Chapter 8: Management of Transaction Exposure

Chapter
MANAGEMENT OF TRANSACTION EXPOSURE

Chapter Outline
1. Forward Market Hedge
2. Money Market Hedge
3. Options Market Hedge
4. Cross-Hedging Minor Currency Exposure
5. Hedging Contingent Exposure
6. Hedging Recurrent Exposure with Swap Contracts
7. Hedging Via Leading and Lagging
8.0 INTRODUCTION TO TRANSACTION EXPOSURE
Transaction exposure is the degree to which the value of future cash transactions can be
affected by exchange rate fluctuations. The value of a firms future contractual
transactions in foreign currencies is affected by exchange rate movements. The
sensitivity of the firms contractual transactions in foreign currencies to exchange rate
movements is referred to as transaction exposure. Transaction exposure can have a
substantial impact on a firms value. It is not unusual for a currency to change by as
much as 10 percent in a given year. If an exporter denominates its exports in a foreign
currency, a 10 percent decline in that currency will reduce the dollar value of its
receivables by 10 percent. This effect could possibly eliminate any profits from
exporting.
When transaction exposure exists, the firm is required to identify its degree of
transaction exposure,decide whether to hedge its exposure, and choose among the
available hedging techniques if it decides on hedging. MNCs will normally compare
the cash flows that could be expected from each hedging technique before determining
which technique to apply. Hedging techniques include:

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Chapter 8: Management of Transaction Exposure

1. Futures hedge,
2. Forward hedge,
3. Money market hedge, and
4. Currency option hedge.
8.1 FORWARD MARKET HEDGE
A forward hedge differs from a futures hedge in that forward contracts are used instead
of futures contract to lock in the future exchange rate at which the firm will buy or sell
a currency. Recall that forward contracts are common for large transactions, while the
standardized futures contracts involve smaller amounts.
Futures hedge involves the use of currency futures. To hedge future payables, the firm
may purchase a currency futures contract for the currency that it will need. To hedge
future receivables, the firm may sell a currency futures contract for the currency that it
will be receiving.
An exposure to exchange rate movements need not necessarily be hedged, despite the
ease of futures and forward hedging.Based on the firms degree of risk aversion, the
hedge-versus-no-hedge decision can be made by comparing the known result of
hedging to the possible results of remaining unhedged.
If you are going to owe foreign currency in the future, agree to buy the foreign currency
now by entering into long position in a forward contract and If you are going to owe or
receive to foreign currency in the future, agree to buy or to sell the foreign currency
now by entering into long or short position in a forward contract.
Example 1 Forward Contract
You are a Somali importer of Italian shoes and have just ordered next years inventory.
Payment of 100M is due in one year, how can you fix the cash outflow in dollars?
Assuming Forward rate of $1.50.

Scenarios
1
2

Possible Future Spot Rates

$1.80
$1.20

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Chapter 8: Management of Transaction Exposure

Solution
Enter a long forward contract 100M in one year.
Scenario1: The importer will be better off if the euro depreciates: he still buys 100m
but at an exchange rate of only $1.20/ he saves $30 million relative to $1.50/
Scenario2: If you agree to buy 100 million at a price of $1.50 per pound, you will lose
$30 million if the price of the euro falls to $1.20/.

Example 2 Forward or Future hedge Payable

Coca- Cola Co. is a Somali-based MNC that will need 100,000 euros in one year. It
could obtain a forward contract to purchase the euros in one year. The one-year forward
rate is $1.20, the same rate as currency futures contracts on euros. If Coca- Cola
purchases euros one year forward, find the dollar cost in one year.

Solution
Cost = Payables Forward rat=100,000 $1.20=$120,000
8.2 MONEY MARKET HEDGE
A money market hedge involves taking one or more money market position to cover a
transaction exposure. If a firm has excess cash, it can create a simplified money market
hedge.

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Chapter 8: Management of Transaction Exposure

Strategy on Future Receivables

Strategy on Future Payables

1. borrow HC ($)
2. Convert FC ()
3. Invest in FC ()
4. Repay in HC ($)

1.
2.
3.
4.

borrow FC()
Convert HC ($)
Invest in HC($)
Repay the loan in FC ()

Example 3 Money Market Hedge

Coca- Cola is a Somali-based MNC that will need 100,000 in one year. Assume spot
rate today of $1.18. Money market interest rate is 8 percent per annum in the Somalia
and 5 percent per annum in euro zone. The one-year forward rate is $1.20/, the same
rate as currency futures contracts on euros. If Coca- Cola purchases euros one year
money market, find the dollar cost in one year.

Solution
1. Borrow home currency of $112,381.

P=

= 100,000/1.05 = 95,238

1 = $1.18 and 95,238 = X

Therefore, X= $112,381
2. Convert the amount of $112,381 into foreign currency () and it is the amount of
95,238.
1 = $1.18 and $112,381= Y
Therefore, Y= 95,238
3. Invest 95,238 in euro zone at 5% and receipt becomes = 95,238 (1.05) =
100,000.
4. Repay in home currency($)and amount of loan repayment=$112,381(1 .08)=
$121,371
In conclusion, forward contract hedge is better than a money market hedge because
$120,000 is less than $121,371.
8.3 OPTION MARKET HEDGE
Firms recognize that hedging techniques such as the forward hedge and money market
hedge can backfire when a payables currency depreciates or a receivables currency
appreciates over the hedged period. In these situations, an unhedged strategy would
likely outperform the forward hedge or money market hedge. The ideal hedge would
insulate the firm from adverse exchange rate movements but allow the firm to benefit
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Chapter 8: Management of Transaction Exposure

from favorable exchange rate movements. Currency options exhibit these attributes. A
currency option provides the right to buy or sell a specified amount of a particular
currency at a specified price (called the strike price, or exercise price) within a given
period of time.
Example 4 Currency Call Option
You want to consider hedging payables of 100,000 euros with a call option that has an
exercise price of $1.20, a premium of $.03, and an expiration date of one year from
now. Also assume that Coca colas forecast for the spot rate of the euro at the time
payables are due is as follows.

Future spot rates

$1.16
$1.22
$1.24

Probability
20%
70%
10%

Solution
Use of Currency Call Options for Hedging Euro Payables (Exercise the call option if
spot price is greater than strike price S > E and E=$1.20, Premium= $.03)
Scenario

Possible
future spot
rates

Premium

Exercise
Decision

Total
Amount paid
per unit

Total
Amount paid
for 100,000

1
$1.16

$.03

No

$1.19

$119,000

1.22

.03

Yes

1.23

123,000

1.24

.03

Yes

1.23

123,000

Amount= $119,000 20%+ 123,000 70% + 123,000 10%=$122,200

In conclusion, forward contract hedge is better than option market hedge because
$120,000 is less than $122,200.
Optimal Hedge versus No Hedge
Even when an MNC knows what its future payables will be, it may decide not to hedge
in some cases. It needs to determine the probability distribution of its cost of payables
when not hedging as explained below.

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Chapter 8: Management of Transaction Exposure

Forward Market Hedge
Money Market Hedge
Option Market Hedge

6
$121,371
$120,000
$122,200

$122,500
$122,000
$121,500
$121,000
$120,500
Series1

$120,000
$119,500
$119,000
$118,500
Forward Hedge

Money Market
Hedge

Option Market
Hedge

UNHEDGE STRATEGY
Amount= $116,000 20%+ 122,000 70% + 124,000 10%=$121,000

This expected value of the payables is $1,000 more than if Coca uses a forward hedge.
In addition, the probability distribution suggests an 80 percent probability that the cost
of the payables when unhedged will exceed the cost of hedging with a forward contract.
Therefore, Coleman decide to hedge its payables position with a forward contract

UNHEDGE STRATEGY
$150,000
$100,000
UNHEDGE
STRATEGY

$50,000
$0
1

Evaluating the Hedge Decision

MNCs can evaluate hedging decisions that they made in the past by estimating the real
cost of hedging payables, which is measured as:

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Chapter 8: Management of Transaction Exposure

Real cost of hedging payables (RCHp)= nominal cost of payables with hedging
nominal cost of payables without hedging
Real cost of hedging receivables (RCHr) =Nominal home currency revenues received
without hedging nominal home currency revenues received with hedging

Example 5
Recall that Coca cola decided to hedge its payables with a forward contract, resulting in
a dollar cost of $120,000. Assume that on the day that it makes its payment (one year
after it hedged its payables), the spot rate of the euro is $1.18.Find the cost real cost of
hedging payables (RCHp).

Solution
RCHp = Cost of hedging payables - Cost of payables if not hedged= $120,000$118,000= $2,000
8.4 CROSS HEDGING MINOR CURRENCY EXPOSURE
Cross-hedging is a common method of reducing transaction exposure when the
currency cannot be hedged. The major currencies are the: U.S. dollar, Canadian dollar,
British pound, Euro, Swiss franc, Mexican peso, and Japanese yen. Everything else is a
minor currency, like the Thai bhat and is difficult, expensive, or impossible to use
financial contracts to hedge exposure to minor currencies. Facing this situation, firms
may use cross hedging techniques to manage its minor currency exposure.
Conceptual Example 5
Gandhi Co. has payables in zloty (Polands currency) one year from now. Because it is
worried that the zloty may appreciate against the U.S. dollar, it may desire to hedge this
position. If forward contracts and other hedging techniques are not possible for the
zloty, Gandhi may consider cross-hedging. In this case, it needs to first identify a
currency that can be hedged and is highly correlated with the zloty. Gandhi notices that
the euro has recently been moving in tandem with the zloty and decides to set up a one
year forward contract on the euro. If the movements in the zloty and euro continue to
be highly correlated relative to the U.S. dollar, then the exchange rate between these
two currencies should be somewhat stable over time. By purchasing euros one year
forward, Gandhi Co. can then exchange euros for the zloty.

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Chapter 8: Management of Transaction Exposure

8.5 HEDGING CONTINGENT EXPOSURE

If only certain contingencies give rise to exposure, then options can be effective
insurance. For example, if your firm is bidding on a hydroelectric dam project in
Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid
wins the contract. Your firm can hedge this contingent risk with options.
8.6 HEDGING RECURRENT EXPOSURE WITH SWAPS
Firms often have to deal with a sequence of accounts payable or receivable in terms of
a foreign currency. Such recurrent cash flows in a foreign currency can be best hedged
using currency swap contract.
8.7 LEADING AND LAGGING
Leading and lagging strategies involve adjusting the timing of a payment request or
disbursement to reflect expectations about future currency movements. Lead strategy
means to pay or collect early where as lagging strategy means to pay or collect late.
Conceptual Example 6
IBM is based in the United States and has subsidiaries dispersed around the world. The
focus here will be on a subsidiary in the United Kingdom that purchases some of its
supplies from a subsidiary in Hungary. These supplies are denominated in Hungarys
currency (the forint). If IBM expects that the pound will soon depreciate against the
forint, it may attempt to expedite the payment to Hungary before the pound depreciates.
This strategy is referred to as leading.
As a second scenario, assume that the British subsidiary expects the pound to
appreciate against the forint soon. In this case, the British subsidiary may attempt to
stall its payment until after the pound appreciates. In this way it could use fewer pounds
to obtain the forint needed for payment. This strategy is referred to as lagging.

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Chapter 8: Management of Transaction Exposure

Problems
Question 1
a. Assume that Ahmed Co. expects to receive S$500,000 in one year. The existing
spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore
dollar is $.62. The company created a probability distribution for the future spot
rate in one year as follows:
Future Spot rate

Probability

$0.61

20%

0.63

50

0.67

30

Assume that one-year put options on Singapore dollars are available, with an exercise
price of $.63 and a premium of $.04 per unit. One-year call options on Singapore
dollars are available with an exercise price of $.60 and a premium of $.03 per unit.
Assume the following money market rates:
U.S
Deposit Rate
Borrowing Rate

Singapore
8%
9

5%
6

Given this information, determine whether a forward hedge, a money market hedge, or
a currency options hedge would be most appropriate. Then compare the most
appropriate hedge to an unhedged strategy, and decide whether Ahmed Co should
hedge its receivables.
b. Assume that AB, Inc. expects to need S$1 million in one year. Using any relevant
information in part (a) of this question, determine whether a forward hedge, a
money market hedge, or a currency options hedge would be most appropriate.
Then, compare the most appropriate hedge to an unhedged strategy, and decide
whether AB should hedge its payables position.
Answers:
[a. Forward=$310,000, Money market hedge=$305,660.52, Option hedge=$301,000
and 70 % we get $294,000 which is forward/future, Unhedge=$319,000]
[b. Forward=$620,000, Money market hedge=$622,857, Option hedge=$630,000,
Unhedge strategy =$638,000]
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Chapter 8: Management of Transaction Exposure

10

Question 2
Hedging with Put Options. A U.S. exporter wants to hedge future receivables of
250,000 New Zealand dollars 90 days from now. Put options are available for a
premium of $.03 per unit and an exercise price of $.49 per New Zealand dollar. The
forecasted spot rate of the NZ$ in 90 days follows:
Future Spot rate

Probability

$0.44

30%

0.40

50

0.38

20

Given that you hedge your position with options, create a probability distribution for
U.S. dollars to be received in 90 days.

Answer:[$115,000]

Question 3
Hedging Payables with Currency Options. Surad, Inc., is a Somali company that
imports British goods. It plans to use call options to hedge payables of 100,000 pounds
in 90 days. Three call options are available that have an expiration date 90 days from
now. Fill in the number of dollars needed to pay for the payables (including the option
premium paid) for each option available under each possible scenario in the following
table:
Scenario Future Spot
price

1.

$1.65

2.

1.70

3.

1.75

4.

1.80

5.

1.85

Exercise Price
=$1.74
Premium=$0.06

Exercise Price
=$1.76;
premium =$0.05

Exercise Price
E= $1.79
premium =$0.03

If each of the five scenarios had an equal probability of occurrence, which option
would you choose? Explain.

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