Transaction Exposure

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 Types of forex exposure
• Forex exposure
• potential change in profitability, net cash flow, market value due to
change in forex rate.
• Transaction Exposure
• changes in value of outstanding financial obligations incurred prior
to change in forex, not due to settle until after forex change.
• Operating (Economic) Exposure
• change in firm PV resulting from change in expected future
operating cash flows due to unexpected forex change
• Translation (Accounting) Exposure
• accounting-derived changes in owner equity due to consolidation
in single currency.
• Tax Exposure
• varies by country, general rule only realized foreign losses are
deductible for calculating income taxes

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 Why Hedge? Pros & Cons…
– Improves planning.
– Reduces likelihood of bankruptcy.
– Management better knows actual risks.
vs.
– Currency risk management costly, may not increase
expected cash flows.
– Shareholders more capable diversifying risk.
– Investors already factored forex exposure into valuation.
– Conducts hedging to benefit management.
– Managers cannot outguess efficient market .
– Management criticized for forex losses but not for cost in
avoiding forex losses.

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 Why Hedge?
•Reduction of risk? Hedged
•Increase/decrease in expected
cash flow?
•Increase in value?

Unhedged

NCF Expected Cash Flow Net Cash Flow (NCF)

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 What causes transaction exposure?

• Purchasing or selling on credit.

• Borrowing or lending in foreign currency.

• Being party to unperformed forward contract.

• Acquiring assets/ incurring liabilities in foreign

currency.
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 Open Account Purchasing/ Selling

t1 t2 t3 t4
Seller Buyer Seller ships Buyer
quotes places product settles A/R
price order

Quotation Backlog Exposure Billing Exposure

Exposure
Anticipa- Contract Signed. Time to get paid.
tion Time b/n quoting
Time to fill order.
Exposure price & reaching
sale.

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 Borrowing &Lending
• Grupo Embotellador de Mexico (Gemex)

– Dollar debt mid-December, 1994:

• $ 264 m  PS 3.45/$ = PS 910,800,000.
– Dollar debt in mid-January, 1995:
• $ 264 m  PS 5.50/$ = PS 1,452,000,000 (59% up!)

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How to manage transaction exposure?
• Contractual hedge
• Operating hedges
– Risk-sharing agreements.
– Leads and lags in payment terms.
– Swaps.
• Natural hedge
• Financial hedge
– offsetting debt obligation.
– financial derivative such as swap.

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 Account Payable Hedge
• Assume £1,000,000 A/P in 90 days
– Unhedged position: expected pay $1,760,000.
– Forward market hedge: purchase forward @ $1.754/£, cost
locked $1,754,000.
– Money market hedge:
• Offset £ obligation by £ asset w/ matching maturity.
• Exchange US$ spot & invest for 90 days in £.
£1,000,000
 £980,392, £980,392  $1.764/£  $1,729,412.
  90 
 
1  .08 x 
  360 

• Carry the cost forward 90 days

  90 
$1,729,412 x 1   0.12 x   $1,781,294.
  360 

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 Account Payable Hedge
• Option hedge:
– purchase call option on payable.
– ATM call option w/ strike $1,75/£ would be 1.5%
premium.
– If spot less $1.75/£ option expire & £1,000,000
purchased on spot market.
– If spot above $1.75/£ option exercised: exchange
£1,000,000 @ $1.75/£ less option premium:
£1,000,000 x 0.015 x $1.75/£  $26,460
– Carried forward 90 days @ 12% p.a. premium
$27,254.
Exercise call option (£1,000,000  $1.75/£ $1,750,000
Call premium (carried forward 90 days) $27,254
Total maximum expense of call option hedge $1,777,254
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 A / P Hedges
US$ value of
£1,000,000 A/R
Uncovered
1.84 Forward
$1.754/£
1.82
Call strike Call option:
1.80 $1.75/£
$1,777,254
1.78
Money market
1.76 $1,781,294

1.74 Forward contract

$1,754,000
1.72

1.70

1.68
1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86

Ending spot (US$/£)

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 Forex Risk Management for Real
• Goals?
– cost center vs. profit center.
• Exposures?
– backlog exposure?
– selectively hedge backlog & anticipated
exposures?
• Contractual Hedges?
– Amount of risk covered, proportional hedges?
– Currency options?

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 Things to remember
• Types of forex exposures
– Transaction
– Operating
– Translation
– Tax
• How to hedge A/R & A/P transaction
exposure?
– Money market?
– Forward market?
– Option market?

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