Weeks 7-8 Flashcards
Comparison of Techniques
to Hedge Payables
Optimal Technique for Hedging Payables
Select optimal hedging technique by:
* Considering whether futures or forwards are preferred.
* Considering desirability of money market hedge versus
futures/forwards based on cost.
* Assessing the feasibility of a currency call option based on
estimated cash outflows.
Choose optimal hedge versus no hedge for payables.
* Even when an MNC knows what its future payables will be, it
may decide not to hedge in some cases.
Evaluate the hedge decision by comparing the real cost of
hedging versus the cost if not hedged.
Hedging Transaction Exposure
FC Payables
- Forward Contract
– Buy FC Forward - Futures
– Take a long position on FC futures
– Gain / Loss on Futures offsets ∆Spot - Money Market
– Borrow Domestic & Invest Internationally - Call Options
– Right to Purchase
Hedging Transaction Exposure
FC Receivables
- Forward Contract
– Sell FC Forward - Futures
– Take a short position on FC futures
– Gain / Loss on Futures offsets ∆Spot - Money Market
– Borrow Internationally & Invest Domestically - Put Options
– Right to Sell
Comparison of Techniques
for Hedging Receivables
Optimal Technique for Hedging Receivables:
* Consider whether futures or forwards are preferred.
* Consider desirability of money market hedge versus
futures/forwards based on receipts.
* Assess the feasibility of a currency put option based
on estimated cash inflows.
Optimal hedge versus no hedge on receivables
* An MNC may know what its future receivables will
be yet still decide not to hedge. In that case, the
MNC needs to determine the probability distribution
of its revenue from receivables when not hedging
Forward Hedge
Allows an MNC to lock in a specific exchange rate at
which it can purchase a currency and hedge payables or
receivables. A forward contract is negotiated between
the firm and a financial institution.
The contract will specify the:
* currency that the firm will pay.
* currency that the firm will receive.
* amount of currency to be received by the firm.
* rate at which the MNC will exchange currencies (called the
forward rate).
* future date at which the exchange of currencies will occur.
Forward Contract Variants
* Non-Deliverable Forwards (NDF)
Like a forward contract, represents an agreement
regarding a position in a specified currency, a specified
exchange rate, and a specified future settlement date,
but does not result in delivery of currencies. Instead, a
payment is made by one party in the agreement to the
other party based on the exchange rate at the future date.
[Madura p.700]
* Break Forwards
Forward with an optional exit
Synthetic Hedge
The Problem:
– What if a forward contract was unavailable?
– Firms can create their own forward contract
using borrowing and lending in the money
market.
– We may desire a combination of currencies that
is currently unavailable or expensively priced.
* In our coming example we should acknowledge that
in reality both the AUD and the CHF are highly liquid
currencies.
Money Market Hedge on Payables
Involves taking a money market position to
cover a future payables position.
If a firm prefers to hedge payables without
using its cash balances, then it must:
– Borrow funds in the home currency and
– Invest in the foreign currency
To hedge a receivable:
– Borrow funds in the overseas market
How to construct a hedge
using futures (1)
- Am I long or short in the physical market?
- If long in underlying, short in future.
If short in underlying, long in future.
To complete the hedge: - Close the futures position
* a profit/loss is made - Transact in the physical market
* profit/loss offset by loss/profit in the future
what is basis risk?
Basis risk refers to the risk that arises when the price of a hedging instrument (such as a futures or forward contract) does not move in perfect correlation with the price of the underlying asset being hedged. This difference between the spot price of the asset and the price of the derivative (futures or forward) is called the “basis,” and any fluctuation in this relationship creates basis risk.
Basis risk arises if:
1. Hedger uncertain as to exact date asset will be bought or
sold.
2. Hedge may require the futures contract to be closed out
well before its expiration date
Hedging with Options (Concepts)
- Call option
– The right to buy at a fixed price
– Long position - Put option
– The right to sell at a fixed price
– Short position - Choice of option is dependent upon the type of transaction exposure.
– Long transaction exposure
Short hedge
Buy put options
– Short transaction exposure
Long hedge
Buy call options
Hedging with Options (Result)
Assuming delivery:
* Future FC payment
– Short Transaction Exposure
– Buy Call option
* Future FC receipt
– Long Transaction Exposure
– Buy Put options
assuming cash settlement:
- as value FC increases -> cost decrease, value of option increase (gain)
- as value FC decrease -> receipts decrease, value of option increase (gain)
why use options
Currency options have not been designed as a substitute for forward markets but as a new, distinct financial vehicle that offers significant opportunities and advantages to those seeking either protection or profit from exchange rates.
- Asymmetric payoff
– Option holder will only exercise options that are ‘in the
money’
– Able to limit risk while still maintaining exposure to
favourable exchange rate movements
what is financial engineering
- The upfront cost of hedging with options can be substantial.
- Companies who do not wish to incur this cost while
remaining hedged may of course use futures or forward
contracts. - However, it is possible that companies may wish to retain
some of the positive characteristics associated with option
contracts yet may not wish to incur the full cost of hedging
in this manner. - To reduce the cost of hedging, various option strategies can
be taken which alter the payoff structure of the hedge
while reducing the upfront cost to the company.
zero-premium options
Zero-premium options (also known as zero-cost options or costless collars) are a type of options strategy in which an investor or company sets up two offsetting options (usually a call and a put) in such a way that the premiums of the options cancel each other out. This results in no upfront cost (zero premium) to the investor for establishing the hedge.
–Cylinder Options
–Range Forwards
–Participating Forwards
Synthetic Forwards (Options)
Previously we created a synthetic forward using a money market hedge.
– We can also create a synthetic forward using a combination of option
contracts.
This is done by combining call and put options with the same strike price.
- Premium & Chosen Strike Price
– Note that there will be NO initial cost if the chosen
strike price (X) is equal to the current market forward
rate (F).
– We would expect this to hold as there is no difference
in payoffs between the synthetic forward using options
and the actual market forward contract available,
which has no initial cost. - Alternatively:
– We can choose a settlement price different from that of the Forward
Rate (F). - Should the strike price vary from the market forward contract, then
this strategy will have an expected payoff of F-X.
– Thus, we would expect to pay (or receive) the present value of F-X to
pursue this strategy. This will occur at t0, as the difference between the
premium of the call and put options.
Path Dependent Options
Options where the payoff is dependent upon the
path of the underlying asset over all or part of
its life.
* Barrier Options
* Average Rate Options
* Average Strike Options
Barrier Options
- Example: Knock-out option is like a standard option
but becomes worthless should the FX rate cross a
pre-defined barrier. - Once the FX price moves beyond a ‘barrier’ the option
expires.
Thus, the writer of the option only demands compensation for
the risk that they face up to a certain point, making these
types cheaper than standard options. - Alternatives: Down and Out, Up and Out, Down and In, Up and In
Average Rate Option (Asian Option)
Average Strike Option
Average Rate Option (Asian Option)
* Where the final spot rate applied is the average of
the spot rate over the life of the option.
Less expensive than standard options.
Useful for hedging a cash flow stream evenly spread
over a period.
Average Strike Option
* Final strike applied is the average spot rate.
Compound Options
An option on an option.
* Very little outlay. Premium is to maintain
the right to either pay or receive the second
premium
* Two different maturity dates
* Useful for hedging against potential distant
and highly contingent exposures.
Options on Futures
An option on a Futures Contract
* Two different maturity dates
* Call option on Futures
* If exercised, you receive a Long position in a
Futures contract plus cash
* Put option on Futures
* If exercised, you receive a Short position in a
Futures contract plus cash
Implicit Options
- Firms may create ‘implicit’ options through
transactions involving foreign currencies - Examples of how you create implicit options:
– Fixing a price list in multiple currencies - Hedge - Buy a FC put option
– Bidding on a project with FC revenue and HC costs - Hedge - Buy a FC put option
– Takeover bid on a foreign firm - Hedge - Buy a FC call option
- When your firm has given an implicit option in a foreign currency,
hedge the risk by buying the same kind of currency option
Pure vs. Selective Hedging
- Pure Hedging
– Removal of risk
– No regard to expectations
– Derivatives assumed to be fairly priced - Selective Hedging
– A person who hedges only when he or she believes
that prices are likely to move against him or her
– Currency expectations are considered
Pure Hedging
Forward : Fixed and inviolable
Option : A right but not an obligation
Foreign currency outflow
– Quantity known : Buy FC Forward, Long Futures
– Quantity unknown : Buy FC Call Options, Buy Compound Options
on Calls, Buy Call Options on Futures
– Date unknown : Long Futures, Call Options (Exchange),
Contracts for Difference.
Foreign currency inflow
– quantity known : Sell FC Forward, Short Futures
– quantity unknown : Buy FC Put Options, Buy Compound Options
on Puts, Buy Put Options on Futures
– Date unknown : Short Futures, Put Options (Exchange),
Contracts for Difference.
Selective Hedging
- Selective hedging is a form of speculating
- Employing the use of company forecasts in the
selection of hedging policies
– Direction
– Volatility - Direction
– View on the direction only, then use Futures,
Forwards, Spot or Options - Volatility
– View on volatility only, then use Options
Limitations of Hedging
- Limitation of hedging an uncertain payment
– over-hedging / under-hedging - Limitation of hedging an uncertain date
- Long-term hedging
– availability
– expectations incorporated in an efficient market - Repeated short-term hedging
– rolling the hedge forward - Unavailable hedge asset
– cross hedging
Global Financing Motivations
Theoretical Arguments
A firm is potentially able to lower its cost of capital through
Global Financing by:
* Improving liquidity for its securities
– increasing the supply of capital, both old and new
* Reduction in agency cost (Stulz, 1996)
* Inclusion in market indices
* Overcoming market segmentation
In addition, a firm can benefit from Global Financing by:
* The ability to use those shares in firm acquisitions
* Marketing
* Local employee profit sharing arrangements
Market Segmentation
- Pricing of securities by domestic standards
A market can be efficient yet still segmented by
international standards - Causes: Imperfections (Direct or Indirect Barriers)
– Government constraints, investor perceptions and
specific country risks. - Examples: Regulatory barriers, risk of insider trading and
political risk. - Overcoming market segmentation
Evidence - Mixed
External Sources of Equity
- Domestic Equity Offering
– MNCs can engage in a domestic equity offering in their
home country in which the funds are denominated in their
local currency. - Global Equity Offering
– Some MNCs pursue a global equity offering in which they
simultaneously access equity from multiple countries. - Public or Private Placement of Equity
– Public issues: Listed on domestic or foreign exchanges
– Private issues: Offer a private placement of equity to
financial institutions in their home country or in the foreign
country where they are expanding.
Issuance of Foreign Stock in the U.S.
- Yankee stock offerings
– Non-U.S. corporations that need large amounts of
funds sometimes issue stock in the United States - American Depository Receipts (ADR)
– Certificates representing bundles of stock. ADR
shares can be traded just like shares of a stock. - Effect of Sarbanes-Oxley (2002) Act on
Foreign Stock Listings
– Many non-U.S. firms decided to place new issues of
their stock in the United Kingdom instead of in the
United States so that they would not have to comply
with the law.
International Money Market
Corporations or governments need short-term funds
denominated in a currency different from their home
currency.
Money Market
A money market facilitates the process by which surplus
units can transfer funds to deficit units.
**European Money Market: **Dollar deposits in banks in
Europe and other continents are called Eurodollars or
Eurocurrency. Origins of the European money market can
be traced to the Eurocurrency market that developed
during the 1960s and 1970s.
Asian Money Market: Centred in Hong Kong and Singapore.
Originated as a market involving mostly dollar-
denominated deposits and was originally known as the
Asian dollar market.
Eurocurrencies
“Euro”
Outside of the country which issues the currency of
denomination
Eurodollar
“dollar deposits in banks in Europe (and on other
continents)” Madura p.699
Eurocurrency
A time deposit in a bank account located outside the banking
regulations of the country which issues the currency.
Eurobank
Commercial bank that participates as a financial
intermediary in the Eurocurrency market.
Eurocurrency Creation
Eurocurrencies are not bought and sold.
Eurocurrencies are created through a series
of transactions beginning in the home
country.
Example:
A firm has a deposit with a U.S. bank.
Ownership of the deposit is transferred to a UK bank.
The UK Bank has a deposit with the U.S. bank, and a
liability to the firm, both is USD.
Global Equity Offerings:
Euro-Equity Issues
“Euro”
Outside of the country which issues the currency of
denomination
Euro-Equity
* Where a company issues underwritten equity across
foreign equity markets
– Can be simultaneous with a domestic issue
* A market created by financial institutions
* Began with the privatisation of British Telecom (1984)
International Debt Financing
Debt Financing
– Concept: Standardised Floating Interest Rates
– Concept: Intermediation vs. Disintermediation
– Considerations in the Choice of the Type of Debt
International Debt Financing (Sources)
– Eurocurrency Loans
– Euronotes (NIF’s, ECP & EMTN’s)
– International Bonds
* Foreign Bonds
* Eurobonds
– Floating Rate Notes
* Zero Coupon Bonds
Standardised Floating
Interest Rates
- Standardised floating interest rates are used
extensively in pricing Eurodebt facilities. - Examples
– SOFR (Secured Overnight Financing Rate)
– US Prime Rate
– ESTR (Euro Short Term Rate)
– SORA (Singapore Overnight Rate Average)
– BBSW (Bank Bill Swap Rate / Australia)
– LIBOR : Discontinued (Used by Shapiro)
Financial Intermediation
vs. Disintermediation
- Financial Intermediation
– The process of raising debt finance through
an intermediary - Disintermediation
– The process of raising debt directly from the
market, by issuing securities to debtholders
– Reduces the cost to borrowers
– Increases flexibility
Considerations in the Choice
of the Type of Debt
The MNC’s cost of debt affects its required rate of return when it assesses
proposed projects. Features of debt such as currency of denomination, maturity,
and whether the rate is fixed or floating can affect the cost of debt, and therefore
affect the feasibility of projects that are supported with the debt. (Madura)
* Minimise the after-tax cost of debt
* Currency matching
– Matching the cash flows from Assets and Liabilities in similar denominated
currencies
– Managing changing exposures as debts are repaid
* Maturity matching
– Matching the durations of Assets and Liabilities
– Controlling exposure to movements in interest rates
* Fixed versus floating
* Forward hedging
* Parallel loans
* Ability to Swap
Currency Matching
- If subsidiaries of MNCs desire to match the currency they
borrow with the currency they use to invoice products, their
cost of debt is dependent on the local interest rate of their
host country. - A subsidiary in a host country where interest rates are high
might consider borrowing in a different currency to avoid the
high cost of local debt.
Countries with High Interest Rates
- Subsidiaries based in developing countries may be subject to
relatively high interest rates. - The matching strategy would force MNC subsidiaries in
developing countries to incur a high cost of debt. - The parent of a U.S.-based MNC may consider providing a
loan in dollars to finance the subsidiary so the subsidiary can
avoid the high cost of local debt. However, this will force the
subsidiary to convert some of its funds to dollars to repay the
loan.
Debt Maturity Decision
A MNC must decide on the
maturity for its debt.
Assessment of Yield Curve
* The shape of the yield
curve can vary among
countries. An upward
sloping yield curve may
indicate that investors
require compensation for
illiquidity associated with
long-term debt.
Financing Costs of Loans with Different Maturities
* Must decide whether to obtain a loan with a maturity that
perfectly fits its needs or one with a shorter maturity if it has
a more favourable interest rate and then source additional
financing when this loan matures.
Fixed versus Floating Rate Debt Decision
MNCs that wish to use a long-term maturity but wish to avoid the
prevailing fixed rate may consider floating rate bonds (tied to a
reference rate).
Financing Costs of Fixed versus Floating Rate Loans
* If an MNC considers financing with floating-rate loans it can
first forecast the rate for each year, and that would determine
the expected interest rate it would pay per year, allowing it to
derive forecasted interest payments for all years of the loan.
Managing Economic Exposure
(Through Policy)
* Change the firm’s operating policies
– Leads and Lags
* Interfirm vs. Intrafirm
– Reinvoicing Centers
– Netting
* Change the firm’s financing policies.
– Natural Hedging (matching)
– Forward Contracts + Debt
– Diversifying Currencies
– Parallel Loans
– Currency Swaps
Using Parallel Loans to Execute the Matching Strategy
- If an MNC is not able to borrow a currency that matches its
invoice currency, it might consider financing with a parallel (or
back-to-back) loan so that it can match its invoice currency. - In a parallel (or back-to-back) loan, two parties provide
simultaneous loans with an agreement to repay at a specified
point in the future. - Particularly attractive if the MNC is conducting a project in a foreign country, will receive the cash flows in the foreign currency, and is worried that the foreign currency will depreciate substantially.
Swaps
- Definition:
– …a swap – whether an interest rate swap or a currency swap –
can simply be described as the transformation of one stream of
future cash flows into another stream of future cash flows with
different features. - Swaps allow two parties to transform the nature of their
liabilities/assets
– interest rate swap: agreement to swap interest payments
whereby interest payments based on a fixed interest rate are
exchanged for interest payments based on a floating interest
rate.
– currency swap: agreement to exchange one currency for
another at a specified exchange rate and date. Madura p.704
(includes principal)
– a combination of the above - A financial intermediary is usually involved
Interest Rate Swaps: Purpose
- to hedge interest rate risk
- to take a position in interest rate
markets - to reduce the cost of debt if
imperfections exist - allows construction of longer
horizon hedges.
Hedging Interest Payments
with Interest Rate Swaps
- If MNCs are concerned that interest rates will rise,
they may complement their floating rate debt with
interest rate swaps to hedge the risk of rising interest
rates. - Financial institutions such as commercial and
investment banks and insurance companies often act
as dealers in interest rate swaps. - In a plain vanilla interest rate swap, one
participating firm makes fixed rate payments
periodically in exchange for floating rate payments.
– The payments are based on a notional value.
Financial Intermediaries
There is a cost of time and resources associated
with searching for a suitable swap candidate and
negotiating the swap terms.
Each swap participant also faces the risk that the
counter participant could default on payments.
Financial Intermediaries
➢ ensure legal compliance
➢ act as swap warehouses
➢ reduce information asymmetry of the parties
➢ bear credit risk
➢ share in the potential gains
* we will extend the previous example in which the maximum
possible benefit (100 b.p.) is achieved
Currency Swaps / FX Swaps
Currency Swap: agreement to exchange one currency for another at a
specified exchange rate and date. Madura p.698
Bank of International Settlements
* Currency Swap:
– Contract which commits two counterparties to exchange streams
of interest payments in different currencies for an agreed period
of time and to exchange principal amounts in different
currencies at a pre-agreed exchange rate at maturity.
* FX Swap:
– Transaction which involves the actual exchange of currencies
(principal amount only) on a specific date at a rate agreed at
the time of conclusion of the contract and a reverse exchange of
the same two currencies at a date further in the future and at a
(generally different) rate agreed at the time of the contract.
Using Currency
Swaps to Execute
the Matching
Strategy
- An MNC faces
exchange rate risk
when it is not able to
exchange in the
same currency as its
invoice currency. - A currency swap
specifies the
exchange of
currencies at
periodic intervals
and may allow the
MNC to have cash
outflows in the same
currency in which it
receives most or all
of its revenue
Why do Swaps Work?
- Comparative advantage
– Ricardo’s explanation of international trade
– a convincing argument for swaps? - Market segmentation
- Mispricing of risk
– if risk is mispriced, what are the
consequences? - Low-cost flexibility
The Benefits of Swaps
We have seen how swaps work
– swaps can help corporations vary their
cost and structure of debt
– swaps can hedge interest rate risk
– swaps can hedge foreign exchange risk
SWAPS offer corporations a longer time horizon
for their hedging than do exchange traded
products and many OTC products.
Sources of Debt
Domestic Debt Sources
– Loans from Financial Institutions
* An MNC’s parent commonly borrows funds from financial institutions.
* Syndicated loans (Commonly used in Australia)
– Credit
– Overdraft
– Commercial Paper
– Medium-Term Notes
– Bond Market
* MNCs commonly engage in a domestic bond offering in their home
country in which the funds are denominated in their local currency.
International Sources of Debt
– Eurocurrency Loans
– Euronotes
– International Bonds
* MNCs can engage in a global bond offering, in which they
simultaneously sell bonds denominated in the currencies of multiple
countries.
International Sources of Debt
-Eurocurrency Loans-
Loans sourced in the Eurocurrency markets.
* Syndicated Loan (chapter 3)
Sometimes a single bank is unwilling or unable to lend the
amount needed by an MNC or government agency.
A syndicate of banks can be formed to underwrite the
loans and the lead bank is responsible for negotiating the
terms with the borrower.
* Lower Interest Rate Spreads
– Wholesale market
– High credit ratings
– Lower costs
– Lower requirements
International Sources of Debt
-Euronotes-
- Euronote Market
– Short to medium term debt sourced in
Eurocurrency markets - Major Classes
– Underwritten - Short term promissory notes
- Underwritten by an arranger bank
– Non-Underwritten - Euro Commercial Paper
- Euro Medium Term Notes
International Bond Market
Market Participants
– Countries, MNC’s, large domestic corporations, and international
institutions.
* Foreign bonds
– Bonds sold in the country of denomination with a foreign issuer
– e.g. USD bonds sold and underwritten in the U.S. by an
Australian firm
– Registered:
* Owner’s name is on the bond
– Alternatively, a record of serial numbers is kept
* Updated as bonds are traded
* Eurobonds
– Bonds sold in countries outside of the country of denomination
Eurobonds
Types
* Straight fixed issue / floating rate note / convertible bonds
Common features
* Large denomination & long duration
* Bearer form
* Possession is evidence of ownership
* No ownership records are kept
* Call provisions
– The borrower has the option of retiring the bonds prior
to maturity
* Sinking Funds
– A fixed amount of bonds is retired each year after a
period of time
– Supports the market price by reducing bondholder risk
as not all the debt will fall due at once
Advantages of Eurobonds
Fixed rate
* Useful for hedging known cash flows
Relatively inexpensive, fast and flexible to issue
* Lack of regulations and disclosure requirements
(self regulated market)
* Tax advantages (bearer form)
Swap driven
* Raise one currency in one market to swap for an
alternative interest rate structure or currency
– Choose a currency where you have high
demand, to achieve a saving by swapping for
the curren
