Applied corporate finance 2021/2022
Green = 60% of exam Topic 1, Topic 4, Topic 7, Topic 8, and Topic 11
26-30% of exam Topic 2, Topic 6, Topic 12, and Topic 13
12-14% of exam Topic 3, Topic 5, Topic 9, Topic 14
Topic 1: Managing exposure 1 – transaction exposure 12%
Should we hedge?
View 1: Corporate exposure management would not necessarily add to the value of the firm
Ø Exchange exposure management at a corporate level is redundant when
stockholders can manage the exposure themselves
Ø What matters in the firm valuation is only systematic risk: corporate management
may only reduce the total risk
View 2: There are various market imperfections therefore we should hedge corporate risk.
Ø What are these market imperfections?
1. Information asymmetry
2. Differential transactions costs
3. Default costs
4. Progressive corporate taxes
§ progressive corporate taxes show that hedging can reduce the
payable taxes
Firm A: NO hedging
Corp tax for the first €10M = 20% and Corp tax above 10M = 40%
Probability 50% depreciate and earn 5M and 50% appreciate and earn 15M
Ø Expected earnings = 0.5*5 + 0.5*15 = 10M
Ø Expected tax = 0.5*(0.2*5M) +0.5*(0.2*10M+0.4*5M) = 2.5M
Firm B: hedging
Corp tax for the first €10M = 20% and Corp tax above 10M = 40%
Probability 50% depreciate and earn 10M and 50% appreciate and earn 1M
Ø Expected earnings = 0.5*10 + 0.5*10 = 10M
Ø Expected tax = 10M * 0.20 = 2M
FX Risk Exposures
3 types of FX exposures for a multinational company
,1. Short term effect
Ø Transaction risk exposure
1. Is about how the amount of money the firm owes in foreign currency or
expects to receive in foreign currency in the future changes due to exchange
rate movements
§ having a receivable and a non-guaranteed pay
2. Long term effect
Ø Economic risk exposure
1. the value of the firm that would be affected by unanticipated changes in the
FX market
§ supply and demand
3. Accounting
Ø Translation risk exposure
1. how consolidated financial statements would be affected by FX rates (usually
involving subsidiaries’ financial statements)
§ consolidating
,Managing transactions risk exposures
Hedging receivables
Mini case – Boeing Corporation example
Suppose that Boeing Corporation (USD) exported a landing gear of Boeing 737 aircraft to
British Airways and billed a 10m British pound (GBP) payable in one year.
Ø Boeing has 4 alternatives:
1. Unhedged position (do nothing)
2. Forward Market Hedge
3. Money Market Hedge
4. Option Market Hedge
Forward market hedge
If you are going to owe foreign currency in the future: agree today to buy the foreign
currency in the future, by entering a long position in a forward contract
Ø If you have a payable > buy foreign currency
If you are going to receive foreign currency in the future: agree today to sell the foreign
currency in the future, by entering a short position in a forward contract
Ø If you have a receivable > sell foreign currency
Suppose that Boeing Corporation (USD) exported a landing gear of Boeing 737 aircraft to
British Airways and billed a 10m British pound (GBP) payable in one year. Then what is the
strategy of Boeing?
Ø Short position (sell) in British pound
US interest rate = 6.10%, UK interest rate = 9%, Spot exchange is 1.50 USD/GBP and the
forward exchange rate is 1.46 USD/GBP 1year maturity
Forward market hedging strategy: Boeing sells (short) forward its pound receivable, 10m
GBP for delivery in 1 year, in exchange for a given amount of USD
,Forward is between the counterparties, futures are on the exchange
Money market hedge
Transaction exposure can be hedged by lending and borrowing in the domestic and foreign
money market by using a 5-step approach, self-financing strategy
,option market hedge
The money market and forward market eliminates exchange rate risk exposure. Do we
always enjoy this?
Ø The firm must forgo the opportunity to benefit from favourable exchange rate
changes
Ø Boeing may want to protect itself against GBP depreciation but enjoy possible
appreciation
Call option -> Right to buy
Ø A call option gives the holder the right, but not the obligation to buy a certain
amount of a foreign currency at a specific exchange rate up to or at the maturity
date
Put option -> Right to sell
Ø A Put option gives the holder the option, but not the obligation, to sell a certain
amount of a foreign currency at a specific exchange rate up to or at the maturity
date
,In general, the firm can buy a foreign currency …
è Call – to hedge foreign currency payables
è Put – to hedge the receivables
Receivables hedging summary
,Hedging payables
Cross-hedging minor currency exposure
Hedging with illiquid currencies
What if our FX position was on illiquid currencies?
è How to hedge Indonesian rupiah or Czech koruna?
o Solution: Cross-Hedging
§ A technique to manage the minor currency exposure of the firm
§ Cross Hedging involves a hedging position in one asset by taking a
position of another asset
Hedging with Illiquid currencies
Ø Hedging illiquid currencies are very costly or sometimes impossible
Ø Financial markets of developing countries are usually highly regulated and
underdeveloped
Example: Hedging Korean exposure
Suppose US firms have Account Receivables in Korean won and would like to hedge its Won
position. Won / USD forward market is not well functioning or too costly. How can the US
company hedge its Won position with cross-hedging?
- USD/WON and USD/YEN are highly correlated
US firm can cross hedge its WON position by using YEN/WON forward contracts
The US firm sells a YEN amount, equivalent to WON receivable, forward against the USD
Example: Hedging exposure of oil exporter (Mexican peso exposure)
Mexico produces 5% of the world’s oil and the Mexican peso is positively correlated to the
world oil price. Suppose you have an account receivable in the Mexican peso and want to
hedge this exposure: how?
Ø Use oil commodity futures contracts to hedge Mexican peso exposure
1. Take a short position in Oil futures
Then, how to hedge Brazilian exposure?
è Similarly, you may want to use vein, soybean and coffee future contracts for cross-
hedging Brazilian exposure
Is this cross hedging technique effective?
Ø The effectiveness of this cross-hedging technique would depend on the strength and
stability of the relationship between the exchange rate and the commodity futures
price
, Hedging Contingent exposure
Hedging Recurrent exposure with Swap contracts
Suppose that Boeing is Scheduled to deliver an aircraft to British Airways at the beginning of
each year for the next 5 years. British Airlines will pay 100m GBP each year. How can Boeing
hedge this exposure?
Ø Boeing can hedge this exposure with a swap agreement
A currency swap contract: an agreement
to exchange one currency for another at
a predetermined exchange rate (swap
rate)
A swap contract is like a portfolio of
forward contracts with maturities
• Each year Boeing delivers 100m
GBP to another counter-party
(say a bank) and takes a pre-
determined dollar amount each
year
Hedging through invoice currency
Ø Shift FX risk (with British Airways)
1. Invoice foreign sales in home currency: Invoice will be 150M USD
§ Main concern: Why should British Airways agree?
Ø Share FX risk (with British Airways)
1. Pro-rate the currency of the invoice between foreign and home currencies
Green = 60% of exam Topic 1, Topic 4, Topic 7, Topic 8, and Topic 11
26-30% of exam Topic 2, Topic 6, Topic 12, and Topic 13
12-14% of exam Topic 3, Topic 5, Topic 9, Topic 14
Topic 1: Managing exposure 1 – transaction exposure 12%
Should we hedge?
View 1: Corporate exposure management would not necessarily add to the value of the firm
Ø Exchange exposure management at a corporate level is redundant when
stockholders can manage the exposure themselves
Ø What matters in the firm valuation is only systematic risk: corporate management
may only reduce the total risk
View 2: There are various market imperfections therefore we should hedge corporate risk.
Ø What are these market imperfections?
1. Information asymmetry
2. Differential transactions costs
3. Default costs
4. Progressive corporate taxes
§ progressive corporate taxes show that hedging can reduce the
payable taxes
Firm A: NO hedging
Corp tax for the first €10M = 20% and Corp tax above 10M = 40%
Probability 50% depreciate and earn 5M and 50% appreciate and earn 15M
Ø Expected earnings = 0.5*5 + 0.5*15 = 10M
Ø Expected tax = 0.5*(0.2*5M) +0.5*(0.2*10M+0.4*5M) = 2.5M
Firm B: hedging
Corp tax for the first €10M = 20% and Corp tax above 10M = 40%
Probability 50% depreciate and earn 10M and 50% appreciate and earn 1M
Ø Expected earnings = 0.5*10 + 0.5*10 = 10M
Ø Expected tax = 10M * 0.20 = 2M
FX Risk Exposures
3 types of FX exposures for a multinational company
,1. Short term effect
Ø Transaction risk exposure
1. Is about how the amount of money the firm owes in foreign currency or
expects to receive in foreign currency in the future changes due to exchange
rate movements
§ having a receivable and a non-guaranteed pay
2. Long term effect
Ø Economic risk exposure
1. the value of the firm that would be affected by unanticipated changes in the
FX market
§ supply and demand
3. Accounting
Ø Translation risk exposure
1. how consolidated financial statements would be affected by FX rates (usually
involving subsidiaries’ financial statements)
§ consolidating
,Managing transactions risk exposures
Hedging receivables
Mini case – Boeing Corporation example
Suppose that Boeing Corporation (USD) exported a landing gear of Boeing 737 aircraft to
British Airways and billed a 10m British pound (GBP) payable in one year.
Ø Boeing has 4 alternatives:
1. Unhedged position (do nothing)
2. Forward Market Hedge
3. Money Market Hedge
4. Option Market Hedge
Forward market hedge
If you are going to owe foreign currency in the future: agree today to buy the foreign
currency in the future, by entering a long position in a forward contract
Ø If you have a payable > buy foreign currency
If you are going to receive foreign currency in the future: agree today to sell the foreign
currency in the future, by entering a short position in a forward contract
Ø If you have a receivable > sell foreign currency
Suppose that Boeing Corporation (USD) exported a landing gear of Boeing 737 aircraft to
British Airways and billed a 10m British pound (GBP) payable in one year. Then what is the
strategy of Boeing?
Ø Short position (sell) in British pound
US interest rate = 6.10%, UK interest rate = 9%, Spot exchange is 1.50 USD/GBP and the
forward exchange rate is 1.46 USD/GBP 1year maturity
Forward market hedging strategy: Boeing sells (short) forward its pound receivable, 10m
GBP for delivery in 1 year, in exchange for a given amount of USD
,Forward is between the counterparties, futures are on the exchange
Money market hedge
Transaction exposure can be hedged by lending and borrowing in the domestic and foreign
money market by using a 5-step approach, self-financing strategy
,option market hedge
The money market and forward market eliminates exchange rate risk exposure. Do we
always enjoy this?
Ø The firm must forgo the opportunity to benefit from favourable exchange rate
changes
Ø Boeing may want to protect itself against GBP depreciation but enjoy possible
appreciation
Call option -> Right to buy
Ø A call option gives the holder the right, but not the obligation to buy a certain
amount of a foreign currency at a specific exchange rate up to or at the maturity
date
Put option -> Right to sell
Ø A Put option gives the holder the option, but not the obligation, to sell a certain
amount of a foreign currency at a specific exchange rate up to or at the maturity
date
,In general, the firm can buy a foreign currency …
è Call – to hedge foreign currency payables
è Put – to hedge the receivables
Receivables hedging summary
,Hedging payables
Cross-hedging minor currency exposure
Hedging with illiquid currencies
What if our FX position was on illiquid currencies?
è How to hedge Indonesian rupiah or Czech koruna?
o Solution: Cross-Hedging
§ A technique to manage the minor currency exposure of the firm
§ Cross Hedging involves a hedging position in one asset by taking a
position of another asset
Hedging with Illiquid currencies
Ø Hedging illiquid currencies are very costly or sometimes impossible
Ø Financial markets of developing countries are usually highly regulated and
underdeveloped
Example: Hedging Korean exposure
Suppose US firms have Account Receivables in Korean won and would like to hedge its Won
position. Won / USD forward market is not well functioning or too costly. How can the US
company hedge its Won position with cross-hedging?
- USD/WON and USD/YEN are highly correlated
US firm can cross hedge its WON position by using YEN/WON forward contracts
The US firm sells a YEN amount, equivalent to WON receivable, forward against the USD
Example: Hedging exposure of oil exporter (Mexican peso exposure)
Mexico produces 5% of the world’s oil and the Mexican peso is positively correlated to the
world oil price. Suppose you have an account receivable in the Mexican peso and want to
hedge this exposure: how?
Ø Use oil commodity futures contracts to hedge Mexican peso exposure
1. Take a short position in Oil futures
Then, how to hedge Brazilian exposure?
è Similarly, you may want to use vein, soybean and coffee future contracts for cross-
hedging Brazilian exposure
Is this cross hedging technique effective?
Ø The effectiveness of this cross-hedging technique would depend on the strength and
stability of the relationship between the exchange rate and the commodity futures
price
, Hedging Contingent exposure
Hedging Recurrent exposure with Swap contracts
Suppose that Boeing is Scheduled to deliver an aircraft to British Airways at the beginning of
each year for the next 5 years. British Airlines will pay 100m GBP each year. How can Boeing
hedge this exposure?
Ø Boeing can hedge this exposure with a swap agreement
A currency swap contract: an agreement
to exchange one currency for another at
a predetermined exchange rate (swap
rate)
A swap contract is like a portfolio of
forward contracts with maturities
• Each year Boeing delivers 100m
GBP to another counter-party
(say a bank) and takes a pre-
determined dollar amount each
year
Hedging through invoice currency
Ø Shift FX risk (with British Airways)
1. Invoice foreign sales in home currency: Invoice will be 150M USD
§ Main concern: Why should British Airways agree?
Ø Share FX risk (with British Airways)
1. Pro-rate the currency of the invoice between foreign and home currencies
