Transaction Exposure
(or chapter 8)
1
Agenda
• Types of forex exposures?
• Causes of transaction exposure?
• Pros & cons of hedging transaction exposure?
• How to manage transaction exposure?
– Forward Market Hedge
– Money Market Hedge
– Option Market Hedge
• Institutional practices of forex risk management.
2
Types of forex exposure





Forex exposure
– potential change in profitability, net cash flow, market value due to
change in forex rate.
Transaction Exposure
– changes in value of outstanding financial obligations incurred prior
to change in forex, not due to settle until after forex change.
Operating (Economic) Exposure
– change in firm PV resulting from change in expected future
operating cash flows due to unexpected forex change
Translation (Accounting) Exposure
– accounting-derived changes in owner equity due to consolidation
in single currency.
Tax Exposure
– varies by country, general rule only realized foreign losses are
deductible for calculating income taxes
3
Why Hedge? Pros & Cons…
• Improves planning.
• Reduces likelihood of bankruptcy.
• Management better knows actual risks.
vs.
• Currency risk management costly, may not increase
expected cash flows.
• Shareholders more capable diversifying risk.
• Investors already factored forex exposure into valuation.
• Conducts hedging to benefit management. 
• Managers cannot outguess efficient market .
• Management criticized for forex losses but not for cost in
avoiding forex losses.
4
Why Hedge?
•Reduction of risk?
•Increase/decrease in expected
cash flow?
•Increase in value?
Hedged
Unhedged
NCF
Expected Cash Flow
Net Cash Flow (NCF)
5
What causes transaction exposure?
 Purchasing or selling on credit.
 Borrowing or lending in foreign currency.
 Being party to unperformed forward contract.
 Acquiring assets/ incurring liabilities in foreign currency.
6
Open Account Purchasing/ Selling
t1
t2
t3
Seller
quotes
price
Buyer
places
order
Seller ships
product
Quotation
Exposure
Anticipation
Exposure
Time b/n quoting
price & reaching
sale.
t4
Buyer
settles A/R
Backlog Exposure
Billing Exposure
Contract Signed.
Time to get paid.
Time to fill order.
7
Borrowing &Lending
 Grupo Embotellador de Mexico (Gemex)
• Dollar debt mid-December, 1994:
– $ 264 m  PS 3.45/$ = PS 910,800,000.
• Dollar debt in mid-January, 1995:
– $ 264 m  PS 5.50/$ = PS 1,452,000,000 (59% up!)
8
How to manage transaction exposure?
 Contractual hedge
 Operating hedges
• Risk-sharing agreements.
• Leads and lags in payment terms.
• Swaps.
 Natural hedge
 Financial hedge
• offsetting debt obligation.
• financial derivative such as swap.
9
Hedging Account Receivable
 Suppose October sale for £1,000,000, A/R January.
– Spot $1.764/£
– 3m-forward $1.754/£ (2.27% discount)
– Cost of capital 12.0% annual
– British 3m borrowing rate 10% annual
– British 3m lending rate 8% annual
– US 3m borrowing rate is 8% annual
– US 3m lending rate is 6% annual
– Jan. put on £1,000,000 w/ strike $1.75/£; 1.5%
premium.
– Forecasts 3m future spot $1.76/£.
– Budget rate (lowest acceptable amount) $1.70/£
10
Hedging Account Receivable


Unhedged position: £1,000,000 x $1.76/£ = $1.76 m.
Forward hedge:
•
•
•
•

Forward contract & source of funds to fulfill the contract.
Forward entered @ time A/R created (October).
A/R recorded @ spot $1.764/£, so $1,764,000.
Covered (perfect) vs. uncovered (open) forward hedge.
Money market hedge:
• creates liability offset w/ asset in £: balance sheet hedge.
• borrow PV of £1,000,000: £1,000,000/1.025 = £975,610.
• exchange £975,610 at spot $1.764/£ for $1,720,976.
Received today
Invested in
Rate
Future value in 3 months
$1,720,976
$1,720,976
$1,720,976
Treasury bill
Debt cost
Cost of capital
6% annual or 1.5%/qtr $1,746,791
8% annual or 2.0%/qtr $1,755,396
12% annual or 3.0%/qtr $1,772,605
11
Option Market Hedge

Purchase put option.
• 3 month put option @ ATM strike $1.75/£, premium 1.5%:
Cost  (Size of option) x (premium) x (spot rate)
£1,000,000 x 0.015 x $1.7640  $26,460.
• Premium as of Jan $26,460  1.03 = $27,254.
• Unlimited upside, limited downside.

Breakeven price, option hedge
• Upper bound:
– If pound appreciate above $1.754/£ + $0.0273/£ = $1.7813/£.
• Lower bound
– If pound depreciates below $1.75/£ - $0.0273/£ = $1.722/£.
12
A / R Hedges
US$ value of
£1,000,000 A/R
Uncovered
Forward
$1.7540/£
1.84
1.82
ATM put option
min $1,722,746
Put strike
$1.75/£
1.80
1.78
Money market
$1,772,605 @ 12%
1.76
Forward contract
$1,754,000
1.74
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
Ending spot (US$/£)
1.78
1.80
1.82
1.84
1.86
13
Account Payable Hedge

Assume £1,000,000 A/P in 90 days
• Unhedged position: expected pay $1,760,000.
• Forward market hedge: purchase forward @ $1.754/£, cost
•
locked $1,754,000.
Money market hedge:
– Offset £ obligation by £ asset w/ matching maturity.
– Exchange US$ spot & invest for 90 days in £.
£1,000,000
 £980,392,
 
90 
1

.08
x

 
360 
 
£980,392  $1.764/£  $1,729,412.
– Carry the cost forward 90 days
 
90 
$1,729,412 x 1   0.12 x
  $1,781,294.
360 
 
14
Account Payable Hedge
 Option hedge:
• purchase call option on payable.
• ATM call option w/ strike $1,75/£ would be 1.5%
premium.
• If spot less $1.75/£ option expire & £1,000,000
purchased on spot market.
• If spot above $1.75/£ option exercised: exchange
£1,000,000 @ $1.75/£ less option premium:
£1,000,000 x 0.015 x $1.75/£  $26,460
• Carried forward 90 days @ 12% p.a. premium $27,254.
Exercise call option (£1,000,000  $1.75/£
Call premium (carried forward 90 days)
Total maximum expense of call option hedge
$1,750,000
$27,254
$1,777,254
15
A / P Hedges
US$ value of
£1,000,000 A/R
Uncovered
Forward
$1.754/£
1.84
1.82
Call strike
$1.75/£
1.80
Call option:
$1,777,254
1.78
Money market
$1,781,294
1.76
Forward contract
$1,754,000
1.74
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
Ending spot (US$/£)
1.78
1.80
1.82
1.84
1.86
16
Forex Risk Management for Real
 Goals?
• cost center vs. profit center.
 Exposures?
• backlog exposure?
• selectively hedge backlog & anticipated exposures?
 Contractual Hedges?
• Amount of risk covered, proportional hedges?
• Currency options?
17
Things to remember
 Types of forex exposures
•
•
•
•
Transaction
Operating
Translation
Tax
 How to hedge A/R & A/P transaction exposure?
• Money market?
• Forward market?
• Option market?
18