Chapter 08
Transaction Exposure
1
Transaction Exposure
• 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
2
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
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
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
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.
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
7
Purchasing or Selling on Open Account
• Suppose Dragon Corporation sells merchandise on
open account to a Belgian buyer for €1,800,000
payable in 60 days
• Further assume that the current spot rate is $0.9000/€
and Dragon 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)
– Dragon will receive something other than $1,620,000
expected
– If the euro weakens to $0.8500/€, then Dragon will receive
$1,530,000
– If the euro strengthens to $0.9600/€, then Dragon will
receive $1,728,000
8
Purchasing or Selling on Open Account
• Dragon might have avoided transaction exposure
by invoicing the Belgian buyer in US dollars, but
this might have caused Dragon not being able to
book the sale
• Even if the Belgian buyer agrees to pay in dollars,
however, Dragon 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
9
Purchasing or Selling on Open Account
Life Span of a Transaction Exposure
t1
t2
Seller quotes
a price to
buyer
t3
Buyer places
firm order
with seller at
offered price
Quotation
Exposure
Time between
quoting a price and
reaching a
contractual sale
t4
Seller ships
product and
bills buyer
Backlog Exposure
Time it takes to fill
the order after
contract is signed
Buyer settles
A/R with cash
in amount of
currency
quoted at t1
Billing Exposure
Time it takes to get
paid in cash after A/R
is issued
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/$
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
12
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
13
Dayton’s Transaction Exposure
• CFO of Dayton, 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)
Dayton’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 $1.7500/£; 1.5%
premium
• June call option in OTC market for £1,000,000; strike price $1.7500/£; 1.5%
premium
• Dayton’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/£
14
Dayton’s Transaction Exposure
• Dayton faces four possibilities:
– Remain unhedged
– Hedge in the forward market
– Hedge in the money market
– Hedge in the options market
15
Dayton’s Transaction Exposure
• Unhedged position
– If the future spot rate is $1.7600/£, then Dayton
will receive £1,000,000 x $1.7600/£ = $1,760,000
in 3 months
– However, if the future spot rate is $1.6500/£,
Dayton will receive only $1,650,000 well below
the budget rate
16
Dayton’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 Dayton
– 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, Dayton 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 Dayton’s books as a foreign exchange loss of
$10,000 ($1,764,000 as booked, $1,754,000 as settled)
17
Dayton’s Transaction Exposure
• Money Market hedge
– To hedge in the money market, Dayton 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, Dayton needs to discount the PV
of the £1,000,000 to today
• £1,000,000/1.025 = £975,610
• Dayton 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
• Dayton 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
18
Dayton’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 Dayton 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 Dayton 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.
19
Dayton’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
20
Dayton’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 per quarter
• To convert this 3 month rate to an annual rate,
360
0.0192 x
x 100 = 7.68%
90
• In other words, if Dayton 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
21
Dayton’s Transaction Exposure
Value in US dollars of
Dayton’s £1,000,000 A/R
1.84
Forward rate
is $1.7540/£
Uncovered yields
whatever the ending
spot rate is in 90 days
1.82
Money market hedge
yields $1,772,605
1.80
1.78
1.76
1.74
1.72
1.70
1.68
1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86
Ending spot exchange rate (US$/£)
22
Dayton’s Transaction Exposure
• Option market hedge
– Dayton 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 1.5%
• The cost of this option would be
(Size of option) x (premium) x(spot rate)  cost of option
£1,000,000 x 0.015x$1.7640 /£  $26,460
23
Dayton’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, Dayton would not exercise
its option at any rate above $1.7500/£ and would convert pounds
to dollars at the spot market
• If the spot rate is $1.7600/£, Dayton would exchange pounds on the
spot market to receive £1,000,000 × $1.7600/£ = $1,760,000 less
the premium of the option ($27,254) netting $1,732,746
• If the pound depreciates below $1.7500/£, Dayton would exercise
the put option and exchange £1,000,000 at $1.7500/£ receiving
$1,750,000 less the premium of the option netting $1,722,746
24
Dayton’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 $1.7540/£ 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 $1.7500/£, the net proceeds
would be $1.7500/£ less the cost of $0.0273/£ or $1.7227/£
• 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 (£)
25
Dayton’s Transaction Exposure
Put Option Strike Price
ATM Option $1.75/£
Option cost (future cost)
$1,750,000
Proceeds if exercised
$1,722,746
Minimum net proceeds
Cost of Capital
Maximum net proceeds
Unlimited
Breakeven spot rate (upside)
$1.7813/£
Breakeven spot rate (downside)
$1.7227/£
26
Net Proceeds of Alternatives
A
B
1
Exposure
2
Put Exercise
3
Put Premium
4 Spot Rate
Unhedged
5
1.68
$1,680,000
6
1.69
$1,690,000
7
1.70
$1,700,000
8
1.71
$1,710,000
9
1.72
$1,720,000
10
1.73
$1,730,000
11
1.74
$1,740,000
12
1.75
$1,750,000
13
1.76
$1,760,000
14
1.77
$1,770,000
15
1.78
$1,780,000
16
1.79
$1,790,000
17
1.80
$1,800,000
18
1.81
$1,810,000
19
1.82
$1,820,000
20
1.83
$1,830,000
21
1.84
$1,840,000
22
1.85
$1,850,000
23
1.86
$1,860,000
24
1.87
$1,870,000
25
1.88
$1,880,000
26
1.89
$1,890,000
27
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)
27
Net Proceeds of Alternatives
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
$1,660,000
1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85 1.86 1.87 1.88 1.89 1.90
Exchange Rate ($/£)
28
Strategy Choice and Outcome
• Dayton, 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
• Dayton 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
29
Strategy Choice and Outcome
Hedging Strategy
Remain uncovered
Outcome/Payout
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
30
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 – Dayton could wait the 90
days and at that time exchange dollars for
pounds to pay the obligation
– If the spot rate is $1.76/£ then Dayton would pay
$1,760,000 but this amount is not certain
31
Managing an Account Payable
• Use a forward market hedge – Dayton could
purchase a forward contract locking in the
$1.7540/£ 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 Dayton would exchange US dollars at the spot
rate and invest them for 90 days in pounds
– The pound obligation for Dayton is now offset by a
pound asset for Dayton with matching maturity
32
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
33
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
 
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
(investmen t need) x (1  rate)  (forward proceeds)
$1,729,412 x (1  r)  $1,754,000
r  0.0142 per quarter
34
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 $1.7500/£ and a premium of 1.5%:
(Size of option) x (premium) x(spot rate)  cost of option
£1,000,000 x 0.015x$1.7640 /£  $26,460
– Carried forward 90 days the premium amount is
$26,460 × 1.03 = $27,254 or $27,254 / £1,000,000
= $0.0273/£
35
Managing an Account Payable
• Using a call option hedge
– If the spot rate is less than $1.7500/£ 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 $1.7500/£ then the option would be
exercised and Dayton would exchange the £1,000,000 at
$1.75/£ less the option premium for the payable
• Exercise call option (£1,000,000  $1.75/£) = $1,750,000
• Add call option premium of $27,254 (carried forward 90
days)
• Total maximum expense of call option hedge is $1,777,254
36
Net Cost of Alternatives
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)
37
Net Cost of Alternatives
Hedging Alternatives
Unhedged
MM
Forward
Call Option
$1,920,000
$1,900,000
$1,880,000
$1,860,000
$1,840,000
Net Costs
$1,820,000
$1,800,000
$1,780,000
$1,760,000
$1,740,000
$1,720,000
$1,700,000
$1,680,000
$1,660,000
1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85 1.86 1.87 1.88 1.89 1.90
Exchange Rate ($/£)
38
Risk Management in Practice
• Which Goals?
– The treasury function of most firms is usual considered a cost center;
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
• Which Exposures?
– Transaction exposures exist before they are actually booked yet some
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
39