CH 09

Chapter 9 Managing Transaction Exposure
to Currency Risk
Learning objectives
Transaction exposure
Internal hedges
Multinational netting and leading/lagging
Financial market hedges

Currency forwards, futures, options, swaps,
and money market hedges
Treasury management
Butler / Multinational Finance 6e
Chapter 9 Managing Transaction Exposure to Currency Risk

9-1
9.1 Transaction Exposures to Currency Risk

Currency risk exposure refers to a change in
firm value due to unexpected changes in FX
rates
Transaction exposure to currency risk
- change in the value of contractual cash flows arising from
the firms monetary assets and liabilities
Operating exposure to currency risk

- change in the value of noncontractual cash flows arising
from the firms real assets
Equity exposure
Monetary
Monetary
= net transaction
assets
liabilities
exposure
+ operating
Real
exposure
assets
Common
equity

9-2
9.1 Transaction Exposures to Currency Risk

Managing transaction exposure
Managing transaction exposure internally
- multinational netting (currency diversification)
- leading and lagging
Managing transaction exposure in the

financial markets
-
currency forwards
futures
options
swaps
money market hedges

9-3
9.2 Managing Transaction Exposure Internally

Multinational netting
100m
$75m
U.K.
parent
60m
German
subsidiary
150m
$125m
200m
U.S.
subsidiary
Cross exchange rates 1.5000/

$1.2500/
$0.8333/

9-4

Cash flows before netting
100m
60m
U.K.
parent
40m
German
subsidiary
100m
100m
200m
U.S.
subsidiary

9-5

Cash flows after netting
60m
140m
U.K.
parent
German
subsidiary
U.S.
subsidiary

9-6

Leading and lagging
Leading and lagging refers to altering the
timing of cash flows within the firm to offset
foreign exchange exposures.
For example:
- Leading - If a parent firm is short euros, it
can accelerate euro payments from its
subsidiaries.
- Lagging - If a parent firm is long euros, it
can delay euro payments from its
subsidiaries.

9-7

Leading/lagging when cash flows do not
align
+7.5 million
+7.5 million
+7.5 million
Leading
-10 million
Jan
Lagging
-10 million
Feb
Mar
+7.5 million
-10 million
Jan
Apr
May
June
+7.5 million
-10 million
Feb
-10 million
Mar
Apr
May
July
Aug
+7.5 million
-10 million
June
July
Aug

9-8

Rates of return within the firm
Leading and lagging can be beneficial to the
firm, but it can distort the rates of return
earned by the various affiliates.
- Leading or lagging creates an internal loan
from one unit of the firm to another.
- The best alternative for solving the
incentive problems created by leading or
lagging is for treasury to charge market
rates of interest on these intra-company
deposits and loans.

9-9
9.3 Managing Transaction Exposure

in the Financial Markets
A U.S. firms exposure to the Polish zloty
A U.S. firm expects to receive 40,000 Polish

zlotys (Z) in one year.
The spot rate expected to prevail in one

year is E[S1$/Z] = $0.25/Z.
What effect will an actual spot rate in one

year of S1$/Z = $0.20/Z have on the firm?

9-10

The +Z40,000
underlying zloty exposure
Expected cash flow

= (Z40,000)($0.25/Z)$10,000
Actual cash flow
= (Z40,000)($0.20/Z)$8,000
Unexpected cash flow = Actual Expected $2,000
Actual cash flow is 20% below the expectation
Risk (or payoff) profile of underlying exposure
v$/Z
$/Z
$10,000
$8,000
$0
+ 45 slope
s$/Z
-20%
$0.25/Z
-20%
S$/Z
$0.25/Z
S$/Z
$0.25/Z

9-11

The hedged position
Underlying position (long zlotys) +Z40,000
Sell zlotys forward (and buy dollars) +$10,000
(short zlotys & long dollars)
Z40,000
Net position +$10,000
v$/Z
V$/Z
s$/Z
$0.25/Z
S$/Z
$0.25/Z

9-12

Currency forward contracts
Advantages
- Forward contracts can provide a perfect hedge
of transactions of known size and timing.
Disadvantages
- Bid-ask spreads can be large on small
transactions, long-dated contracts, or
infrequently traded currencies.
- Forwards are a pure credit instrument, so
forward contracts have default or credit risk.

9-13

Currency futures contracts
The futures contract solution to the default

risk of forward contracts:
- An exchange clearinghouse takes one side of
every transaction.
- Futures contracts are marked-to-market on a
daily basis.
- Initial and maintenance margins are required on
futures contracts.

9-14

Currency forwards versus futures contracts
Forwards
Futures
Counterparty Bank Futures exchange

clearinghouse
Maturity
Negotiated
Amount Negotiated
Standardized
Standardized
Fees Bid-ask Commissions

Collateral Negotiated
Margin account

9-15

Currency futures contracts
Advantages
- Low cost if the size, currency and maturity
match the underlying exposure.
- Low credit risk with required margins and daily
marking-to-market.
Disadvantages
- Costs increase with transaction size.
- Exchange-traded futures come in limited
currencies and maturities.
- Daily marking-to-market can cause a cash flow
mismatch with the underlying exposure.

9-16

Currency option hedges
Advantages
- Disaster hedge insures against unfavorable
currency movements.
Disadvantages
- Option premiums reflect option values, so
option hedges can be expensive in volatile
currencies and at distant expiration dates.

9-17

A currency call option
A pound call is an option to buy pounds:

- the option holder gains if pound sterling rises.
- the option holder does not lose if pound falls.
V$/
Option
premium
-$0.30/
A long pound call

is an option to buy
pounds sterling
at a contractual
exercise price K$/
Exercise
price
$1.50/
S$/
9-18

A call option hedge
Call option hedge
V$/
$1.50/
K$/ = $1.50/
Premium = $0.30/
-$0.30/
-$1.50/
-$1.80/
S$/
Option
hedged
position
Short exposure

9-19

A currency put option
A pound put is an option to sell pounds:

- the option holder gains if pound sterling falls.
- the option holder does not lose if pound rises.
V$/
Option
premium
-$0.30/
Exercise
price
$1.50/
A long pound put

is an option to sell
pounds sterling
at a contractual
exercise price
S$/

9-20

A put option hedge
Long exposure
V$/
Option
hedged position
+$1.50/
+$1.20/
-$0.30/
$1.50/
S$/
Put option hedge
K$/ = $1.50/
Premium = $0.30/

9-21

Summary of option payoffs
Kd/f
-CallTd/f
Kd/f
STd/f
STd/f
STd/f
Short put
-PutTd/f
Short call
d/f
Long put
PutTd/f
Long call
CallTd/f
d/f
STd/f

9-22

A currency swap
Suppose you want to lock in pound cash outflows of
1 million per year for the next several years
and suppose i$ = i and Ft$/ = S0$/ = $1.50/
Ill pay you 1 million each period
if you pay me $1.5 million each period.
Net cash flows in a fixed-for-fixed swap are then:
+$1.5m
+$1.5m
-1.0m
-1.0m

9-23

Currency and interest rate swaps
Most currency swaps trade a fixed interest rate

in one currency for a floating rate in another:
- Notional principal: determines the size of the
interest payments on the two sides of the
swap.
- Difference check: usually, only the difference
in the value of the interest payments is
exchanged.
An interest rate swap is similar except the

principal amounts are in the same currency.

9-24

Currency swaps
Advantages
Swaps are used to hedge long-term, repeated
exposures to currency risk.
- Quickly transforms the firms assets or liabilities
into other currencies or payout structures.
- Low cost for plain vanilla swaps in actively
traded currencies.
Disadvantage
- Innovative or exotic swaps can be expensive.

9-25

Money market hedges
Advantages
- Synthetic forward positions can be built in
currencies for which there are no forward
currency markets.
Disadvantages
- Relatively expensive hedge
- Might not be feasible if there are constraints on
borrowing or lending

9-26

+NKW1,000,000
A money market hedge
NKW exposure
A South Korean company (SKW) wants to hedge a

one million North Korean won (NKW) cash inflow due
in one year with a short won forward contract:
iSKW = 2.0 percent per year
iNKW = 10.0 percent per year
S0SKW/NKW = SKW8.640370/N
The implied forward rate from interest rate parity is
F1SKW/NKW = (S0SKW/NKW) (1+iSKW) / (1+iNKW)
= (SKW8.640370/NKW) / [(1.02/1.10)]
= SKW8.011979/NKW

9-27

+SKW8,011,979
A money market hedge
-NKW1,000,000
Recreate this short NKW forward hedge

without using the forward market (i.e., synthetically)
Borrow at iNKW = 10% to get
= (NKW1,000,000)/(1.10)
= NKW909,091
Convert to V0SKW = V0NKW S0SKW/NKW
= (NKW909,091)
(SKW8.640370/NKW)
= SKW7,854,882
Invest at iSKW = 2% to yield
= (SKW7,854,882)(1.02)
= SKW8,011,989
+NKW909,091
-NKW1,000,000
+SKW7,854,882
-NKW909,091
+SKW8,011,979
-SKW7,854,882

9-28

Financial market hedges
Vehicles Advantages Disadvantages
Forwards Exact hedge; Large bid-ask spreads on
Small bid-ask spread small or long-dated deals &
for large deals
thinly traded currencies.
Futures
Low cost for small
Only a few currencies &
deals; low riskmaturities; mark-to-market
with mark-to-market can cause a CF mismatch.
Options
Disaster hedge Option premiums
provides insurance can be expensive.
Swaps Quick & low-cost Innovative swaps costly;
switch of payoff may not be best for
structures near-term exposures.
Money market
Synthetic forward
Relatively expensive;
not
hedges positions always possible.

9-29
9.4 Treasury Management in Practice

Derivatives usage by non-financial firms
Bartram, Brown, and Fehle, International Evidence on Financial

Derivatives Usage, Financial Management (2009).

9-30

Active management of currency risk
Bodnar, Hayt, and Marston, 1998 Wharton Survey of Financial Risk

Management by U.S. Non-Financial Firms, Financial Management (1998).

9-31

Performance evaluation


9-32

Risk management benchmarks


9-33

Active treasuries
Tend to be large firms with centralized risk

management.
Use sophisticated valuation methodologies

such as value-at-risk for managing their
exposures.
Derivatives positions are periodically marked

to market to reflect their market values.
Gczy, Minton, and Schrand, Taking a View: Corporate Speculation,

Governance, and Compensation Journal of Finance (2007).

9-34

Active treasuries manage their managers:
Managers actions are closely monitored.
Firms use compensation contracts to align

managers objectives with those of other
stakeholders.
Firms use derivatives-specific controls such as

performance benchmarks to manage performance and prevent abuses.
Gczy, Minton, and Schrand, Taking a View: Corporate Speculation,

Governance, and Compensation, Journal of Finance (2007).

9-35

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Chapter 9 Managing Transaction Exposure

Multinational netting and leading/lagging

Financial market hedges

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.1 Transaction Exposures to Currency Risk

Operating exposure to currency risk

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.1 Transaction Exposures to Currency Risk

Managing transaction exposure in the

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.2 Managing Transaction Exposure Internally

Cross exchange rates 1.5000/

Chapter 9 Managing Transaction Exposure to Currency Risk

9.2 Managing Transaction Exposure Internally

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.2 Managing Transaction Exposure Internally

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.2 Managing Transaction Exposure Internally

Chapter 9 Managing Transaction Exposure to Currency Risk

9.2 Managing Transaction Exposure Internally

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.2 Managing Transaction Exposure Internally

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

A U.S. firm expects to receive 40,000 Polish

The spot rate expected to prevail in one

What effect will an actual spot rate in one

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

Expected cash flow

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

Sell zlotys forward (and buy dollars) +$10,000

(short zlotys & long dollars)

Net position +$10,000

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

The futures contract solution to the default

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

Counterparty Bank Futures exchange

Fees Bid-ask Commissions

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

Butler / Multinational Finance 6e

Chapter 9 Managing Transaction Exposure to Currency Risk

9.3 Managing Transaction Exposure

A pound call is an option to buy pounds:

A long pound call

Butler / Multinational Finance 6e