Transaction Exposure

(Hedging and Foreign Exchange Risk Management)

Contents
1. Alternative Ways of Hedging Against Exchange Risk on Transaction
2. Hedging Through Options

Learning Objectives:
1. Identify transaction exposure,. Which assets or liabilities and cash flows are
exposed to changes in exchange rates?
2. Strategies to hedge or not to hedge against the exchange rate risk. How to
manage transaction exposure?
3. How to conduct hedging through a forward contract?
4. How to conduct a spot hedge or a money-market hedge?
5. How to conduct hedging through an option?
6. Evaluate various strategies and make a decision in favor of a certain strategy.

Hedging and Foreign Exchange Risk

Management
Various currency derivatives such as forward, futures, and options may be used to
hedge against the exchange risk. An example presented here illustrates various
hedging strategies to protect transaction exposure against exchange rate changes.

1.0 ALTERNATIVE WAYS OF HEDGING AGAINST EXCHANGE

RISK IN TRANSACTIONS
Example:
General Dynamics, Inc., a US MNC, sells a gas turbine for power generation, to a
British firm in March for 1 million. Payment is due in June.
The following quotes are observed:
Spot exchange rate
$1.400/
3-month forward rate
$1.4175/
UK 3-month interest rate
8% p.a.
US 3-month interest rate
10% p.a.
June Put option on Philadelphia Options Exchange for 12,500:
Strike price 140:2.50 cents/. Brokerage cost $25 per contract.
June put option in the OTC market at strike price of 140:2% premium.
Forecast of future spot rate: 3-month spot rate $1.4350/.
Four alternatives will be considered:
1.
2.
3.
4.

Speculate or remain un-hedged

Forward market hedge
Money market hedge
Option market hedge

2.0 Objective:
To hedge the transaction exposure on current asset of accounts receivable that
comes in existence in March, and to maximize dollar receipt against the accounts
receivable denominated in pounds.
The main concern is that pound will depreciate against dollar (or dollar will appreciate
against pound) so that dollar receipt against pound receivables will be adversely
affected.
2.1 Remain un-hedged
GD may be just happy with the transaction risk. If the managers of GD place a very
high trust in the Foreign Exchange Advisorys forecast of $1.4350/, they may decide
not to hedge. In this case they are exposed to risk,and their expected receipt is
1,000,000($1.4350/)=$1,435,000 in 3 months. (This amount, however, is at risk).
Suppose, if the pound falls to $1.3800/ in June, GD would receive only $1,380,000
($1,435,000- $1,380,000= $55,000 less). However, if the transaction were left
uncovered and pound strengthened even more than the forecast, GD could receive
more than $1,435,000. Thus, depending upon the future spot rate, there will be
transaction gain or loss.

2.2 Forward Market Hedge

This hedge involves a forward contract and a source of funds to fulfill that contract.
The forward contract is entered into at the time the transaction exposure is created. In
the case of GD, the transaction exposure is created in March, when the sale to the
British firm was booked as an account receivable. If the funds to fulfill the contract are
either in hand or due because of business operation, the hedge is considered "covered",
"perfect" or "square" because no residual foreign exchange risk is left. Funds on hand
or to be received are matched by funds to be paid.
If the funds to fulfill the forward exchange contract are not already available or
due later, but must be purchased in the spot market at some future date, then such a
hedge is "open" or "uncovered".
The dollar value of receivables through forward hedge = 1,000,000 x$1.4175/
= $1.4175 million.

2.3 Money Market Hedge or Spot market Hedge

Like a forward market hedge, a money market hedge or Spot market Hedge also
involves a contract and a source of funds to fulfill that contract. In this instance, the
contract is a loan agreement. The firm seeking the money market hedge borrows in
one currency and exchanges the proceeds for another currency. Funds to fulfill the
contract to repay the loan may be generated from business operations.
Note: The cost of money market hedge is determined by interest rate differential. If
the markets are efficient, such that the interest rate parity (IRP) holds, the cost of
forward market hedge and money market hedge will be identical.
How the money market hedge is conducted
Note that funds in are generated due to business operations in the form of receivables. One can borrow (enter into a loan agreement) against the current asset of
accounts receivables, which serves as a collateral.

1.

Borrow pounds. How much? Of course the present value of 1,000,000. GD

will need to borrow just enough to repay both principal and interest with the sale
proceeds (1,000,000). The interest is 8% per annum (or 2% for 3 months)
PV=1,000,000/1.02=980,393.
The firm should borrow 980,392 and after 3 months repay that amount plus the
interest of 19,608.
2.

Exchange 980,392 for $ at the current spot rate of $1.40/ and receive

$1,372,549.
3.

Invest in $ money market at the 3-month rate of 2.50% (10% per annum) to

receive in June:
FV=$1,372,549 (1+0.025)=$1,406,862.73
Note that the above cash flow is less than that obtained through the forward market
hedge because quarterly forward rate differential is not equal to the quarterly interest
rate differential (you may like to verify this proposition by calculating the forward and
interest rate differentials and checking whether the IRP holds). Since the IRP does not
hold, under the given conditions, the forward hedge is superior to the money market
hedge.

2.4 Options Market Hedge

2.41 PHLX Options
GD could cover its 1,000,000 exposure by purchasing a put option on . The idea is
to take advantage on the upside potential on the value of while limiting the downside
risk to a known amount.
1.

GD can buy a put option on PHLX with a June expiration date, a strike of 140,

a premium cost of 2.50 cents per pound, and a contract size of 12,500.
2.

Through the put options, GD can lock in the minimum price of in dollars.

Put options on means option to sell . Accounts receivables are the source of , but
the put option enables to hedge against the depreciation of .
3.

Premium Cost $0.025/.(12,500)=$312.50 per one option contract.

Brokerage Cost

=25.00 per one option contract

Total Cost

=$337.50 per one option contract

Option Cost per

=$337.50/$12500=$0.027/

Number of options needed=1,000,000/12500=80

Total Cost for 80 options=80.($337.50)=$27,000.

2.42 OTC Options
Alternatively GD could also buy a similar put from a participating international bank
over-the-counter (OTC) for a 2% premium.
1. Up-front premium cost = size of option * premium.
= 1,000,000x$1.40/x$0.02/ = $28,000.
Therefore, GD should choose OTC put option, which costs $1000 less.
2. When a sum of 1,000,000 is received in June, the value in dollars will depend
upon the spot rate in June.
Consider the following two scenarios:
A.

depreciates against dollar (for example $1.35/).

B. appreciates against dollar. At any exchange rate above $1.400 (the exercise
price), GD would allow its option to expire unexercised and would exchange
the pounds for dollars at the spot rate. That rate could be $1.4175 (the forward
rate), $1.4350 (the expected forecast rate), or any other higher rate.
For instance, if the expected rate of $1.4350 is realized in June, then GD will receive
1,000,000=$1,435,000 in the future spot market.
Net proceeds=1,4365,000-27,000 (ignoring the interest cost on $27,000 from March to
June)
=$1,408,000
The downside risk is limited with an option. If the pound depreciated below $1.4000,
GD would exercise its option to sell (put) 1,000,000 at $1.4000/ receiving
$1,400,000 gross, and a net of the $1,373,000 after the premium cost. Although this

downside result is worse than the downside of the forward or money market hedges,
the upside potential is not limited. Thus the superiority of the option strategy over
other hedges depends upon the degree to which the management is riskaverse.
The break even upside spot price of must be
1.4175+0.0270=1.4445.
If the pound has a considerable volatility, there is good chance that it may appreciate
against dollar above $1.4455/, then the option would be a better strategy.

3.0

Graphical Presentation of Various Hedging Alternatives

Spot at
maturity
$/ (X)

Unhedged (Y1)

Forward Hedge (Y2)

Money market Hedge

(Y3)

Option Market Hedge

(Y4)

Total
Recepts
$
million

Recept Per
unit $/

Total
Recepts
$
million

Recept
Per unit
$/

Total
Recepts
$ million

Recept Per
unit $/

Total
Recepts
$
million

Receipt
Per unit
$/

1.35

$ 1.35/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.3730

$ 1.3730/

ITM

1.36

1.3

$ 1.36/

1.41 5

$ 1.4175/

1.40682

$ 1.40682/

1.3730

$ 1.3730/

ITM

1.37
1.38

1.37

$ 1.37/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.3730

$ 1.3730/

ITM

1.38

$ 1.38/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

$ 1.3730/

ITM

1.39

$ 1.39/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.373
=
1.3730

$ 1.3730/

ITM

1.40

1.40

$ 1.40/

1.4175

$ 1.4175/

$ 1.40682/

1.3730

$ 1.3730/

ATM

1.41
1.4175*

1.41

$ 1.41/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

$ 1.3830/

OT

1. 175

$ 1.4175/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.3905

$ 1.3905/

OTM

1.42

1.42

$ 1.42/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.3930

$ 1.3930/

OTM

1.43
1.4350**

1.43
1.4 50

$ 1.43/
$ 1.4350/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.4030

$ 1.4030/

OTM

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.4080

$ 1.4080/

OTM
OTM
OTM

1.35

1. 9

1.3830

1.44

1.44

$ 1.44/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.4130

$ 1.4130/

1.45

1.45

$ 1.45/

1.4175

$ 1.4175/

1.4068

$ 1.40682/

1.4230

$ 1.4230/

1.46

1.46

$ 1.46/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.4330

$ 1.4330/

OTM

1.47

1.47

$ 1.47/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.4430

$ 1.4430/

OTM

1.48

1.48

$ 1.48/

1.4175

$ 1.4175/

1 40682

$ 1.40682/

1. 530

$ 1.4530/

TM

1.49

1.49

$ 1.49/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.4630

$ 1.4630/

OTM

1.50

1.50

$ 1.50/

1.4175

$ 1.4175/

1.40682

$ 1.40682/

1.4730

$ 1.4730/

OTM

1.51

1.51

$ 1.51/

1. 175

$ 1.4175/

1.40682

$ 1.40682/

1.4830

$ 1.4830/

OTM

* Forward Rate
** Forecast Rate

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3.1

Interpretation of the Graph

Following the graph of alternative hedges we can conclude:

1.

If St ($/) < $ 1.400/ (put is ITM), the put option will be exercised at the

exercise price of x = 1.4. The portfolio value (underlying current assets of accounts
receivable + the put option ) is:
$ 1.4000/ * 1,000,000 27,000 = 1,373,000
So if depreciates unduly below the exercise price, the dollar value of accounts
receivable is protected and a guaranteed sum of $ 1,373,000 will be received.
2.

If St = 1.435 ( The forecast of exchange rate is realized, put is OTM)

The put option will not be exercised because it is more profitable to sell in the spot
market at the exchange rate of $ 1.435/.

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3.

Suppose we want to compare the forward and option hedges. What is the spot

rate at which the two hedges are equivalent?

F * (1m) = St (/m) P (1m)
F

St P

1.4175 =

St 0.027

St

1.4445

If the spot rate exceeds $1.44$/, then option is a better choice.

3.2

Conclusion

If you expect that the spot exchange rate will be realized in the range 1.373
1.4450, then both remaining unhedged and the forward hedge are superior to
the put option hedge

If you expect that S will be realized above 1.4450, then put option hedge is a
better choice.

If S < 1.3730, then forward hedge may be a good choice.

If exchange rates are highly volatile (large variability), so that there is a high
probability that the spot rate will shoot above 1.4445, then put option hedge is
quite desirable.

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4.0

Summary of Hedging Actions

GOAL:
Receive ____
maximum $
from sale

ALTERNATIVES

RESULTS

Unhedged
Wait 3 months, then
sell 1m for $ in the
spot market.

Receive in 3 months
1. An unlimited
Max.
2. An Exp.
$1,435,000.
3. A Min of zero.

FWD, MKT, HEDGE

Sell 1m forward for
$
@ ST =$1.4175/ to
get $1,417,500 three
months later.
MONEY MKT,
HEDGE
borrow 980,392 in
U.K. (PV of
1m)@8% p.a. Buy
spot $@$1.4/ to get
$1,372,549 which can
be invested in US for
3 months.
OPTION MKT,
HEDGE
buy 3-month PUT of
1m Exercise price
S=$1.40/ p=$27,000

Receive $1,417,500
in 3 months (certain)

Receive $1,372,549
in March. Future
value after 3 months
depends on US Int
rate. i s . with
i s =10% receive
$1,406,862.73
1. Receive in 3
months (unlimited
Max -27,000)
2. An expected
amount of 1,408,000
3. A Min 1,373,000

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HEDGING THROUGH AMERICAN OPTIONS: THE CASE OF GENERAL

DYNAMICS (The payment date is not certain)
Example:
General Dynamics, a U.S. importer will have a net cash outflow of 250,000 in
payment for goods bought. The payment date is not known with certainty, but should
occur around October 31. On September 16 the importer looks in a ceiling purchase
for pounds by buying eight PHLX calls on the pound, with a strike price of $1.5/ and
an expiration date in December. The option premium on that date is $0.0220/. There
is a brokerage commission of $4 per option contract for each transaction of buy or sell.
The opportunity cost on funds is 9% p.a. (Assume 360 days in a year).
1. What is the initial total cost of eight options contracts?
2. What is the ceiling price of in dollars that the importer has assured though the
options?
3. Consider two possible scenarios on Nov. 30:
a)

spot exchange rate is $1.46/:

b)

spot exchange rate is $1.55/

In each scenario, determine whether the importer should exercise the options, and find
the cost of in terms of $. On October 30, the call premium has increased to $0.055/
for the same options that mature in December.
We will answer the above questions as follows:

The total cost of the eight contracts is:

8( 31,250)($0.0220)+8($4)=$5,532

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If opportunity cost for about 45 days (Sept 16 to October 30) is also considered, then
the total cost is:
5,532(1+0.01125)=5594.235
Or, $5594.235/250,000 = $0.022377/

Measured from todays viewpoint, the importer has essentially assured that the

purchase price for pounds will not be greater than

$1.50/ + $0.022377/ = $1.522377/
Notice here that the add factor $0.022377/ is larger than the option premium of
$0.0220/ by $0.000377/, which represents the dollar brokerage cost and opportunity
cost for 45 days.
The number $1.52237 is the importers ceiling price (the maximum price). The
importer is assured he will not pay more than this, but he could pay less. The price the
importer will actually pay will depend on the spot price on the October payment date.
To illustrate this, we consider two possible scenarios for the spot rate on October 30 .
Suppose the spot rate on October 30 payment date is $1.46/. The importer would
not use the options but would buy pounds spot for the cheaper rate of $1.46/. He or
she would then sell the eight calls for whatever market value they hold. Given the
brokerage fee of $4 per contract for the sale, the options would be sold as long as their
market value was greater than $4 per option. The total cost per pound will be:
=$1.46/ + $0.022377/ - 0.055 + [(8x4)/250,000] = $1.427/
Suppose the spot rate on October 30 is $1.55/.
Here, we are required to find the alternative, whether to exercise or not to exercise,
that gives lower cost.

15

a. If GD does not exercise the option.

The cost of
= spot price + (call premium paid initially + interest foregone) - (call premium
received from sale of unexercised option) + brokerage cost of setting options
= $1.55/ + $0.022377/ - 0.055 + [(8x4)/250,000] = $1.49537/
b. If GD exercises the options, the cost of in $ is:
= strike price + call premium paid initially + brokerage fee + interest
foregone
=$1.50/ + $0.022377/
=$1.52377/ (greater than $1.49537/ in a. above)
Hence, the US importer is better of by not exercising the options even though the spot
rate is above exercise price.

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