CHAPTER 8 - MANAGEMENT OF TRANSACTION EXPOSURE Transaction exposure - Currency risk when a firm faces contractual CFs fixed (invoiced)

in another currency - receive or pay a fixed amount of foreign currency in the future, i.e. any receivable ( !), or payable ( ") in a foreign currency. #ource of currency risk from transaction exposure for $%C could be either& a) export'import activities, or b) borrowing'lending activities - anytime future CFs (to be paid or received) are fixed in a foreign currency. Example: (.#. firm sells its product to a )erman client for *+m, payable in , months, now faces transaction exposure since the CFs are fixed in -uros, and the future value of the -uro is uncertain, meaning that the dollars received are uncertain. .orried about// 00000000000000 Example: (.#. firm borrows in (.1. pounds, owes 2+m in one year, faces transaction exposure since the CFs are fixed in a foreign currency. .orried about// 000000000000000 (nlike many forms of currency risk (economic exposure), currency risk in the form of transaction exposure is always easily identifiable and 3uantifiable, because the exact amount of the CFs, payable or receivable, are known and certain, and the timing of the CFs is known. n example of economic exposure is the effect of future currency fluctuations on sales revenue for $erck or )$, which is more uncertain and harder to 3uantify. 4ransaction exposure always involves known and certain CFs, so the risk exposure is well defined. Financial contracts (derivatives) and operational techniques (see p. +5,) can be used to deal with transaction exposure. n important part of 6ntl. Finance is the management of transaction exposure. 4o illustrate transaction exposure, consider case of 7oeing Corporation, p. +58. 7oeing Corporation (%9#-& 7 , :;6 stock), a (.#. $%C, exports a <8< to 7ritish irways, invoice is for 2+=m, payable in one year. 6nt. rates and F> rates are& (.#. interest rate (one year) ? @.+=A (.1. interest rate (one year) ? 5.==A # ? B+.C='2 F+ ? B+.8@'2 (one-year forward rate) Check for IRP (full formula): +.=@+ ? +.=5 x (B+.8@ ' B+.C=) IRP is Ho !in" .ithout a hedge, 7oeing is exposed to currency risk, see -xhibit D.+ on p. +58, specifically if 00000000000000. Hedging Options for Boeing: #$ For%ar! He!"e$ $ost direct and popular way to hedge currency risk is a currenc for!ard contract, sell the 2+=m forward at B+.8@'2 for a guaranteed receipt of B+8.@m (2+=m x B+.8@'2), regardless of what happens to the spot rate. #ee -xhibits D.E and D., on p. +5C& 6f 2 depreciates to B+.8= (what 7oeing is worried about), they only receive B+8m for the order (selling 2+=m at the spot rate), but the profit on the forward contract is B=.@=m to make up the difference and 7oeing nets B+8.@m. 6f 2 appreciates to B+.C=, 7oeing will receive B+Cm for the order, but will lose B=.8m on the forward contract, for a net of B+8.@m. %o matter what happens to #, 7oeing will net B+8.@m with a currency forward hedge, and will lock in ex-rate of B+.8@'2.
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Currenc "utures contract could also be considered, and would essentially have the same outcome as a forward contract. &$ Mone' Mar(et He!"e. nother strategy for 7oeing& 7orrow for + year in the (.1. in 7"s H 5A, with a 2+=m payoff, convert 7"s to (#:s at the spot rate, invest in the (# H @.+=A, and use the 2+=m receivable from 7ritish irways in one year to pay off the 7" loan in (.1. and keep the (#:s from the payoff in the (.#. money market. Steps) +. 7orrow in (1& 2+=m ' +.=5 ? 25,+<8,,+E today for one year H 5A, pay back 2+=m in one year E. Convert the pounds into dollars today H#?B+.C='7", for B+,,<@+,8@D (25,+<8,,+E x B+.C='2) ,. 6nvest B+,,<@+,8@D in the (.#. H @.+A 8. Collect 2+=m in one year from 7ritish irways in (1 and pay off the loan in (.1. (pay back 2+=m) C. !eceive the dollar proceeds of the investment in (.#. of B+8,@==,5+D (B+,,<@+,8@D x +.=@+) #ee CF diagram, -xhibit D.8 on p. +5<. 6f 6!" is holding, the payoff for a forward contract and money market hedge are the same. 6F 6!" is not holding, then either the forward contract or the money market hedge may dominate the other. 4hese options, being considered by many $%Cs in competitive financial markets, would help to eliminate deviations from 6!". ( ssumes that there is a single interest rate in both countries for borrowing and lending.) "or a pa a#le& $%C would borrow (#:s in the (#, convert to 7"s, invest in the (1 money market for one year, and use the 7" proceeds from the money market to pay the invoice in 7"s in one year, and pay back the loan in the (.#. with dollars. *$ Options Mar(et He!"e$ "ossible disadvantage of a complete hedge with forward, futures contracts, money market hedge/ -liminates II currency risk, even any favorable exchange rate changes that can increase profits by raising revenues in the home currency when the foreign currency appreciates for !, or lowering costs in home currency when the dollar appreciates for ". Jptimal amount of risk is not KeroL Example: 6f the spot rate goes to B+.@='2, 7oeing would get B+@m instead of B+8.@m, and gain B+.8m in additional dollar revenues. 6n other words, hedging would CJ#4 the firm B+.8m on an ex post (after the fact) basis. 7oeing might regret hedging when the pound appreciates, to its advantage. Currency Jptions provide a possible solution by limiting the downside risk (2 depreciating) while preserving some of the upside risk potential (2 appreciating), in this case by buying a 7" put option. #uppose that 7" put options are selling for EM, or B=.=E'7", with an exercise (strike) price of B+.8@'7", and + year expiration. 7oeing buys 2+=m worth of put options for BE==,=== (2+=m x B=.=E'2), giving it the right to sell 2+=m H B+.8@'2 for B+8,@==,===. 7" "ut Jption "ayoff :iagram& N
$x%Price&
profit B+.88 B+.8@'2

O
(B=.=E)

O
(loss)

'pot Rate (()*) in + ear

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"rofessor $ark ;. "erry

Jption premium is due now, so considering the time value of money, the future dollar cost (one year) of the put options H @.+A is BE==,=== (+.=@+) ? BE+E,E== (BE==,=== N B+E,E== in foregone (.#. interest by tying up BE==,=== for a year and losing the interest income). #uppose ' & (+,-.)* in one year. 7oeing exercises the option and receives B+8.@m in gross proceeds for the 2+=m as follows& a. #pot& 2+=m x B+.,='2 ? B+,m (Converting 2+=m ! in 7" to (#: H # ? B+.,='2) b. (B+.8@'2 - B+.,='2) x 2+=m ? B+.@m )ross "rofit on Jptions Contract TOT/0 (+1,2m 3ross 4ollars Proceeds c. Jptions Cost (inc. opp. cost) (BE+E,E==) 5$T PROC$$4' (+16-7867.. 9 *+.m & $ffecti:e $x%rate: (+,1-78)* 6f the 7" does depreciate significantly (what 7 is worried about), this establishes the minimum dollar receipt possible (vs. B+,m without option in this case), and sets a floor for the 2+=m receivable. 4he put premium is like buying an insurance policy now for BE==,=== that will guarantee that 7oeing will get a $6% of B+8,,D<,D== in one year, and maybe more if 0000000000000. #uppose ' & (+,1.)* in one year. 7oeing exercises the option and receives B+8.@m in gross proceeds for the 2+=m as follows& a. 2+=m x B+.8='2 ? b. (B+.8@'2 - B+.8='2) x 2+=m ? TOT/0 B+8m (Converting 2+=m ! in 7" to (#: H # ? B+.8='2) B=.@m )ross "rofit on Jptions Contract (+1,2m 3ross 4ollars Proceeds

c. Jptions Cost (inc. opp. cost) (BE+E,E==) 5$T PROC$$4' (+16-7867.. 9 *+.m & $ffecti:e $x%rate: (+,1-78)* ' & (+,;.)* in one year. %ow 7oeing does not exercise the option, 2 has appreciated in 7oeingPs favor. a. 2+=m x B+.C='2 ? B+Cm (Converting 2+=m ! in 7" to (#: H # ? B+.C='2) b. Jptions Cost (inc. opp. cost) (BE+E,E==) 5$T PROC$$4' (+1687867.. 9 *+.m &$ffecti:e $x%rate: (+,1878)* ' & (+,2.)* in one year. 7oeing does not exercise the option (it expires). a. 2+=m x B+.@='2 ? B+@m (Converting 2+=m ! in 7" to (#: H # ? B+.@='2) b. Jptions Cost (inc. opp. cost) (BE+E,E==) 5$T PROC$$4' (+;687867.. 9 *+.m & $x%rate: (+,;878)* #ee -xhibits D.C and D.@, p. +55. 7reak-even #Q between put option and forward contract is B+.8D'2. 6f # R B+.8D, put option is better alterative, if # S B+.8D then forward hedge is slightly better by BE+E,E==, the cost of the put option (assumes no cost for a forward contract). "ut option allows 7oeing to significantly limit the downside risk (2 falling), but preserve the upside potential (2 appreciating). 3uarantee: $inimum proceeds of B+8,,D<,D==, and minimum ex-rate of B+.8,D<'2, with chance of B+@m or more.
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"rofessor $ark ;. "erry

nother advantage of put option vs. forward contract& Forward Contracts are only available at one forward rate for a given maturity, vs. put options - available at several exercise prices. For example, 7oeing could buy another put option with a -x-" higher than B+.8@, (e.g., B+.8D'2) and increase the minimum net dollar proceeds. "roblem/ #ee -xhibit <.< on p. +<C for 3uotes for -uro and 9en put options F note that there are < different puts for euro and += for 9en, at various exercise prices and premiums. For example, current currency puts and calls on the "hiladelphia #tock -xchange ("GI>)&
4ecem#er <..2 Put Options for BP (*-+6<;.) "GI> ('pot rate !as (+,=+<;)* in 5o:em#er <..2) $x%Price B+.5E'2 B+.5+ B+.5= B+.D5 B+.DD B+.D< B+.D@ B+.DC B+.D8 Premium (>)*) E.88M +.D8 +.EC =.<5 =.85 =.,+ =.E+ =.+8 =.+E Contract Cost Breake:en ($x%P ? Premium) B<@E.C= B+.D5C@'2 BC<C.== B+.D5+@ B,5=.@EC B+.DD<C BE8@.D<C B+.DDE+ B+C,.+EC B+.D<C+ B5@.D<C B+.D@<5 B@C.@EC B+.DC<5 B8,.<C B+.D8D@ B,<.C= B+.D,DD

4ecem#er <..2 Call Options for BP (*-+6<;.) PH0@ $x%P Premium (>)*) B+.DD'2 E.,,M B+.D5 +.@C B+.5= +.+= B+.5+ =.<= B+.5E =.8@ B+.5, =.,+ B+.58 =.EE B+.5C =.+8 B+.5@ =.+E Contract Cost B<ED.+EC BC+C.@EC B,8,.<C BE+D.<C B+8,.<C B5@.D<C B@D.<C B8,.<C B,<.C= Breake:en ($x%P A Premium) B+.5=,,'2 B+.5=@C B+.5++= B+.5+<= B+.5E8@ B+.5,,+ B+.58EE B+.5C+8 B+.5@+E

(http://www.phlx.com/market/index.html? pcq_ticker=XBP&pcq_app=options&pcq_submit= et&pcq_ran!e=""""&pcq_show=#&pcq_months=$%

#ee -xhibit D.<, p. E== for summary of , strategies for hedging currency risk of a receivable& Forward Contract, $oney $arket, "ut Jptions. 5e! $xample: Hedging "oreign Currenc Pa a#les 7oeing imports a Tet-engine from !olls !oyce (!!) in (1, for 2Cm payable in one year. #ee ex-rates and interest rates on p. E==. %ote& 6!" is %J4 holding (7" is expected to depreciate by 00000, implying an effective dollar return of 000000000000 in (1 vs. @A in (#). 7oeing is worried about/ 00000000 Hedging strategies: +, "or!ard contract, 7uy 2Cm forward at F+?B+.<C'7", for a total of BD,<C=,=== (2Cm x B+.<C'2)
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7(# 8@@'C@@& 6nternational Finance F CG D

"rofessor $ark ;. "erry

<, Bone Barket Hedge, $%C would borrow (#: in the (#, convert to 7"s at spot rate, invest in the (1 for one year, and use the 7" proceeds in one year to pay the invoice in 7"s. "ay back loan in (.#. 'teps: +. Compute "U of foreign currency " at (1 interest rate& 2Cm ' +.=@C ? 28,@58,D,C E. 6nvest 28,@58,D,C in (1 today at @.CA to have exactly 2Cm in one year to pay !! in (1 ,. 7oeing borrows BD,8C=,<=8 today (28,@58,D,C x B+.D='2) in (# H @A to buy 28,@58,D,C at spot 8. 7oeing pays back BD,5C<,<8@ in one year (BD,8C=,<=8 x +.=@), which is the cost of the order 4he cost of the " using a forward hedge is only BD.<Cm vs. BD.5C<m with the money market hedge. 6n this case, the forward hedge is better than the money market hedge because 6!" is %J4 holding. Covered interest arbitrage would take place because the effective dollar return for one year bonds is 00000 in (1 vs. 00000 in (#. rbitrage& 00000000 in the (1 and 00000000 in the (#. 6nvestors would convert 00000 and sell for 0000000, which would appreciate the 000000 and depreciate the 000000, causing the B'7" spot rate to 00000000. 4o cover currency risk, investors would sell the 000000 forward, which would 0000000 the (#: and 0000000 the 7" in the forward market, causing the F (B'7") rate to 0000000000. 7orrowing pressure would cause interest rates in the 000000 to 00000 and lending pressure in the 00000 would cause bond prices to 00000 and interest rates to 0000000. -ventually, 6!" would be restored and a money market hedge would be the same as a forward contract. One Possi#le Outcome& From& @A R @.CA - E.<<A (or ,.<,A) to CA ? <A - EA and # ? B+.<5'2 and F ? B+.<C8E'2

-, Currenc option hedge6 using call options for the BP. 7oeing could consider buying 7" call options, to hedge against the (#: 00000 and the 7" 000000. Jne-year call options on the 7" are available at an ex-" of B+.D='7", for a premium of +.DM or B=.=+D per 7". 4he premium for 2Cm would be 2Cm x B=.=+D'2 ? B5=,===, the future value in + year would be B5=,=== x +.=@ ? B5C,8==. 4he payoff diagram would be& N
B+.D='2 B+.D+D'2

O
(B=.=+D'2)

'pot Rate (()*) in one ear

% 6f 7" appreciates above B+.D=, 7oeing will exercise. For example, suppose that #uppose that ' & (+,=. in one year ($xercise option)& "rofit from the option (B+.5= - B+.D=) x 2Cm ? "urchase 2Cm at B+.5= ? Cost of options ? 5$T CO'T 7(# 8@@'C@@& 6nternational Finance F CG D NBC==,=== )ross profit (B5,C==,===) (B5C,8==) ((=6.=;61..) 9 2Cm ? B+.D+5+'7"
C

"rofessor $ark ;. "erry

' & (+,7; in one year ($xercise Option)& "rofit from the option (B+.DC - B+.D=) x 2Cm ? "urchase 2Cm at B+.DC ? Cost of options ? 5$T CO'T NBEC=,=== profit (B5,EC=,===) (B5C,8==) ((=6.=;61..) 9 2Cm ? B+.D+5+'7"

' & (+,8; in one year (4onCt exercise option, let it expire)& "urchase 2Cm at B+.<C ? Cost of options ? 5$T CO'T (BD,<C=,===) (B5C,8==) ((7671;61..) 9 2Cm ? B+.<@5+'7"

' & (+,8. in one year (4onCt exercise, let option expire)& "urchase 2Cm at B+.<= ? Cost of options ? 5$T CO'T (BD,C==,===) (B5C,8==) ((76;=;61..) 9 2Cm ? B+.<+5+'7"

Conclusion& .orst case scenario is that 7" will appreciate ((#: depreciates) and 7oeing will pay B+.D+5+ per 2, and the order will cost B5,=5C,8==, but that sets maximum cost of the 7"s and the maximum cost of the order. 6f the ex-change moves in its favor (dollar appreciates, 7" depreciates), the cost per 7" and the cost of the order could fall to BD.D8Cm or BD.C5Cm in the example above. #ee -xhibit D.D on p. E=E. Cross%Hedging Currenc Risk is possible when forward contracts are not available for minor currencies like 1orean won, 4hai baht, 7raKilian real, $exican peso, etc. $arkets are too thin for those currencies, or nonexistent, or inefficient because of currency controls or regulations. Strategy: (se a currency futures or forward contract for a maTor currency to hedge currency risk for a highly correlated minor currency. Exa+p e) (se a 9en contract to cross-hedge 1orean won currency risk ( ! in won for (.#. $%C), assuming that the 9en'.on correlation is high. nother type of cross-hedging is commodity-currency hedging, e.g. using oil or silvers futures contracts to hedge $exican peso, copper futures to hedge "eruvian currency, gold for #. frican rand, wool for ustralian dollar, cocoa for %igerian currency, coffee for Colombian peso, cotton for 6ndian rupee, or soybean or coffee futures to hedge 7raKilian real. .orks when a commodity futures prices move closely with an ex-rate. Exa+p e) 7raKil exports coffee to (.#. and produces ECA of world market, correlation between world coffee price in dollars and the 7raKilian currency (real) should be high. #uppose there is a real shock, an increase in demand for coffee. .hat happens to the 7raKilian currency/ 000000000 .hat happens to futures price of coffee in (#/ 00000000000000

7(# 8@@'C@@& 6nternational Finance F CG D

"rofessor $ark ;. "erry

#uppose there is a nominal shock, overall price inflation in the (.#., and the dollar price of coffee in the (# goes000000 in the spot and futures market, and the dollar goes 00000 and the real goes 000000 in the currency markets. 4herefore there should be a 00000000 correlation between coffee prices on %97J4. He!"in" Exa+p es& a) #uppose )$ buys transmissions from a company in 7raKil and has a 5=-day payable ( '") for +m reals. 6t would be worried about the dollar 0000 and the real 0000, so it would take a 0000000 position on ,-month coffee futures. ( ssume there are no currency futures contracts for reals.) b) #uppose )$ sells engines to a company in 7raKil and has a 5=-day receivable ( '!) for +m reals. 6t would be worried about the real 00000 and would take a 00000 position on ,-month coffee futures. HE,GING CONTINGENT EXPOSURE Jptions are also useful for a Vcontingent exposure,V when a firm may or may not be exposed to currency risk. 4he risk is contingent on whether some future event happens. )- (in (.#.) makes a competitive bid on a hydroelectric plant in Canada, outcome wonWt be known for , months. 6F )- gets bid, it will receive an initial down payment of CB+==m. 6F %J4, it will get =. Forward hedge is not useful (sell CB forward), because )- may not have the CB to sell if it doesnWt get the bid. :oing nothing is risky (if CB 0000). 7uying a , month CB currency put option for CB+==m is ideal solution. )ain N
-x-"

'-(()C4)

Ioss Four possi- e outco+es) +. 7id accepted, # S -x-", C: depreciates, -xercise put option and sell CB+==m for (#: H -x-". E. 7id accepted, # R -x-", Iet option expire since C: appreciated, convert CB+==m H #. ,. 7id not accepted, # S -x-", -xercise option and either make money or reduce cost of premium. 8. 7id not accepted, # R -x-", Iet option expire, lose premium. #ee -xhibit D.5 on p. E=8 for a summary of outcomes for , cases& a) no hedging, b) hedge with a short position on a forward contract, and c) hedge with put option. 4he option premium is like the cost of an insurance policy to protect the firm from contingent (potential) transaction exposure, HE,GING THROUGH IN.OICE CURRENC/ (OP$R/TIO5/0 T$CH5IDE$') ssume that 7oeing has a contract to build five <8<s for 7ritish irways, and deliver one each year for the next C years, and receive 2+=m per plane. 7y negotiating and adTusting terms of the invoice, 7oeing can s0i1t2 s0are or !i3ersi1' currency risk.

<

7(# 8@@'C@@& 6nternational Finance F CG D

"rofessor $ark ;. "erry

a) 6f 7oeing can invoice in (#:, then it has eliminated currency risk for itself and shifted it to 7ritish irways. %ow if # ? B+.C='2, 7ritish irways has a B+Cm " and 7oeing has a (+;m !. b) 7oeing could split (share) the currency risk with 7ritish irways by invoicing C=A in (#: and C=A in 7"& B<.Cm N 2Cm for each plane, and each company shares half the risk. "otential disadvantage for 7oeing of shifting or sharing/ Iess favorable terms may result in lost sales. .ho has more power in the deal, and who is more desperate to make the deal/ 7uyersW market or sellersW market/ VGe who cares the least......6%#.V c) 6nvoice in a -as(et o1 currencies to diversify and reduce currency risk with a portfolio of currencies& e.g. #:!s (B, *, X, 2Y weights are 88A, ,8A, ++A, ++A) or in the past, -C(s (++ currencies). Companies can issue bonds denominated in #:!s or -C( (prior to euro) to diversify risk, -gyptian govt. charges fees in #:!s for passage through the #ueK Canal. 6nvoicing in currency baskets can be a useful hedging tool when no forward or currency contracts are available, and has the advantage of 000000000.

SPEE,ING4S5O6ING AR AN, AP IN FOREIGN CURRENC/ Genera ru es) For ! ( ccounts !eceivable) in foreign currency& #peed up (or lead) collections of depreciating currencies (e.g., peso !s), and #low down (or lag) collections of appreciating currencies (e.g., -uro !s). For " ( ccounts "ayable) in foreign currency& #peed up (or lead) payments of appreciating foreign currencies (e.g. -uro "s, when dollar is depreciating), and #low down (or lag) payments of depreciating currencies (e.g., $exican peso "s when dollar is appreciating). TO HE,GE OR NOT TO HE,GE - SHOU5, THE FIRM HE,GE7 :oes hedging create value for the firm (shareholders)/ $xtreme :ie!: %obel "riKe economists $odigliani and $iller& i) Capital structure (mix of debt and e3uity), and ii) :ividend policy (investors care about total return and donWt care whether they get dividends or capital gains) are irrelevant and donWt affect the value of the firmY therefore hedging doesnWt affect the value of the firm since it is Tust a form of financing. nd since hedging is costly (option premiums), it may lower value of the firm. V:onWt do for shareholders what they can do for themselves.V #hareholders can hedge on their own if they want to using/ 0000000000000000000 lthough $Z$ may be right in theory if capital markets are perfect, a case can be made for hedging based on various capital market imperfections. +, Information /s mmetr , $anagers know more about the various risks the firm is exposed to, therefore it makes more sense for the managers of the firm to determine optimal hedging, not the shareholders.
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"rofessor $ark ;. "erry

<, Transaction Costs, 4he firm is in a better position to achieve low cost hedging compared to shareholders, and may have full-time risk management professionals'specialists, trained in financial engineering. -, 4efault Costs, Gedging can reduce probability of default, resulting in better credit rating for the $%C, which will lower overall financing costs, an outcome that shareholders cannot achieve on their own. 1, Progressi:e Corporate Taxes, ssume that corporations pay E=A tax on income from B=-+=m, and 8=A tax on earnings above B+=m. 6n this tax environment, it would be better to receive a fixed, stable annual income of B+=m (hedged) with a tax rate of E=A, compared to BCm one year and B+Cm the next year (unhedged), since BCm of the B+Cm would be taxed at 8=A. Gedging could result in lower overall tax liability by stabiliKing CFs in the face of a progressive corporate tax system. #ee -xhibit D.++ on p. E++ for a summary of currency risk products used by corporations. Forward contracts are used most often, followed by currency swaps and currency options.
Updated: November 18, !1"

7(# 8@@'C@@& 6nternational Finance F CG D

"rofessor $ark ;. "erry