Transaction Exposure

1
Chapter 8 Transaction Exposure
2
Chapter 8Transaction Exposure

• Learning Objectives
• Distinguish between the three major foreign
  exchange exposures experienced by firms
• Identify foreign exchange transaction exposure
• Analyze the pros and cons of hedging foreign
  exchange transaction exposure
• Identify the alternatives available to a firm
  for managing a large and significant transaction
  exposure
• Evaluate the institutional practices and concerns
  of foreign exchange risk management

3
Foreign Exchange Exposure

• Foreign exchange exposure is a measure of the
  potential for a firms profitability, net cash
  flow, and market value to change because of a
  change in exchange rates
• These three components are the key financial
  elements of how we view a firms success, thus a
  financial manager must know how to limit the
  firms exposure to changes in exchange rates

4
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 due to be settled until after the 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

5
Foreign Exchange Exposure

• Translation Exposure also called accounting
  exposure, is the potential for accounting derived
  changes in owners 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

6
Foreign Exchange Exposure
7
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

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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
• Managements 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 firms market valuation

9
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 firms 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

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Why Hedge - the Pros Cons
Net Cash Flow (NCF)
NCF
Expected Value, E(V)
Hedging reduces the variability of expected cash
flows about the mean of the distribution. This
reduction of distribution variance is a reduction
of risk.
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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

12
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
• Transaction exposure arises because of the risk
  that Trident will 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

13
Purchasing or Selling on Open Account

• Trident might have avoided transaction exposure
  by invoicing the Belgian buyer in US dollars, but
  this might have lead to 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

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Purchasing or Selling on Open Account
Life Span of a Transaction Exposure
15
Borrowing and Lending

• A second example of transaction exposure arises
  when funds are loaned or borrowed
• Example PepsiCos 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/US
• On 12/22/94, the government allowed the peso to
  float due to internal pressures and it sank to
  Ps4.65/US

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Borrowing and Lending

• Gemexs peso obligation now looked like this
• Dollar debt mid-December, 1994
• US264,000,000 ? Ps3.45/US Ps910,800,000
• Dollar debt in mid-January, 1995
• US264,000,000 ? Ps5.50/US Ps1,452,000,000
• Dollar debt increase measured in Ps
• Ps541,200,000
• Gemexs dollar obligation increased by 59 due to
  transaction exposure

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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

18
Contractual Hedges

• Transaction exposure can be managed by
  contractual, operating, or financial hedges
• The main contractual hedges employ forward,
  money, futures and options markets
• 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 payable arising from the conduct of
  business
• A financial hedge refers to either an offsetting
  debt obligation or some type of financial
  derivative such as a swap

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Tridents Transaction Exposure

• Maria Gonzalez, 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
  three months time, June
• Assumptions
• Spot rate is 1.7640/
• 3 month forward rate is 1.7540/ (a 2.2676
  discount)
• Tridents 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.

20
Tridents Transaction Exposure

• Assumptions
• 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 1.5 premium
• Tridents foreign exchange advisory service
  forecasts future spot rate in 3 months to be
  1.7600/
• Trident operates on thin margins and Maria wants
  to secure the most amount of US dollars her
  budget rate (lowest acceptable amount) is
  1.7000/

21
Tridents Transaction Exposure

• Maria faces four possibilities
• Remain unhedged
• Hedge in the forward market
• Hedge in the money market
• Hedge in the options market

22
Tridents Transaction Exposure

• Unhedged position
• Maria may decide to accept the transaction risk
• If she believes that the future spot rate will be
  1.76/, then Trident will receive 1,000,000 x
  1.76/ 1,760,000 in 3 months time
• However, if the future spot rate is 1.65/,
  Trident will receive only 1,650,000 well below
  the budget rate

23
Tridents Transaction Exposure

• Forward Market hedge
• A forward hedge involves a forward or futures
  contract and a source of funds to fulfill the
  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 Trident does not have an offsetting A/P in the
  same amount, then the firm is considered uncovered

24
Tridents Transaction Exposure

• Forward Market hedge
• Should Maria want to cover this exposure with a
  forward contract, then she will sell 1,000,000
  forward today at the 3 month rate of 1.7540/
• She is now covered and Trident no longer has
  any transaction exposure
• 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 Tridents books as a
  foreign exchange loss of 10,000 (1,764,000 as
  booked, 1,754,000 as settled)

25
Tridents Transaction Exposure

• Money Market hedge
• 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
• Hedges can be left open (i.e. no investment) or
  closed (i.e. investment)

26
Tridents Transaction Exposure

• Money Market hedge
• To hedge in the money market, Maria 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, Maria needs to
  discount the PV of the 1,000,000 to today
• 1,000,000/1.025 975,610
• Maria should borrow 975,610 today and in 3
  months time repay this amount plus 24,390 in
  interest (1,000,000) from the proceeds of the
  sale

27
Tridents Transaction Exposure

• Money Market hedge
• Trident would exchange the 975,610 at the spot
  rate of 1.7640/ and receive 1,720,976 at once
• This hedge creates a pound denominated liability
  that is offset with a pound denominated asset
  thus creating a balance sheet hedge

28
Tridents Transaction Exposure

• In order to compare the forward hedge with the
  money market hedge, Maria 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
• Three logical choices exist for an assumed
  investment rate for the next 3 months

29
Tridents Transaction Exposure

• First, if Trident is cash rich the loan proceeds
  might be invested at the US rate of 6.0 p.a.
• Second, Maria could use the loan proceeds to
  substitute an equal dollar loan that Trident
  would have otherwise taken for working capital
  needs at a rate of 8.0 p.a.
• Third, Maria might invest the loan proceeds in
  the firm itself in which case the cost of capital
  is 12.0 p.a.

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
30
Tridents 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 Maria used
  the proceeds to replace a dollar loan (8) or
  conduct general business operations (12)
• The forward hedge would be preferable if Maria
  were to just invest the loan proceeds (6)
• We will assume she uses the cost of capital as
  the reinvestment rate

31
Tridents Transaction Exposure

• A breakeven investment rate can be calculated in
  order to forgo numerous calculations and still
  aid Maria in her decision

• To convert this 3 month rate to an annual rate,

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Tridents Transaction Exposure

• In other words, if Maria 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
• The following chart shows the value of Tridents
  A/R over a range of possible spot rates both
  uncovered and covered using the previously
  mentioned alternatives

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Tridents Transaction Exposure
34
Tridents Transaction Exposure

• Option market hedge
• Maria could also cover the 1,000,000 exposure by
  purchasing a put option. This allows her to
  speculate on the upside potential for
  appreciation of the pound while limiting her
  downside risk
• Given the quote earlier, Maria could purchase 3
  month put option at an ATM strike price of
  1.75/ and a premium of 1.5
• The cost of this option would be

35
Tridents Transaction Exposure

• Because we are using future value to compare the
  various hedging alternatives, it is necessary to
  project the cost of the option in 3 months
  forward
• 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
• Since the upside potential is unlimited, Trident
  would not exercise its option at any rate above
  1.75/ and would purchase pounds on the spot
  market
• If for example, the spot rate of 1.76/
  materializes, 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

36
Tridents Transaction Exposure

• Unlike the unhedged alternative, Maria has
  limited downside with the option
• Should the pound depreciate below 1.75/, Maria
  would exercise her option and exchange her
  1,000,000 at 1.75/ receiving 1,750,000
• Less the premium of the option, Maria nets
  1,722,746
• Although this downside is less than that of the
  forward or money market hedge, the upside
  potential is not limited

37
Tridents Transaction Exposure

• As with the forward and money market hedges,
  Maria can also calculate her breakeven price on
  the option
• 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 in a
  similar manner
• If the pound depreciates below 1.75/, the net
  proceeds would be 1.75/ less the cost of
  0.0273/ or 1.722/

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Tridents Transaction Exposure
39
Tridents Transaction Exposure
Option cost (future cost) 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/
40
Strategy Choice and Outcome

• Trident, like all firms, must decide on a
  strategy to undertake before the exchange rate
  changes but how will Maria choose among the
  strategies?
• Two criteria can be utilized to help Maria choose
  her strategy
• Risk tolerance - of the firm,as expressed in its
  stated policies and
• Viewpoint Marias own view on the expected
  direction and distance of the exchange rate

41
Strategy Choice and Outcome

• After all the strategies have been explained,
  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 and Maria has a budget
  rate at which she cannot fall below on this
  transaction

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Strategy Choice and Outcome
Remain uncovered Unknown
Forward Contract hedge _at_ 1.754/ 1,754,000
Money market hedge _at_ 8 p.a. 1,755,396
Money market hedge _at_ 12 p.a. 1,772,605
Put option hedge _at_ strike 1.75/
Minimum if exercised 1,722,746
Maximum if not exercised Unlimited
43
Managing an Account Payable

• Just as Marias alternatives for managing the
  receivable, 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 1.76/ then Trident would
  pay 1,760,000 but this amount is not certain

44
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 spot 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

45
Managing an Account Payable

• Using a money market hedge
• To ensure that exactly 1,000,000 will be
  received in 90 days time, Maria discounts the
  principal by 8 p.a.

• This 980,392.16 would require 1,729,411.77 at
  the current spot rate

46
Managing an Account Payable

• Using a money market hedge
• Finally, carry the cost forward 90 days in order
  to compare the payout from the money market hedge

• This is higher than the forward hedge of
  1,754,000 thus unattractive

47
Managing an Account Payable

• Using an option hedge instead of purchasing a
  put as with a receivable, Maria would want to
  purchase a call option on the payable
• The terms of an ATM call option with strike price
  of 1,75/ would be a 1.5 premium

• Carried forward 90 days the premium amount is
  comes to 27,254

48
Managing an Account Payable

• Using an 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/ 1,750,000 Call option premium (carried
forward 90 days) 27,254 Total maximum
expense of call option hedge 1,777,254
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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

50
Risk Management in Practice

• Which Contractual Hedges?
• Transaction exposure management programs are
  generally divided along an option-line those
  which use options and those that do not
• Also, these programs vary in the amount of risk
  covered these proportional hedges are policies
  that state which proportion and type of exposure
  is to be hedged by the treasury

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Summary of Learning Objectives

• MNEs encounter three types of currency exposure
  (1) transaction (2) operating and (3)
  translation exposure
• Transaction exposure measures gains or losses
  that arise from the settlement of financial
  obligations whose terms are stated in a foreign
  currency
• Operating exposure measures the change in the
  present value of the firm resulting from any
  change in future operating cash flows caused by
  an unexpected change in exchange rates
• Translation exposure is the potential for
  accounting-oriented changes in owners equity
  when a firm translates foreign subsidiaries
  financial statements to consolidated financial
  statements

52
Summary of Learning Objectives

• Transaction exposure arises from (1) purchasing
  or selling on credit and prices are stated in
  foreign currencies (2) borrowing or lending
  funds when repayment is to be made in a foreign
  currency (3) being party to an unperformed
  forward contract and (4) otherwise acquiring
  assets or liabilities denominated in foreign
  currencies
• Considerable theoretical debate exists as to
  whether or not firms should hedge currency risk

53
Summary of Learning Objectives

• Transaction exposure can be managed by
  contractual techniques and certain operating
  strategies. Contractual techniques include
  forward contracts, money market and option hedges
• The choice of which hedge to use depends on the
  individual firms currency risk tolerance and its
  expectations of the probable movement of exchange
  rates over the transaction exposure period

54
Summary of Learning Objectives

• In general, if an exchange rate is expected to
  move in a firms favor, the preferred contractual
  hedges are those which allow the firm to
  participate in some of the upside potential, but
  protect it against adverse exchange rate
  movements
• In general, if an exchange rate is expected to
  move against the firm, the preferred contractual
  hedge is one which locks-in an exchange rate

55
Summary of Learning Objectives

• Risk management in practice requires a firms
  treasury department to identify its goals. Is
  the treasury a cost or a profit center?
• Treasury must also choose which contractual
  hedges it wishes to use and what proportion of
  the currency risk should be hedged.
  Additionally, treasury must determine whether the
  firm should buy and/or sell currency options, a
  strategy that has historically been risky for
  some firms and banks