BMGT446: Manage Transaction Hedging

transaction exposure

is the sensitivity of realized domestic currency values of firm’s contractual cash flows (that is, account receivables or payables) denominated in foreign currencies to unexpected changes in exchange rates

information asymmetry

the managers may have better information than the shareholders

differential transaction costs

the firm may be able to hedge at better prices than the shareholders

default costs

hedging may reduce the firm’s cost of capital if it reduces the probability of default

progressive corporate taxes

stable earnings may lead to lower corporate taxes than volatile earnings due to progressive tax rates

Allayannis and Weston (2001)

U.S. firms that face currency risk and use currency derivatives for hedging have, on average, about 5% higher value than firms that do not use currency derivatives

Mackay and Moeller (2007)

hedging in general can add value equivalent to 2-3 percent of firm value (if revenues are concave in product prices or if the costs are convex in factor prices)

E[S_t] approx equal to F

-expected gains or losses are approx zero, but forward hedging eliminated exchange exposure

-firm will be inclined to hedge if it is averse to risk

E[S_t] < F

firm expects a positive gain from forward hedging and would be even more inclined to hedge than in Scenario 1

E[S_t] > F

would be less inclined to hedge under this scenario, other things being equal

options hedge

allows the firm to limit downside risk while preserving the upside potential, but firm must pay for this flexibility in terms of the option premium

forward hedge - receivable

sell the foreign currency receivable amount forward by entering into a short position on a forward contract

forward hedge - payable

buy the foreign currency payable amount forward by entering into a long position on a forward contract

money market hedge - receivable

borrow in foreign currency against the foreign currency receivable, buy U.S. dollars with the loan, and invest in the U.S.

money market hedge - payable

borrow in domestic currency, buy foreign currency today with the loan, and invest abroad against the foreign currency payable

options hedge - receivable

buy put options on the foreign currency receivable

options hedge - payable

buy call options on the foreign currency payable

contingent exposure

is the risk due to uncertain situations in which a firm does not know if it will face exchange risk exposure in the future