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7.

Transaction Exposure
7-1. Foreign Exchange Exposure- a general definition of foreign exchange exposure. In its most general sense, foreign exchange exposure is the possibility of either beneficial or harmful effects on a company caused by a change in foreign exchange rates. The effect on the company may be on its profits, its cash flows, or its market value. 7-2. Exposure Types. The differences among transaction, operating, and translation exposure are: a. Transaction exposure is the potential for a gain or loss in contractedfor, near-term cash flows caused by a foreign-exchange-rate-induced change in the value of amounts due to the MNE or amounts that the MNE owes to other parties. As such, it is a change in the home currency value of cash flows that are already contracted for. b. Operating exposure is the potential for a change in the value of an MNE, usually viewed as the present value of all future cash inflows, caused by unexpected exchange rate changes. As such, it is a change in expected long-term cash flows; i.e., future cash flows expected in the course of normal business but not yet contracted for. c. Translation exposure is the possibility of a change in the equity section (common stock, retained earnings, and equity reserves) of an MNEs consolidated balance sheet, caused by a change (expected or not expected) in foreign exchange rates. As such it is not a cash flow change, but is rather the result of consolidating into one parent companys financial statement the individual financial statements of related subsidiaries and affiliates.

7-3. Translation versus Transaction Exposure. Translation exposure measures accounting (book) gains and losses from a change in exchange rates, and therefore does not alter corporate cash flows. Transaction exposure measures cash (realized) gains and losses from a change in exchange rates, and therefore does alter corporate cash flows. 7-4. Tax Exposure. Tax exposure is separate from the triumvirate of transaction, operating, and accounting exposure because it is basically the tax consequences of a gain or loss caused by this triumvirate. Transaction exposure is a cash loss and so results in a tax savingsin the sense that a lowering of profits because of a transaction loss lowers income taxes, other things being equal. Any loss from operating exposure is difficult to measure; a resultant drop in market value of an MNEs shares has no tax consequences for the companyalthough it may have tax consequences for investors holding the shares. To the extent that operating exposure causes a lowering of corporate profits in future years, taxes in those years are reduced. Translation exposure is a measurement loss, rather than a cash loss, and so has no tax consequences. 11-5. Hedging. A hedge is the acquisition of a contract or a physical asset that will offset a change in value of some other contract or physical asset. Hedges are entered into to reduce or eliminate risk. Exhibit 7.1 in the text shows two normal distributions about a mean called expected value.

Exibit 7.1 The impact of the hedging on the CF


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Exibit

a. The areas toward the center of the distributions, where the hedged line is higher than the unhedged line, implies that a greater proportion of expected values will be near the expected mean value when the cash flows are hedged. Variability of expected results is reduced. b. The areas toward the outlying edges of the distributions, where the unhedged line is higher than the hedged line, imply that a greater likelihood exists for significantly higher cash flows as well as significantly lower cash flows than exist when the cash flows are hedged. Hedging is not cost free; something is paid to obtain the hedge. Hence the expected value for hedged cash flows should be that of the unhedged cash flow less the cost of the hedge. Thus one might argue that the mean expected value of the hedged cash flow should be to the left of that for the unhedged cash flow. (No reason exists for the mean cash flow of the hedged flows to be to the right of that for the unhedged cash flows.)

7-6. Investor Expectations. Proponents of the efficient market hypothesis argue that an MNE should not hedge because investors can hedge themselves if they do not like the foreign exchange risks carried by the firm. Proponents of the efficient market hypothesis believe that the current market price of an MNEs shares of stock fully and appropriately discounts all the risks of the firm, including foreign exchange risk, and that the firm should not pay the cash cost of hedging because investors can individually hedge or not as they see fit, and that the present share price already reflects this risk. These proponents also argue that the propensity to carry risk is different for management than for shareholders, and that risk hedging is often undertaken by management to protect its own interests, which differ from the interests of shareholders. Lastly they argue that management is more likely to hedge accounting risks, which are more precisely measured, than operating risks, which are conceptual and deal with future expectations. The argument that management might appropriately hedge its foreign currency risks is based on the logic that management has firsthand knowledge of foreign currency risks, that the nature and magnitude of these risks change from day to day (or at least month to month), and that the specifics of such risks cannot be known (and so discounted) by the impersonal forces of an efficient market. Other arguments in favor of hedging include improved cash flow management for the firm and the need to preserve liquidity for debt service and/or unexpected variations in near-term cash flows. 7-7. Creating Transaction Exposure. In order to identify and create a hypothetical example for each of the four causes of transaction exposure lets assume a hypothetical U.S. company named Smith Company. a. Purchasing or selling on open account. Smith Company sells goods to a buyer in Great Britain with the sale denominated in British pounds sterling and payment due in 60 days.
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When Smith Company receives the pounds sterling 60 days after the sale, the U.S. dollar value of those pounds may be less, or more, than was expected at the time of sale. b. Borrowing and lending. Smith Company finds that it can borrow Swiss francs at 4% per annum interest, and exchange them for the needed U.S. dollars, whereas borrowing dollars in the U.S. will cost 7% per annum. Hence it borrows Swiss francs for one year in order to save on the interest cost. One year hence the Swiss franc has strengthened against the dollar by more than the 3% interest differential, and the Swiss franc borrowing ends up costing more than 7% in U.S. dollar terms. c. Owning an unperformed foreign exchange forward contract. Believing that the Japanese yen will weaken within three months, Smith Company decides to speculate by selling yen forward. It hopes to profit by buying the yen to deliver against this forward sale at a cheaper exchange rate in three months. In fact the yen strengthens and Smith Company must buy yen to cover its forward yen obligation at a price higher than will be received via the forward sale. d. Acquiring assets or incurring liabilities denominated in foreign currencies. Having excess cash and faced with euro interest rates of 8% and U.S. rates of 5%, Smith Company invests the cash in euro money market obligations. At maturity the euro has weakened by more than three percentage points and Smith Company ends up earning in dollars less than the 5% it could have earned by investing in a U.S. dollar asset. Transaction exposure arises from the payment of one currency to a party wanting, in the end, a different currency. Thus a movement of currency value from one currency to another is required. Foreign currency cash balances held for operating purposes by a foreign subsidiary are not

inherently intended for exchange for another currency, nor is such an exchange required. Hence they do not create transaction exposure. (They do, however, create translation exposure.) 7-8. Natural versus Contractual Hedges. The difference between a natural hedge and a contractual hedge. Give a hypothetical example of each. A natural hedge is one that results from matching foreign currency cash flows that come about from the normal operations of a MNE. An example would be for a MNE that had euro operating inflows from sales to borrow an equivalent amount of euros to finance working capital. Should the dollar/euro exchange rate change, any gain or loss from the euro operating inflows would be offset by a loss or gain on the euro borrowing. In effect, the euro operating inflows would be used to pay the euro debt. Any foreign exchange transaction is avoided. A contractual hedge is a contract specifically entered into as a financial rather than operating hedge. Examples are forward and future foreign exchange agreements, money market hedges, and the purchase of options. 7-9. Risk Tolerance. Risk tolerance is the psychological or philosophical willingness of a firm, or of its managers, to bear risk. As such, it cannot be measured or quantified, although observations and comparisons of management decisions over time can provide a rough inkling of such managements risk tolerance. Variations in risk tolerance reflect the fact that different individuals have different opinions about whether or not a risk is worth bearing, or conversely, whether or not a risk should be left open ended or hedged.