Political Economy of Trade

Political Economy of Trade

Managing Currency Exposure 2019 Melvin Jameson Types of Currency Exposure Transaction exposure: Occurs when contracts are denominated in a foreign currency Operating (Economic) exposure: Occurs when the value of cash flows depends on exchange rates Translation exposure: Occurs when of financial statements must

be consolidated 2019 Melvin Jameson Types of Exchange Rate Risk Transaction exposure occurs when contract are denominated in a foreign currency. Foreign currency cash flows are fixed Home currency ($) cash flows are uncertain Operating (or Economic) exposure - occurs

when ongoing operations involve other currencies. Foreign currency cash flows are adjustable Home currency ($) cash flows are uncertain 2019 Melvin Jameson Managing Transaction Exposure: Hedging mechanics 1. Hedging with forward contract 2. Hedge with other derivatives (futures, options, swaps) 3. Money-market hedge (synthetic forward

contract) 2019 Melvin Jameson Forward contract Agreement made today to transact on a specified future date at a specified price. Transaction price independent of spot price at the time. A binding obligation for both parties.

A forward contract eliminates price uncertainty No risk from an unfavorable price move. Note no risk is not the same as no regret. 2019 Melvin Jameson Call Option: Definition The right to buy at exercise price X Value of a call at expiration

C = Max ( 0, S - X) where C = value of the call S = spot price of currency X = exercise price Value of a call at expiration Thus, if you own an option, you may win, but you will never lose

Thats what you pay for when you buy Of course if your write (=sell or go short) an option, thereafter you can only lose never win. Put Option: Definition The right to sell at exercise price X Value of a put at expiration P = Max( 0, X - S) Value of a put at expiration

Value of being short a put Money market hedge (Synthetic forward contract) Synthetic forward sale of currency Borrow foreign currency against foreign receivable. Buy home currency today. Buy home country bond. Result the same as a forward sale Obligation to pay set amount of foreign at a set date.

Will receive set amount of home currency at same time. 2019 Melvin Jameson Discussion Lufthansa case 2019 Melvin Jameson Managing Transaction Exposure: Policy Issues 2019 Melvin Jameson

What type of hedging strategy Micro-hedging = hedging each transaction individually Macro-hedging = track net exposure for the entire multinational and hedge that 2019 Melvin Jameson Limitations of Hedging Quantity Uncertainty Anticipated Price changes cannot be hedged

(forward prices predict spot prices) 2019 Melvin Jameson Is hedging appropriate? - con Why not bear risk ourselves? (Let shareholders bear the risk) Argument against hedging: diversified shareholders manage their own risk Diversify to avoid idiosyncratic risk, Balance portfolio for desired level of

systematic risk. 2019 Melvin Jameson Is hedging appropriate? - pro Argument for hedging: Potential costs of bankruptcy or near-bankruptcy Higher financing costs/impaired financial market access Managerial attention expended to

avoid/manage a bankruptcy Direct costs (legal etc.) of bankruptcy itself Key question: How large is the exposure relative to the business? 2019 Melvin Jameson Questionable Motives for Hedging Career risk for managers (agency problem) Selective hedging based on superior

information = speculation 2019 Melvin Jameson Operating exposure Operating (or Economic) exposure - occurs when ongoing operations involve other currencies. Foreign currency cash flows are adjustable Home currency ($) cash flows are uncertain Occurs from operating subsidiaries abroad

GM owns and operates a parts supplier in Mexico GM owns and operates a distribution network in Europe 2019 Melvin Jameson Managing Operating Exposure Adjusting Production/sales markets Respond to price changes - (change location of production) Diversify locations Try to balance cash flows in local currency

match production and sales more closely Adjusting Financing Borrow in local currency to offset local currency income stream. (Real exchange rate movements only) 2019 Melvin Jameson Operating exposure A Napa Valley winery sells 100% of its output domestically. Is the winery exposed to exchange rate risk?

2019 Melvin Jameson FX risk management alternatives - Viewed as alternative allocation of FX risk Who bears the risk? Shareholders Do nothing Speculator hedge via forward contract or other derivative security

Customer/supplier denominate all contracts in home currency currency risk sharing agreements 2019 Melvin Jameson Home currency invoicing Papeys Louisiana Catfish requires its Japanese customers to make all payments in US dollars. Does this policy eliminate Papeys transaction exposure? If the yen-dollar exchange rate increases in volatility, will this policy spare Papeys from

costs due to the increased exchange rate risk? Does this policy eliminate Papeys operating exposure? 2019 Melvin Jameson Risk sharing example A U.S. customer owes a Spanish supplier 100,000. It is anticipated the spot rate will be about 1.06 $/. The U.S. customer bears the exchange rate risk. Possible risk sharing agreement

Pay 100,000 if the rate is between 1.02 $/ and 1.10 $/ Pay $110,000 if the rate is above 1.10 $/ Pay $102,000 if the rate is below 1.02 $/ 2019 Melvin Jameson Risk sharing result U.S. terms U.S. customer pays

Spanish supplier gets 1.10$/ < S $110,000 Less than 100,000 1.02$/ < S < 1.10$/

Between $102,000 and $110,000 100,000 S < 1.02$/ $102,000 European terms U.S. customer pays

More than 100,000 Spanish supplier gets 0.91 /$ > 1/S $110,000 Less than 100,000 .98 /$ > 1/S

> .91 /$ Between $102,000 and $110,000 100,000 $102,000 More than 100,000 0.98 /$

1/S > 2019 Melvin Jameson General types of hedging Contractual hedge using financial derivatives or specifying currency in contract. Operational hedge adjusting locations of production and sales to match, as nearly as possible, currency inflows and outflows in local currencies.

Financial hedge borrower in a foreign currency to offset anticipated inflows in that currency. 2019 Melvin Jameson

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