Chapter 9 IF

Chapter 9
Transaction
Exposture
Learning Objectives
• Distinguish between the three major foreign

exchange exposures experienced by firms
• Analyze the pros and cons of hedging foreign
exchange transaction exposure
• Examine the alternatives available to a firm for
managing a large and significant transaction
exposure
• Evaluate the institutional practices and concerns of
foreign exchange risk management
9-2 © 2016, Pearson Education, Ltd. All rights reserved.

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 and manage foreign exchange exposure
• Foreign exchange exposure can be measured in
several ways.

Exhibit 9.1 Corporate Foreign
Exchange Exposure

Types of Foreign Exchange Exposure
• Transaction exposure measures changes in the

value of outstanding financial obligations incurred
prior to a change in exchange rates but not due to
be settled until after the exchange rates change.
• Exposure to foreign exchange risk resulting from
the sensitivity of the domestic currency value of
contractual cash flows to change in the exchange
rate
• Is the level of risk faced by companies involved in
international trade, specifically, the risk that
currency exchange rates will change after a
company has already entered into financial
obligations.
• Thus, this type of exposure deals with changes in

cash flows the result from existing contractual
obligations.
• A high level of exposure to fluctuating exchange
rates can lead to major losses for firms.
• A company that has agreed to but not yet settled a
cross-currency contract that has transaction
exposure.

Measurement of Transaction
Exposure
• Transaction exposure examples:

– Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
– Borrowing or lending funds when repayment is to be
made in a foreign currency
– Being a party to an unperformed forward contract and
– Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies

• 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. Or:
• Is a type of foreign exchange exposure caused by the
effect of unexpected currency fluctuations on a
company’s future cash flows, foreign investments and
earnings.
• Degree to which exchange rate changes, will alter a
company’s future operating cash flows.

• Transaction exposure and operating exposure exist

because of unexpected changes in future cash flows
• But transaction exposure is concerned with future
cash flows already contracted for, while 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

• 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.
• Exposure to foreign exchange risk resulting from
the effect of changes in the exchange rate on the
domestic currency values of foreign currency
balance sheet and income statement items

• Translation exposure is the risk that a company's

equities, assets, liabilities or income will change in
value as a result of exchange rate changes. This
occurs when a firm denominates a portion of its
equities, assets, liabilities or income in a foreign
currency, and it's also known as "accounting
exposure.”

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.

Why Hedge?
• Hedging is the taking of a position, acquiring either

a cash flow, an asset, or a contract (including a
forward contract) that will rise (fall) in value and
offset a fall (rise) in the value of an existing
position.
• The covering of foreign exchange risk in order to
eliminate or reduce the variability of the domestic
currency value of a foreign currency position
• 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.

Why Hedge?
• Hedging is a way for a company to minimize or

eliminate foreign exchange risk. Two common
hedges are forward contracts and options.
• The value of a firm is the present value of all

expected future cash flows.
• Expected but not certain
• Currency risk is 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.

Exhibit 9.2 Hedging’s Impact on the
Expected Cash Flows of the Firm

Why Hedge?
• Is a reduction in the variability of cash flows

sufficient reason for currency risk management?
• Opponents argue:
– Shareholders are much more capable of diversifying
currency risk than the management of the firm
• They can diversify their portfolio to manage the risk in a way that
satisfies them.
– Currency hedging does not increase the expected cash
flows of the firm. Currency risk management does.
– Hedging activities can benefit management at the expense
of the shareholders (agency conflict)
– Managers cannot outguess the market

Why Hedge?
• Proponents of hedging cite:

– Reduction in risk of future cash flows improves planning
capabilities of the firm
– 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 in knowing the
actual currency risk of the firm
– Management is in better position to take advantage of
disequilibrium conditions in the market

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
• transaction exposure is concerned with future cash
flows already contracted for
• The most common examples of transaction
exposure:
– Receivables or payables denominated in a foreign currency
– Funds loaned or borrowed in foreign currency

Measurement
• Transaction exposure arises when a firm has a

receivable or payable denominated in a foreign
country.
• The total transaction exposure consists of quotation,
backlog and billing exposures.

Exhibit 9.3 The Life Span of a
Transaction Exposure

Purchasing or Selling on Open
Account
Trident Corporation (U.S. Firm) sell merchandise on
open account to Belgian €1,800,000, payment in 60
days
Spot exchange rate = $1.12/ €
So €1,800,000 x $1.12/ € = $ 2,016,000 (payment
received)
Transaction exposure arises because of the risk that
Trident will receive other than $ 2,016,000 expected
and booked
Booked-Value of the sales that is posted to the firm’s
books

Purchasing or Selling on Open
Account
If Belgian (euro) weakens to $1.1000/ €,
US seller received payment only €1,800,000 x $1.100/ € = $
1,980,000
So:
Transaction settlement : €1,800,000 x $1.100/ € = $ 1,980,000

Transaction booked: €1,800,000 x $1.100/ € = $ 2,016,000
Foreign exchange gain (loss) on sale = $ 36,000
If the euro strengthen to $1.300/ €, Tridents receives

€1,800,000 x $1.30/ € = $2,340,000, an increase of $324,000
over the amount expected

Borrowing or Lending
Funds are borrowed or loaned, amount denominated in a foreign

currency
In mid December had U.S. dollars debt $264 million

Exchange rate December 1994 Ps3.45/$
New exchange January 1995 Ps5.50/$
Dollar debt in mid-December 1994: $264,000 x Ps3.45/$ Ps10,800,000

Dollar debt in mid-January 1995 : $264,000 x Ps5.50/$ Ps1,452,000,000
Dollar debt increase measure in Ps541,200,000
Mexican Peso
The number of peso needed to repay dollar debt increased

Measurement
• Foreign exchange transaction exposure can be
managed by contractual, operating, and financial
hedges.
• The main 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.

Measurement
• The term natural hedge refers to an off-setting

operating cash flow, a payable arising from the
conduct of business.
• A financial hedge refers to either an off-setting debt
obligation (such as a loan) or some type of financial
derivative such as an interest rate swap.
• Care should be taken to distinguish operating
hedges from financing hedges.

Transaction Exposure Management:
The Case of Trident
• 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.

The Case of Trident
• Tridents Corporation, US firm sale to Regency, British
firm for £1,000,000
• Payment in March, due 3 month, in June
• Acceptable margin at a sales price $1,700,000
• Lowest exchange rate $1.70/£
• Any exchange below this rate, would result in Trident
realizing no profit on the deal
• Exhibit 9.4 summarized the financial and market
information for the analysis of currency exposure
problem
• The unknown- transaction exposure: actual realized
value of the receivable in U.S. dollars at the end of
90 days
Exhibit 9.4 Trident’s Transaction
Exposure

The Case of Trident
Remain unhedged
• Believes on foreign exchange advisor, she expect

the exchange rate $1.76/£,
• Accept the transaction risk, if expect to receive
£1,000,000 x $1.76 = $1,760,000 in three month
• If the pound fall, $1.65/ £, she will receive only
$1,650,000

The Case of Trident
• A forward hedge involves a forward (or futures)

contract and a source of funds to fulfill the contract.
• When funds to fulfill the forward exchange contract
are due to be received later (“open” or “uncovered”
hedge), involves considerable risk because of the
uncertain future spot rate to fulfill the forward
contract

The Case of Trident: Forward Hedge
• Booked at the spot rate of exchange on the booking

date $1.7640/£ = $1,764,000 (receivable account)
• Funds to fulfill forward contract available in Jun, Tridents
receive £1,000,000 from Regency
Hedge transaction exposure with forward

• Sell £1,000,000 forward today at the 3 month forward
rate of $1.7540/£
• This is covered transaction, Tridents no longer has any
foreign exchange risk

The Case of Trident: Forward Hedge
• In 3 month, firm receives £1,000,000 from the British

buyer, deliver that sum to the bank against its forward
sale and receive $1,754,000
• So, Trident’s income statement as a foreign exchange
loss of $10,000 (booked $1,764,000, settled
$1,754,000)

The Case of Trident: Money Market
Hedge
• A money market hedge also involves a contract
and a source of funds to fulfill that contract.
• In this instance, the contract is a loan agreement.
• The firm seeking the money market hedge borrows
in one currency and exchanges the proceeds for
another currency.

The Case of Trident
• Funds to fulfill the contract – to repay the loan –

may be generated from business operations, in
which case the money market hedge is covered.
• Alternatively, funds to repay the loan may be
purchased in the foreign exchange spot market
when the loan matures (uncovered or open money
market hedge).

The Case of Trident
• Hedge in the money market:

• Maria borrows pound in London at once, immediately
convert the borrowed pounds into dollars, and repay
the pound loan in 3 months with the proceeds from
the sale of the generator.
• Borrow pound – convert into dollar – repay the
pound
• Borrowing interest rate: 10% per annum or 2.5% for
3 month

The Case of Trident
• Therefore the amount to borrow now for the repayment

in 3 month
• £1,000,000/1+0.025 = £975,610
• Marie would borrow £975,610 now, and in 3 month repay

that amount plus £24,390 of interest. Total £1,000,000
• Tridents would exchange the £975,610 loan proceeds for

Dollars at the current spot exchange rate of $1.7640/£,
receiving $1,720,976
• So, money hedge created a pound-denominated liability,
to offset the pound-denominated asset, a/c receivable
The Case of Trident
Liabilities and Net

Assets Worth
Account Bank loan (principal)
receivable £1,000,000 £975,610
Interest payable
24,390
£1,000,000 £1,000,000

The Case of Trident
• To compare the forward hedge and money hedge,

analyze how Trident’s loan proceeds will be utilized for
the next 3 months
• Hence we must calculate the future value of the loan
proceeds or PV of the forward contract proceeds
• Make clear choice based on the yield or assumed rate of
investment or use of the loan
• Tridents might be invested in U.S. dollar money market
instruments, yield 6% per annum
• Use the pound loan proceeds to pay down dollars loans
that currently cost Tridents 8% per annum
• Invest in the general operation of the firm, cost of capital
of 12 % per annum
The Case of Trident
• Use the WACC of 12% to calculate the FV of proceeds

under the money market hedge
• Use the WACC of 12% (3% for 3month), to calculate the

FV of proceeds under the money market hedge:
FV
$1,720,976 x 1.03 = $1,772,605
• calculate break-even rate between the forward hedge and
the money market hedge

The Case of Trident
• R is the unknown 3month investment rate that would

equalize the proceeds from the forward and money
market hedge
Loan proceeds x (1+rate) = (Forward proceeds)

$1,720,976 x(1+r) = $1,754,000
R = 0.0192
• Convert this 3-month investment rate to an annual

percentage as follow:
0.0192 x 360/90 x 100 = 7.68%

The Case of Trident
• So, If Marie can invest in the loan proceeds at a rate

higher than 7.68% per annum, she would prefer money
market hedge
• If she can only invest in at a rate lower than 7.68%, she
would prefer the forward hedge

The Case of Trident: Option Market
Hedge
Option Market Hedge
• Using a put option to cover the exposure
• Maria purchase 3 month put option on £1,000,000 at an
at-the-money (ATM) strike price of $1.75/£ with a
premium cost 1.50%
FORMULA
The cost of the option-the premiums is
• (Size of option) x (Premium) x (spot rate) = cost of
option
• £1,000,000 x 0.015 x $1.7640 = $26,460
Hedge
• Using FV to compare hedging alternatives
• Calculate the premium cost of the option in 3months
• Hence use Cost of capital of 12% per annum
• Therefore, the premium cost of the put option as of
June
$26,460(1.03) = $27,254, equal to $0.0273 per pound

(27,254 ÷ £1,000,000)

Hedge
• When receives £1,000,000 on June the value in Dollars
depend on the spot rate that time
• At any exchange rate above $1.75/£, Tridents would allow
its option to expire unexercised and would exchange the
pound for the dollar at the spot rate
• If the expected rate of $1.76/£ materializes, Tridents
would exchange the £1,000,000 in the spot market for
$1,760,000

Hedge
• Net proceeds would be $1,760,000 - $27,254 =
$1,732,746
• If the pound depreciates below $1.75/£, Maria would
exercise option to sell (put) £1,000,000 at $1.75/£ receive
$1,750,000 gross
– $1,750,000 - $27,254 = $1,722,746
• In finance, the strike price (or exercise price) of an

option is the fixed price at which the owner of the option
can buy (in the case of a call), or sell (in the case of a
put), the underlying security or commodity.

Hedge
• Calculate the break-even points for the option compared with
other strategies
• The upper bound of the range is determined by comparison
with forward rate
• The pound must appreciate enough above the $1.7540
forward rate to cover the $0.0273/£ cost of option
• Therefore the break-even upside spot price of the pound
must be $1.7540 + $0.02373 =$1.7813
• If the spot pound appreciates above $1.7813/£ proceed
under option strategy greater than forward hedge
• If the spot pound depreciates below $1.7813/£ the forward
hedge is better

Hedge
• The lower bound of the range is determined by the unhedged
strategy.
• If the spot price falls below $1.754/£, Maria would exercise
her put and sell the proceeds at $1.75/£ receiving
$1,750,000 gross
• If the spot rate falls below $1.7227/£ the net proceeds from
exercising the option would be greater selling from the
unhedged pounds in the spot market
• At any spot rate above $1.7221/£, the spot proceeds from
remaining unhedged will be greater

The Case of Trident: Comparison of
Alternatives
• Exhibit 9.5 shows the value of Trident’s £1,000,000 account
receivable over a range of possible ending spot rates and
hedging alternatives
• If the exchange rate move to the left of $1.76/£, the money
market preferred with guarantee value $1,772,605
• If the exchange rate move to the right of $1.76/£, choice of
hedge lies between remaining unhedged, the money market
hedged or the put option.

Exhibit 9.5 Valuation of Cash Flows Under
Hedging Alternatives for Trident with Option

Exhibit 9.6 Valuation of Hedging
Alternatives for an Account Payable

Management of an Account Payable
• If firm required to make a foreign currency payment at future

date.
• If Trident had £1,000,000 account payable in 90 days, the
hedging choice:
– Remain unhedged: waits for 90 days, exchange dollars for
pounds at that time, and make its payment. If expects
that spot rate in 90 days to be $1.7600/ £, the payment
cost $1,760,000.
• Forward market hedge: buy £1,000,000 forward, locking in a
rate $1.7540/ £ and total dollar cost $1,754,000. This is
$6,000 less than the expected cost of remaining unhedged.
• Money marked hedged:

Management of an Account Payable:
Money Market Hedge
• Money marked hedged: would exchange U.S. dollars spot and

invest for 90 days in a pound denominated interest bearing
account. The principal and interest in British pounds at the
end of the 90-day period would be used to pay the
£1,000,000 acc payable
• In order to assure the principal and interest exactly equal to
£1,000,000 due in 90 days, Tridents would discount the
£1,000,000by the pound investment interest rate of 8% for
90 days in order to determine pounds needed today
• £1,000,000/(1 + (0.08 x 90/360)) = £980,392.16

• This £980,392.16 needed today would require $1,729,411.77
at current spot rate of $1.7640/ £
– £980,392.16 X $1.7640 = $1,729,411.77

Management of an Account Payable
Money Market Hedge
• Finally in order to compare the money market hedge outcome

with the other hedging alternatives, the $1,729,411.77 cost
today must be carried forward 90 days to the same future
date as the other hedge choices
• This £980,392.16 needed today would require $1,729,411.77
at current spot rate of $1.7640/ £
– £980,392.16 X $1.7640 = $1,729,411.77
• If the current dollar cost is carried forward at Trident’s WACC of 12%, the
total money market hedge is $1,781,294.12
$1,729,411.77 x(1+(0.12 x 90/360)) = $1,781,294.12

• This is higher than the forward hedge and therefore unattractive

Risk Management in Practice
• The treasury function of most private firms, the

group typically responsible for transaction exposure
management, is usually considered a cost center.
• The treasury function is not expected to add profit
to the firm’s bottom line.
• Currency risk managers are expected to err on the
conservative side when managing the firm’s money.

• Firms must decide which exposures to hedge:

– Many firms do not hedge quotation exposure
or backlog exposure
– Unless the transaction exists on the accounting
books of the firm
– But an increasing number of firms are actively
hedging backlog, quotation and anticipated
exposures without contracts or agreements

• As might be expected, transaction exposure

management programs are generally divided along
an “option-line,” those that use options and those
that do not.
• Firms that do not use currency options rely almost
exclusively on forward contracts and money
market hedges.

• Many MNEs have rigid transaction exposure risk

management policies that mandate proportional
hedging
• These policies require the use of forward contract
hedges on a percentage of existing transaction
exposures
• The remaining portion of the exposure is then
selectively hedged on the basis of the firm’s risk
tolerance, view of exchange rate movements, and
confidence level

Summary of Learning Objectives
• MNEs encounter three types of currency exposure:

(1) transaction; (2) operating; and (3) translation
exposure
• Transaction exposure measures gains or losses
that arise from the settlement of financial
obligations whose terms are stated in a foreign
currency

• Operating exposure measures the change in the

present value of the firm resulting from any
change in future operating cash flows caused by
an unexpected change in exchange rates
• Translation exposure is the potential for
accounting-oriented changes in owner’s equity
when a firm translates foreign subsidiaries’
financial statements to consolidated financial
statements

• Considerable theoretical debate exists as to

whether firms should hedge currency risk.
Theoretically, hedging reduces the variability of
the cash flows to the firm. It does not increase the
cash flows to the firm. In fact, the costs of
hedging may potentially lower them

• Transaction exposure can be managed by

contractual techniques and certain operating
strategies. Contractual hedging techniques include
forward, futures, money market, and option
hedges
• The choice of which contractual hedge to use
depends on the individual firm’s currency risk
tolerance and its expectation of the probable
movement of exchange rates over the transaction
exposure period

• In general, if an exchange rate is expected to

move in a firm’s favor, the preferred contractual
hedges are probably those which allow it to
participate in some up-side potential, but protect
it against significant adverse exchange rate
movements

• In general, if the exchange rate is expected to

move against the firm, the preferred contractual
hedge is one which locks in an exchange rate,
such as the forward contract hedge or money
market hedge
• Risk management in practice requires a firm’s
treasury department to identify its goals. Is
treasury a cost center or profit center?

• Treasury must also choose which contractual

hedges it wishes to use and what proportion of the
currency risk should be hedged. Additionally,
treasury must determine whether the firm should
buy and/or sell currency options, a strategy that
has historically been risky for some firms and
banks

Chapter 9 IF

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Chapter 9 IF

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Chapter 9

• Distinguish between the three major foreign

9-2 © 2016, Pearson Education, Ltd. All rights reserved.

• Foreign exchange exposure is a measure of the

9-3 © 2016, Pearson Education, Ltd. All rights reserved.

9-4 © 2016, Pearson Education, Ltd. All rights reserved.

• Transaction exposure measures changes in the

• Thus, this type of exposure deals with changes in

9-6 © 2016, Pearson Education, Ltd. All rights reserved.

• Transaction exposure examples:

9-7 © 2016, Pearson Education, Ltd. All rights reserved.

• Operating exposure, also called economic exposure,

9-8 © 2016, Pearson Education, Ltd. All rights reserved.

• Transaction exposure and operating exposure exist

9-9 © 2016, Pearson Education, Ltd. All rights reserved.

• Translation exposure, also called accounting

9-10 © 2016, Pearson Education, Ltd. All rights reserved.

• Translation exposure is the risk that a company's

9-11 © 2016, Pearson Education, Ltd. All rights reserved.

• MNEs possess a multitude of cash flows that are

9-12 © 2016, Pearson Education, Ltd. All rights reserved.

• Hedging is the taking of a position, acquiring either

9-13 © 2016, Pearson Education, Ltd. All rights reserved.

• Hedging is a way for a company to minimize or

• The value of a firm is the present value of all

9-14 © 2016, Pearson Education, Ltd. All rights reserved.

9-15 © 2016, Pearson Education, Ltd. All rights reserved.

• Is a reduction in the variability of cash flows

9-16 © 2016, Pearson Education, Ltd. All rights reserved.

• Proponents of hedging cite:

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• Transaction exposure measures gains or losses that

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• Transaction exposure arises when a firm has a

9-19 © 2016, Pearson Education, Ltd. All rights reserved.

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9-21 © 2016, Pearson Education, Ltd. All rights reserved.

Transaction settlement : €1,800,000 x $1.100/ € = $ 1,980,000

If the euro strengthen to $1.300/ €, Tridents receives

9-22 © 2016, Pearson Education, Ltd. All rights reserved.

Funds are borrowed or loaned, amount denominated in a foreign

In mid December had U.S. dollars debt $264 million

Dollar debt in mid-December 1994: $264,000 x Ps3.45/$ Ps10,800,000

The number of peso needed to repay dollar debt increased

9-23 © 2016, Pearson Education, Ltd. All rights reserved.

9-24 © 2016, Pearson Education, Ltd. All rights reserved.

• The term natural hedge refers to an off-setting

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• These choices apply to an account receivable

9-26 © 2016, Pearson Education, Ltd. All rights reserved.

9-28 © 2016, Pearson Education, Ltd. All rights reserved.

• Believes on foreign exchange advisor, she expect

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• A forward hedge involves a forward (or futures)

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• Booked at the spot rate of exchange on the booking

Hedge transaction exposure with forward

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• In 3 month, firm receives £1,000,000 from the British

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9-33 © 2016, Pearson Education, Ltd. All rights reserved.

• Funds to fulfill the contract – to repay the loan –

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