Trident’s Transaction Exposure

Trident sells equipment to a British firm, Regency, for £1m.

The sale is large in relation to total sales; it is made in March for payment three months later.
CFO would be very happy if the £ appreciated against the $ but is concerned it might fall. She
budgets the minimum acceptable margin is at sales price of $1.7m. She has collected the
following financial and market information for the analysis of her currency exposure problem:
・ Budget rate (lowest acceptable FX rate): $1.70/£
・ Spot rate: $1.7640/£
・ 3‐month forward rate: $1.7540/£ (a 2.2676% per annum discount on the pound)
・ Trident’s cost of capital: 12.0% p.a.
・ UK 3‐month borrowing rate: 10.0% p.a. (or 2.5% per quarter)
・ UK 3‐month investment rate: 8.0% p.a. (or 2.0% per quarter)
・ US 3‐month borrowing rate: 8.0% p.a. (or 2.0% per quarter)
・ US 3‐month investment rate: 6.0% p.a. (or 1.5% per quarter)
・ June put option in the over‐the‐counter (bank) market for £1m; strike price $1.75 (nearly at‐
the‐money); 1.5% premium
・ Trident’s foreign exchange advisory service forecast of 3‐month future spot rate:
$1.76/£

1. Remain unhedged
According to FX adviser, Trident should receive $1.76m in 3 months time. But this is a risk
‐ may get this, may get more or may get less.

2. Forward market hedge
Forward hedge involves a forward (or futures) contract and a source of funds to fulfil that
contract.
Forward contract is entered into at time transaction backlog exposure is created ie. in
March, when sale is booked as account receivable.
Sale booked at spot rate, sale of $1.764m.
Forward hedge involves sale of £1m forward at 3‐mth forward rate $1.754/£. Funds will
be available from Regency’s payment (a business operation) to fulfil forward contract in 3
months time, so hedge is covered/perfect/square and no residual FX risk remains – funds
on hand match funds to be paid.
In 3 months time, Trident will receive £1m from Regency, deliver that sum to the bank and
receive $1.754m against its forward sale.
This certain sum is $6,000 less than the uncertain $1.76m expected from the unhedged
position because forward market quotation different from firm’s 3‐month spot forecast.
This certain sum is $10,000 less than the value of the sale originally booked ‐ this
difference is then booked as $10,000 FX loss. Note that the operating margin is not
affected by the FX loss.

3. Money market hedge

Like forward hedge, also involves contract & source of funds to fulfil contract.
Contract is loan agreement, borrow in one currency & exchange proceeds for another.
If funds to fulfil contract (repay loan) generated from business activities, hedge is covered.
Money market hedges can cover single or repeat transactions, “matching” expected
foreign currency inflows & outflows by currency & maturity.
Trident borrows £ ‐ if £ depreciates/appreciates, FX effect on cash inflows in £
approximately offset by cash outflows in £ from repaying loan + interest.
Difference from forward hedge is that cost determined by interest rates rather than
forward rate quotation. In efficient markets, same thing, but… and interest rate to
corporate unlikely same as risk‐free govt bill rates/Eurocurrency rates.
Trident borrows £ and converts to $ now, repaying loan from sale proceeds in 3 months
time. How much to borrow? Just enough to repay both principal and interest with sale
proceeds. Interest rate 10% pa, so borrow £1m/(1+0.025) = £975,610
Exchange this at $1.764/$ to get $1,720,976 now.
Loan proceeds received now whereas forward contract proceeds received in 3 months
time. Possible uses of proceeds:
Invest in T bill 6%/yr FV=$1,720,976 x (1+0.06/4) = $1,746,791
Pay off $ debt 8%/yr FV=$1,720,976 x (1+0.08/4) = $1,755,396
Invest in business 12%/yr FV=$1,720,976 x (1+0.12/4) = $1,772,605
Compare with forward hedge proceeds of $1.754m in 3 months time.
Can calculate break even investment rate making Trident indifferent between two.
(Loan proceeds) x (1+rate)=(forward proceeds)
r=0.0192 => 0.0192x360/90=7.68% pa
If Trident can invest proceeds at rate higher than 7.68%, money market hedge better than
forward hedge.

4. Options market hedge
Want downside protection but with possibility to benefit from upside:
Purchase put option, 3 month put option on £1m at a (nearly at the money) strike price of
$1.75/£ and a premium cost of 1.50%.
Cost of option:
(Size of option) x (premium) x (spot rate) = £1m x 0.015 x $1.764 = $26,460

FV of cost using 12% cost of capital = $26,460 x 1.03 = $27,254

In 3 months’ time:
・ if spot price is $1.76/£, exchange £ proceeds in spot market and $ proceeds =
$1.76m‐$27,254 option cost = $1,732,746
・ if spot price is $1.74/£, exercise option, get $1.75m gross less $27,254 option cost,
$1,722,746 net
Downside result < forward or money market hedges, but upside potential unlimited.
Choice depends on degree of risk aversion.
Trident’s Hedging Alternatives, Including an ATM Put Option
  

ATM put option becomes better alternative than:

・ Forward contract hedge if ending spot rate is above rate 1.754000+0.027254 =
$1.781/£
・ Money market hedge if ending spot rate is above rate 1.772605+0.027254 =
$1.800/£
The same principles can be applied to analyse an accounts payable transaction exposure.