Transaction Exposure
Risk due to lags in payments
Hedging strategies
July 17, 2016
Transaction Exposure
1
Exposure
 Transaction exposure
 changes in the value of outstanding contracts
 Operating exposure (economic exposure)
 change in the PV of the firm (real exchange
rates)
 Translation exposure (accounting exposure)
 change in value of owner equity
 Tax exposure
July 17, 2016
Transaction Exposure
2
Transaction exposure sources
 lending or receivables denominated in
foreign currency
 borrowing or payables denominated
in foreign currency
 holding a defaulted forward contract
July 17, 2016
Transaction Exposure
3
Lags and transaction exposure
 t0 - order placed
 Forward contract agreed to
 t1 - order shipped (10 days)
 t2 - order delivered (24 days)
 t3 - order settled (90 days)
July 17, 2016
Transaction Exposure
4
Balance sheet perspective
 Contract: price, quantity, due date (today)
 Forward contract purchased (today)
 Input inventories purchased (today)
 Inventories increase
 (Payables increase)
 May also be funded by LT debt
 Output inventories created (8days)
 Input inventories decrease
 Output inventories increase
 (Accruals increase)
 May also be funded by LT debt
 Goods shipped (no change) (10 days)
July 17, 2016
Transaction Exposure
5
Balance sheet perspective
(cont)
 Goods received (24 days)
 Inventories decrease
 Receivables increase
 Contract paid (90 days)
 Receivables decrease
 Take delivery on forward contract
 Cash increases
 During this process
 Payables paid
 Accruals paid
July 17, 2016
Transaction Exposure
6
To Hedge
 Reduce the volatility of future cash
flows
 Eliminate one source of risk
 Exchange rate volatility
 Cost of the hedge
 Does not change default risk
 Management either hedges or
speculates ??
 Does not have expertise in exchange
rate risk
July 17, 2016
Transaction Exposure
7
To not Hedge
 Shareholders better able to diversify risk
than firm
 If parity holds NPV of hedging negative
 Costs of hedging
 Efficient markets have already impounded
the risk into share price
 Agency problem
 Management is risk averse relative to their jobs
not to stockholder value
July 17, 2016
Transaction Exposure
8
Accounting practices
non-hedged position
 Balance sheet
 Input inventories at cost
 Output inventories at COGS
 Receivable denominated in cd
 Spot in effect at time of delivery
 Income statement
 At payment
 Gain or loss realized
 Counted on income statement
July 17, 2016
Transaction Exposure
9
Types of hedges
 contractual hedges
 forwards, futures, option,
 money market hedges
 operating & financial hedges
 risk-sharing
 leads & lags
 swaps
July 17, 2016
Transaction Exposure
10
Forward hedge - 90 day
 short goods (delivered)
 selling goods for 154,000 usd
 long bill of exchange (bankers accept)
 payment 154,000 usd promised forward
 long a forward contract
 forward contract set for delivery of 229,460 cd
 delivery of 154,000 usd
 delivery of 229,460 cd
 discounted value 225,796.28
July 17, 2016
Transaction Exposure
11
Forward hedge - Sources of
risk
 delivery on bill
 bank backing the bill could default
 delivery on forward contract
 bank delivering cd forward could defaulat
 risk of default is low
 the hedge reduces transaction
exposure
July 17, 2016
Transaction Exposure
12
Accounting practices
Hedged position
 Contract values
 231,000 receivable @ spot = 1.50
 229,460 payable @ forward = 1.49
 Balance sheet
 Input inventories at cost
 Output inventories at COGS
 Receivable denominated
 Denominated at spot in effect at time of
delivery
 Forward contract as payable
 Denominated at forward rate
July 17, 2016
Transaction Exposure
13
Money market hedge - 90 day
 short goods (delivered)
 154,000 usd
 long bill for 154,000 usd
 short loan 154,000/(1.0765)
151,188
 exchange for 225,270 cd
 delivery of 154,000 usd
 pay off loan of 154,000
July 17, 2016
Transaction Exposure
.25
=
14
Money market hedge
- Sources of risk
 delivery on bill
 bank backing the bill could default
 no forward contract
 risk of default is lower
 the hedge reduces transaction
exposure
July 17, 2016
Transaction Exposure
15
One can also discount the bill 90 day
 short goods
 154,000 usd
 long bill of exchange
 sell bill at discount to bank @ 8.65%
 150,839 usd
 exchange for 224,750 cd
July 17, 2016
Transaction Exposure
16
Discounting bill of exchange
- Sources of risk
 no risk delivery on bill
 bill sold at discount to another party
 no forward contract
 risk of default is eliminated
 the hedge eliminates transaction
exposure
July 17, 2016
Transaction Exposure
17
OTC option contract - 90 day
 short goods
 154,000 usd
 long bill of exchange
 long call option to buy 229,508 cd
 @0.0025 usd/cd cost = 573.77 usd
 exercise price = 6710
 delivery of 154,000
 if e > x, exercise option
 get 229,508 cd net of cost of hedge
July 17, 2016
Transaction Exposure
18
Option contract - Sources of
risk
 risk of bank default on delivery on bill
 risk of default by bank on option
contract
 the hedge reduces transaction
exposure
July 17, 2016
Transaction Exposure
19
Present value of the hedges
 forward hedge = 225,796 cd
 money market hedge = 225,270
 discounting = 224,750
 option contract = 229,508 cd /
(1.0667).25 - (573.77 usd *
1.49cd/usd) = 224,989 cd
July 17, 2016
Transaction Exposure
20
Accounting for unhedged
positions
 Payables and receivables are booked
at current spot
 income statements
 balance sheets
 at settlement - changes to book value
must be counted
 losses
 gains
July 17, 2016
Transaction Exposure
21
Accounting hedged positions
 Payables and receivables are booked at
current spot
 Use your forward rate as best estimator of
future expected spot
 foreign exchange gain/loss = forward - spot
 forward contract loss = 0
 Gains/losses will be the difference between
 contract evaluated at forward and
 contract evaluated at spot
July 17, 2016
Transaction Exposure
22
Risk management
 Hedging costs money
 Hedging exposure
 As contracts are anticipated
 Contracts may not be signed
 If contracts signed unanticipated exchange rate
changes
 As contracts are signed
 Risk that contract may be refused
 Risk that goods may not clear customs
 As contracts are delivered
 Default by the importer


July 17, 2016
Out goods
Must deliver on forward contract
Transaction Exposure
23
Other hedge practices
 Proportional hedges
 Forward contracts hedge percentage of exposure
 Percentage cover directly related to term to
maturity
 Forward points (using Interest Rate Parity)
1.0575 
f 90  1.49  
1.0625 

90
360
 1.4882
 The usd sells forward at discount
 May not hedge this transaction because they
may get a better exchange rate in the future
July 17, 2016
Transaction Exposure
24