Transaction Exposure

• Transaction exposure measures gains or

losses that arise from the settlement of
existing financial obligations whose terms
are stated in a foreign currency.
• The most common example of transaction
exposure arises when a firm has a
receivable or payable denominated in a
foreign currency.
1
 Life Span of a Transaction Exposure
Time and Events

t1 t2 t3 t4
Seller quotes Buyer places Seller ships Buyer settles A/R
a price to buyer firm order with product and with cash in
(in verbal or seller at price bills buyer amount of currency
written form) offered at time t1 (becomes A/R) quoted at time t1

Quotation Backlog Billing

Exposure Exposure Exposure

Time between quoting Time it takes to Time it takes to

a price and reaching a fill the order after get paid in cash after
contractual sale contract is signed A/R is issued
2
Management of Transaction Exposure

• Foreign exchange transaction exposure can be

managed by contractual, operating, and financial
hedges.
• Contractual hedges employ the forward, money,
futures, and options markets.
• Operating and financial hedges employ the use of
risk-sharing agreements, leads and lags in
payment terms, swaps, and other strategies.
3
 Management of Transaction Exposure

• Natural hedge refers to an off-setting

operating cash flow, a payable arising from
the conduct of business.
• Financial hedge refers to either an off-
setting debt obligation (such as a loan) or
some type of financial derivative such as an
interest rate swap.

4
 Case Study – Dilly
Automobiles Ltd.(DAL)

5
 DAL’s Information
DAL, a U.S. based manufacturer has just sold a machine to
a firm based in U.K. for £ 1,000,000 The sale is made in the
month of March and the payment is to be received in June.

Spot Rate $1.7640/£ 3m forward Rate Cost of Capital

$1.7540/£ 12%
U.K. 3m interest OTC June OTC June
rate 8%/10% Put(X=$1.75) at Put(X=$1.71) at
1.5% Premium 1.0% Premium

U.S. 3m interest Spot Rate Forecast Budget Rate

rate 6%/8% 3m $1.7600/£ $1.7000/£

6
 Alternatives to DAL
• Remain unhedged
• Hedge in the forward market
• Hedge in the money market
• Hedge in the options market

7
 Remain Unhedged
• Do nothing today
• Receive £ 1,000,000 at the end of 3 months and
sell spot to receive $.
• If pound falls , there will be a considerable loss
and vice versa , if it appreciates.
• As per the forecast, the value of receivable will be
$ 1,760,000.

8
 Forward Hedge
• A forward hedge involves a forward (or futures) contract
and a source of funds to fulfill the contract. Sometimes,
funds to fulfill the forward exchange contract are not
already available or due to be received later, but must be
purchased in the spot market at some future date.
• It is “open” or “uncovered” and involves considerable risk.
The purchase of such funds at a later date is referred to as
covering.
• DAL sells at 3 month forward rate i.e. $1.7540/£ and
receives $ 1,754,000.
9
 Money Market Hedge
• A money market hedge also involves a contract and a
source of funds to fulfill that contract. In this instance,
the contract is a loan agreement. Hedging firm borrows
in one currency and exchanges the proceeds for another
currency.

• Funds to fulfill the contract – to repay the loan – may be

generated from business operations, in which case the
money market hedge is covered. Alternatively, funds to
repay the loan may be purchased in the foreign
exchange spot market when the loan matures
(uncovered or open money market hedge).

10
 Money Market Hedge
• DAL borrows £975,610 and pays £975,610 + £24390
(interest) from the proceeds.
• DAL sells £975,610 at spot $1.7640/£ and receives
$1,720,976.

Investment Options Terminal Value

$1,720,976 6%(Investment Rate) $1,746,791

$1,720,976 8%(Borrowing rate) $1,755,396

$1,720,976 12%(Cost of capital) $1,772,605

11
 Options Market Hedge
• Hedging with options allows for participation
in any upside potential associated with the
position while limiting downside risk.
• The choice of option strike prices is a very
important aspect of utilizing options as option
premiums, and payoff patterns will differ
accordingly.

12
 Options Market Hedge
• Buy Put(at-the-money) to sell pounds at $1.75/£. Pay
$26,460(+12%*3/12) i.e. $27,254 for put option.
• Deliver £ 1,000,000 against put or sell spot if the
current spot rate > $1.75/£
Receive an unlimited maximum less $27,254

Receive expected $1,760,000 less $27,254

Receive a minimum of $1,750,000 less $27,254

13
Valuation of Cash Flows Under Hedging Alternatives for DAL

Value in US dollars of Uncovered

DAL’s £1,000,000 A/R
Put option strike
1.84 price of $1.75/£ OTM put
option hedge
1.82 Put option strike
price of $1.71/£
1.80
ATM put
option hedge
1.78

1.76 Money market hedge

1.74
Forward contract hedge
1.72

1.70

1.68
1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86

Ending spot exchange rate (US$/£) 14

Valuation of Hedging Alternatives for an Account Payable

Cost in US dollars of Call option strike Uncovered costs

DAL £1,000,000 A/P price of $1.75/£ whatever the ending
spot rate is in 90 days
1.84 Forward rate
is $1.7540/£
1.82

1.80 Money market hedge

Locks in a cost of $1,781,294
1.78

1.76
Forward contract hedge
1.74 Call option hedge
locks in a cost of $1,754,000
1.72

1.70

1.68
1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86

Ending spot exchange rate (US$/£) 15

 Risk Management in Practice
• The treasury function of most private firms, the
group typically responsible for transaction
exposure management, is usually considered a
cost center.
• The treasury function is not expected to add profit
to the firm’s bottom line.
• Currency risk managers are expected to err on the
conservative side when managing the firm’s
money.
16
 Risk Management in Practice
• Firms must decide which exposures to hedge:
• Many firms do not allow the hedging of quotation
exposure or backlog exposure as a matter of policy
• Many firms feel that until the transaction exists on the
accounting books of the firm, the probability of the
exposure actually occurring is considered to be less
than 100%
• An increasing number of firms, however, are actively
hedging not only backlog exposures, but also
selectively hedging quotation and anticipated
exposures.
• Anticipated exposures are transactions for which there
are – at present – no contracts or agreements between 17
parties
 Risk Management in Practice
• As might be expected, transaction exposure
management programs are generally
divided along an “option-line”; those that
use options and those that do not.
• Firms that do not use currency options rely
almost exclusively on forward contracts and
money market hedges.

18
 Risk Management in Practice
• Many MNEs have established rather rigid
transaction exposure risk management policies
that mandate proportional hedging.
• These contracts generally require the use of
forward contract hedges on a percentage of
existing transaction exposures.
• The remaining portion of the exposure is then
selectively hedged on the basis of the firm’s risk
tolerance, view of exchange rate movements, and
confidence level.
19
 Risk Management in Practice
• In addition to having required minimum
forward-cover percentages, many firms also
require full forward-cover when forward
rates “pay them the points.”
• The points on the forward rate is the
forward rate’s premium or discount.

20
 Risk Management in Practice
• A further distinction in practice can be made
between those firms that buy currency options
(buy a put or buy a call) and those that both buy
and write currency options.
• Those firms that do use currency options are
generally more aggressive in their tolerance of
currency risk.
• However, in many cases firms that are extremely
risk-intolerant will utilize options to hedge
backlog and/or anticipated exposures.
21
 Risk Management in Practice
• Since the writer of an option has a limited profit
potential with unlimited loss potential, the risks
associated with writing options can be substantial.
• Firms that write options usually do so to finance
the purchase of a second option.
• The most frequently used complex options are
range forwards, participating forwards, break
forwards, and average rate options.
22