TRANSACTION EXPOSURE

KINDS OF EXPOSURES
Impact of changing exchange rates in
the income statement, values of assets
and liabilities or business outlook.
Three distinct kinds:
Translation Exposure
Transaction Exposure
Economic Exposure

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 DIFFERENCES
Translation Transaction Economic
Changes in the Changes in the amount of Changes in the
income statement, future cash flows, for amount of future
and values of assets contracts entered in cash flows
and liabilities; foreign currency but not determined by future
denominated in settled competitive position.
foreign currency
Notional Real Real

Retrospective in Retrospective and Prospective;

nature; deals with prospective as well;
activities happened in Contracts entered: past
the past but not settled: prospective

Concerns only foreign Concerns only foreign Concerns both local

currency currency and foreign currency

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MANAGING EXPOSURES
Of the three exposures transaction exposure
is most important
Immediate impact on real cash flows
Translation exposure is notional and
Economic exposure has long term implications
and deals with rather uncertain future.
Objectives are not well defined:
Eliminate all exchange rate risks: Shall we do
business in foreign countries in foreign currencies.
Managing translation and economic
exposure creates transaction exposure

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IRRELEVANCE
OF EXCHANGE RATE RISK
PPP Argument
Exchange rates are matched by the price movements.
Importer vs domestic producer:
Depreciation of local currency increases cost of purchase for
the importer;
simultaneously domestic producer facing higher inflation will
have increased cost of production,
keeping relative competitive position unchanged hence no
need to manage the exchange rate risk.
COUNTER
Does PPP hold???

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IRRELEVANCE
OF EXCHANGE RATE RISK
Investor Hedge Argument:
Firms mange ER risk for stability of cash flows and
increase the value to shareholders.
Investors can themselves hedge through various
instruments.
Firm should not be concerned for what investors
can achieve in their individual capacities.
COUNTER:
Do investors actually hedge??
Do investors have enough knowledge??
Does the law allow??

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IRRELEVANCE
OF EXCHANGE RATE RISK
Currency Diversification Argument:
MNCs have exposures in many currencies.
Though exposed in each currency, there
could be offsetting effect keeping the overall
cash flows constant.
COUNTER
Most MNCs are exposed to few currencies.
It is nave to assume offsetting.

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IRRELEVANCE
OF EXCHANGE RATE RISK
Shareholders Diversification Argument:
Shareholders have well diversified portfolios.
Any adverse effect of exchange rate will be
diversified away.
COUNTER
Is FE risk unsystematic and hence diversifiable.
Diversification can be achieved better by firms than
individuals.
FIRMS THAT MANAGE EXCHANGE RATE RISK
ARE VIEWED BETTER BY INVESTORS, OTHER STAKE
HOLDERS
CAN BORROW AT CHEAPER RATES.
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HEDGE
Usually means setting up of offsetting
positions so as to result in known cash flows.

Gain Value of Asset/Liability

Exchange rate

Loss Position of hedging instrument

Does not maximise cash flow, but renders

only certainty to it.
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MANAGING TRANSACTION
EXPOSURE
Instrument specific
Forward Hedge
Money Market Hedge
Futures Hedge
Options Hedge
Strategic
Leading and Lagging
Risk Shifting
Exposure Netting

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FORWARD HEDGE
Selective Hedging:
Account Receivable:
Depreciating local currency (Appreciating foreign
currency); DO NOT HEDGE
Appreciating local currency (Depreciating foreign
currency); SELL FORWARD
Account Payable:
Depreciating local currency (Appreciating foreign
currency); BUY FORWARD
Appreciating local currency (Depreciating foreign
currency); DO NOT HEDGE

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FORWARD HEDGE - RECEIVABLE
Example:
INFOSYS expects $ 10 M after 6 month.
Spot rate: Rs. 45/$ 6m Forward Rate: Rs. 43/$
(Indicates depreciating $/appreciating rupee)
Hedging:
Hedge only if future spot rate is expected to be
lower than the forward rate of Rs. 43/$.
If yes:
Sell $ 10 M forward at Rs. 43,
Realise Rs. 430 M after 6 months; irrespective of
future spot rate.
INFOSYS realises a fixed rate that is known today.

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FORWARD HEDGE - PAYABLE
Example:
TISCO needs to pay $ 10 M after 6 month.
Spot rate: Rs. 45/$ 6m Forward Rate: Rs. 47/$
(Indicates depreciating rupee/appreciating $)
Hedging:
Hedge only if future spot rate is expected to be
higher than the forward rate of Rs. 47/$.
If yes:
Buy $ 10 M forward at Rs. 47,
Pay Rs. 470 M after 6 months; irrespective of future
spot rate.
TISCO fixes liability at a fixed rate that is known
today.
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FORWARD HEDGE
Forward hedge transforms foreign currency
receivable/ payable in local currency.
Eliminates risk of foreign exchange rate
movement. (Eliminates downside risk at the
expense of foregoing upside potential gain).
Overbooking of forward contract amounts to
speculation, and is not hedging.
Speculation: Is taking a view on future spot rates and
book forward contract without the underlying
physical transaction.

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COST OF FORWARD HEDGE
Normally reckoned by the forward premium/
discount over spot rate.
(F1 S0)/S0
True cost of forward hedge cannot be
calculated in advance.
Would be dependent upon the future spot
rate.
True cost of forward hedge:
(F1 S1)/S0

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MONEY MARKET HEDGE
Does not use forward market at all.
Uses spot market and money markets in
two currencies.
Involves simultaneous borrowing in one
currency, its spot conversion, and
investing in another and using money
markets of the two currencies.
Enables locking in of a fixed exchange
rate for receivable/payable.
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MONEY MAKET HEDGE
for RECEIVABLE
Example:
INFOSYS expects $ 10 M after 6 month.
Spot rate: Rs. 45/$ Interest Rates Rupee: 10% $: 14% (Indicates
depreciating $/appreciating rupee)
Hedging:
Borrow $10/1.07M at 14%; mature to $ 10M in 6m
Convert in rupees at spot rate to realise Rs.
45x10/1.07 M,
Invest for 6 months at 10%;
Maturity value = 45 x 1.05 x 10/1.07 M.
Effective rate realised = Rs. 44.1589.
Pay $ borrowed from the receivable.

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 MONEY MAKET HEDGE
for PAYABLE
Example: TISCO needs to pay $ 10 M after 6 m.
Spot rate: Rs. 45/$ Interest Rates Rupee: 14%, $: 10% (Indicates
appreciating $/depreciating rupee)
Hedging steps:
Borrow Rupees at 14% for 6
Convert rupees at spot rate to realise $,
Invest $ for 6 months at 10% so as to mature to $10 M.
Effective Exchange Rate:
$ needed for investment = 10/1.05 M
Rupees needs to be borrowed today = 45 x 10/1.05 M
Rupees loan to be repaid = 45 x 1.07 x 10/1.05 M
Effective exchange rate = Rs. 45.8571/$

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MONEY MARKET HEDGE &
FORWARD HEDGE
Money market is a home-made forward rate.
If IRP holds money market and forward market will
give identical results.
If IRP is distorted, a corporate manager has a choice
between money market & forward market hedges.
For receivable: choose the hedge that gives maximum
rate
For payable: choose the hedge that give least rate
Cost associated with money market
Bid Ask spread in the spot market
Difference in lending and borrowing rates
Use appropriate rates.
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COMPARISON
Money Market & Forward Market
Example: ITC expects to receive 10,000 in 6 months. Following
scenario exists
Spot: 80.20 80.50; 6m Forward: 81.50 82.00
Interest Rates Rs: 10.00 10.50; : 5.50 6.00
Forward hedge:
Sell forward at Rs. 81.50 (forward bid rate)
Money Market Hedge:
Borrow at 6% ( borrowing rate) for 6 m ( borrowed =
10,000/1.03)
Convert spot; Get Rs. 10,000 x 80.20/1.03 (spot bid rate)
Invest Rupees for 6 m; realise 10,000 x 80.20 x 1.05/1.03
Effective rate = Rs 81.76 (higher than forward)
CHOOSE MONEY MARKET HEDGE
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RANGE FORWARD
Rate Realised

44 45 Spot Rate

When importer/exporter are prepared to bear some

risk but need protection for wild movement (beyond
the acceptable range) RANGE FORWARD can be
used.
Cheaper than the forward contract.
Risk sharing with the counter party (incorporating a
price adjustment clause in the contract)
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CROSS HEDGE
When no forward contract is available in
currency of exposure.
Hedge through a currency having linkage with
the currency of exposure, and on which
forward contract is available.
(Exposure in Chinese Yuan pegged to dollar can be
hedged with forward in dollar)
Need to establish the relationship and find
degree of correlation using past data.
Greater the value of R2 (explains the fraction of
variation explainable) in the regression, better
is the cross hedge.
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RISK SHIFTING
No invoicing in foreign currency will eliminate
foreign exchange risk.
The foreign exchange risk shifts from one
party to another. (from seller to buyer for
receivable, from buyer to seller for payable)
Depends upon relative position of customer
and supplier, and will be accepted by the
counter party if it feels benefited.
CAUTION:
Not to use spot rate but use forward rate for
analysis of such negotiations
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EXPOSURE NETTING
Hedging need not be done for entire amount
outstanding, Netting to be done:
Adjust receivable against payable in the same
currency,
Across all subsidiaries,
Similar currencies can be treated as one
Receivable in euro and payable in dollar provide natural
hedge if euro and dollar are positively correlated with
rupee.
Receivable in euro and receivable in dollar provide
natural hedge if euro and dollar are negatively
correlated with rupee.
Reduces cost of hedging
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LEADING & LAGGING
Decision to avail or extend credit terms.
When tools of hedging are not available.
If foreign currency appreciating:
Lead the payable (pay as low as possible)
Lag the receivable (receive as much as possible)
If foreign currency depreciating:
Lag the payable
Lead the receivable
Must compare with cost of funds,
Also use forward rate instead of spot rate.

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