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Chapter 11

Transaction Exposure

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Transaction 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 effect on a firm when foreign exchange rates change can be measured in several ways.

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Exhibit 11.1 Conceptual Comparison of Transaction, Operating, and Translation Foreign Exchange Exposure

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• Thus.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. All rights reserved. Copyright © 2010 Pearson Prentice Hall. this type of exposure deals with changes in cash flows the result from existing contractual obligations. 11-4 .

11-5 . All rights reserved.Types of Foreign Exchange Exposure • Operating exposure. Copyright © 2010 Pearson Prentice Hall. competitive exposure. or strategic exposure. also called economic 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.

All rights reserved. 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. Copyright © 2010 Pearson Prentice Hall. 11-6 .Types of Foreign Exchange Exposure • Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. • The difference between the two is that transaction exposure is concerned with future cash flows already contracted for.

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.Types of Foreign Exchange Exposure • Translation exposure. All rights reserved. . 11-7 Copyright © 2010 Pearson Prentice Hall. also called accounting exposure.

• “Realized” means that the loss or gain involves cash flows. only realized foreign exchange losses are deductible for purposes of calculating income taxes. however.Types of Foreign Exchange Exposure • The tax consequence of foreign exchange exposure varies by country. 11-8 . • Similarly. only realized gains create taxable income. Copyright © 2010 Pearson Prentice Hall. All rights reserved. • As a general rule.

All rights reserved. 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. interest rates. 11-9 Copyright © 2010 Pearson Prentice Hall. .Why Hedge? • MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates.

acquiring either a cash flow. Copyright © 2010 Pearson Prentice Hall. All rights reserved. an asset. 11-10 . • While hedging can protect the owner of an asset from a loss.Why Hedge? • Hedging is the taking of a position. it also eliminates any gain from an increase in the value of the asset hedged against. 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 fact that these cash flows are expected emphasizes that nothing about the future is certain. according to financial theory. Copyright © 2010 Pearson Prentice Hall. • A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows. 11-11 . • Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. All rights reserved.Why Hedge? • The value of a firm. is the net present value of all expected future cash flows.

All rights reserved. 11-12 .Exhibit 11.2 Impact of Hedging on the Expected Cash Flows of the Firm Copyright © 2010 Pearson Prentice Hall.

Why Hedge? • However. 11-13 . is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of hedging state (among other things): – 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 Copyright © 2010 Pearson Prentice Hall. All rights reserved.

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 Copyright © 2010 Pearson Prentice Hall. 11-14 . All rights reserved.

11-15 .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. All rights reserved. • The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency. Copyright © 2010 Pearson Prentice Hall.

11-16 .3 The Life Span of a Transaction Exposure Copyright © 2010 Pearson Prentice Hall. All rights reserved.Exhibit 11.

swaps. and options markets. and financial hedges. • Operating and financial hedges employ the use of risk-sharing agreements. and other strategies. futures. • The main contractual hedges employ the forward. 11-17 .Measurement of Transaction Exposure • Foreign exchange transaction exposure can be managed by contractual. leads and lags in payment terms. operating. Copyright © 2010 Pearson Prentice Hall. All rights reserved. money.

• A financial hedge refers to either an offsetting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap. a payable arising from the conduct of business.Measurement of Transaction Exposure • The term natural hedge refers to an offsetting operating cash flow. All rights reserved. Copyright © 2010 Pearson Prentice Hall. 11-18 . • Care should be taken to distinguish operating hedges from financing hedges.

Trident’s Transaction Exposure • With reference to Trident’s Transaction Exposure. has four alternatives: – Remain unhedged. or – hedge in the options market. All rights reserved. – hedge in the money market. • These choices apply to an account receivable and/or an account payable. 11-19 . Maria Gonzalez. – hedge in the forward market. the CFO. Copyright © 2010 Pearson Prentice Hall.

11-20 .Trident’s Transaction Exposure • A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract. All rights reserved. Copyright © 2010 Pearson Prentice Hall. funds to fulfill the forward exchange contract are not already available or due to be received later. • In some situations. but must be purchased in the spot market at some future date. • The purchase of such funds at a later date is referred to as covering. • This type of hedge is “open” or “uncovered” and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract.

in which case the money market hedge is covered.Trident’s Transaction Exposure • A money market hedge also involves a contract and a source of funds to fulfill that contract. funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge). • Funds to fulfill the contract – to repay the loan – may be generated from business operations. the contract is a loan agreement. • The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. • In this instance. • Alternatively. 11-21 . Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Exhibit 11. 11-22 .4 Valuation of Cash Flows by Hedging Alternative for Trident Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• The choice of option strike prices is a very important aspect of utilizing options as option premiums.Trident’s Transaction Exposure • Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk. All rights reserved. 11-23 . Copyright © 2010 Pearson Prentice Hall. and payoff patterns will differ accordingly.

11-24 . Including an ATM Put Option Copyright © 2010 Pearson Prentice Hall.5 Trident’s Hedging Alternatives.Exhibit 11. All rights reserved.

All rights reserved. 11-25 .Exhibit 11.6 Valuation of Hedging Alternatives for an Account Payable Copyright © 2010 Pearson Prentice Hall.

is usually considered a cost center.Risk Management in Practice • The treasury function of most private firms. • Currency risk managers are expected to err on the conservative side when managing the firm’s money. the group typically responsible for transaction exposure management. • The treasury function is not expected to add profit to the firm’s bottom line. 11-26 . Copyright © 2010 Pearson Prentice Hall. All rights reserved.

however.Risk Management in Practice • Firms must decide which exposures to hedge: – Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy – Many firms feel that until the transaction exists on the accounting books of the firm. the probability of the exposure actually occurring is considered to be less than 100% – An increasing number of firms. All rights reserved. – Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties Copyright © 2010 Pearson Prentice Hall. 11-27 . but also selectively hedging quotation and anticipated exposures. are actively hedging not only backlog exposures.

• Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges. 11-28 . transaction exposure management programs are generally divided along an “option-line”. Copyright © 2010 Pearson Prentice Hall.Risk Management in Practice • As might be expected. All rights reserved. those that use options and those that do not.

All rights reserved. • These contracts generally 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.Risk Management in Practice • Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging. view of exchange rate movements. . 11-29 Copyright © 2010 Pearson Prentice Hall. and confidence level.

Mini-Case Questions: Xian-Janssen Pharmaceutical • How significant an impact do foreign exchange gains and losses have on corporate performance at XJP? What is your opinion of how they structure and manage their currency exposures? Copyright © 2010 Pearson Prentice Hall. 11-30 . All rights reserved.

It has always pursued a highly decentralized organizational structure. All rights reserved.Mini-Case Questions: Xian-Janssen Pharmaceutical • J&J has roughly 200 foreign subsidiaries worldwide. 11-31 . How is this reflected in the situation in which XJP finds itself? Copyright © 2010 Pearson Prentice Hall. in which the individual units are responsible for their own performance from the top to the bottom line of the income statement.

and the expectations for the Chinese subsidiary’s financial results by the U. parent company? • If you were Paul Young. what would you do? Copyright © 2010 Pearson Prentice Hall. the forward rate.S. All rights reserved. the budgeted spot exchange rate. 11-32 .Mini-Case Questions: Xian-Janssen Pharmaceutical • What is the relationship between actual spot exchange rate.

All rights reserved.Chapter 11 Additional Chapter Exhibits Copyright © 2010 Pearson Prentice Hall. .

1999–2003) Copyright © 2010 Pearson Prentice Hall. 11-34 . All rights reserved.Exhibit 1 Chinese Renminbi/Euro Spot Exchange Rate (monthly average.

Exhibit 2 Xian-Janssen Pharmaceutical (China) Copyright © 2010 Pearson Prentice Hall. All rights reserved. 11-35 .