C H A P T E R 11
Managing Transaction Exposure
Chapter Overview
A. Transaction Exposure
B. Hedging Exposure to Payables
C. Hedging Exposure to Receivables
D. Cross hedging
Foreign Exchange Exposure
 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 to be settled until after the exchange
rate changes
 Operating (Economic)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
Question: Is transaction exposure part of economic exposure, or
vice versa?
Foreign Exchange Exposure
 Translation Exposure – also called accounting exposure, is the
potential for accounting derived changes in owner’s 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
9-4
Conceptual Comparison of Transaction,
Operating, and Translation Foreign Exchange
Exposure
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
Why Hedge - the Pros & Cons
 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
 Management’s 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 firm’s market valuation
Why Hedge - the Pros & Cons
 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 firm’s 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
Impact of Hedging on the Expected Cash
Flows of the Firm
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
The Life Span of a Transaction
Exposure
Alternative ways of hedging transaction
exposure
 Transaction exposure:
 The value of a firm’s future 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 transaction exposure.
 Using financial contract to hedge transaction risk
 Forward (Future) Market Hedge
 Money Market Hedge
 Options Market Hedge
 Call
 Put
Hedging Currency Payable
 Using financial contract to hedge transaction risk involved
with currency receivable:
 Forward or Futures Hedge contract specifies
a. Fixed amount of currency
b. Fixed exchange rate
c. Fixed delivery date
 Forward (Future) Market Hedge – long position
If you are going to owe foreign currency in the future, agree to …… the
foreign currency now by entering into long position in a forward contract
 Money Market Hedge

Involves taking a money market position to cover a future payables position
 Options Market Hedge

Call – pay call option premium to purchase call options
Alternative ways of hedging
transaction exposure
A U.S.–based importer of Italian bicycles
 In one year owes €100,000 to an Italian supplier.
 The spot exchange rate is $1.18 = €1.00
 The one year forward rate is $1.20 = €1.00
 The one-year interest rate in Italy is i€ = 5%
 The one-year interest rate in US is i$ = 8%
Approach one: Using forward contract to hedge on payable
Can hedge this payable by set up a forward contract to buy Euros
in one year today.
Cost in $ (one year later)
= payables * forward rate
= €100,000 * 1.2 $/ €
= $120,000
Alternative ways of hedging
transaction exposure on payable
A U.S.–based importer of Italian bicycles
 In one year owes €100,000 to an Italian supplier.
 The spot exchange rate is $1.18 = €1.00
 The one year forward rate is $1.20 = €1.00
 The one-year interest rate in Italy is i€ = 5%
 The one-year interest rate in US is i$ = 8%
Approach two: Using money market to hedge on payable
Can hedge this payable by buying €95,238 =
€100,000
1.05
today and investing €95238 at 5% in Italy for one year.
At maturity, he will have €100,000 = €95238 × (1.05)
$1.18
Dollar cost today = $112381 = €95238 ×
€1.00
Money Market Hedge on payable
 With this money market hedge, we have redenominated a one-year
€100,000 payable into a $112381 payable due today, or
 So $112381 is the “locked in” cost in dollars today
 But if you do not have excess $, you can borrow at US bank @
8%. So one year later, you need to pay back to US bank of
$112381*(1+0.08) = $121371
 Net exposure to Euro is zero at the maturity
 The money market hedge is fully self-financing
 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
Question: What are the differences of the two approaches?
Alternative ways of hedging
transaction exposure on payable
Today, deposit €95, 238 in
Foreign market @5%, due
one year later
Payback the payable
of €100,000 one year
later
Today, borrowed $112,381
today @ 8% in US market and
convert to €95, 238 at spot rate
One year later, need to payback
$121371 to the bank, for the loan of
$112,381
Options Market Hedge on payable
 Options provide a flexible hedge against the downside, while
preserving the upside potential.
 To hedge a foreign currency payable buy calls on the currency.
 To hedge a foreign currency receivable buy puts on the
currency.
8-19
Alternative ways of hedging
transaction exposure on payable
A U.S.–based importer of Italian bicycles
 In one year owes €100,000 to an Italian supplier.
 The spot exchange rate is $1.18 = €1.00
 The one year forward rate is $1.20 = €1.00
 The one-year interest rate in Italy is i€ = 5%
 The one-year interest rate in US is i$ = 8%
 Call option exercise price is $1.2/ € with premium of $0.03.
Approach two: Buy call options to hedge on payable
Alternative ways of hedging
transaction exposure on payable
Approach two: Buy call options to hedge on payable
Possible outcomes:
When one year’s spot rate >=$1.2  exercise call option @$1.2
Total cost = €100,000 *($1.2+$0.03)=$123000.
When one year’s spot rate <$1.2  let go call option and convert at
low spot rate Total cost = €100,000 *(spot rate+$0.03)
So, the expected value of cost of using call options
= 119000 * 0.2 + 123000*0.7+123000*0.1=$122200.
Contingency Graph for Hedging Payables With Call Options
11.1
Alternative ways of hedging
transaction exposure on payable
 Which of the three hedging approaches are optimal?
We can compare the final costs and the least expensive one
is optimal.
However, the expected cost based on call option depends on
the forecast (probability) of future exchange rate.
 What about the final cost without any hedge?
So, the expected value of cost of no hedging
= 116000 * 0.2 + 122000*0.7+124000*0.1=$121000.
8-23
Graphic Comparison
of Techniques to
Hedge Payables
11.4
Hedging Currency Receivable
 Using financial contract to hedge transaction risk involved with
currency receivable:
 If you are going to receive foreign currency in the future, agree to ……..
the foreign currency now by entering into short position in a forward
contract – such as receivable
 Money Market Hedge – invest in the money market
 This is the same idea as covered interest arbitrage.
 Options Market Hedge
 Put – pay call option premium to purchase put options for the right to
sell foreign currency at strike price
Alternative ways of hedging
transaction exposure
A U.S.–based exporter of US bicycles to Swiss distributors
 In 6 months receive SF200,000 from an Swiss distributor
 The spot exchange rate is $0.71 = SF1.00
 The 6 month forward rate is $0.71 = SF1.00
 The one-year interest rate in Swiss is iSF = 5%
 The one-year interest rate in US is i$ = 8%
Approach one: Using forward contract to hedge on receivable
Can hedge this receivable by sell a 6 month forward contract in
Swiss Francs.
Value in $ (6 month later)
= receivable * forward rate
= SF200,000 * 0.71 $/ €
= $142,000
Alternative ways of hedging
transaction exposure on Receivable
A U.S.–based exporter of US bicycles to Swiss distributors
 In 6 months receive SF200,000 from an Swiss distributor
 The spot exchange rate is $0.70 = SF1.00
 The 6 month forward rate is $0.71 = SF1.00
 The 6 month interest rate in Swiss is iSF = 3%
 The 6 month interest rate in US is i$ = 2%
Approach two: Using money market to hedge on receivable
SF200,000
Can hedge this receivable by borrowing SF194175 =
1.03
today and investing SF194175 at 3% in Swiss for 6 months.
At maturity, firm will have SF200,000 = SF194175× (1.03) to
payback the loan of SF200,000.
And firm can convert the proceeds to $ today from borrowed
SF200,000 and invest $ in US market. If so,
Dollar received today = $135922 = SF194175 * 0.70 $/SF
And 6 month later, dollar value = $135922*(1+0.02)=$138640.
Alternative ways of hedging
transaction exposure on receivable
Borrowed SF194,175 today @ 3%
in foreign market
Use the receivable,
SF200,000, due 6
month later, to
payback the loan of
SF194,175
Convert to $ at 0.70 $/SF
today: $135,922
Deposit the $135,922 @ 2% in
US market due 6 month laterFinal value: $138,640.
Money Market Hedge on receivable
 With this money market hedge, we have redenominated a 6
month SF200,000 receivable into a $135922 receivable today, or
 So $135922 is the “locked in” value in dollars today
 Net exposure to Swiss Francs is zero at the maturity
 The money market hedge is fully self-financing
Question: What are the differences of the two approaches?
Options Market Hedge on receivable
 Options provide a flexible hedge against the downside, while
preserving the upside potential.
 To hedge a foreign currency payable buy calls on the currency.
 To hedge a foreign currency receivable buy puts on the
currency.
Alternative ways of hedging
transaction exposure on receivable
A U.S.–based exporter of US bicycles to Swiss distributors
 In 6 months receive SF200,000 from an Swiss distributor
 The spot exchange rate is $0.70 = SF1.00
 The 6 month forward rate is $0.71 = SF1.00
 The 6 month interest rate in Swiss is iSF = 3%
 The 6 month interest rate in US is i$ = 2%
 Put option exercise price is $0.72/ SF with premium of $0.02.
Approach two: Buy put options to hedge on receivable
Alternative ways of hedging
transaction exposure on payable
Approach three: Buy call options to hedge on receivable
Possible outcomes:
When 6 month’s spot rate <=$0.72  exercise put option
@$0.72 Total value =SF200,000 *($0.72-$0.02)=$140000.
When 6 month’s spot rate >$0.72  let go put option and convert
at high spot rate Total value = SF200,000 *(spot rate-$0.02)
So, the expected value of using put options
= 140000 * 0.3 + 144000*0.4+148000*0.3=$144000
Contingency Graph for Hedging Receivable with Put Options
11.5
Alternative ways of hedging
transaction exposure on payable
 Which of the three hedging approaches are the most optimal?
We can compare the final value and the highest one is the
most optimal.
However, the expected value based on put option depends on
the forecast (probability) of future exchange rate.
 What about the final value without any hedge?
So, the expected value of cost of no hedging
= 142000 * 0.3 + 148000*0.4+152000*0.3=$147400.
8-34
Graphic Comparison
of Techniques to
Hedge receivables
Refer to Exhibit 11.9
for a review of the
Alternatives for hedging
on page 324.
11.4
Cross-Hedging
Minor Currency Exposure
 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.
 It is difficult, expensive, or impossible to use financial
contracts to hedge exposure to minor currencies.
Cross-Hedging
Minor Currency Exposure
 Cross-Hedging involves hedging a position in one asset by
taking a position in another asset.
 The effectiveness of cross-hedging depends upon how well
the assets are correlated.
 To hedge Thai bhat, you can hedge Japanese Yen, since Thai
bhat and Japanese Yen are highly correlated.