08

1
Chapter 8
Transaction
Exposure
Copyright 2006 Pearson Addison-Wesley. All rights reserved. 8-2
Learning Objectives
Distinguish between the three major foreign
exchange exposures experienced by firms
Identify foreign exchange transaction exposure
Analyze the pros and cons of hedging foreign
exchange transaction exposure
Identify the alternatives available to a firm for
managing a large and significant transaction
exposure
Evaluate the institutional practices and
concerns of foreign exchange risk
management
Foreign Exchange Exposure
Foreign exchange exposure is a measure of the
potential for a firms profitability, net cash flow, and
market value to change because of a change in
exchange rates
These three components (profits, cash flow and market
value) are the key financial elements of how we view the
relative success or failure of a firm
While finance theories tell us that cash flows matter and
accounting does not, we know that currency-related
gains and losses can have destructive impacts on
reported earnings which are fundamental to the
markets opinion of that company
2
Types of foreign exchange exposure
Transaction Exposure measures changes in
the value of outstanding financial obligations
incurred prior to a change in exchange rates but
not due to be settled until after the exchange
rate changes
Operating Exposure also called economic
exposure, measures the change in the present
value of the firm resulting from any change in
expected future operating cash flows caused by
an unexpected change in exchange rates
Translation Exposure also called accounting
exposure, is the potential for accounting derived
changes in owners equity to occur because of
the need to translate financial statements of
foreign subsidiaries into a single reporting
currency for consolidated financial statements
Tax Exposure the tax consequence of foreign
exchange exposure varies by country, however
as a general rule only realized foreign losses
are deductible for purposes of calculating
income taxes
Moment in time when exchange rate changes
Time
Accounting exposure
Changes in reported owners equity
in consolidated financial statements
caused by a change in exchange rates
Operating exposure
Change in expected future cash flows
arising from an unexpected change in
exchange rates
Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates
3
Why Hedge?
Hedging protects the owner of an asset (future
stream of cash flows) from loss
However, it also eliminates any gain from an
increase in the value of the asset hedged
against
Since the value of a firm is the net present
value of all expected future cash flows, it is
important to realize that variances in these
future cash flows will affect the value of the firm
and that at least some components of risk
(currency risk) can be hedged against
Why Hedge - the Pros & Cons
Opponents of hedging give the following reasons:
Shareholders are more capable of diversifying risk than
the management of a firm; if stockholders do not wish to
accept the currency risk of any specific firm, they can
diversify their portfolios to manage that risk
Currency risk management does not increase the
expected cash flows of a firm; currency risk management
normally consumes resources thus reducing cash flow
Management often conducts hedging activities that
benefit management at the expense of shareholders
Opponents of hedging give the following reasons
(continued):
Managers cannot outguess the market; if and when
markets are in equilibrium with respect to parity
conditions, the expected NPV of hedging is zero
Managements motivation to reduce variability is
sometimes driven by accounting reasons; management
may believe that it will be criticized more severely for
incurring foreign exchange losses in its statements than
for incurring similar or even higher cash cost in avoiding
the foreign exchange loss
Efficient market theorists believe that investors can see
through the accounting veil and therefore have already
factored the foreign exchange effect into a firms market
valuation
4
Proponents of hedging give the following reasons:
Reduction in risk in future cash flows improves the
planning capability of the firm
Reduction of risk in future cash flows reduces the
likelihood that the firms cash flows will fall below a
necessary minimum
Management has a comparative advantage over the
individual investor in knowing the actual currency risk of
the firm
Markets are usually in disequilibirum because of
structural and institutional imperfections
Expected Value, E(V)
Net Cash Flow (NCF) NCF
Hedging reduces the variability of expected cash flows about the mean of the distribution.
This reduction of distribution variance is a reduction of risk.
Unhedged
Hedged
Measurement of Transaction
Exposure
Transaction exposure measures gains or losses that
arise from the settlement of existing financial
obligations, namely
Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
Borrowing or lending funds when repayment is to be
made in a foreign currency
Being a party to an unperformed forward contract and
Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies
5
Purchasing or Selling on Open
Account
Suppose Trident Corporation sells merchandise on
open account to a Belgian buyer for 1,800,000
payable in 60 days
Further assume that the spot rate is $1.2000/ and
Trident expects to exchange the euros for 1,800,000 x
$1.2000/ = $2,160,000 when payment is received
Transaction exposure arises because of the risk that
Trident will something other than $2,160,000 expected
If the euro weakens to $.1000/, then Trident will receive
$1,980,000
If the euro strengthens to $1.3000/, then Trident will
receive $2,340,000
Account
Trident might have avoided transaction
exposure by invoicing the Belgian buyer in US
dollars, but this might have lead to Trident not
being able to book the sale
Even if the Belgian buyer agrees to pay in
dollars, however, Trident has not eliminated
transaction exposure, instead it has transferred
it to the Belgian buyer whose dollar account
payable has an unknown euro value in 60 days
Quotation Exposure
Time between quoting
a price and reaching a
contractual sale
Backlog Exposure
Time it takes to fill the
order after contract is
signed
Billing Exposure
Time it takes to get
paid in cash after A/R
is issued
Seller quotes a
price to buyer
t
1
Buyer places
firm order with
seller at
offered price
t
2
Seller ships
product and
bills buyer
t
3
Buyer settles
A/R with cash
in amount of
currency
quoted at t
1
t
4
Life Span of a Transaction Exposure
Account
6
Borrowing and Lending
A second example of transaction exposure arises
when funds are loaned or borrowed
Example: PepsiCos largest bottler outside the US is
located in Mexico, Grupo Embotellador de Mexico
(Gemex)
On 12/94, Gemex had US dollar denominated debt of
$264 million
The Mexican peso (Ps) was pegged at Ps$3.45/US$
On 12/22/94, the government allowed the peso to float
due to internal pressures and it sank to Ps$4.65/US$
Borrowing and Lending
Gemexs peso obligation now looked like this
Dollar debt mid-December, 1994:
US$264,000,000 Ps$3.45/US$ =
Ps$910,800,000
Dollar debt in mid-January, 1995:
US$264,000,000 Ps$5.50/US$ =
Ps$1,452,000,000
Dollar debt increase measured in Ps
Ps$541,200,000
Gemexs dollar obligation increased by 59%
due to transaction exposure
Other Causes of Transaction
Exposure
When a firm buys a forward exchange contract,
it deliberately creates transaction exposure;
this risk is incurred to hedge an existing
exposure
Example: US firm wants to offset transaction
exposure of 100 million to pay for an import
from Japan in 90 days
Firm can purchase 100 million in forward
market to cover payment in 90 days
7
Contractual Hedges
Transaction exposure can be managed by
contractual, operating, or financial hedges
The main contractual hedges employ forward,
money, futures and options markets
Operating and financial hedges use risk-sharing
agreements, leads and lags in payment terms, swaps,
and other strategies
A natural hedge refers to an offsetting operating cash
flow, a payable arising from the conduct of business
A financial hedge refers to either an offsetting debt
obligation or some type of financial derivative such as
a swap
Tridents Transaction Exposure
Maria Gonzalez, CFO of Trident, has just concluded a
sale to Regency, a British firm, for 1,000,000
The sale is made in March for settlement due in three
months time, June
Assumptions
Spot rate is $1.7640/
3 month forward rate is $1.7540/ (a 2.2676% discount)
Tridents cost of capital is 12.0%
UK 3 month borrowing rate is 10.0% p.a.
UK 3 month investing rate is 8.0% p.a.
Assumptions
US 3 month borrowing rate is 8.0% p.a.
US 3 month investing rate is 6.0% p.a.
June put option in OTC market for 1,000,000;
strike price $1.75; 1.5% premium
Tridents foreign exchange advisory service
forecasts future spot rate in 3 months to be
$1.7600/
Trident operates on thin margins and Maria
wants to secure the most amount of US
dollars; her budget rate (lowest acceptable
amount) is $1.7000/
8
Maria faces four possibilities:
Remain unhedged
Hedge in the forward market
Hedge in the money market
Hedge in the options market
Unhedged position
Maria may decide to accept the transaction risk
If she believes that the future spot rate will be
$1.76/, then Trident will receive 1,000,000 x
$1.76/ = $1,760,000 in 3 months time
However, if the future spot rate is $1.65/,
Trident will receive only $1,650,000 well below
the budget rate
Forward Market hedge
A forward hedge involves a forward or futures contract
and a source of funds to fulfill the contract
The forward contract is entered at the time the A/R is
created, in this case in March
When this sale is booked, it is recorded at the spot rate.
In this case the A/R is recorded at a spot rate of
$1.7640/, thus $1,764,000 is recorded as a sale for
Trident
If Trident does not have an offsetting A/P in the same
amount, then the firm is considered uncovered
9
Forward Market hedge
Should Maria want to cover this exposure with a forward
contract, then she will sell 1,000,000 forward today at
the 3 month rate of $1.7540/
She is now covered and Trident no longer has any
transaction exposure
In 3 months, Trident will received 1,000,000 and
exchange those pounds at $1.7540/ receiving
$1,754,000
This sum is $6,000 less than the uncertain $1,760,000
expected from the unhedged position
This would be recorded in Tridents books as a foreign
exchange loss of $10,000 ($1,764,000 as booked,
$1,754,000 as settled)
Money Market hedge
A money market hedge also includes a contract
and a source of funds, similar to a forward
contract
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)
Money Market hedge
To hedge in the money market, Maria will
borrow pounds in London, convert the pounds
to dollars and repay the pound loan with the
proceeds from the sale
To calculate how much to borrow, Maria needs to
discount the PV of the 1,000,000 to today
1,000,000/1.025 = 975,610
Maria should borrow 975,610 today and in 3
months time repay this amount plus 24,390 in
interest (1,000,000) from the proceeds of the
sale
10
Account receivable 1,000,000
1,000,000
Bank loan (principal) 975,610
Interest payable 24,390
1,000,000
Assets Liabilities and Net Worth
Money Market hedge
Trident would exchange the 975,610 at the spot rate of
$1.7640/ and receive $1,720,976 at once
This hedge creates a pound denominated liability that is
offset with a pound denominated asset thus creating a
balance sheet hedge
In order to compare the forward hedge with the
money market hedge, Maria must analyze the
use of the loan proceeds
Remember that the loan proceeds may be used
today, but the funds for the forward contract
may not
Because the funds are relatively certain,
comparison is possible in order to make a
decision
Three logical choices exist for an assumed
investment rate for the next 3 months
Received today Invested in Rate Future value in 3 months
$1,720,976 Treasury bill 6% p.a. or 1.5%/quarter $1,746,791
$1,720,976 Debt cost 8% p.a. or 2.0%/quarter $1,755,396
$1,720,976 Cost of capital 12% p.a. or 3.0%/quarter $1,772,605
First, if Trident is cash rich the loan proceeds might be
invested at the US rate of 6.0% p.a.
Second, Maria could use the loan proceeds to
substitute an equal dollar loan that Trident would have
otherwise taken for working capital needs at a rate of
8.0% p.a.
Third, Maria might invest the loan proceeds in the firm
itself in which case the cost of capital is 12.0% p.a.
11
Because the proceeds in 3 months from the
forward hedge will be $1,754,000, the money
market hedge is superior to the forward hedge
if Maria used the proceeds to replace a dollar
loan (8%) or conduct general business
operations (12%)
The forward hedge would be preferable if
Maria were to just invest the loan proceeds
(6%)
We will assume she uses the cost of capital as
the reinvestment rate
0.0192 r
$1,754,000 r) (1 $1,720,976
proceeds) (forward rate) (1 proceeds) (Loan
=
= +
= +
7.68% 100 x
90
360
x 0192 . 0 =
To convert this 3 month rate to an annual rate,
A breakeven investment rate can be calculated
in order to forgo numerous calculations and still
aid Maria in her decision
In other words, if Maria can invest the loan
proceeds at a rate equal to or greater than
7.68% p.a. then the money market hedge will
be superior to the forward hedge
The following chart shows the value of
Tridents A/R over a range of possible spot
rates both uncovered and covered using the
previously mentioned alternatives
12
1.68 1.70 1.74 1.76 1.72 1.82 1.80 1.78 1.86 1.84
Value in US dollars of
Tridents 1,000,000 A/R
1.68
Ending spot exchange rate (US$/)
1.70
1.72
1.74
1.76
1.78
1.80
1.82
1.84
Money market hedge
yields $1,772,605
Forward rate
is $1.7540/
Forward contract hedge
yields $1,754,000
Uncovered yields
whatever the ending
spot rate is in 90 days
$26,460 $1.7640 x 0.015 x 1,000,000
option of cost rate) (spot x (premium) x option) of (Size
=
=
Option market hedge
Maria could also cover the 1,000,000 exposure
by purchasing a put option. This allows her to
speculate on the upside potential for
appreciation of the pound while limiting her
downside risk
Given the quote earlier, Maria could purchase 3
month put option at an ATM strike price of
$1.75/ and a premium of 1.5%
The cost of this option would be
Because we are using future value to compare the
various hedging alternatives, it is necessary to project
the cost of the option in 3 months forward
Using a cost of capital of 12% p.a. or 3.0% per quarter,
the premium cost of the option as of June would be
$26,460 1.03 = $27,254
Since the upside potential is unlimited, Trident would
not exercise its option at any rate above $1.75/ and
would purchase pounds on the spot market
If for example, the spot rate of $1.76/ materializes,
Trident would exchange pounds on the spot market to
receive 1,000,000 $1.76/ = $1,760,000 less the
premium of the option ($27,254) netting $1,732,746
13
Unlike the unhedged alternative, Maria has
limited downside with the option
Should the pound depreciate below $1.75/,
Maria would exercise her option and exchange
her 1,000,000 at $1.75/ receiving
$1,750,000
Less the premium of the option, Maria nets
$1,722,746
Although this downside is less than that of the
forward or money market hedge, the upside
potential is not limited
As with the forward and money market hedges,
Maria can also calculate her breakeven price
on the option
The upper bound of the range is determined by
comparison of the forward rate
The pound must appreciate above $1.754/
forward rate plus the cost of the option,
$0.0273/, to $1.7813/
The lower bound of the range is determined in a
similar manner
If the pound depreciates below $1.75/, the net
proceeds would be $1.75/ less the cost of
$0.0273/ or $1.722/
1.68 1.70 1.74 1.76 1.72 1.82 1.80 1.78 1.86 1.84
Value in US dollars of
Tridents 1,000,000 A/R
1.68
Ending spot exchange rate (US$/)
1.70
1.72
1.74
1.76
1.78
1.80
1.82
1.84
Money market
Forward rate
is $1.7540/
Forward contract
Uncovered
ATM put option
14
Put Option Strike Price ATM Option $1.75/
Option cost (future cost) $27,254
Proceeds if exercised $1,750,000
Minimum net proceeds $1,722,746
Maximum net proceeds unlimited
Breakeven spot rate (upside) $1.7813/
Breakeven spot rate (downside) $1.7221/
Strategy Choice and Outcome
Trident, like all firms, must decide on a strategy
to undertake before the exchange rate
changes but how will Maria choose among the
strategies?
Two criteria can be utilized to help Maria
choose her strategy
Risk tolerance - of the firm,as expressed in its
stated policies and
Viewpoint Marias own view on the expected
direction and distance of the exchange rate
After all the strategies have been explained,
Trident now needs to compare the alternatives
and their outcomes in order to choose a
strategy
There were four alternatives available to
manage this account receivable and Maria has
a budget rate at which she cannot fall below on
this transaction
15
Hedging Strategy Outcome/Payout
Remain uncovered Unknown
Forward Contract hedge @ $1.754/ $1,754,000
Money market hedge @ 8% p.a. $1,755,396
Money market hedge @ 12% p.a. $1,772,605
Put option hedge @ strike $1.75/
Minimum if exercised $1,722,746
Maximum if not exercised Unlimited
Managing an Account Payable
Just as Marias alternatives for managing the
receivable, the choices are the same for
managing a payable
Assume that the 1,000,000 was an account
payable in 90 days
Remain unhedged Trident could wait the 90
days and at that time exchange dollars for
pounds to pay the obligation
If the spot rate is $1.76/ then Trident would
pay $1,760,000 but this amount is not certain
Use a forward market hedge Trident could
purchase a forward contract locking in the
$1.754/ rate ensuring that their obligation will
not be more than $1,754,000
Use a money market hedge this hedge is
distinctly different for a payable than a
receivable
Here Trident would exchange US dollars spot
and invest them for 90 days in pounds
The pound obligation for Trident is now offset by
a pound asset for Trident with matching maturity
16
6 980,392.1
360
90
x .08 1
1,000,000
=
(
|
.
|
\
|
+
$1,729,411 $1.7640/ x 6 980,392.1 =
This 980,392.16 would require $1,729,411.77 at the current
spot rate
Using a money market hedge
To ensure that exactly 1,000,000 will be
received in 90 days time, Maria discounts the
principal by 8% p.a.
294 , 781 , 1 $
360
90
x 12 . 0 1 x 77 . 411 , 729 , 1 $ =
(
|
.
|
\
|
+
This is higher than the forward hedge of $1,754,000 thus
unattractive
Using a money market hedge
Finally, carry the cost forward 90 days in order
to compare the payout from the money market
hedge
$26,460 $1.75/ x 0.015 x 1,000,000 =
Carried forward 90 days the premium amount is comes to
$27,254
Using an option hedge instead of purchasing
a put as with a receivable, Maria would want to
purchase a call option on the payable
The terms of an ATM call option with strike price
of $1,75/ would be a 1.5% premium
17
Exercise call option (1,000,000 $1.75/ $1,750,000
Call option premium (carried forward 90 days) $27,254
Total maximum expense of call option hedge $1,777,254
Using an option hedge
If the spot rate is less than $1.75/ then the
option would be allowed to expire and the
1,000,000 would be purchased on the spot
market
If the spot rate rises above $1.75/ then the
option would be exercised and Trident would
exchange the 1,000,000 at $1.75/ less the
option premium for the payable
Risk Management in Practice
Which Goals?
The treasury function of most firms is usual considered a
cost center; it is not expected to add to the bottom line
However, in practice some firms treasuries have
become aggressive in currency management and act as
profit centers
Which Exposures?
Transaction exposures exist before they are actually
booked yet some firms do not hedge this backlog
exposure
However, some firms are selectively hedging these
backlog exposures and anticipated exposures
Risk Management in Practice
Which Contractual Hedges?
Transaction exposure management programs
are generally divided along an option-line;
those which use options and those that do not
Also, these programs vary in the amount of risk
covered; these proportional hedges are policies
that state which proportion and type of exposure
is to be hedged by the treasury
18
Summary of Learning Objectives
MNEs encounter three types of currency exposure: (1)
transaction; (2) operating; and (3) translation exposure
Transaction exposure measures gains or losses that
arise from the settlement of financial obligations whose
terms are stated in a foreign currency
Operating exposure measures the change in the
present value of the firm resulting from any change in
future operating cash flows caused by an unexpected
change in exchange rates
Translation exposure is the potential for accounting-
oriented changes in owners equity when a firm
translates foreign subsidiaries financial statements to
consolidated financial statements
Transaction exposure arises from (1)
purchasing or selling on credit and prices are
stated in foreign currencies; (2) borrowing or
lending funds when repayment is to be made in
a foreign currency; (3) being party to an
unperformed forward contract; and (4)
otherwise acquiring assets or liabilities
denominated in foreign currencies
Considerable theoretical debate exists as to
whether or not firms should hedge currency
risk
Transaction exposure can be managed by
contractual techniques and certain operating
strategies. Contractual techniques include
forward contracts, money market and option
hedges
The choice of which hedge to use depends on
the individual firms currency risk tolerance and
its expectations of the probable movement of
exchange rates over the transaction exposure
period
19
In general, if an exchange rate is expected to
move in a firms favor, the preferred contractual
hedges are those which allow the firm to
participate in some of the upside potential, but
protect it against adverse exchange rate
movements
In general, if an exchange rate is expected to
move against the firm, the preferred
contractual hedge is one which locks-in an
exchange rate
Risk management in practice requires a firms
treasury department to identify its goals. Is the
treasury a cost or a profit center?
Treasury must also choose which contractual
hedges it wishes to use and what proportion of
the currency risk should be hedged.
Additionally, treasury must determine whether
the firm should buy and/or sell currency
options, a strategy that has historically been
risky for some firms and banks
Mini Case: Lufthansas Purchase
of Boeing 737s
In January 1985 Lufthansa, the national airline
of Germany, signed a contract with Boeing
(US) for the purchase of 20 Boeing 737 jets
Boeing agreed to deliver the 20 aircraft to
Lufthansas specifications in one year, by
January 1986
Lufthansa would have a single payment due at
that time of $500 million
Given a spot exchange rate of DM3.2/$ in
January 1985, this was an expected purchase
of DM 1.6 billion
20
of Boeing 737s
Heinz Ruhnau (Lufthansas Chairman) was concerned
over the exchange rate exposure Lufthansa was
bearing in this transaction
The U.S. dollar had been steadily appreciating in value
against the Deutschemark for several years
While many currency analysts believed the dollar to be
overvalued, it continued to climb
Regardless, Herr Ruhnau felt this was too large a
transaction to be left unhedged
Analyze the decision and the outcome
2.20
2.40
2.60
2.80
3.00
3.20
3.40
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Ruhnau could
see the past
But not the
future
Contract
signed
Cash
settlement
DM/$
Lufthansa: What Herr Ruhnau Could and
Could Not See
of Boeing 737s
Do you think Heinz Ruhnaus hedging strategy
made sense?
To what degree did he limit the upside and
downside exposure of the transaction by
hedging one half of it?
Do you agree with his critics that he was
speculating?
Is it fair to judge transaction exposure
management effectiveness with 20-20
hindsight?
21
Exhibit 8.1 Conceptual Comparison of
Transaction, Operating, and Translation
Exhibit 8.2 Impact of Hedging on the
Expected Cash Flows of the Firm
Exhibit 8.3 The Life Span of a
Transaction Exposure
22
Exhibit 8.4 Valuation of Cash Flows
by Hedging Alternative for Trident
Exhibit 8.5 Tridents Hedging Alternatives,
Including an ATM Put Option
Exhibit 8.6 Valuation of Hedging
Alternatives for an Account Payable
23
Exhibit 8.7 Bank of America Corporate FX
Risk Management Survey Results
Mini-Case Lufthansa 19851986: What
Herr Ruhnau Could and Could Not See

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