FX Risk Management
Transaction Exposure
 Overview
• The three major foreign exchange exposures
• Foreign exchange transaction exposure
• Pros and cons of hedging foreign exchange transaction
exposure
• Alternatives of managing significant transaction
exposure
• Practices and concerns of foreign exchange risk
management
Slide 1
Foreign Exchange Exposure

Types of foreign exchange exposure
• Transaction Exposure – measures changes in the value of
•
•
•
outstanding financial obligations due to 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
changes in owner’s equity because of the need to “translate”
financial statements of foreign subsidiaries into a single
reporting currency for consolidated financial statements
Tax Exposure – as a general rule only realized foreign losses are
deductible for purposes of calculating income taxes
Slide 2
Foreign Exchange Exposure
Moment in time when exchange rate changes
Accounting exposure
Operating exposure
Changes in reported owners’ equity
in consolidated financial statements
caused by a change in exchange rates
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
Time
Slide 3
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
Currency risk management does not increase the expected cash
flows of a firm
Management often conducts hedging activities that benefit
management at the expense of shareholders
Managers cannot outguess the market
Management’s motivation to reduce variability is sometimes
driven by accounting reasons
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
Slide 4
Why Hedge - the Pros & Cons
 Proponents of hedging give the following reasons:
• Reduction in the risk of 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 – avoiding bankruptcy costs
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
Reduction in variability of income reduces a firm’s
overall tax burden
Slide 5
Why Hedge - the Pros & Cons
Hedged
Unhedged
NCF
Expected Value, E(V)
Net Cash Flow (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, but who benefits from it.
Slide 6
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
Slide 7
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 $0.9000/€ and Trident
expects to exchange the euros for €1,800,000 x $0.9000/€ =
$1,620,000 when payment is received (assuming no change in
exchange rate)
• Transaction exposure arises because of the risk that Trident will
•
•
receive something other than $1,620,000 expected
If the euro weakens to $0.8500/€, then Trident will receive
$1,530,000
If the euro strengthens to $0.9600/€, then Trident will receive
$1,728,000
Slide 8
Purchasing or Selling on Open Account
 Trident might have avoided transaction exposure by

invoicing the Belgian buyer in US dollars, but this
might have caused 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
Slide 9
Purchasing or Selling on Open Account
Life Span of a Transaction Exposure
t1
t2
t3
Seller quotes a
price to buyer
Buyer places
firm order with
seller at
offered price
Seller ships
product and
bills buyer
t4
Buyer settles
A/R with cash
in amount of
currency
quoted at t1
Quotation Exposure
Backlog Exposure
Billing Exposure
Time between quoting
a price and reaching a
contractual sale
Time it takes to fill the
order after contract is
signed
Time it takes to get
paid in cash after A/R
is issued
Slide 10
Borrowing and Lending
 A second example of transaction exposure arises

when funds are loaned or borrowed
Example: PepsiCo’s largest bottler outside the US is
located in Mexico, Grupo Embotellador de Mexico
(Gemex)
• On 12/94, Gemex had US dollar denominated debt of
$264 million
• The Mexican peso (Ps) was pegged at Ps3.45/$
• On 12/22/94, the government allowed the peso to float
due to internal pressures and it sank to Ps4.65/$
Slide 11
Borrowing and Lending
 Gemex’s peso obligation now looked like this
• Dollar debt mid-December, 1994:
– $264,000,000  Ps3.45/$ = Ps910,800,000
• Dollar debt in mid-January, 1995:
– $264,000,000  Ps5.50/$ = Ps1,452,000,000
• Dollar debt increase measured in Ps
– Ps541,200,000
 Gemex’s dollar obligation increased by 59% due to
transaction exposure
Slide 12
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
Slide 13
Hedging Alternatives
 Transaction exposure can be managed by




contractual, operating, or financial hedges
Contractual hedges: forward, money market, futures,
and options
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 financial hedge refers to either an offsetting debt
obligation or some type of financial derivative such
as a swap
Slide 14
Foreign Currency Derivatives


Derivatives drive their values from the underlying asset
They might be used for two distinct management objectives:
• Speculation – the financial manager takes a position in the
•


expectation of profit
Hedging – the financial manager uses the instruments to reduce
the risks of the corporation’s cash flow
In the wrong hands, derivatives can cause a corporation to
collapse (Barings, Allied Irish Bank), but used wisely they
allow a financial manager the ability to plan cash flows
The derivatives we will consider are:
• Foreign Currency Futures
• Foreign Currency Options
Slide 15
Foreign Currency Futures
 A foreign currency futures contract is an alternative
to a forward contract
• It calls for future delivery of a standard amount of
currency at a fixed time and price
• These contracts are traded on exchanges with the
largest being the Chicago Mercantile Exchange (CME)
 Contract Specifications:
• Size of contract – called the notional principal, trading
in each currency must be done in an even multiple
• Method of stating exchange rates – “American terms”
are used; quotes are in US dollar cost per unit of
foreign currency, also known as direct quotes
Slide 16
Foreign Currency Futures
 Contract Specifications
• Maturity date – contracts mature on the 3rd Wednesday
of January, March, April, June, July, September,
October or December
• Last trading day – contracts may be traded through the
second business day prior to maturity date
• Collateral & maintenance margins – the purchaser or
trader must deposit an initial margin or collateral
– At the end of each trading day, the account is marked to
market and the balance in the account is either credited
if value of contracts is greater or debited if value of
contracts is less than account balance
Slide 17
Foreign Currency Futures
 Contract Specifications
• Settlement – only 5% of futures contracts are settled by
physical delivery, most often buyers and sellers offset
their position prior to delivery date by taking offsetting
positions
– The complete buy/sell or sell/buy is termed a round turn
• Commissions – customers pay a single commission to
their broker to execute a round turn
• Use of a clearing house as a counterparty – All
contracts are agreements between the client and the
exchange clearing house. Therefore, there is no
counter-party risk
Slide 18
Using Foreign Currency Futures
 If an investor wishes to speculate on the movement of
a currency can pursue one of the following strategies
• Short position – selling a futures contract based on
view that currency will fall in value
• Long position – purchase a futures contract based on
view that currency will rise in value
Slide 19
Using Foreign Currency Futures
 Example (cont.): Amy believes that the value of the


peso will fall, so she sells a March futures contract
By taking a short position on the Mexican peso, Amy
locks-in the right to sell 500,000 Mexican pesos at
maturity at a set price above their current spot price
Amy sells one March contract for 500,000 pesos at
the settle price: $0.10958/Ps
Value at maturity (Short position) = – Notional principal  (Spot – Futures)
Slide 20

Using Foreign Currency Futures
To calculate the value of Amy’s position we use the following
formula
Value at maturity (Short position) = – Notional principal  (Spot – Futures)

Using the settle price from the table and assuming a spot rate
of $0.09450/Ps at maturity, Amy’s profit is
Value = – Ps500,000  ($0.09450/Ps – $0.10958/Ps) = $7,540

If Amy believed that the Mexican peso would rise in value, she
would take a long position on the peso
Value at maturity (Long position) = Notional principal  (Spot – Futures)

Using the settle price from the table and assuming a spot rate
of $0.11500/Ps at maturity, Amy’s profit is
Value = Ps500,000  ($0.11500/Ps – $0.10958/Ps) = $2,710
Slide 21
Foreign Currency Futures Versus Forward
Contracts
Contract size
Delivery date
Participants
Forward Markets
Customized.
Customized.
Banks, brokers, MNCs. Public
speculation not encouraged
Futures Markets
Standardized.
Standardized.
Banks, brokers, MNC. Qualified
public speculators.
Security deposit Compensating bank balances or
credit lines needed
Small security deposit required
Clearing
operation
Handled by individual banks and
brokers
Handled by exchange clearinghouse.
Daily settlements.
Marketplace
Regulation
Worldwide
Self-regulating.
Central exchange
Commodity Futures Trading
Commission (CFTC) and National
Futures Association
Liquidation
Mostly settled by actual delivery
Mostly settled by offsetting
transactions
Transaction
Costs
Bank’s bid/ask spread
Negotiated brokerage fees
Slide 22
Foreign Currency Options
 A foreign currency option is a contract giving the
purchaser of the option the right to buy or sell a given
amount of currency at a fixed price per unit for a
specified time period
• The most important part of clause is the “right, but not
the obligation” to take an action
• Two basic types of options, calls and puts
– Call – buyer has right to purchase currency
– Put – buyer has right to sell currency
• The buyer of the option is the holder and the seller of
the option is termed the writer
Slide 23
Foreign Currency Options
 Every option has three different price elements
• The strike or exercise price is the exchange rate at
which the foreign currency can be purchased or sold
• The premium, the cost, price or value of the option
itself paid at time option is purchased
• Spot exchange rate in the market
 There are two types of option maturities
• American options may be exercised at any time during
the life of the option
• European options may not be exercised until the
specified maturity date
Slide 24
Foreign Currency Options
 Options may also be classified as per their payouts
• At-the-money (ATM) options have an exercise price
equal to the spot rate of the underlying currency
• In-the-money (ITM) options may be profitable,
excluding premium costs, if exercised immediately
• Out-of-the-money (OTM) options would not be
profitable, excluding the premium costs, if exercised
Slide 25
Foreign Currency Options Markets


Over-the-Counter (OTC) Market – OTC options are most
frequently written by banks for US dollars against British
pounds, Swiss francs, Japanese yen, Canadian dollars and the
euro
• Main advantage is that they are tailored to purchaser
• Counterparty risk exists
• Mostly used by individuals and banks
Organized Exchanges – similar to the futures market,
currency options are traded on an organized exchange floor
• The Chicago Mercantile and the Philadelphia Stock Exchange
•
serve options markets
Clearinghouse services are provided by the Options
Clearinghouse Corporation (OCC)
Slide 26


Trident’s Transaction Exposure
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 June (3 months)
• Assumptions
–
–
–
–
–
–
–
–

Spot rate is $1.7640/£
3-month forward rate is $1.7540/£ (a 2.27% discount)
Trident’s 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.
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/£;
priced at $0.0265/£
– Trident’s foreign exchange advisory service forecasts future spot rate in 3
months to be $1.7600/£
The budget rate (lowest acceptable amount) is based on an
exchange rate of $1.7000/£
Slide 27
Trident’s Transaction Exposure
 Trident faces four possibilities:
•
•
•
•
•
Remain unhedged
Hedge in the forward market
Hedge in the money market
Hedge in the futures market
Hedge in the options market
Slide 28
Trident’s Transaction Exposure
 Unhedged position
• If the future spot rate is $1.76/£, then Trident will
receive £1,000,000 x $1.76/£ = $1,760,000 in 3
months
• However, if the future spot rate is $1.65/£, Trident will
receive only $1,650,000 well below the budget rate
Slide 29

Trident’s Transaction Exposure
Forward Market hedge
• A forward hedge involves a forward 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 the firm wants to cover this exposure with a forward contract, then
the firm will sell £1,000,000 forward today at the $1.7540/£
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 Trident’s books as a foreign exchange loss
of $10,000 ($1,764,000 as booked, $1,754,000 as settled)
Slide 30
Trident’s Transaction Exposure
 Money Market hedge
• To hedge in the money market, Trident 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, Trident needs to discount
the PV of the £1,000,000 to today
– £1,000,000/1.025 = £975,610
– Trident should borrow £975,610 today and in 3 months
repay this amount plus £24,390 in interest (£1,000,000)
from the proceeds of the sale
– Trident would exchange the £975,610 at the spot rate of
$1.7640/£ and receive $1,720,976 at once (today)
– This hedge creates a pound denominated liability that is
offset with a pound denominated asset thus creating a
balance sheet hedge
Slide 31

Trident’s Transaction Exposure
In order to compare the forward hedge with the money market
hedge, we 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 (the comparison is made on future values)
Three logical choices exist for an assumed investment rate for the
next 3 months
– First, if Trident is cash rich the loan proceeds might be invested at the
US rate of 6.0% p.a.
– Second, the loan proceeds can be substituted for an equal dollar loan
that Trident would have otherwise taken for working capital needs at
a rate of 8.0% p.a.
– Third, the loan proceeds can be invested in the firm itself in which
case the cost of capital is 12.0% p.a.
Slide 32
Trident’s Transaction Exposure



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 the proceeds are used to replace a dollar loan
(8%) or conduct general business operations (12%)
The forward hedge would be preferable if the loan proceeds
are invested at (6%)
We will assume the cost of capital as the reinvestment rate
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
Slide 33
Trident’s Transaction Exposure
 A breakeven investment rate can be calculated
between forward and money market hedge
(Loan proceeds) x (1 + rate) = (forward proceeds)
$1,720,976 x (1 + r) = $1,754,000
r = 0.0192
 To convert this 3 month rate to an annual rate,
360
0.0192 x
x 100 = 7.68%
90

In other words, if Trident 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
Slide 34
Trident’s Transaction Exposure
Value in US dollars of
Trident’s £1,000,000 A/R
Uncovered yields
whatever the ending
spot rate is in 90 days
Forward rate
is $1.7540/£
1.84
1.82
Money market hedge
yields $1,772,605
1.80
1.78
1.76
Forward contract hedge
yields $1,754,000
1.74
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
1.78
1.80
Ending spot exchange rate (US$/£)
1.82
1.84
1.86
Slide 35
Trident’s Transaction Exposure

Futures market hedge
• Trident could also cover the £1,000,000 exposure by selling futures
•
contracts now at say $1.7540/£ - most futures contracts are not
delivered therefore instead of spot rate you would have purchase
price of the futures contract below
If spot rate is $1.7600/£ then the result of futures position is:
Value at maturity (Short position) = – Notional principal  (Spot – Futures)
Value at maturity (Short position) = – £1,000,000  ($1.7600/£ – $1.7540/£ )
Value at maturity (Short position) = – $6,000
• The loss on futures would reduce the value of receivable
Value of receivable = £1,000,000  $1.7600/£ = $1,760,000
• The net value of receivable is:
• $1,760,000 – $6,000 = $1,754,000
• Implied exchange rate of conversion is
• $1,754,000 / £1,000,000 = $1.7540/£ (Rate at which we sold futures
Slide 36
contracts.
Trident’s Transaction Exposure
 Option market hedge
• Trident could also cover the £1,000,000 exposure by
purchasing a put option. This provides the upside
potential for appreciation of the pound while limiting
the downside risk
– Given the quote earlier, a 3-month put option can be
purchased with a strike price of $1.75/£ and a premium
of $0.0265/£
– The cost of this option would be
(Size of option) x (premium) = cost of option
£1,000,000 x $0.0265/£ = $26,460
Slide 37
Trident’s Transaction Exposure


Because we are using future value to compare the various hedging
alternatives, we need future value of the option cost in 3 months
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 or $27,254 / £1,000,000 = $0.0273/£



Since the upside potential is unlimited, Trident would not exercise
its option at any rate above $1.75/£ and would convert pounds to
dollars at the spot market
If the spot rate is $1.76/£, 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
If the pound depreciates below $1.75/£, Trident would exercise the
put option and exchange £1,000,000 at $1.75/£ receiving
$1,750,000 less the premium of the option netting $1,722,746
Slide 38
Trident’s Transaction Exposure
 As with the forward and money market hedges, a
breakeven price on the option can be calculated
• 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 by
comparison to the strike price
– If the pound depreciates below $1.75/£, the net proceeds
would be $1.75/£ less the cost of $0.0273/£ or $1.722/£
– Note that the following graph shows the net proceeds of
the option contract under varying exchange rates. Net
proceeds are not same of a put option payoff diagram
because we have exposure to the underlying asset (£)
Slide 39
Trident’s Transaction Exposure
Put Option Strike Price
Option cost (future cost)
ATM Option $1.75/£
$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/£
Slide 40
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
B
Exposure
Put Exercise
Put Premium
Spot Rate
Unhedged
1.68
$1,680,000
1.69
$1,690,000
1.70
$1,700,000
1.71
$1,710,000
1.72
$1,720,000
1.73
$1,730,000
1.74
$1,740,000
1.75
$1,750,000
1.76
$1,760,000
1.77
$1,770,000
1.78
$1,780,000
1.79
$1,790,000
1.80
$1,800,000
1.81
$1,810,000
1.82
$1,820,000
1.83
$1,830,000
1.84
$1,840,000
1.85
$1,850,000
1.86
$1,860,000
1.87
$1,870,000
1.88
$1,880,000
1.89
$1,890,000
1.90
$1,900,000
C
£1,000,000
1.75
0.0273
MM
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
$1,772,605
D
E
(FV)
Forward
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
$1,754,000
Put Option
$1,722,746
$1,722,746
$1,722,746
$1,722,746
$1,722,746
$1,722,746
$1,722,746
$1,722,746
$1,732,746
$1,742,746
$1,752,746
$1,762,746
$1,772,746
$1,782,746
$1,792,746
$1,802,746
$1,812,746
$1,822,746
$1,832,746
$1,842,746
$1,852,746
$1,862,746
$1,872,746
Cell E5 Entry is =IF(A5<$C$2,($C$2-$C$3)*$C$1,(A5-$C$3)*$C$1)
Slide 41
Hedging Alternatives
Unhedged
MM
Forward
Put Option
$1,920,000
$1,900,000
$1,880,000
$1,860,000
$1,840,000
Net Proceeds
$1,820,000
$1,800,000
$1,780,000
$1,760,000
$1,740,000
$1,720,000
$1,700,000
$1,680,000
$1,660,000
1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85 1.86 1.87 1.88 1.89 1.90
Exchange Rate ($/£)
Slide 42
Strategy Choice and Outcome
 Trident, like all firms, must decide on a strategy to

undertake before the exchange rate changes but how a
choice can be made among the strategies?
Two criteria can be utilized:
• Risk tolerance - of the firm,as expressed in its stated
policies and
• Viewpoint – managers’ view on the expected direction
and distance of the exchange rate
 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
Slide 43
Strategy Choice and Outcome
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
Slide 44
Managing an Account Payable
 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 $1.7600/£ then Trident would pay
$1,760,000 but this amount is not certain
Slide 45
Managing an Account Payable
 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 at the spot
rate 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
Slide 46
Managing an Account Payable
 Using a money market hedge –
• To ensure that exactly £1,000,000 will be received in 3
months, discount the principal by 8% p.a.
£1,000,000
90
1+ 0.08 x
360
= £980,392.16
• This £980,392.16 would require $1,729,411.77 at the
current spot rate
£980,392.16 x $1.7640/£ = $1,729,411.77
Slide 47
Managing an Account Payable
 Using a money market hedge –
• Finally, carry the cost forward 90 days using the cost
of capital in order to compare the payout from the
money market hedge
 
90 
$1,729,411.77 x 1   0.12 x
  $1,781,294.12
360 
 
• This is higher than the forward hedge of $1,754,000
thus unattractive
Slide 48
Managing an Account Payable

Futures market hedge
• Trident could also cover the £1,000,000 exposure by buying futures
•
contracts now at say $1.7540/£
If spot rate is $1.7600/£ then the result of futures position is:
Value at maturity (Long position) = Notional principal  (Spot – Futures)
Value at maturity (Long position) = £1,000,000  ($1.7600/£ – $1.7540/£)
Value at maturity (Long position) = $6,000
• The gain on futures would reduce the value of payable
Value of payable = –£1,000,000  $1.7600/£ = –$1,760,000
• The net value of payable is:
• –$1,760,000 + $6,000 = –$1,754,000
• Implied exchange rate of conversion is
• $1,754,000 / £1,000,000 = $1.7540/£ (Rate at which we bought
futures contracts.
Slide 49
Managing an Account Payable
 Using an option hedge – instead of purchasing a put
as with a receivable, you want to purchase a call
option on the payable
• The total cost of an ATM call option with strike price
of $1.75/£ and a premium of $0.0265/£:
(Size of option) x (premium) = cost of option
£1,000,000 x $0.0265/£ = $26,460
• Carried forward 90 days the premium amount is
$26,460  1.03 = $27,254 or $27,254 / £1,000,000 =
$0.0273/£
Slide 50
Managing an Account Payable
 Using a call 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
Exercise call option (£1,000,000  $1.75/£)
Call option premium (carried forward 90 days)
Total maximum expense of call option hedge
$1,750,000
$27,254
$1,777,254
Slide 51
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
B
Exposure
Call Exercise
Call Premium
Spot Rate
Unhedged
1.68
$1,680,000
1.69
$1,690,000
1.70
$1,700,000
1.71
$1,710,000
1.72
$1,720,000
1.73
$1,730,000
1.74
$1,740,000
1.75
$1,750,000
1.76
$1,760,000
1.77
$1,770,000
1.78
$1,780,000
1.79
$1,790,000
1.80
$1,800,000
1.81
$1,810,000
1.82
$1,820,000
1.83
$1,830,000
1.84
$1,840,000
1.85
$1,850,000
1.86
$1,860,000
1.87
$1,870,000
1.88
$1,880,000
1.89
$1,890,000
1.90
$1,900,000
C
£1,000,000
1.75
0.0273
MM
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
$1,781,294
D
E
(FV)
Forward Call Option
$1,754,000 $1,707,254
$1,754,000 $1,717,254
$1,754,000 $1,727,254
$1,754,000 $1,737,254
$1,754,000 $1,747,254
$1,754,000 $1,757,254
$1,754,000 $1,767,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
$1,754,000 $1,777,254
Cell E5 Entry is =IF(A5>$C$2,($C$2+$C$3)*$C$1,(A5+$C$3)*$C$1)
Slide 52
Hedging Alternatives
Unhedged
MM
Forward
Call Option
$1,920,000
$1,900,000
$1,880,000
$1,860,000
$1,840,000
Net Proceeds
$1,820,000
$1,800,000
$1,780,000
$1,760,000
$1,740,000
$1,720,000
$1,700,000
$1,680,000
$1,660,000
1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85 1.86 1.87 1.88 1.89 1.90
Exchange Rate ($/£)
Slide 53
Risk Management in Practice

Which Goals?
• The treasury function of most firms is usual considered a cost center;
•

Which Exposures?
• Transaction exposures exist before they are actually booked yet some
•

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
firms do not hedge this backlog exposure
However, some firms are selectively hedging these backlog
exposures and anticipated exposures
Which Contractual Hedges?
• Transaction exposure management programs are generally divided
•
along an “option-line;” those which use options and those that do not
Also the amount of risk covered may vary. Tare are proportional
hedging policies that state which proportion and type of exposure is
to be hedged by the treasury
Slide 54
Example



Dragon Inc, of Moorhead purchased a Korean company that produces plastic
nuts and bolts for auto manufacturers. The purchase price was Won7,030
million. Won1,000 million has already been paid and the remaining Won6,030
million is due in six months. The current spot rate is Won1,200/$, and the 6month forward rate is Won1,260/$
Additional data:
• Six-month Korean interest rate: 16.00% p.a.
• Six-month US interest rate: 4.00% p.a.
• Six-month call option on Korean Won at 1,260 with a premium of
Won33.33/$
• Six-month put option on Korean Won at 1200 with a premium of
Won41.67/$
• Dragon can invest at the rates given above or borrow at 2% p.a. above those
rates. Dragon’s cost of capital is 25%.
Compare hedging alternatives and make a recommendation.
Slide 55