
 This > 0 because the spread is generally larger in forward
markets.
 Hence the cost of hedging is half the difference between the
forward bid-ask spread and the spot bid-ask spread.
 The spot bid-ask spread for the euro is 0.0005; the 3-mth
forward bid-ask spread is 0.00147; hence the estimated cost
of hedging is 0.000485/€ or $485 for €1m.
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Futures Market Hedging
 Futures-market hedging achieves essentially the
same result as forward hedging.
 However, with futures the foreign exchange is
bought or sold at the spot rate matmaturity, and the
balance of receipts from selling a foreign currency
or cost of buying a foreign currency is reflected in
the margin account.
 Because interest rates vary, the exact receipt or
payment with currency futures is uncertain.
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Hedging using options
 Foreign currency accounts payable can be hedged
by buying a call option on the foreign currency, and
account receivable can be hedged by buying a put
option on the foreign currency.
 Options set a limit on the worst that can happen
from unfavorable exchange rate movements without
preventing enjoyment of gains from favorable
exchange rate movements.
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Hedging Using Swaps
 An importer can hedge with a swap by borrowing in the
home currency, buying the foreign currency spot, and
investing in the foreign currency.
 Exporters can hedge with a swap by borrowing in the
foreign currency, buying the home currency spot, and
investing in the home currency: the loan is repaid from the
export proceeds.
 Lets us compute the cost of this strategy for an importer.
 Consider the case of WMT, which had to pay €1m. in 3
months.
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Cost of using swaps
 Assume 3-mth interest rates in euros are (2.88/2.92), and in
dollars (4.45/4.52). The spot rate today is 1.2616/1.2621; the
3-mth forward rate 1.268590/1.270240.
 Now, WMT needs €1m in 3 mths; it can invest in riskfree
euro securities at the rate of 2.88%; so it will need
1/(1+0.0288/4) = €992,851 today; this can be obtained by
buying spot with 992,851(1.2621) = $1,253,078.
 Alternatively, WMT can buy the euros forward by
committing to pay $1,270,240, which can be acquired by
putting 1,270,240/(1+0.045/4) = $1,256,109 in riskfree
dollar securities.
 The cost of hedging using swaps over forward is 1,256,109 1,253,078 or $3031 in today’s dollars.
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Hedging through currency of invoicing
 Forex exposure can be eliminated by invoicing in
domestic currency.
 Exposure can also be reduced by invoicing in a
mixture of currencies or by buying inputs in the
currency of exports.
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Risk Sharing
 Risk-Sharing is a contractual arrangement in which the
buyer and seller agree to share or split currency movement
impacts on payments that pass between them.
 This is worthwhile if the relationship between the two firms
is long-term.
 For example, Ford and Mazda may agree that all purchases
by Ford will be made in Japanese yen at the current rate, as
long as it is between 115 and 125 yen/$.
 If the rate falls outside this range, they may agree to share
the difference equally.
 Of course, if the equilibrium rate level changes drastically,
the agreement will have to be changed.
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Reinvoicing Centers
 A reinvoicing center is a separate corporate subsidiary that
manages in one location all transaction exposure from
intracompany trade.
 Effectively, the reinvoicing center centralizes transaction
exposure risk, and diversifies the exposure of the parent
company to transaction exposure. It need only hedge
residual exposure risk.
 This method releases individual company subsidiaries from
having to worry about transaction exposure for
intracompany trades.
 The reinvoicing center can manage intra-affiliate cash flows,
including leads and lags of payments.
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Reinvoicing Centers
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Managing Operating Exposure
Strategically – Diversifying Operations
 The key to operating exposure management is to anticipate
and influence the effect of unexpected changes in exchange
rates on a firm’s future cash flows.
 Management can diversify the firm’s operating and
financing base.
 Diversifying operations means diversifying sales, location of
production facilities and raw material sources.
 Diversifying financing means raising funds in more than one
capital market and in more than one currency.
 It can change the firm’s operating and financing policies.
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Strategic Diversification of Operations
 There might be a change in comparative costs in the firms’
own plants located in different countries.
 Management can make marginal shifts in sourcing raw
materials, components, or finished products. If spare
capacity exists, production runs can be lengthened in one
country and reduced in another.
 There might be a change in profit margins or sales volume in
one area compared to another, depending on price and
income elasticities of demand and competitor’s reactions.
 Marketing efforts can be strengthened in export markets
where the firms’ products have become more pricecompetitive.
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Managing Operating Exposure –
Diversifying Financing
 Interest rates differentials might not adjust fully to expected
changes in interest rates.
 In this case, provided the firm is established and known in
different markets, it can change the source of its short and
long-term financing.
 Diversifying financing per se can also help diversify risks of
restrictive capital market policies or government borrowing
competition in the capital market
 It can help diversify political risks – expropriation, war,
blocked funds, or unfavorable changes in laws.
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Modifying Financing Policies –
Natural Hedges
 Suppose we have a US firm selling to a Canadian client.
One way to offset an anticipate continuous long exposure to
a particular currency is to acquire debt denominated in that
currency; in this case, the Canadian dollar.
 If stable (in foreign currency) and continuing receipts from
sales are expected, debt in the foreign currency could be
issued; the sales receipts would be used to make interest
payments on the debt. This is a form of matching.
 The firm could also seek raw material suppliers in Canada,
so that sales receipts could be used to pay for purchases.
 The firm could arrange to pay raw material suppliers from a
third country using the foreign currency of the sales receipts.
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Natural Hedges – An Example
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Currency Swaps
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Currency Risk Sharing
 Suppose GE expects to receive €10m. from Lufthansa from
the sale of turbines in 1 year.
 Suppose the current spot price is $1.00/€ and the forward
price is $0.957/€.
 GE can avoid the transaction exposure to euros if Lufthansa,
its customer would allow it to bill in dollars.
 However, since Lufthansa is aware of the forward rate and
the alternative available to GE, it would be willing to accept
such billing only if it receives a discount of $0.43m, for a
total bill of $9.57m as before.
 If Lufthansa uses the spot rate of $1/€ and accepted a quote
of $10m, it would be forgoing $0.43m.
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Currency Risk Sharing
 Lufthansa and GE can agree to share the currency risks associated
with their turbine contract. This can be done by developing a
customized hedge contract embedded in the underlying trade
transaction.
 Possible agreement:
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A neutral zone ($0.98-$1.02/€) within which there will be no price
adjustment. In this zone, Lufthansa will pay GE, the dollar equivalent of
€10m at the base rate of $1/€.
If the euro depreciates from $1 to, say, $0.90, the actual rate wil have
moved $0.08 beyond the lower boundary of the neutral zone ($0.98/€).
This amount is shared equally. The actual rate used, here is $0.96€ ($1.000.08/2)
If the euro appreciates to, say, $1.1, the actual rate will have moved $0.08
beyond the upper boundary ($1.02/€)/ The actual rate used will be $1.04/€.
GE collects $10.4m and Lufthansa pays €9.45 (10.4/1.1)
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Protection with Currency Risk Sharing
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Currency Collars/ Range Forwards
 A currency collar is a contract that provides protection against currency
moves outside an agreed-upon price range.
 Suppose GE is willing to accept variations in the value of its euro
receivable associated with fluctuations in the euro in the range of $0.95
to $1.05, but not more.
 With a currency collar purchased from a bank, GE can obtain the
following forward euro rate:
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If e1 < $0.95, then RF = $0.95
If $0.95 < e1 < $$1.05, then RF = e1
If e1 > $1.05, then RF = $1.05
 If e1 < $0.95, GE will be shielded from losses on its receivable.
 If e1 > $1.05, the bank will make a profit.
 By forgoing the profit, the cost, for GE, of the downside protection will
be lower.
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Protection with Currency Collars
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Cross Hedging
 Hedging with futures is similar to hedging with forwards.
 However, it is very difficult to find a futures contract that
matches the needs of the hedger in currency, maturity and
amount simultaneously.
 As long as the futures price on the futures contract that is
available is positively correlated with the exposure being
hedged, the company can obtain some protection. Such use
of futures contracts is called cross-hedging.
 Suppose a US firm has a Danish Krone receivable, but it
wants to use euro futures to hedge. Then, the slope
coefficient from the regression of changes in the DK/$ rate
against changes in the €/$ rate is the number of euros it
should sell forward per DK.
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Foreign Currency Options
 Using forwards/futures or currency collars makes sense if
the extent of the exposure is known. However, at times, a
firm might want to hedge against a future exposure that
might or might not materialize.
 In this case, using forwards might not be a good idea. If the
exposure does materialize, well and good. However, if the
exposure does not materialize, then the firm would end up
with an unwanted exposure, once again.
 One way around this would be to buy an option. This is
more like insurance.
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Foreign Currency Options
 Suppose GE bids on a contract worth €10m. to be paid in 3
months. However, GE will only know in 2 months if the bid
has been accepted.
 If GE sells a forward contract maturing in 3 months at a price
of $0.98/€, it will receive $9.8b. if the bid is accepted, no
matter what the euro rate in 3 months.
 If the bid is not accepted, then GE will be contractually
obligated to sell euros at $0.98/€ in 3 months time, no matter
what the euro rate.
 If GE buys an option allowing it to sell €10m. for dollars in 3
months at a rate of $0.98/€, it can use the option if its bid is
accepted. If not, it can let the option lapse – unless the euro
depreciates by then to less than $0.98/€. The cost to GE will be
the cost of the option.
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Options versus Forwards
 Options are more useful than forwards when the amount of
the exposure is uncertain.
 However, if there is some part of the exposure that is known
for sure, such as that the exposure will be at least €5b., the
firm can hedge the €5b. in the forward market and the rest of
the potential exposure in the options market.
 This assumes that the objective of the manager is to reduce
risk, and that both forwards and options are priced fairly.
Obviously, if these conditions do not hold, then the optimal
policy might be different.
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Contractual Hedging and Long-term
Exposure
 Normally, firms take contractual positions like forward contracts and
options in order to hedge positions that do not have quantity risk (but only
exchange rate risk), such as hedging transaction exposure.
 However, firms that have relatively predictable cash flows might use
contractual strategies to hedge operating exposure as well. This is usually
difficult because it is necessary for the firm to be able to predict
competitor response as well.
 Another question with contractual hedging to protect against changes in
strategic position is that it is purely a short-term hedge. A change in
strategic posture would be a longer-term response.
 Hence contractual hedging would be effective only if the “strategic”
impacts are temporary.
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