Transaction Exposure

-Prepared by Mr. Amit A Rajdev,

-Faculty of Finance, VMPIM.

1. What is TE?
Transaction exposure can be defined as the sensitivity

of realized domestic currency values of the firms

contractual cash flows denominated in foreign
currencies to unexpected exchange rate changes.
TE defined as the risk for changes in the exchange

rates for the contracts that are entered but not yet
settled.
Transaction

exposure
arises
from
fixed-price
contracting in a world where exchange rates are
changing randomly.

2. Management of TE
Financial Contracts
Forward Market
Hedge
Money Market
Hedge
Option Market
Hedge
Swap Market Hedge

Operational
Techniques
Choice of Invoice
Currency
Lead/Lag Strategy
Exposure Netting

Example: Write in your book.

Boeing

Corporation exported a Boeing 747 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 USA interest rate

6.10% p.a.

The UK interest rate

9.00% p.a.

The spot exchange rate

$1.50/

The forward exchange

rate

$1.46/

Using Financial Contracts

2.1 Using Forward

Boeing Can Sell Forward Pound receivable, 10

million for delivery in one year, in exchange for a

given amount in dollars. In exchange Boeing can
take $14.6 million ($1.46*10 million), regardless of
the spot exchange rate that may prevail on the
maturity date.
Receipts from the British Sale
Spot
Exchange
rate on
Maturity Date

Un-hedged
Position

Forward
Hedge

Gains/Losses
from Hedge

$ 1.30

$1,30,00,000

$1,46,00,000

$16,00,000

$ 1.40

$1,40,00,000

$1,46,00,000

$6,00,000

$ 1.46

$1,46,00,000

$1,46,00,000

$ 1.50

$1,50,00,000

$1,46,00,000

- $4,00,000

$ 1.60

$1,60,00,000

$1,46,00,000

- 14,00,000

2.2 Money Market Hedge

The firm may borrow (lend) in foreign currency to

hedge its foreign currency receivables (payables),

thereby matching its assets and liabilities in the
same currency.
Continuing with same example, Boeing can

eliminate the exchange exposure arising from the

British sale by first borrowing in pounds, then
converting the loan proceeds into dollars, which
then can be invested at the dollar interest rate.
On maturity date of the loan, Boeing is going to

use to pound receivable to pay off the pound loan.

2.2 Money Market Hedge

If

Boeing borrows a particular pound

amount so that the maturity value of this
loan becomes exactly equal to pound
receivable from the British sale, Boeings
net pound exposure is reduced to zero, and
Boeing will receive the future maturity
value of the dollar investment.

2.2 Money Market Hedge

First Step: decide the amount to borrow.

(which is discounted present value of

pound receivable, i.e., (10 million/1.09) =
91,74,312. When Boeing borrows
91,74,312, it then has to repay 10 million
in one year, which equivalent to its pound
receivable. The step-by-step procedure of
money market hedging can would be:

2.2 Money Market Hedge

1. Borrow 91,74,312 in the U.K
2. Convert 91,74,312 into $1,37,61,468 at

the current spot exchange rate of $1.50/.

3. Invest $1,37,61,468 in the USA.
4. Collect $10 million from British Airways and
use it to repay the pound loan.
5. Receive the maturity value of the dollar
investment,
that
is,
$1,4600,918
=
$1,37,61,468(1.061), which is guaranteed
dollar proceeds from the British Sale.

2.3 Options Market Hedge

The options hedge will allow the firm to limit the

downside risk while preserving the upside

potential.
E.g Boeing can purchase a put option on 10
million British Pounds with an exercise price of
$1.46 and a one-year expiration.
Assume that option premium (price) was $0.02
per pound. Boeing thus paid $2,00,000 for the
option. Considering the time value of money, this
upfront
cost
is
equivalent
to
$2,12,200
(=$2,00,000*1.061) as of the expiration date. So,
net dollar proceeds from the British sale =
$1,43,87,800 = $1,46,00,000 - $2,12,000

2.3 Options Market Hedge

Future
Spot
Exchange
Rate

Exercise
Decision

Gross
Dollar
Proceeds

Option
Cost

Net Dollar
Proceeds

$ 1.30

Exercise

$1,46,00,000 $2,12,200

$1,43,87,80
0

$ 1.40

Exercise

$1,46,00,000 $2,12,200

$1,43,87,80
0

$ 1.46

Neutral

$1,46,00,000 $2,12,200

$1,43,87,80
0

$ 1.50

Not Exercise

$1,50,00,000 $2,12,200

$1,47,87,80
0

$ 1.60

Not Exercise

$1,60,00,000 $2,12,200

$1,57,87,80
0

2.4 Hedging Through SWAPs

Firms often have to deal with a sequence of

accounts payable or receivable in terms of a

foreign currency.
Such

recurrent cash flows in a foreign

currency can best be hedged using a currency
swap contract, which is an agreement to
exchange one currency for another at a
predetermined exchange rate, that is, the
swap rate, on a sequence of future dates.

Using Opeational Techniques

3.1 Hedging Through Invoice

Currency
The

firm can shift, share, or diversify

exchange risk by appropriately choosing
the currency of invoice.

3.2 Hedging via Lead & Lag

The lead means to pay or collect early,

whereas to lag means to pay or collect late.

3.3 Exposure Netting

If the firm has a portfolio of currencies

positions, it makes sense to hedge residual

exposure rather than hedge each currency
option separately.

Examples

1. A Japanese auto dealer has supplied cars

in Germany for which the payment of

6.15 million is due after 6 months from
now. Following exchange rate scenario is
prevailing in the market in Tokyo:
Spot Exchange rate (/) :
160175
6-m forward rate (/):
155167

The dealer is inclined to book a forward

contract to sell euro as yen is showing a

rising trend. The banker of the dealer has
suggested that it would be better to have
Euros now than by borrowing the same.
The interest rate applicable for the euro
loan would be 5%.
Examine the desirability of the proposal of
the banker. The interest rates prevailing in
the Yen market are 2%.

Solution-1
Spot Exchange rate (/) : 160-175
6-m forward rate (/):
155-167
Yen is appreciating while euro is depreciating.
Forward Hedge:
Exporter can sell his receivable at the rate of

155.00.
Therefore, amount realizable = 155* 6.15m =
953.25m

Solution-1
Interest rate
:
2.00%
5.00%
Money Market Hedge:
Borrow the foreign currency in such a manner that its
maturity value is liquidated by the receivable.
(6.15/1.025 = 6.00m)
Convert the borrowing at the spot exchange rate into
local currency. (6.00m* 160= 960m).
Invest the amount in at the rate of 1.00% (960*1%=
969.60)
Total amount Money Market Hedge =
969.60million
Gain MM Hedge Forward Hedge
(969.60 953.25 = 16.35m)

2. An

Indian importer is negotiating payment

terms for acquiring a machine costing 25,000
that is payable after 3 months. The exchange
rate market is quoting following rates:
Spot Exchange rate (Rs./)
:
59.80-60.10
6-m Swap points
:
120160
a) If the cost of borrowing for the importer is
15.00% per annum, should the importer pay
now or after 3 months?
b) Would your decision change if the supplier
offers a cash discount of (i)1%(ii)2%.

Solution-2
Spot Exchange rate (Rs./)
:
59.80-60.10
6-m Swap points
:
120-160
Swap points are low/high. They suggest
depreciation of Indian rupee.
Spot Exchange rate (Rs./)
:
59.80-60.10
6-m Swap points
:
60.0061.70
The Indian firm by booking the forward contract
would pay = 25,000*61.70=Rs. 15,42,500.
If the firm decides to pay now its cash out flow
would be:
= 25,000*60.10=Rs.15,02,500

Solution-2
Cost of borrowing = 15%p.a.
Interest payable for 3-m =

15,02,500*3.75% = Rs.56344.
Effective amount = 15,02,500 +
56,344 = 15,58,844.
a. Conclusion: Since forward amount is less
Rs. 15,42,500 compared to loan amount
firm should go for credit period.

Solution-2
b) If the vendor for the machine offers a cash
dis. of 1%.
Amount payable in the spot 24,750*60.10 =
Rs.14,87,475.
Cost of borrowing = 15%
Interest payable for 3-m = 14,87,475*3.75% =
Rs.55,780
Effective amount payable = 14,87,475 + 55,780 =
Rs.15,43,255.
Conclusion: Since forward amount is less Rs.
15,42,500 compared to loan amount firm should go
for credit period.

Solution-2
b) If the vendor for the machine offers a cash
dis. of 2%.
Amount payable in the spot 24,500*60.10 =
Rs.14,72,450.
Cost of borrowing = 15%
Interest payable for 3-m = 14,72,450*3.75% =
Rs.55,217
Effective amount payable = 14,72,450+ 55,217 =
Rs.15,27,667.
Conclusion: As the 2% cash discount will be beneficial
to firm, it must accept the same and avoid forward
amount which is higher Rs. 15,42,500.

3. Following scenario exists in the foreign

exchange markets and money markets in

India and Britain:
Spot Rate (Rs./)
:
80.2080.50
6-m Forward Rate (Rs./) :
81.5082.00
Interest rates:
Rs.
:
10.00-10.50

:
05.50-06.00

1. ITL Ltd. expects to receive 10,000 in 6

months and faces a choice of covering the

exposure, either through money market or
forward market. Find out which hedge is
more efficient.
2. IPL Ltd. has to pay 10,000 in 6 months. It
has also the option of covering the
exposure, either through money market
hedge or forward market. Find out which
hedge is more efficient.

Solution-3

1.

Interest Rate:
Spot (Rs./)
:80.20-80.50 Rs.:10.00-10.50
Forward (Rs./) :81.50-82.00 : 05.50-06.00

Forward Hedge:
ITL Ltd. may book a 6-m forward sell contract for
receivables and realize = 81.50*10,000 = Rs. 8,15,000.
Money Market Hedge:
Borrow at 6%(borrowing rate) = 10,000/1.03 =
9708.74
Convert borrowed amt at spot =
9708.74*80.20=Rs.7,78,640.95.
Invest rupees for 6-m (deposit
rate)=7,78,640.95*1.05=Rs. 8,17,573.
Since realization in MM hedge is higher company should
go for MM hedge.

Solution-3

2.

Interest Rate:
Spot (Rs./)
:80.20-80.50 Rs.:10.00-10.50
Forward (Rs./) :81.50-82.00 : 05.50-06.00

Forward Hedge:
IPL Ltd. may book a 6-m forward buy contract for payment
and realize = 82.00*10,000 = Rs. 8,20,000.
Money Market Hedge:
Borrow Rs. at 10.5%(borrowing rate) Find the amount:
= 10,000/1.0275 (5.5%)= 9732.36
Convert borrowed amt at spot =
9732.36*80.50=Rs.7,83,454.99.
Value of rupee if invested in India=7,83,454.99*1.0525=
Rs. 8,24,586.37
Since payment in MM hedge is higher than forward hedge,
IPL ltd. should go for forward hedge.

Thank u