Ch 8 Transaction Exposure Management

Chapter 8 Management of Foreign Exchange Exposure

Transaction Exposure • Foreign exchange exposure is a measure of
• Forward Market Hedge the potential for a firm’s profitability, net cash
flow, and market value to change because of
• Money Market Hedge a change in exchange rates.
• Options Market Hedge • An important task of the financial manager is
• Exposure Netting to measure foreign exchange exposure and
to manage it so as to maximize the
• Should the Firm Hedge? profitability, net cash flow, and market value
• What Risk Management Products Do Firms of the firm.
Use? • Many MNCs attempt to manage their
currency exposures through hedging.
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Three Basic Types of Foreign Exchange Exposure

Economic Exposure = Accounting Exposure Three Types of Exposure

Operating Exposure
+
Transaction Exposure*
Translation Exposure • It is conventional to classify foreign currency
The extent to which assets,
liabilities, revenues, expenses, exposures into three types:
Operating Exposure
The extent to which revenues
gains, and losses denominated
in foreign currencies result in 1. Transaction exposure is the potential change in the
value of financial positions due to changes in the
Aspects and costs are affected by foreign exchange gains and Aspects
of both currency fluctuations losses of both
operating
and
translation
and
exchange rate between the inception of a contract
transaction Transaction Exposure transaction and the settlement of the contract
exposure exposure
E.g., contractual
The extent to which contractually
binding transactions that have
2. Economic exposure is the possibility that cash flows
sales transactions
affect revenues
not been executed will be E.g., A/R, debt
and the value of the firm may be affected by
affected by currency fluctuations
at settlement unanticipated changes in the exchange rates
*Although transaction exposure is properly included as economic exposure, it is often included
3. Translation exposure is the effect of an unanticipated
in accounting exposure because certain contractually binding transactions are included in a change in the exchange rates on the consolidated
financial reports of an MNC
firm’s financial statements.

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Transaction Exposure
Economic Exposure • Transaction exposure stems from the possibility of incurring future
exchange gains or losses on foreign-currency-denominated transactions
§ Economic Exposure
already entered into but not settled.
= Transaction Exposure + Operating Exposure
§ Arises because exchange rate changes alter the value of future • Transaction exposure is measured currency by currency and equals the
revenues and costs. difference between contractually fixed future cash inflows and outflows in
§ Transaction and operating exposures are cash flow exposures. each currency.
• Example: Boeing sells five 747s to Air India for Rs 50 billion and agrees to
§ Transaction exposure is concerned with future cash flows already buy Indian parts worth Rs 22 billion.
contracted for.
– Inflows = Rs 50 billion; outflows = Rs 22 billion
§ Operating exposure focuses on expected future cash flows (not yet
contracted for) that might change because a change in exchange – Net transaction exposure = inflows – outflows = Rs 28 billion.
rates has altered international competitiveness. – If e0 = $0.0243, net transaction exposure in dollars = Rs 28 billion ×
$0.0243 = $680.4 million.
§ The change in firm value, as measured by the present value of
future cash flows, is due to a change in exchange rates. – If e0 decreases to $0.02425 at settlement, transaction loss = ($0.02425
- $0.0243) × Rs 28 billion = -$1.4 million.
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1
Ch 8 Transaction Exposure Management

Hedging Managing Transaction Exposure

• A transaction exposure arises whenever a company is
• Objective: reduce/eliminate volatility of earnings as committed to a foreign currency-denominated
a result of exchange rate changes. transaction.
• Hedging is the taking of a position, acquiring either • The general rules
a cash flow, an asset, or a contract (including a
forward contract) that will rise (fall) in value and – Protect against currency appreciation
offset a fall (rise) in the value of an existing For foreign currency outflows (payable)
position.
Øif amount known, buy forward/futures.
• Hedging a particular currency exposure means
establishing an offsetting currency position. Øif amount unknown, buy currency call option.
• Whatever is lost or gained on the original currency – Protect against currency depreciation
exposure is exactly offset by a corresponding For foreign currency inflows (receivable)
foreign exchange gain or loss on the currency
hedge. Øif amount known, sell forward/futures.
Øif amount unknown, buy currency put option.
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Forward Market Hedge: Imports Forward Market Hedge: Exports

• If you expect to owe foreign currency in the future, you can hedge by • If you are going to receive foreign currency in the future, agree to
agreeing today to buy the foreign currency in the future at a set price sell the foreign currency in the future at a set price by entering into
by entering into a long position in a forward contract. short position in a forward contract.

Importer Exporter

Forward Forward
Contract Foreign Foreign
Supplier Contract Customer
Counterparty Counterparty
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Exporter’s Forward Market Cross-Currency Hedge Exporter’s Forward Market Cross-Currency Hedge
Your firm is a U.K.-based exporter of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer. • The UK exporter has to convert the €750,000 receivable first into dollars
Payment (in euros) is due in six months. Your firm wants to hedge the receivable into pounds.
and then into pounds.
Country U.S. $ equiv. Currency per U.S. $ • If we sell the €750,000 receivable forward at the six-month forward rate
Britain (£62,500) $2.0000 £0.5000 of $1.50/€, we can do this with a SHORT position in 6 six-month euro
1 Month Forward $1.9900 £0.5025 forward contracts. €750,000
6 contracts =
3 Months Forward $1.9800 £0.5051 €125,000/contract
6 Months Forward $2.0000 £0.5000 § Selling the €750,000 forward at the six-month forward rate of $1.50/€
12 Months Forward $2.1000 £0.4762 generates $1,125,000: $1.50
Euro (€125,000) $1.4700 €0.6803
$1,125,000 = €750,000 ×
€1
l At the six-month forward exchange rate of $2/£, $1,125,000 will buy
£1
1 Month Forward $1.4800 €0.6757
£562,500.
3 Months Forward $1.4900 €0.6711 £562,500 = $1,125,000 ×
6 Months Forward $1.5000 €0.6667 $2
12 Months Forward $1.5100 €0.6623
l We can secure this trade with a LONG position in 9 six-month pound forward
contracts: £562,500
Sizes of forwards on this exchange are £62,500 and €125,000. 9 contracts =
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2
Ch 8 Transaction Exposure Management

Exporter’s Forward Market Cross-Currency Currency Futures versus Forwards

Hedge: Cash Flows at Maturity • A firm could use a currency futures contract, rather
Short position
in 6 six-month than a forward contract, for hedging purposes
euro forward €750,000 • A futures contract is not as suitable as a forward
contracts on contract for hedging purposes for two reasons:
€125,000 $1,125,000 Exporter
Bicycles Customer 1. Unlike forward contracts that are tailor-made to the firm’s
at $1.50/€1
specific needs, futures contracts are standardized
€750,000
Long position instruments in terms of contract size, delivery date, etc.
$1,125,000
in 9 six-month • Thus, in most cases, the firm can only hedge approximately
pound forward £562,500 2. Due to the marking-to-market property, there are interim
contracts on cash flows prior to the maturity date of the futures contract
£62,500 at that may have to be invested at uncertain interest rates
$2.00/£1 • Again, this makes exact hedging difficult
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Importer’s Money Market Hedge Importer’s Money Market Hedge

• This is the same idea as covered interest arbitrage.
A U.S.–based importer of Italian bicycles owes €100,000
• To eliminate a transaction exposure, a money market hedge to an Italian supplier in one year.
uses simultaneous borrowing and lending activities in two – The spot exchange rate is $1.50 = €1.00.
different currencies to lock in the dollar value of a future – The one-year interest rate in Italy is i€ = 4%.
foreign currency cash flow. – The importer can hedge this payable by buying
• To hedge a foreign currency payable, buy the present value of
€100,000
that foreign currency payable today and put it in the bank at €96,153.85 =
interest. 1.04
– Buy the present value of the foreign currency payable and investing €96,153.85 at 4% in Italy for one year. At
today at the spot exchange rate. maturity, he will have €100,000 = €96,153.85 × (1.04).
– Invest that amount at the foreign rate. $1.50
– At maturity your investment will have grown enough to Dollar cost today = $144,230.77 = €96,153.85 ×
€1.00
cover your foreign currency payable.
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Importer’s Money Market Hedge Foreign Currency Options

• With this money market hedge, we have redenominated • When transaction is uncertain, currency options are a
a one-year €100,000 payable into a $144,230.77 good hedging tool in situations in which the quantity of
payable due today. foreign exchange to be received or paid out is
uncertain.
• If the U.S. interest rate is i$ = 3%, we could borrow the • A call option is valuable when a firm has offered to
$144,230.77 today and owe $148,557.69 in one year. buy a foreign asset at a fixed foreign currency price
but is uncertain whether its bid will be accepted.
$148,557.69 = $144,230.77 × (1.03) • The firm can lock in a maximum dollar price for its
tender offer, while limiting its downside risk to the call
€100,000 premium in the event its bid is rejected.
$148,557.69 = S($/€)× × (1+ i$)T • A put option allows the company to insure its profit
(1+ i€)T margin against adverse movements in the foreign
currency while guaranteeing fixed prices to foreign
customer.
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3
Ch 8 Transaction Exposure Management

What Risk Management Products Do

Exposure Netting
Firms Use?
• Protection can be gained by selecting currencies that minimize
exposure. • Among U.S. corporations, based on a survey of
• MNC chooses currencies that are not perfectly positively correlated. Fortune 500 firms, the most popular product was the
• Exposure in one currency can be offset by the exposure in the same traditional forward contract
or another currency.
• Three ways to reduce transaction exposure through exposure – Jesswein, Kwok, and Folks (1995) found 93% of
netting: respondents reported using forward contracts
1. Offset a long position in one currency with a short position in the • Kim and Chance (2018) study:
same currency.
2. If the exchange rate movements of two currencies are positively – Examined actual currency risk management practices of
correlated, offset a long position in one currency with a short 101 largest nonfinancial corporations in South Korea
position in another currency.
– Authors document a great discrepancy between what firms
3. If the exchange rate movements of two currencies are negatively
correlated, short or long positions in both currencies will offset say they do versus what they actually do, attributing the
each other. discord to attempts by companies to time their hedges
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