Transaction exposure, can be defined as the sensitivity of “realized” domestic currency

values of the firm’s contractual cash flows denominated in foreign currencies to unexpected
exchange rate changes. Since settlements of these contractual cash flows affect the firm’s
domestic currency cash flows, transaction exposure is sometimes regarded as a short-term
economic exposure. Transaction exposure arises from fixed-price contracting in a world
where exchange rates are changing randomly.

Economic exposure, can be defined as the extent to which the value of the firm would be
affected by unanticipated changes in exchange rates. Any anticipated changes in exchange
rates would have been already discounted and reflected in the firm’s value.

Translation exposure, refers to the potential that the firm’s consolidated financial statements
can be affected by changes in exchange rates. Consolidation involves translation of
subsidiaries’ financial statements from local currencies to the home currency.
Consider a U.S. multinational firm that has subsidiaries in the United Kingdom and Japan.
Each subsidiary will produce financial statements in local currency. To consolidate financial
statements worldwide, the firm must translate the subsidiaries’ financial statements in local
currencies into the U.S. dollar, the home currency.

Transaction exposure
The firm is subject to transaction exposure when it faces contractual cash flows that are fixed
in foreign currencies.
Suppose that a U.S. firm sold its product to a German client on three-month credit terms and
invoiced €1 million.
Spot Rate (03 June,2021) = 1Euro = 20$
3Month F :
1. F3 = 19$ (Dollar Appreciated)
2. F3 = 21$ (Dollar depreciated)
When the U.S. firm receives €1 million in three months, it will have to convert (unless it
hedges) the euros into dollars at the spot exchange rate prevailing on the maturity date, which
cannot be known in advance. As a result, the dollar receipt from this foreign sale becomes
uncertain; should the euro appreciate (depreciate) against the dollar, the dollar receipt will be
higher (lower). This situation implies that if the firm does nothing about the exposure, it is
effectively speculating on the future course of the exchange rate.
Consider a Japanese firm entering into a loan contract with a Swiss bank that calls for the
payment of SF100 million for principal and interest in one year. To the extent that the
Yen/Swiss franc exchange rate is uncertain, the Japanese firm does not know how much yen
it will take to buy SF100 million spot in one year’s time. If the yen appreciates (depreciates)
against the Swiss franc, a smaller (larger) yen amount will be needed to pay off the SF-
denominated loan.
These examples suggest that whenever the firm has foreign-currency-denominated
receivables or payables, it is subject to transaction exposure, and their settlements are likely
to affect the firm’s cash flow position.
Hedging:
Mitigation (Risk)
Opposite Position: Position = Long/Short
Hedging transaction exposure using various financial contracts and operational techniques:
Financial contracts
 Forward market hedge
 Money market hedge
 Option market hedge
 Swap market hedge
Operational techniques
 Choice of the invoice currency
 Lead/lag strategy
 Exposure netting

P1. Boeing Corporation exported a Boeing 737 to British Airways and billed £10 million
payable in one year. The money market interest rates and foreign exchange rates are given as
follows:
The U.S. interest rate: 6.10% per annum.
The U.K. interest rate: 9.00% per annum.
The spot exchange rate: $1.50/£.
The forward exchange rate: $1.46/£ (1-year maturity).

1 Pound = $1.50 (3 June, 2021) On 3 June 2021 you sell 10 million pounds @
F1 = 1.46$
1 Pound = $1.46 (2 June, 2022)
The most direct and popular way of hedging transaction exposure is by currency forward
contracts. Generally speaking, the firm may sell (buy) its foreign currency receivables
(payables) forward to eliminate its exchange risk exposure. In the above example, in order to
hedge foreign exchange exposure,

Since Boeing’s pound receivable is exactly offset by the pound payable (created by the
forward contract), the company’s net pound exposure becomes zero. Since Boeing is assured
of receiving a given dollar amount, $14.6 million, from the counter-party of the forward
contract, the dollar proceeds from this British sale will not be affected at all by future changes
in the exchange rate.

Once Boeing enters into the forward contract, exchange rate uncertainty becomes irrelevant
for Boeing. Graph illustrates how the dollar proceeds from the British sale will be affected by
the future spot exchange rate when exchange exposure is not hedged. It shows that the dollar
proceeds under the forward hedge will be higher than those under the unhedged position if
the future spot exchange rate turns out to be less than the forward rate, that is, F = $1.46/£,
and the opposite will hold if the future spot rate becomes higher than the forward rate. In the
latter case, Boeing forgoes an opportunity to benefit from a strong pound.

Suppose that on the maturity date of the forward contract, the spot rate turns out to be
$1.40/£, which is less than the forward rate, $1.46/£. In this case, Boeing would have
received $14.0 million, rather than $14.6 million, had it not entered into the forward contract.
Thus, one can say that Boeing gained $0.6 million from forward hedging. Needless to say,
Boeing will not always gain in this manner. If the spot rate is, say, $1.50/£ on the maturity
date, then Boeing could have received $15.0 million by remaining unhedged. Thus, one can
say ex post that forward hedging cost Boeing $0.40 million.
The gains and losses from forward hedging can be illustrated as

The gain/loss is computed as follows:

Gain = (F - S T) x £10 million
The gain will be positive as long as the forward exchange rate (F) is greater than the spot rate
on the maturity date (ST), that is, F > ST, and the gain will be negative (that is, a loss will
result) if the opposite holds. The firm theoretically can gain as much as $14.6 million when
the pound becomes worthless, which, of course, is unlikely, whereas there is no limit to
possible losses.
It is important, however, to note that the above analysis is ex post in nature, and that no one
can know for sure what the future spot rate will be beforehand. The firm must decide whether
to hedge or not ex ante. To help the firm decide, it is useful to consider the following three
alternative scenarios:

where S´T denotes the firm’s expected spot exchange rate for the maturity date.

Under the first scenario, where the firm’s expected future spot exchange rate, S´T , is about the
same as the forward rate, F , the “expected” gains or losses are approximately zero.

Money-Market hedging:
A money market hedge on payables involves taking a money market position to cover a
future payables position. If a firm has excess cash, it can create a simplified money market
hedge. However, many MNCs prefer to hedge payables without using their cash balances.
A money market hedge can still be used in this situation, but it requires two money market
positions:
(1) borrowed funds in the home currency, and
(2) a short term investment in the foreign currency.

Options Market Hedge

In many circumstances, the firm is uncertain whether the hedged foreign currency cash
inflow or outflow will materialise. Currency options obviate this problem. There are two
kinds of options – put options and call options.
A put option gives the buyer the right, but not the obligation, to sell a specified number of
foreign currency units to the option seller at a fixed price up to the option’s expiration date.
Alternatively, a call option is the right, but not the obligation, to buy a foreign currency at a
specified price, up to the expiration date.
A call option is valuable, for example, when a firm has offered to buy a foreign asset, such as
another firm, at a fixed foreign currency price but is uncertain whether its bid will be
accepted.

The general rules to follow when choosing between currency options and forward contracts
for hedging purposes are summarised as follows:
1. When the quantity of a foreign currency cash outflow is known, buy the currency forward,
when the quantity is unknown, buy a call option on the currency.
2. When the quantity of a foreign currency cash inflow is known, sell the currency forward,
when the quantity is unknown, buy a put option on the currency.
3. When the quantity of foreign currency cash flow is partially known and partially uncertain,
use a forward contract to hedge the known portion and an option to hedge the maximum
value of the uncertain remainder.

Exposure Netting
Exposure netting involves offsetting exposures in one currency with exposures in the same or
another currency, where exchange rates are expected to move in such a way that losses
(gains) on the first exposed position should be offset by gains (losses) on the second currency
exposure.
The assumption underlying exposure netting is that the net gain or loss on the entire exposure
portfolio is what matters, rather than the gain or loss on any individual monetary unit.
The above mentioned methods show how a firm can hedge exchange exposures if it wishes.
The next question therefore is – should a firm try to hedge to start with? Based on literature
survey there is no consensus on whether the a should hedge or not. Some writers argue that
transaction exposure management at the organisational level is not required and that
shareholders can manage the exposure themselves. The various reasons in favour of exposure
management at the corporate level are:
1. Information asymmetry: Management is aware about the firm’s exposure position much
better than shareholders. Thus, management of the firm should manage exchange exposure.
2. Transaction costs: The firm is in a better position to acquire low cost hedges and hence,
transaction costs can be significantly reduced. For individual shareholders, the transactions
costs can be substantial.
3. Default cost: In a corporate hedging, probability of default is significantly lower. This, in
turn, can lead to a better credit rating and lower financing costs.

Example:
Boeing Corporation exported a Boeing 737 to British Airways and billed £10 million payable
in one year. The money market interest rates and foreign exchange rates are given as follows:
The U.S. interest rate: 6.10% per annum.
The U.K. interest rate: 9.00% per annum.
The spot exchange rate: $1.50/£.
The forward exchange rate: $1.46/£ (1-year maturity).
Probable Spot Exchange Rates on the Maturity Date (ST)
$1.30
$1.40
$1.46
$1.50
$1.60
Put Option premium (price) = $0.02 per pound
I. Forward Hedge:

The spot exchange rate: $1.50/£.

The forward exchange rate: $1.46/£ (1-year maturity).

a. Boeing will SELL forward its pounds receivable, £10 million for delivery in one year, in
exchange for a given amount of U.S. dollars.
b. On the maturity date of the contract, Boeing will have to deliver £10 million to the bank,
which is the counterparty of the contract, and, in return, take delivery of $14.6 million ($1.46
3 10 million). Boeing will, of course, use the £10 million that it is going to receive from
British Airways to fulfill the forward contract.
Gain = (F - S T) x £10 million

Gain/Loss Matrix for probable spot rates on maturity

ST Unhedged Position Forward Hedge Gains/Losses
$1.30 $13,000,000 $14,600,000 $1,600,000
$1.40 $14,000,000 $14,600,000 $600,000
$1.46 $14,600,000 $14,600,000 0
$1.50 $15,000,000 $14,600,000 -$400,000
$1.60 $16,000,000 $14,600,000 -$1,400,000

II. Money Market Hedging:

The first important step in money market hedging is to determine the amount of pounds to
borrow. Since the maturity value of borrowing should be the same as the pound receivable,
the amount to borrow can be computed as the discounted present value of the pound
receivable, that is, £10 million/(1.09) = £9,174,312. When Boeing borrows £9,174,312, it
then has to repay £10 million in one year, which is equivalent to its pound receivable.

The U.S. interest rate: 6.10% per annum.

The U.K. interest rate: 9.00% per annum.
The spot exchange rate: $1.50/£.
The forward exchange rate: $1.46/£ (1-year maturity).
The step-by-step procedure of money market hedging:
Step 1: Borrow £9,174,312.
Step 2: Convert £9,174,312 into $13,761,468 at the current spot exchange rate of $1.50/£.
Step 3: Invest $13,761,468 in the United States @ 6.10%
Step 4: Collect £10 million from British Airways and use it to repay the pound loan.
Step 5: Receive the maturity value of the dollar investment, that is,
$14,600,918 = ($13,761,468) X (1.061), which is the guaranteed dollar proceeds from the
British sale.

III. Options Market Hedging:

Put Option premium (price) = $0.02 per pound

Step 1: Boeing purchased a put option on 10 million British pounds with an exercise price of
$1.46 and a one-year expiration.
Put Option premium (price) = $0.02 per pound = $200,000 …. ($0.02 x 10 million)
(This transaction provides Boeing with the right, but not the obligation, to sell up to
£10 million for $l.46/£, regardless of the future spot rate.)
Step 2: Calculate Value of Option premium after one year:
Premium Paid = $200,000 …. ($0.02 x 10 million)
Interest Rate (home) = 6.10%
Value of Premium at maturity = $212,200 ($200,000 x 1.061)

Step 3: Net dollar proceeds from the British sale

Receivable amount = $14.6 million
Premium Value = $212,200
 Net Proceeds = Receivable amount – Premium Value
= $14,600,000 - $212,200
= $ 14,387,800

Step 4: Calculate Dollar proceeds for various ST price in future

1. When Spot Rate is LESS than Forward Rate= Exercise The Right
2. When Spot Rate is More Than Forward rate = Not Exercise
Break-even point
The break-even spot rate, which is useful for choosing a hedging method, can be determined
as follows:
$(10,000,000) x ST - $212,200 = $14,600,000
Break-even ST = $1.48
The break-even analysis suggests that if the firm’s expected future spot rate is greater (less)
than the break-even rate, then the options (forward) hedge may be preferred.

P1. DC Corporation is a US-based software consulting firm, specialising in financial software

for several Fortune 500 clients. It has offices in India, the UK, Europe and Australia. In 2002,
DC required £100,000 in 180 days and had four options before it:
_ A forward hedge
_ A money market hedge
_ An option hedge
_ No hedge
Its analysts developed the following information which was used to assess the alternative
solutions:
_ Current spot rate of pound = $ 1.50
_ 180-day forward rate of pounds as of today = $ 1.48
Interest rates were as follows:
 U.K U.S.
180-days deposit rate 4.5% 4.5%
180-days borrowing rate 5.1% 5.1%

The company also had the following information available to it:

_ A call option on Pound that expires in 180 days has an exercise price of $ 1.49 and a
premium of $ 0.03.
_ A put option on Pound that expires in 180 days has an exercise price of 1.50 and a premium
of $ 0.02.

The future spot rates in 180 days were forecasted as follows:

Possible Outcome Probability

$ 1.44 20%
$ 1.46 60%
$ 1.53 20%

P2.
P3.

P4.
Measure Economic Exposure
Currency risk or uncertainty, which represents random changes in exchange rates, is not the
same as the currency exposure, which measures “what is at risk.” Under certain conditions, a
firm may not face any exposure at all, that is, nothing is at risk, even if the exchange rates
change randomly.

Exposure to currency risk thus can be properly measured by the sensitivities of (i) the future
home currency values of the firm’s assets (and liabilities) and (ii) the firm’s operating cash
flows to random changes in exchange rates.
Assets include the tangible assets (property, plant and equipment, inventory) as well as
financial assets. Let us first discuss the case of asset exposure.

For expositional convenience, assume that dollar inflation is nonrandom. Then, from the
perspective of the U.S. firm that owns an asset in Britain, the exposure can be measured by
the coefficient ( b ) in regressing the dollar value ( P ) of the British asset on the dollar/pound
exchange rate ( S ).
P=a+bxS+e
where a is the regression constant and e is the random error term with mean zero, that is,
E(e) = 0; P = SP*, where P * is the local currency (pound) price of the asset. The regression
coefficient b measures the sensitivity of the dollar value of the asset ( P ) to the exchange rate
(S ). If the regression coefficient is zero, that is, b = 0, the dollar value of the asset is
independent of exchange rate movements, implying no exposure.
On the basis of the above analysis, one can say that exposure is the regression coefficient.
Statistically, the exposure coefficient , b , is defined as follows:
b = Cov (P, S) / Var(s)
where Cov (P, S) is the covariance between the dollar value of the asset and the exchange
rate, and Var (S) is the variance of the exchange rate.

Suppose that a U.S. firm has an asset in Britain whose local currency price is random. Let us
assume that there are three possible states of the world, with each state equally likely to
occur. The future local currency price of this British asset as well as the future exchange rate
will be determined, depending on the realized state of the world.
Three cases: local currency price of the asset (P * ) and the dollar price of the pound ( S )
Case 1: Positively Correlated
Case 2: Negatively Correlated
Case 3: local currency price of the asset is fixed at £1,000
Case 1, (Table): It indicates that the local currency price of the asset (P*) and the dollar price
of the pound ( S ) are positively correlated, so that depreciation (appreciation) of the pound
against the dollar is associated with a declining (rising) local currency price of the asset.
The dollar price of the asset on the future (liquidation) date can be $1,372, or $1,500 or
$1,712, depending on the realized state of the world. When we compute the parameter values
for Case 1, we obtain

Cov (P,S) = 34/3,

Var (S) = 0.02/3,

and
b = Cov (P, S) / Var(s)
b = £1,700.
This pound amount, £1,700, represents the sensitivity of the future dollar value of the British
asset to random changes in exchange rate. This finding implies that the U.S. firm faces a
substantial exposure to currency risk. Note that the magnitude of the exposure is expressed in
British pounds.

Case 2: This case indicates that the local currency value of the asset is clearly negatively
correlated with the dollar price of the British pound. In fact, the effect of exchange rate
changes is exactly offset by movements of the local currency price of the asset, rendering the
dollar price of the asset totally insensitive to exchange rate changes.
The future dollar price of the asset will be uniformly $1,400 across the three states of the
world. One thus can say that the British asset is effectively denominated in terms of the
dollar. It shows that uncertain exchange rates or exchange risk does not necessarily constitute
exchange exposure.
Despite the fact that the future exchange rate is uncertain, the U.S. firm has nothing at risk in
this case. Since the firm faces no exposure, no hedging will be necessary.

Case 2
Probabilit P* S
y
0.33 1000 1.4
0.33 933 1.5
0.33 875 1.6

b = cov(S,P) / Var (S)

Step 1: P = P* x S
Step 2: Cov (P,S)

S’ = Sum of S / n
S – S’

Case 3, where the local currency price of the asset is fixed at £1,000. In this case, the U.S.
firm faces a “contractual” cash flow that is denominated in pounds. This case, in fact,
represents an example of the special case of economic exposure, transaction exposure.
Intuitively, what is at risk is £1,000, that is, the exposure coefficient, b, is £1,000

Once the magnitude of exposure is known, the firm can hedge the exposure by simply selling
the exposure forward. In Case 3, where the asset value is fixed in terms of local currency, it is
possible to completely eliminate the variability of the future dollar price of the asset by
selling £1,000 forward.
In Case 1, however, where the local currency price of the asset is random, selling £1,700
forward will not completely eliminate the variability of the future dollar price; there will be a
residual variability that is independent of exchange rate changes.
On the basis of regression,
P=a+bxS+e
we can decompose the variability of the dollar value of the asset, Var( P ), into two separate
components: exchange rate-related and residual.
Specifically,
Var (P) = b2Var (S) + Var (e)

b2Var (S) represents the part of the variability of the dollar value of the asset that is related to
random changes in the exchange rate.
Whereas Var (e), captures the residual part of the dollar value variability that is independent
of exchange rate movements.
The consequences of hedging the exposure by forward contracts are below.
Case 1, where the firm faces an exposure coefficient (b) of £1,700. If the firm sells £1,700
forward, the dollar proceeds that the firm will receive are given by $1,700( F - S )

where F is the forward exchange rate and S is the spot rate realized on the maturity date. Note
that for each pound sold forward, the firm will receive a dollar amount equal to ( F - S ).
The forward exchange rate is assumed to be $1.50, which is the same as the expected future
spot rate. Thus, if the future spot rate turns out to be $1.40 under state 1, the dollar proceed
from the forward contract will be $170 = 1,700(1.50 - 1.40).
Since the dollar value ( P ) of the asset is $1,372 under state 1, the dollar value of the hedged
position (HP) will be $1,542 = $1,372 +1 $170) under state 1.
The variance of the dollar value of the hedged position is only 392($), whereas that of the
unhedged position is 19,659($). This result implies that much of the uncertainty regarding the
future dollar value of the asset is associated with exchange rate uncertainty. As a result, once
the exchange exposure is hedged, most of the variability of the dollar value of the asset is
eliminated.
The residual variability of the dollar value of the asset that is independent of exchange rate
changes, Var( e ), is equal to 392($).

Let us now turn to Case 3 where the local currency price of the asset is fixed. In this
case, complete hedging is possible in the specific sense that there will be no residual
variability. As shown in part B of Exhibit 9.5 , the future dollar value of the asset,
which is totally dependent upon the exchange rate, has a variance of 6,667($) 2 . Once
the firm hedges the exposure by selling £1,000 forward, the dollar value of the hedged
position (HP) becomes nonrandom, and is $1,500 across the three states of the world.
Since the asset now has a constant dollar value, it is effectively redenominated in terms
of the dollar.