Lec 8+9 - Chapter 10-11-12

Chapter
10+11+12
Foreign
Exchange
Exposure
LECTURE OUTLINE
• Chapter 10: Transaction Exposure

• Chapter 11: Translation Exposure
• Chapter 12: Operating Exposure
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1-2 © 2013 Pearson Education
Foreign Exchange Exposure
• Foreign exchange exposure is a measure of the

potential for a firm’s profitability, net cash flow,
and market value to change because of a change
in exchange rates.
• An important task of the financial manager is to
measure foreign exchange exposure and to
manage it so as to maximize the profitability, net
cash flow, and market value of the firm.
• The three main types of foreign exchange
exposure:
– Transaction exposure,
– Translation exposure, and
– Operating exposure.
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Exhibit 10.1 Corporate Foreign
Exchange Exposure
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Transaction Exposure
• Transaction exposure measures changes

in the value of outstanding financial
obligations incurred prior to a change in
exchange rates but to be settled after
change in exchange rates .
• Thus, this type of exposure deals with
changes in cash flows that result from
existing contractual obligations.
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Operating Exposure
• Operating exposure:
– also called economic exposure,
competitive exposure, or strategic
exposure.
– measures the change in the present value
of the firm resulting from any change in
future operating cash flows of the firm
caused by an unexpected change in
exchange rates.
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Transaction vs Operating
exposure
• Transaction exposure and operating
exposure exist because of unexpected
changes in future cash flows.
• The difference between the two:
– transaction exposure is concerned with
future cash flows already contracted for,
– operating exposure focuses on expected
(not yet contracted for) future cash flows
that might change because a change in
exchange rates has altered international
competitiveness.
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7-7
Translation Exposure
(Accounting)
• Translation exposure, also called
accounting exposure, is the potential for
accounting-derived changes in owner’s
equity to occur because of the need to
“translate” foreign currency financial
statements of foreign subsidiaries into a
single reporting currency to prepare
worldwide consolidated financial statements.
(self-study)
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Why Hedge?
• MNEs possess a multitude of cash flows that

are sensitive to changes in exchange rates,
interest rates, and commodity prices.
• These three financial price risks are the
subject of the growing field of financial risk
management.
• Many firms attempt to manage their
currency exposures through hedging.
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Why Hedge?
• Hedging is the taking of a position, acquiring
either a cash flow, an asset, or a contract that will
rise (fall) in value to offset a fall (rise) in the value
of an existing position.
– The value of a firm, according to financial theory, is the
net present value of all expected future cash flows.
– Currency risk : the variance in expected cash flows
arising from unexpected exchange rate changes.
→ A firm that hedges these exposures reduces some

of the variance in the value of its future expected
cash flows.
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Exhibit 10.2 Hedging’s Impact on
the Expected Cash Flows of the Firm
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Why Hedge?
• While hedging can protect the owner of an asset

from a loss, it also eliminates any gain from an
increase in the value of the asset hedged against.
• Currency hedging reduces risk. Reduction of risk is
not, however, the same as adding value or return.
• The firm must expend resources to hedge, then
hedging will add value only if the value of hedging
is sufficiently large to compensate for the cost of
hedging.
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Why Hedge?
• Opponents of hedging state:

– Shareholders are much more capable of diversifying
currency risk than the management of the firm
– Currency risk management does not increase the expected
cash flows of the firm
– Management often conducts hedging activities that benefit
management at the expense of the shareholders (agency
conflict)
– Managers cannot outguess the market
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Why Hedge?
• Proponents of hedging cite:

– Reduction in risk in future cash flows improves the
planning capability of the firm
– Reduction of risk in future cash flows reduces the likelihood
that the firm’s cash flows will fall below a necessary
minimum (the point of financial distress)
– Management has a comparative advantage over the
individual shareholder in knowing the actual currency risk
of the firm
– Management is in better position to take advantage of
disequilibrium conditions in the market
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Measurement
of Transaction Exposure
Transaction exposure measures gains or losses that

arise from the settlement of existing financial
obligations whose terms are stated in a foreign
currency.
– Purchasing or selling on credit goods or services when
prices are stated in foreign currencies (receivable or
payable denominated in a foreign currency)
– Borrowing or lending funds when repayment is to be made
in a foreign currency
– Being a party to an unperformed foreign exchange forward
contract
– Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies
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Exhibit 10.3 The Life Span of
Transaction Exposure
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Example: Purchasing or selling on
an open account
Suppose that Trident Corporation, a U.S. firm, sells
merchandise on open account to a Belgian buyer for
€1,800,000, with payment to be made in 60 days. The
spot exchange rate on the date of the sale is $1.1200/€.
→The $2,016,000 (= 1.8m*1.12) is the value of the sale
which is posted to the firm’s books.
→Transaction exposure arises because of the risk that
Trident will receive something other than the $2,016,000
expected and booked.
a) If the euro weakens to $1.1000/€
→ Value of the transaction settled = 1.8*1.1=$1,980,000
b) If the euro should strengthen to $1.3000/€
→ Value of the transaction settled= 1.8*1.3= $2,340,000
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Example: Borrowing/Lending
• In mid-December 1994, Gemex, PepsiCo’s largest bottler

- a Mexican company, had U.S. dollar debt of $264
million. At that time, Mexico’s new peso (“Ps”) was traded
at Ps3.45/US$, a pegged rate that had been maintained
with minor variations since January 1,1993, when the
new currency unit had been created.
On December 22, 1994, the peso was allowed to float
because of economic and political events within Mexico,
and in one day it sank to Ps4.65/US$. For most of the
following January it traded in a range near Ps5.50/US$.
→ What happen to the value of the US$ debt in Peso term?
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7-18
Measurement
of Transaction Exposure
• Foreign exchange transaction exposure can be
managed by:
– contractual,
– operating, and
– financial hedges.
• The contractual hedges employ the forward,
money, futures, and options markets.
• Operating and financial hedges employ the use of
risk-sharing agreements, leads and lags in payment
terms, swaps, and other strategies.
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7-19
Trident’s Transaction Exposure
• Trident’s A/R exposure

– A sale of equipment to a British firm for £
1mil.
– The sale is made in March with payment
due 3 months later – June.
– Spot exchange rate: $1.7640/ £
– FX advisory forecast that spot rate in 3
months will be $1.76/ £
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7-20
• With reference to Trident’s Transaction

Exposure, the CFO, Maria Gonzalez, has
four alternatives:
– Remain unhedged;
– hedge in the forward market;
– hedge in the money market; or
– hedge in the options market.
• These choices apply to an account

receivable and/or an account payable.
(Trident’s case: Account receivable)
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Exhibit 10.4 Trident’s Transaction
Exposure
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Option 1: Remain unhedged
What happen to the A/R if the Spot rate

a) S = $1.6/£
b) S = $1.9/£
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7-23
• Option 2: forward hedge involves a forward (or
futures) contract and a source of funds to fulfill the
contract.
• If funds to fulfill the forward contract are on hand or are

due because of a business operation, the hedge is
considered covered, perfect, or square because no
residual foreign exchange risk exists. Otherwise, it will be
“open” or “uncovered” hedge and involves considerable
risk
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• Option 2: forward hedge
– If you are going to owe foreign currency in the

future (A/P: you have to buy foreign currency in
the future) → entering into long position in a
forward contract
– If you are going to receive foreign currency in the

future (A/R: you have to sell foreign currency in
the future),→ entering into short position in a
forward contract
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7-25
• Option 3: A money market hedge also involves a
contract and a source of funds to fulfill that contract.
To hedge a foreign currency receivable:
– Borrow the present value of the foreign currency
receivable today
– Convert that amount into the domestic currency at the
spot exchange rate.
– Invest the amount of domestic currency at WACC.
– Use your foreign currency receivable in the future to
repay the loan
– At maturity collect the proceeds from the domestic
investment. → This is your guaranteed domestic
currency proceeds from the sale.
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• Option 3: A money market hedge
In Trident’s case (AR), the contract is a loan agreement.
The firm borrows in one currency and exchanges the
proceeds for another currency.
– Maria will borrow pounds in London at once,
– immediately convert the borrowed pounds into
dollars, and
– repay the pound loan in three months with the
proceeds from the sale.
→ Loan principal and interest (FV of the loan)= the sale
proceeds.
→ Loan principal (PV of the loan) = £1,000,000/(1+0.025)
= £975,610
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7-27
• Future value of the proceeds under MMH:

= $1,720,976*(1+WACC*360/n)
= $1,720,976*(1+0.12*360/90)
= $1,772,605
• Compared with forward hedge:
→ Break-even point:
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7-28

The money-market hedge, if selected by Trident, creates
a pound-denominated liability (the pound loan), to
offset the pound-denominated asset (A/R). The
money market hedge works as a hedge by matching
assets and liabilities according to their currency of
denomination.
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7-29

To hedge a foreign currency payable,
– Borrow the present value of the foreign
currency payable today in domestic
currency/OR: use residual cash from operation
– Convert to foreign currency
– Invest (the present value of the foreign
currency payable) today at the foreign rate.
– At maturity use the proceeds from the foreign
investment to pay the foreign currency payable.
– Repay the domestic currency loan
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7-30
Option 4: Hedging with options allows for participation in

any upside potential associated with the position while
limiting downside risk.
• With a foreign currency payable (receivable), the firm

would like to protect itself only if the foreign currency
strengthens (weakens), while retaining the opportunity to
benefit if the foreign currency weakens (strengthens). →
the firm can buy a call (put) option
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7-31
Option 4: Hedging with options

• Trident’s case: Maria could purchase from her bank a 3-
month put option on £1,000,000 at a strike price of
$1.75/£ with a premium cost of 1.50%
(=1m*0.015*1.75=$26,460) → in 3m, exercised when
S<1.75
• Cost of option (in home currency) = (Size of option) * (spot
rate) * (%premium)
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7-32
A/R value in dollars in June

(A/R = £1,000,000)
Forward hedge
$1,754,000
(F = $1.7540/£)
Money market
$1,720,976*1.03 = $1,772,605
hedge
Option $1,750,000 - $27,254 = $1,722,746
(X= $1.7540/£) (premium (June) = $26,460(1.03)= $27,254)
10-33
7-33
Exhibit 10.5 Valuation of Cash Flows Under
Hedging Alternatives for Trident with Option
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7-34
Managing Account Payable
• Trident’s exposure
– A/P of £ 1mil on equipment purchase from
a British firm.
– The delivery is in March with payment due
3 months later – June.
– Spot exchange rate: $1.7640/ £
– FX advisory forecast that spot rate in 3
months will be $1.76/ £
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7-35
• Option 1: Remain unhedged
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7-36
• Option 2: Forward hedge
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7-37
• Option 3: Money market hedge
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• Option 4: Option hedge
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Exhibit 10.6 Valuation of Hedging
Alternatives for an Account Payable
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7-40
Operating Exposure
• Operating exposure, also called economic

exposure, competitive exposure, and even
strategic exposure, on occasion, measures
any change in the present value of a firm
resulting from changes in future operating
cash flows caused by an unexpected change
in exchange rates.
10-41
7-41
Attributes of Operating Exposure
• Operating exposure analysis assesses the impact of

changing exchange rates on a firm’s own operations
over coming months and years and on its
competitive position vis-à-vis other firms.
• The goal is to identify strategic moves or operating
techniques the firm might wish to adopt to enhance
its value in the face of unexpected exchange rate
changes.
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7-42
Static vs. Dynamic Operating
Exposure
• Static operating exposure: required analysis of
short and intermediate term fixed or static
contracts (generally termed transactions).
• Dynamic operating exposure: required analysis
of longer term/more dynamic forecasting (as prices
change and competitors react, the more
fundamental economic and competitive drivers of
the business may alter all cash flows of all units).
10-43
7-43
Trident Corporation’s basic structure
and currencies of operation
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7-44
• The cash flows of the MNE can be divided into

operating cash flows and financing cash flows.
– Operating cash flows arise from intercompany
(between unrelated companies) and
intracompany (between units of the same
company) receivables and payables, rent and
lease payments, royalty and license fees and
assorted management fees.
– Financing cash flows are payments for loans
(principal and interest), equity injections and
dividends of an inter and intracompany nature.
10-45
7-45
Exhibit 12.2 Financial and Operating
Cash Flows Between Parent and Subsidiary
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7-46
• Operating exposure is far more important for the

long-run health of a business than changes caused
by transaction or translation exposure.
• However, operating exposure is inevitably
subjective because it depends on estimates of
future cash flow changes over an arbitrary time
horizon.
• Planning for operating exposure is a total
management responsibility because it depends on
the interaction of strategies in finance, marketing,
purchasing and production.
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7-47
Impact of exchange rates changes on
expected cash flows
Exhibit 12.3 Operating Exposure’s Phases of Adjustment and
Response
10-48
7-48
Exhibit 12.4 Trident and Trident
Germany
10-49
7-49
Trident Germany value changes to
depreciation of the Euro
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7-50
Strategic Management of
Operating Exposure
• The objective of both operating and transaction
exposure management is to anticipate and
influence the effect of unexpected changes in
exchange rates on a firm’s future cash flows
→ Management can diversify or change the firm’s
operating and financing base.
• A diversification strategy does not require
management to predict disequilibrium, only to
recognize it when it occurs.
10-51
7-51
Operating Exposure
Diversifying operation:
• If a firm’s operations are diversified
internationally, management is pre-positioned
both to recognize disequilibrium when it occurs
and to react competitively.
• The variability of MNEs cash flows is probably
reduced by international diversification →
operating exposure would be neutralized.
• Domestic firms may be subject to the full impact
of foreign exchange operating exposure (no
variability of CF)
10-52
7-52
Operating Exposure
Diversifying financing
• If a firm’s financing sources are diversified, it will
be pre-positioned to take advantage of temporary
deviations from the international Fisher effect.
• However, to switch financing sources, a firm must
already be well-known in the international
investment community.
• Again, this would not be an option for a domestic
firm (if it has limited its financing to one capital
market).
10-53
7-53
Proactive Management of
Operating Exposure
• Operating and transaction exposures can be

partially managed by adopting operating or
financing policies that offset anticipated foreign
exchange exposures.
• The four most commonly employed proactive

policies are:
– Matching currency cash flows
– Risk-sharing agreements
– Back-to-back or parallel loans
– Currency swaps
10-54
7-54
Operating Exposure
1. Matching currency cash flows
Exhibit 12.8 depicts the exposure of a U.S. firm
with continuing export sales to Canada
– One way to offset an anticipated continuous long
exposure to a particular company is to acquire
debt denominated in that currency (matching).
– An alternative would be for the US firm to seek
out potential suppliers of raw materials or
components in Canada as a substitute for U.S.
or other foreign firms.
– In addition, the company could engage in
currency switching, in which the company would
pay foreign suppliers with Canadian dollars.
10-55
7-55
Exhibit 12.8 Debt Financing as a
Financial Hedge
10-56
7-56
Operating Exposure
Currency Clauses - Risk-Sharing:

– An alternate method for managing a long-term
cash flow exposure between firms is risk-sharing.
– This is a contractual arrangement in which the
buyer and seller agree to “share” or split
currency movement impacts on payments
between them.
– This agreement is intended to smooth the impact
on both parties of volatile and unpredictable
exchange rate movements.
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7-57
Class example
• Ford and Mazda to agree that all purchases by Ford will be

made in Japanese yen at the current exchange rate, as
long as the spot rate on the date of invoice is between ¥115/$
and ¥125/$. If, however, the exchange rate falls outside this
range on the payment date, Ford and Mazda will share the
difference equally.
• Ford has an account payable of ¥25,000,000 for the month of
March. What will be the value of this A/P in USD if the spot rate
on the date of invoice is ¥110/$?
• Value of A/P in USD =25m/(110+(115-110)/2) = $222,222.22
• New value in JPY for Mazda = $222,222.22* 110 = JPY
24,444,444.44
10-58
7-58
Proactive Management
of Operating Exposure
Back-to-Back Loans
– also referred to as a parallel loan or credit swap,
occurs when two business firms in separate
countries arrange to borrow each other’s
currency for a specific period of time.
– At an agreed terminal date they return the
borrowed currencies.
– Such a swap creates a covered hedge against
exchange loss, since each company, on its own
books, borrows the same currency it repays.
– Exhibit 12.9 illustrates a back-to-back loan.
10-59
7-59
Exhibit 12.9 Back-to-Back Loans for
Currency Hedging
10-60
7-60
There are two fundamental impediments to

widespread use of the back-to-back loan:
– It is difficult for a firm to find a partner, termed a
counterparty for the currency amount and timing
desired.
– A risk exists that one of the parties will fail to
return the borrowed funds at the designated
maturity – although each party has 100%
collateral (denominated in a different currency).
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7-61
Cross-Currency Swaps
– A currency swap resembles a back-to-back loan
except that it does not appear on a firm’s
balance sheet.
– In a currency swap, a firm and a swap dealer or
swap bank agree to exchange an equivalent
amount of two different currencies for a specified
amount of time.
– The swap dealer or swap bank acts as a
middleman in setting up the swap agreement.
10-62
7-62
Exhibit 12.10 Using Cross-Currency
Swaps
10-63
7-63
Contractual Approaches: Hedging
the Unhedgeable
• Some MNEs now attempt to hedge their operating
exposure with contractual hedges.
• Merck and Eastman Kodak have undertaken long-
term currency option positions hedges designed to
offset lost earnings from adverse exchange rate
changes.
• The ability to hedge the “unhedgeable” is
dependent upon:
– Predictability of the firm’s future cash flows
– Predictability of the firm’s competitor’s responses to
exchange rate changes
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Lecture summary
• Transaction exposure:
– Forward hedge
– Money market hedge
– Option hedge
• Operating exposure
– Attributes: static vs dynamic, operating vs financing
– Strategic management: diversification
– Proactive strategies
• Matching currency cashflows
• Risk-sharing agreements
• Back-to-back loan
• Cross-currency swap
10-65
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Chapter

• Chapter 10: Transaction Exposure

• Foreign exchange exposure is a measure of the

• Transaction exposure measures changes

• MNEs possess a multitude of cash flows that

→ A firm that hedges these exposures reduces some

• While hedging can protect the owner of an asset

• Opponents of hedging state:

• Proponents of hedging cite:

Transaction exposure measures gains or losses that

• In mid-December 1994, Gemex, PepsiCo’s largest bottler

• Trident’s A/R exposure

• With reference to Trident’s Transaction

• These choices apply to an account

Option 1: Remain unhedged

What happen to the A/R if the Spot rate

• If funds to fulfill the forward contract are on hand or are

– If you are going to owe foreign currency in the

– If you are going to receive foreign currency in the

• Future value of the proceeds under MMH:

• Option 3: A money market hedge

• Option 3: A money market hedge

Option 4: Hedging with options allows for participation in

• With a foreign currency payable (receivable), the firm

Option 4: Hedging with options

A/R value in dollars in June

• Option 1: Remain unhedged

• Option 2: Forward hedge

• Option 3: Money market hedge

• Option 4: Option hedge

• Operating exposure, also called economic

• Operating exposure analysis assesses the impact of

• The cash flows of the MNE can be divided into

• Operating exposure is far more important for the

• Operating and transaction exposures can be

• The four most commonly employed proactive

Currency Clauses - Risk-Sharing:

• Ford and Mazda to agree that all purchases by Ford will be

There are two fundamental impediments to

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