MANAGEMENT OF TRANSACTION EXPOSURE

Chapter 8: Management of Transaction Exposure 1

International Finance Ahmed Tall

Chapter Outline

1. Forward Market Hedge

2. Money Market Hedge

3. Options Market Hedge

4. Cross-Hedging Minor Currency Exposure

5. Hedging Contingent Exposure

6. Hedging Recurrent Exposure with Swap Contracts

7. Hedging Via Leading and Lagging

8.0 INTRODUCTION TO TRANSACTION EXPOSURE

Transaction exposure is the degree to which the value of future cash transactions can be

affected by exchange rate fluctuations. The value of a firm’s future contractual

transactions in foreign currencies is affected by exchange rate movements. The

sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate

movements is referred to as transaction exposure. Transaction exposure can have a

substantial impact on a firm’s value. It is not unusual for a currency to change by as

much as 10 percent in a given year. If an exporter denominates its exports in a foreign

currency, a 10 percent decline in that currency will reduce the dollar value of its

receivables by 10 percent. This effect could possibly eliminate any profits from

exporting.

When transaction exposure exists, the firm is required to identify its degree of

transaction exposure,decide whether to hedge its exposure, and choose among the

available hedging techniques if it decides on hedging. MNCs will normally compare

the cash flows that could be expected from each hedging technique before determining

which technique to apply. Hedging techniques include:

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MANAGEMENT OF TRANSACTION EXPOSURE



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1. Futures hedge,

2. Forward hedge,

3. Money market hedge, and

4. Currency option hedge.

8.1 FORWARD MARKET HEDGE

A forward hedge differs from a futures hedge in that forward contracts are used instead

of futures contract to lock in the future exchange rate at which the firm will buy or sell

a currency. Recall that forward contracts are common for large transactions, while the

standardized futures contracts involve smaller amounts.

Futures hedge involves the use of currency futures. To hedge future payables, the firm

may purchase a currency futures contract for the currency that it will need. To hedge

future receivables, the firm may sell a currency futures contract for the currency that it

will be receiving.

An exposure to exchange rate movements need not necessarily be hedged, despite the

ease of futures and forward hedging.Based on the firm’s degree of risk aversion, the

hedge-versus-no-hedge decision can be made by comparing the known result of

hedging to the possible results of remaining unhedged.

If you are going to owe foreign currency in the future, agree to buy the foreign currency

now by entering into long position in a forward contract and If you are going to owe or

receive to foreign currency in the future, agree to buy or to sell the foreign currency

now by entering into long or short position in a forward contract.

Example 1 Forward Contract

You are a Somali importer of Italian shoes and have just ordered next year’s inventory.

Payment of €100M is due in one year, how can you fix the cash outflow in dollars?

Assuming Forward rate of $1.50.

Scenarios Possible Future Spot Rates1 $1.802 $1.20



Solution

Enter a long forward contract €100M in one year.

Scenario1: The importer will be better off if the euro depreciates: he still buys €100m

but at an exchange rate of only $1.20/€ he saves $30 million relative to $1.50/€

Scenario2: If you agree to buy €100 million at a price of $1.50 per pound, you will lose

$30 million if the price of the euro falls to $1.20/€.

Example 2 Forward or Future hedge Payable

Coca- Cola Co. is a Somali-based MNC that will need 100,000 euros in one year. It

could obtain a forward contract to purchase the euros in one year. The one-year forward

rate is $1.20, the same rate as currency futures contracts on euros. If Coca- Cola

purchases euros one year forward, find the dollar cost in one year.

Solution

Cost = Payables × Forward rat=100,000 × $1.20=$120,000

8.2 MONEY MARKET HEDGE

A money market hedge involves taking one or more money market position to cover a

transaction exposure. If a firm has excess cash, it can create a simplified money market

hedge.



Solution











Solution





hedge.



Solution











Solution





hedge.



Strategy on Future Payables Strategy on Future Receivables

1. borrow HC ($)2. Convert FC (€)3. Invest in FC (€)4. Repay in HC ($)

1. borrow FC(€)2. Convert HC ($)3. Invest in HC($)4. Repay the loan in FC (€)

Example 3 Money Market Hedge

Coca- Cola is a Somali-based MNC that will need €100,000 in one year. Assume spot

rate today of $1.18. Money market interest rate is 8 percent per annum in the Somalia

and 5 percent per annum in euro zone. The one-year forward rate is $1.20/€, the same

rate as currency futures contracts on euros. If Coca- Cola purchases euros one year

money market, find the dollar cost in one year.

Solution

1. Borrow home currency of $112,381.P = = €100,000/1.05 = €95,238

€1 = $1.18 and €95,238 = X

Therefore, X= $112,381

2. Convert the amount of $112,381 into foreign currency (€) and it is the amount of€95,238.

€1 = $1.18 and $112,381= Y

Therefore, Y= €95,238

3. Invest €95,238 in euro zone at 5% and receipt becomes = €95,238 (1.05) =€100,000.

4. Repay in home currency($)and amount of loan repayment=$112,381(1 .08)=$121,371

In conclusion, forward contract hedge is better than a money market hedge because

$120,000 is less than $121,371.

8.3 OPTION MARKET HEDGE

Firms recognize that hedging techniques such as the forward hedge and money market

hedge can backfire when a payables currency depreciates or a receivables currency

appreciates over the hedged period. In these situations, an unhedged strategy would

likely outperform the forward hedge or money market hedge. The ideal hedge would

insulate the firm from adverse exchange rate movements but allow the firm to benefit



from favorable exchange rate movements. Currency options exhibit these attributes. A

currency option provides the right to buy or sell a specified amount of a particular

currency at a specified price (called the strike price, or exercise price) within a given

period of time.

Example 4 Currency Call Option

You want to consider hedging payables of 100,000 euros with a call option that has an

exercise price of $1.20, a premium of $.03, and an expiration date of one year from

now. Also assume that Coca cola’s forecast for the spot rate of the euro at the time

payables are due is as follows.

Solution

Use of Currency Call Options for Hedging Euro Payables (Exercise the call option if

spot price is greater than strike price S > E and E=$1.20, Premium= $.03)

Scenario Possiblefuture spot

rates

Premium ExerciseDecision

TotalAmount paid

per unit

TotalAmount paidfor €100,000

1$1.16 $.03 No $1.19 $119,000

2 1.22 .03 Yes 1.23 123,000

3 1.24 .03 Yes 1.23 123,000

Amount= $119,000× 20%+ 123,000 × 70% + 123,000 × 10%=$122,200

In conclusion, forward contract hedge is better than option market hedge because

$120,000 is less than $122,200.

Optimal Hedge versus No Hedge

Even when an MNC knows what its future payables will be, it may decide not to hedge

in some cases. It needs to determine the probability distribution of its cost of payables

when not hedging as explained below.

Future spot rates Probability$1.16 20%$1.22 70%$1.24 10%



Forward Market Hedge $121,371

Money Market Hedge $120,000

Option Market Hedge $122,200

UNHEDGE STRATEGY

Amount= $116,000× 20%+ 122,000 × 70% + 124,000 × 10%=$121,000

This expected value of the payables is $1,000 more than if Coca uses a forward hedge.

In addition, the probability distribution suggests an 80 percent probability that the cost

of the payables when unhedged will exceed the cost of hedging with a forward contract.

Therefore, Coleman decide to hedge its payables position with a forward contract

Evaluating the Hedge Decision

MNCs can evaluate hedging decisions that they made in the past by estimating the real

cost of hedging payables, which is measured as:

$118,500

$119,000

$119,500

$120,000

$120,500

$121,000

$121,500

$122,000

$122,500

Forward Hedge Money MarketHedge

Option MarketHedge

Series1

$0

$50,000

$100,000

$150,000

1

UNHEDGE STRATEGY

UNHEDGESTRATEGY



Real cost of hedging payables (RCHp)= nominal cost of payables with hedging –

nominal cost of payables without hedging

Real cost of hedging receivables (RCHr) =Nominal home currency revenues received

without hedging – nominal home currency revenues received with hedging

Example 5

Recall that Coca cola decided to hedge its payables with a forward contract, resulting in

a dollar cost of $120,000. Assume that on the day that it makes its payment (one year

after it hedged its payables), the spot rate of the euro is $1.18.Find the cost real cost of

hedging payables (RCHp).

Solution

RCHp = Cost of hedging payables - Cost of payables if not hedged= $120,000-

$118,000= $2,000

8.4 CROSS HEDGING MINOR CURRENCY EXPOSURE

Cross-hedging is a common method of reducing transaction exposure when the

currency cannot be hedged. The major currencies are the: U.S. dollar, Canadian dollar,

British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a

minor currency, like the Thai bhat and is difficult, expensive, or impossible to use

financial contracts to hedge exposure to minor currencies. Facing this situation, firms

may use cross hedging techniques to manage its minor currency exposure.

Conceptual Example 5

Gandhi Co. has payables in zloty (Poland’s currency) one year from now. Because it isworried that the zloty may appreciate against the U.S. dollar, it may desire to hedge thisposition. If forward contracts and other hedging techniques are not possible for thezloty, Gandhi may consider cross-hedging. In this case, it needs to first identify acurrency that can be hedged and is highly correlated with the zloty. Gandhi notices thatthe euro has recently been moving in tandem with the zloty and decides to set up a oneyear forward contract on the euro. If the movements in the zloty and euro continue tobe highly correlated relative to the U.S. dollar, then the exchange rate between thesetwo currencies should be somewhat stable over time. By purchasing euros one yearforward, Gandhi Co. can then exchange euros for the zloty.



8.5 HEDGING CONTINGENT EXPOSURE

If only certain contingencies give rise to exposure, then options can be effective

insurance. For example, if your firm is bidding on a hydroelectric dam project in

Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid

wins the contract. Your firm can hedge this contingent risk with options.

8.6 HEDGING RECURRENT EXPOSURE WITH SWAPS

Firms often have to deal with a sequence of accounts payable or receivable in terms of

a foreign currency. Such recurrent cash flows in a foreign currency can be best hedged

using currency swap contract.

8.7 LEADING AND LAGGING

Leading and lagging strategies involve adjusting the timing of a payment request or

disbursement to reflect expectations about future currency movements. Lead strategy

means to pay or collect early where as lagging strategy means to pay or collect late.

Conceptual Example 6

IBM is based in the United States and has subsidiaries dispersed around the world. The

focus here will be on a subsidiary in the United Kingdom that purchases some of its

supplies from a subsidiary in Hungary. These supplies are denominated in Hungary’s

currency (the forint). If IBM expects that the pound will soon depreciate against the

forint, it may attempt to expedite the payment to Hungary before the pound depreciates.

This strategy is referred to as leading.

As a second scenario, assume that the British subsidiary expects the pound to

appreciate against the forint soon. In this case, the British subsidiary may attempt to

stall its payment until after the pound appreciates. In this way it could use fewer pounds

to obtain the forint needed for payment. This strategy is referred to as lagging.



Problems

Question 1

a. Assume that Ahmed Co. expects to receive S$500,000 in one year. The existing

spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore

dollar is $.62. The company created a probability distribution for the future spot

rate in one year as follows:

Future Spot rate Probability

$0.61 20%

0.63 50

0.67 30

Assume that one-year put options on Singapore dollars are available, with an exercise

price of $.63 and a premium of $.04 per unit. One-year call options on Singapore

dollars are available with an exercise price of $.60 and a premium of $.03 per unit.

Assume the following money market rates:

U.S Singapore

Deposit Rate 8% 5%Borrowing Rate 9 6

Given this information, determine whether a forward hedge, a money market hedge, or

a currency options hedge would be most appropriate. Then compare the most

appropriate hedge to an unhedged strategy, and decide whether Ahmed Co should

hedge its receivables.

b. Assume that AB, Inc. expects to need S$1 million in one year. Using any relevant

information in part (a) of this question, determine whether a forward hedge, a

money market hedge, or a currency options hedge would be most appropriate.

Then, compare the most appropriate hedge to an unhedged strategy, and decide

whether AB should hedge its payables position.

Answers:

[a. Forward=$310,000, Money market hedge=$305,660.52, Option hedge=$301,000

and 70 % we get $294,000 which is forward/future, Unhedge=$319,000]

[b. Forward=$620,000, Money market hedge=$622,857, Option hedge=$630,000,

Unhedge strategy =$638,000]



Question 2

Hedging with Put Options. A U.S. exporter wants to hedge future receivables of

250,000 New Zealand dollars 90 days from now. Put options are available for a

premium of $.03 per unit and an exercise price of $.49 per New Zealand dollar. The

forecasted spot rate of the NZ$ in 90 days follows:

Future Spot rate Probability

$0.44 30%

0.40 50

0.38 20

Given that you hedge your position with options, create a probability distribution for

U.S. dollars to be received in 90 days. Answer:[$115,000]

Question 3

Hedging Payables with Currency Options. Surad, Inc., is a Somali company that

imports British goods. It plans to use call options to hedge payables of 100,000 pounds

in 90 days. Three call options are available that have an expiration date 90 days from

now. Fill in the number of dollars needed to pay for the payables (including the option

premium paid) for each option available under each possible scenario in the following

table:

Scenario Future Spotprice

Exercise Price=$1.74

Premium=$0.06

Exercise Price=$1.76;

premium =$0.05

Exercise PriceE= $1.79

premium =$0.03

1. $1.65

2. 1.70

3. 1.75

4. 1.80

5. 1.85

If each of the five scenarios had an equal probability of occurrence, which option

would you choose? Explain.

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