- Discuss and compare hedging transaction exposure using the forward contract versus money market instruments. When do alternative hedging approaches produce the same result?
International trade is a growth strategy that many firms have taken because of the many benefits a firm gets from it. However all business activities have inherent risks. Traction exposure is the term for the risk that companies doing international trade face. Investopedia (2012) defines this as the risk associated with the fluctuations in exchange rates which affect corporations that have entered into financial obligations thus leading to possible losses. Transaction exposure is well-defined and is often short-term in nature, compared for example to economic or country risks which are systemic and long-term in nature.
A firm may also hedge in the options market. In some instances, the firm can use options for forward contracts. The hedge will only be effective for the person acquiring the hedge if the result of the forward contract is favorable. If it is not, the option can be exercised and that option simply is to “honor the hedge” or not, after the contract is realized. In this way, a hedge can eliminate the downside of the transaction exposure risk but retain the potential for an upside. Hedges with options however, are expensive and require an up-front payment or premium because of the security they offer (Transaction Exposure).
- Should a firm hedge? Why or why not?
If perfect capital markets exist, there will be no need for insurance or hedging instruments. But because markets are never perfect, protection against risk is important. If a company is engaged in foreign trade, it is prudent for the company to hedge. A hedge is an off-setting contract that provides insurance to a firm. It protects the home currency of the firm’s receivables or payables that are denominated in a foreign currency. The foreign exchange, which goes up or down, changes the firm’s profitability and long-term viability and hedging, is a way of insulating the firm from the foreign exchange risk.
Corporate management’s role is to ensure shareholder wealth maximization. The idea of providing insurance through hedging is a way of ensuring shareholder wealth maximization because the risks of losing money is being mitigated. Callahan (2002) stated that a hedge not only protects cash flows, it also reduces the firm’s expenditures and its cost of capital through the mitigation of any default risks from unstable cash flows.
A study by Breeden and Wisvanathan (1998) states that corporate managers respond to asymmetrical (incomplete) information through hedging. Managers that have the ability to control risks will natural use their skills to control those risks, but those risks that they neither have expertise nor experience with, they mitigate through instruments such as hedging. Therefore one factor why firms hedge is the skill level of managers and their desire to protect their reputation and the firm’s overall financial position, which is tied to their managerial reputation.
Management knows its financial positions better than its shareholders and will have that luxury of knowing when a hedge is needed or not. A hedge protects the firm especially if the threat of default is large. Finally, a firm that faces progressive taxes should definitely hedge. A firm should hedge because it prudently recognizes risks and a firm that recognizes the risks it faces is already one step ahead of its game.
- Cray Research sold a supercomputer to the Max Planck Institute in Germany on credit and invoiced €IO million payable in six months. Currently, the six-month forward exchange rate is $1.1O/€ and the foreign exchange adviser for Cray Research predicts that the spot rate is likely to be $1.05/€ in six months.
- What is the expected gain/loss from a forward hedge?
The expected gain from a forward hedge is computed as follows:
- If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? Why or why not?
Definitely. There is a 500,000 increase in value which makes the move to hedge logical.
- Suppose the foreign exchange adviser predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case?
Why or why not?
I will recommend going ahead with the hedge since the risks will be eliminated even if the values do not change, assuming that I have no up-front cost to acquire the hedge.
- Suppose that your company has an equity position in a French firm. Discuss the condition under which dollar/euro exchange rate uncertainty does not constitute exchange exposure for your company.
Kuepper (2012) defines currency risk or foreign exchange risk as the type of risk coming from changes in the valuation of currencies. However, if currencies do change, this does not automatically mean that there is currency exposure. Currency risk will happen if the equity that is valued in French Francs moves in the same direction as the change in the US dollar value of the equity. If this does not happen then the company is not exposed to currency risk.
- General Motors exports cars to Spain, but the strong dollar against the euro hurts sales of GM cars in Spain. In the Spanish market, GM faces competition from Italian and French car makers, such as Fiat and Renault, whose operating currencies are the euro. What kind of measures would you recommend so that GM can maintain its market share in Spain?
This is an operational question as much as it is a finance question. One way of working around this problem is to locate a production facility in Spain making the cars sold by GM produced in Euros (majority of the total cost of a car will be in Euro denominations). If it cannot do so, GM should find cost reduction strategies in the US or nearby areas such as Mexico to offset the currency risks.
- Exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case.
Under a certain set of circumstances, firms do not have to worry about exchange risk exposures. These circumstances are when the firm’s competitive position is due to its operations in diverse markets, when the firm has the ability to source inputs from many sources, when it can produce products cost efficiently and operate at its optimum levels and when the nominal exchange rates do not affect the Purchasing Power Parity between countries.
- Recently, many foreign firms from both developed and developing countries acquired high-tech U.S. firms. What might have motivated these firms to acquire U.S. firms?
The acquisition of US firms indicates that investors are beginning to see the potential again in the US economy. Although the US is currently in a tight spot in terms of economic performance, it is still a very strong economy and the negative press about its recent performance means that the US equities are undervalued. This is the same as buying at a discount and investors are looking at gains even at the simplest form. When the market corrects itself after the US economy turns from the slump, equity prices will rise making investments in the US profitable for those that have bought equities are discounted prices.
- How would you explain the fact that China emerged as one of the most important recipients of FDI in recent years?
In the last decade, China has received the highest volume and value of Foreign Direct Investments (FDI). Throughout the 1990s, FDI in China reached stratospheric levels, seeping into every aspect of Chinese economy particularly with the rise in both the US and EU investments in China, especially those industries that are technology intensive (rather than labor intensive). The provinces of Jiangsu and Shanghai became the two most prominent provinces for investments in China as well. Pianyao (2002) attributes these to the reforms of President Deng Xiaoping and his South Tour in the summer of 1992 that led to the establishment of China’s economic reform, the seed investments in FDI from 1991’s US $ 4.366 billion, the accelerated growth internally in China starting in 1992 brought about by political stability which then led to investor confidence and trade liberalization. These are all political and economic reforms that are needed by firms who want to capitalize on China’s abundant and competitive labor and infrastructure resources.
- Why do you think the host country tends to resist cross-border acquisitions rather than greenfield investments?
Greenfield investments are new foreign direct investments into a host country. This means new facilities to be constructed, new materials to be purchased, new personnel to be hired. All of these indicate a positive addition to the economy. A cross-border acquisition is a foreign take-over of an existing facility and does not expand the economy any more than the previous owners of the facility. From this standpoint, host countries prefer greenfield investments rather than cross-border acquisitions.
References
Breeden, D. and Wisvanathan, S. (1998) Why Do Firms Hedge? An Asymmetric Information Model. Wharton School, University of Pennsylvania. Retrieved from
Callahan, M. 2002. To Hedge or Not to HedgeThat Is the Question: Empirical Evidence from the North American Gold Mining Industry 1996-2000. The Leonard N. Stern School of Business, Glucksman Institute for Research in Securities Markets. Retrieved from
Chapter 8: Transaction Exposure. Retrieved from
Investopedia. 2012. Transaction Exposure. Retrieved from
Kuepper, J. 2012. International Investing. Retrieved from
Pingyao, L. 2002. Foreign Direct Investment in China: Recent Trends and Patterns. China & World Economy Number 2, 2002. Retrieved from
