The fundamental question to this discussion is whether companies hedging decision increase shareholder value. At first, let see the theoritical perspective on why hedging does not benefit shareholders. According to the Capital Asset Pricing Model a well diversified investor is unwilling to pay a premium for a specific company (share), just because it hedges its exposure. Infact this shareholders may not be concerned about the cash flow variability caused by swings in Financial exchange rates or commodity price. It is only the risk they can’t get rid off that counts. They will become concerned if such variability materially raises the probability of financial distress. Individual investors can easily themselves reduce to get rid off their exposure risks through adjusting theri portfolios and thus compensate for the volatile behaviour of one specific investment. So if a company want to reduce its systematic or unsystematic risks through hedging, this will not only reduce risk but also the expected return and thus not influence the value of the firm. It can actually be argued that engaging in these hedging activities will destroy shareholder value. It may also decrease the cash flow of the company, thus in conjunction with the reduced cost of capital, due to the reduced risk, at best it will not affect the value of the company.
It can also be argued that hedging is unnecessary as the theory of PPP (Purchasing Power Parity) expects exchange rate movements to just compensate for inflation differentials and thus changes in nominal values (prices).
PPP is the low of one price, which means that in theory all commodities and goods should have the same price in all markets, as people otherwise could gain from arbitrage which means that the purchase of goods on one market for immediate resale on another country in order to profit from a price discrepancy.
The problem with PPP is that there are time lags between the changes of price levels and the changes in exchange rates which could leave importing companies exposed in the short term. An exporter will remain exposed even if exchange rates more in line with general inflation, if the price of this expecting product does not increase by as much as inflation.
In a neoclassical, Modigliani-Miller type of world, management could not increase firm value by engaging into risk management activities. In such a perfect world without any information asymetrics, transaction costs or taxes, all hedging activities by the firm could be done or undone in the same way by investors. The reason for this is that the firm does not have any.
On the other hand, having looked at the more theoritical arguments mainly taking the view that hedging at the best doesn’t influence company value at the worst reduces shareholder value, we will now look at the pros on why a company should involve itself in hedging activities and the benefits for shareholders. The primary purpose of foriegn exchange hedging is to reduce the cashflow volatility caused by precisely these kinds of foreign exchange movements.
In turn according to Thomas Copeland & Yash Joshi, the reduction in foreign exchange induced volatility is expected to dampen the volatility of a company’s total cashflow and can increase maximise market value of the firm:
- By reducing the probability of business disruption costs. Large swings in cashflows can lead to liquidity crises when cashflows turn negative unexpectedly. The cost of doing business will the rise because because suppliers are slow to deliver when dealing with a customer in distress, customers shy away from its products need servicing, and workers depart as demand extra pay from an employer that may be gone tommorrow.
- By creating new business opportunities. Firms with smoother cashflows can gain competitive advantage over other companies in their industry and could increase Research and Development in order to keep up the supply of new products.
- By reducing taxes. Since tax rates are progressive, that is, a higher income attracts a higher percentage tax. Smoothing cashflows across tax years reduces the tax percentage and thus the tax liability.
- By increasing debt capacity. Lenders are more willing to deal with companies that have stable cashflows. If a company reduces the probability of a cash crunch it improves its ability to borrow
Academic theory suggests that some companies facing large exposures to interest rates, exchange rates, interest rates or commodity prices can use derivatives in order to reduce the variability of cash flows and in so doing reduces various costs associated with financial distress if total risk matters. For instance the cost of purchasing, as suppliers should be willing to give better credit terms due to the better past performance of the company and the knowledge of the company hedging its exposures. Mangement will also be more efficient, as they will not have to spend a lot of time concentrating on short term survival strategies but can concentrate on improving the long term competitiveness of the firm. An increase in cash flow stability should also give the company a better credit rating from financial agencies S&P Moodys which will reduce its cost of debt and thus the discount rate by which cashflows are discounted increase the value of the firm. (Derivatives & corporate risk management, 1995).
However, even a diversified investor, does not gain from a company getting engaged in hedging activities, in practice especially for small investors who are not well diversified due to the fact that they have a minimum stock broking commissions, which probably only make diversification efficient for a big portfolio as the big institutions have better to hedge it.
After reviewed all the general issues when deciding whether or not to hedge, shell should take action to reduce the potential impact of exchange volatility on future cashflows. Reduction of such volatility removes an important element of uncertainity confronting the strategic management of the company consequently, a hedging programme will be useful if it allows the company to maximise its own value by having the ability to monetize investment and growth oppurtunities.
2. Specify the particular exposures your firm has and suggest an appropriate method to hedge that exposure.
Exchange rate exposure is usually divided (e.g. Shapiro (1996)) into three different types: transaction, translation and operating exposure. The combined effect of transaction exposure and operating exposure is usually referred to as economic exposure (Sercu and Uppal, 1995).
- Transaction exposure arises from the possibility that future incomes (or costs) from a contract denominated in foreign currency change between the date when a firm commits to a transaction and the actual transaction date. It is clear that many companies see transaction exposure as a problem (e.g see the survey by Bodnar and Marston (1996)). However since this kind of exposure usually is well defined and short term, it can be (if the firm so desires) hedged quite easily using derivatives.
- Translation exposure is the difference between assets and liabilities that are exposed to currency fluctuations. Consider an U.S. multinational firm that operates in several different countries and has subsidiaries operating in local currency. Even if the subsidiary faces no exchange rate risk at all in local currency the shareholders of the multinational firm might be interested in U.S. dollars. Therefore the remittance from the foreign unit of the firm are exposed to exchange rate fluctuations when it is translated back to U.S. dollars.
- A more complex and more interesting measure of exchange rate exposure is economic exposure. If we define the value of a firm as the present value of expected future cash flows, economic exposure measures the degree to which movements in exchange rates affect the firm’s value. This could be through existing contracts (transaction exposure) or by changing the value of future revenues and costs, so called operating exposure. Hence economic exposure depends on the operations of the firm (locations of factories, competitive structure etc.) and is in theory the type of currency exposure companies want to deal with, but in practice very complicated to identify and hedge.
Using economic exposure as the measure it is quite clear that few firms stay unaffected by currency fluctuations. It is also obvious that currency exposure will vary substantially across firms.
Rolls Royce a uk based manufacturer of aero engine producer, has just concluded negotiations for the sale of its engine with American airline for the sum of $1,000,000.
The sale is concluded in March but payment will be made three months later, in June.
Assumptions
Spot exchange rate: $1.7640/£.
Three-month forward rate: $1.7540/£.
Rolls Royce ‘s cost of capital: 12%.
U.K. three-month borrowing (lending) rate: 10% (8%) per annum.
U.S. three-month borrowing (lending) rate: 8% (6%) per annum.
Rolls Royce can: Remain unhedged
Hedge in the forward market
Hedge in the money market
Rolls Royce will lose when the dollars weakens and gains when the dollars strengthens. Foreign exchange hedging would simply neutralize the operational losses caused by foreign exchange change movements and often any gains too.
Suppose Rolls Royce decides to accept the transaction risk.
If the future spot rate is $1.76/£, Rolls Royce will receive
$1;000;000/$1,76 =568181,82 in 3 months.
However, if the future spot rate is $1.65/£, then Rolls Royce will receive £606060,60 well above the acceptable rate.
The two common methods utilized by MNCs to manage transaction exposure to foreign exchange risk are: 1) the forward hedge, and 2) the money market hedge. To determine which of these two strategies is preferable, we will evaluate this methods through example.
Forward rates are usually set around the interest rate parity between countries. The interest rate parity is the difference in interest rates for like type of securities with maturity’s of less than one year, taking into consideration the forward exchange rate discount or premium.
Of course this doesn’t take into consideration transaction costs or slippage which The forward contract is entered at the time the Agreement is created, i.e.in March.
The sale is recorded at the spot rate, in this case $1.7640/£.
Hedging in the forward market here means selling $1,000,000
forward at the 3-month forward rate of $1.7540/£.
In 3 months, Dayton will received $1,000,000 and exchange them at the rate $1.7540/£, receiving £570125,43 with certainty.
This is £35935,17 less than the uncertain £606060,60 expected from the unhedged position. The forward hedge would be used when the company has an account receivable from a client who is going to pay in a foreign currency. The funds to fulfill the forward contract will be received when the foreign client makes the payments, therefore the hedge is covered.
The money market hedge is based on quotations of forward rates by lending institutions based on the interest rate parity. The money market hedge can also be used for account receivables, the difference is that the cost of the money market hedge is determined by the interest rate differential, where the cost of the forward rate hedge is a function of the forward rate quotes.
In this case, the contract is a loan agreement. The firm borrows in one currency and exchanges the proceeds for another currency.
Hedges can be left “open” (i.e. no investment) or “closed” (i.e. investment).
To hedge in the money market, Rolls Royce will borrow dollars in New york, convert the dollars to pound and repay the dollars loan with the proceeds from the sale.
To calculate how much to borrow, Rolls Royce needs to discount the
PV of the $1,000,000, i.e. $1000000* 1,025= $1025000
Thus Rolls Royce must borrow $1025000 today and repay $1,000,000 in 3 months with the proceeds from the sale.
In order to compare the forward hedge with the money market hedge, Rolls Royce must analyze the use of the loan proceeds.
What can Rolls Royce do with the loan?
It can exchange the $1025000 at the spot rate of $1.7640/£, which
gives £581065,76 and invest it in a UK£-denominated asset.
Unlike the funds involved in a forward contract, the loan amount can be used immediately.
The loan proceeds can be:
- Invested at the US rate of 6.0% per annum;
- Used instead of a loan that would have otherwise been taken for working capital needs at the rate of 8.0% per annum;
- Invested in the firm itself, the cost of capital being 12.0% per annum.
conclusion
Thus, as noted above, the results of this study find only mixed support for the view that The money market hedge is superior to the forward hedge if the proceeds are used to replace a dollar loan (8%) or conduct general business operations (12%).
More specifically, with respect to US Dollars, the two hedging techniques did yield approximately equal results. However, in the case of the British pound, the evidence suggests that MNCs may have been better served by employing the forward hedge for receivables and the money market hedge for payables. .
Word count :2752
References :
Adler, M. and Dumas, B., 1984, \Exposure to currency risks: de¯nition and measurement,"
Financial Management, Summer.
Bodnar, G. M., Hayt, G. S., and Marston, R. C. (1996) 1995 Wharton survey of derivatives usage by US non-financial firms, Financial Management (4), 113–133.
Stulz, Rene, “Optimal hedging policies,” Journal of Financial and Quantitative
Analysis, 1984, 19, 127 – 140.
Tufano, Peter, “Who Manages Risk? An Empirical Examination of Risk
Management Practices in the Gold Mining Industry,” Journal of Finance,
September 1996, LI (4), 1097 – 1137.
Shapiro, A. C. (1999): Multinational Financial Management. 6. Aufl. Upper Saddle River (N.J.).
MMU MBA 2003/2004
International Finance Pajany Gowry
