Chapter 11

Managing Transaction
Exposure
 Presented By
“
1.
Group Member
Saman Nawaz
2. Mehroz Gul
3. Nayab Akram
4. Hina Bibi
5. Arooj Zahid

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Transaction Exposure

╸ The transaction exposure is a type of foreign exchange risk involved in

the international trade wherein the cross currency transactions are
involved

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Policies For Hedging
Transaction Exposure

╸ Hedging most of the exposure

╸ Selective hedging

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Hedging Exposure To
Payables

╸ Payable( import)
╸ Hedging
Receivable( export)
⮚ There are various techniques of hedging exposure
1. Forward or future hedge
2. Money market hedge
3. Call option hedge

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1. Forward or future
hedge on payables

╸ Forward contract and future contract allow an MNC to lock in a specific

exchange rate at which it can purchase a specific currency, thereby
hedging payables denominated in that currency

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The contract will specify
❑ The currency that the firm will pay
❑ The currency that the firm will receive
❑ The amount of currency to be received by the firm
❑ The rate at which the MNC will exchange currencies
❑ The future date at which the exchange of currencies will occur

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Example of forward contract
▪ Purchase 100000$ in one year
▪ Forward rate is Rs 1.20
▪ Cost in Rs= payable x forward rate
= 100000$ x Rs 1.20
= Rs 120000

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2. Money market hedge
on payables

╸ A money market hedge on payables involves taking a money market

position to cover a future payables position
╸ Two money market position
1. Borrowed funds in the home currency
2. Short term investment in the foreign currency

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╸ Payment ($100000) in 2020

XYZ company ABC company

( Pakistan) (USA)

╸ Good exported in 2019

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❑ PAKISTAN Deposit/ invest 2019 USA

Return 2020
Rs 100000
❑ Pakistan borrow Market ( Pakistan)
interest rate
❑ Pakistan USA USA
Borrow Deposit Payment

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Three rate are involved
1. Borrowing rate
2. Deposit rate
3. Spot rate

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Example of Money Market
▪ Coca cola company need 100000 dollar in one year then it could convert rupees to
dollar and deposit a dollar in bank today
❑ Deposit in US @ Deposit rate 4%
deposit amount to hedge payable
= 100000/1+0.04
=96153 $

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❑ Convert deposit amount in Rs @ spot rate 1.18
deposit amount in Rs = 96153$ x 1.18
= 113460 Rs
❑ Borrow at home currency @ borrowing rate 8%
= 113460 x( 1+0.08)
= 122536

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3. Call option hedge on
payables

╸ A currency call option provides the right to buy a specified amount of a

particular currency at a specified price ( called the strike price, exercise
price) within a given period of time
Exercise price
╸ Cost of hedging
Premium

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Cost of call option based
on contingency Graph

❖ Cost of hedging with call is not

known with uncertainty at the
time when options are
purchased
❖ Cost of hedging include
⇒ Price paid for Currency
⇒ Premium for call option

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Cost of call option
based on Currencyy
Forecast
╸ MNC whish to incorporate its own forecast of the
spot rate at the time payable are due.
→ $1.16 (20% probability)
→ $1.22 (70% probability)
→ $1.24 (10% probability)

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So
Expected value of cost= ($119,000*20%)+(123,000*80%)
=$122,200

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Comparison of
Techniques

Forward Hedge
Purchase $ 1 year forward.
Dollars needed in 1 year= payables in Rs x forward rate of $
=Rs 100,000 x $1.20
=$120,000

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Money Market Hedge Borrow $, convert to Rs, invest Rs, repay $
loan in 1 year.

Amount in Rs to be invested = 100,000/ 1 + .05

= Rs. 95,238
Amount in $ needed to convert into Rs. for deposit = Rs.95,238 x $1.18
= $112,381
Interest and principal owed on $ loan after 1 year= $112,381 x (1 .08)
=$121,371

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“ Step 1: Compare forward with Money
Market Hedge. Forward market hedge is
more desirable.
Step 2: Compare Forward with Call
Option.
So, Forward Hedge is optimal Hedge.

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Optimal Hedge
versus No Hedge

╸ Expected value of payables

╸ =($116,000 x 20%) + ($122,000 x 70%) +
($124,000 x 10%)
╸ =$121,000
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Evaluating Hedging
Decision

╸ MNCs can evaluate hedging decisions that they made in the past by
estimating the real cost of hedging payables, which is measured as:
╸ RCHp = Cost of hedging payables x Cost of payables if not hedged

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Hedging Exposure To
Receivables.

Techniques used:
Forward and FUTURE hedge
Money market hedge
Put option hegde
Forward and Future hedge.
Example of National food
Pakistan based MNC.

National food will received 5000 Dollar in 180 days. It

would obtain a forward contract to sell 5000 dollar in 180
days. The 180 days forward rate is RS160. The same rate
as currency future contracts on Dollars. If national food
sells dollars 180 days forward, it can estimate the amount
of rupee t be received in 180 days as follow :

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Continue…….

Cash flow In Rupee = Receivables *Forward

rate
= $5000 * 160=800000
(same process would apply if future contract
were used instead of forward contracts)

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Money market hedge

Continues with previous example if national food select money market

hedge than :
It can borrow funds denominated in dollar at a rate of 3% over a
period of 180 days.(after 180 days when receive the cash from us will
pay the entire loan)
Amount borrow =$5000/1+0.03)=$4754.36
So Firm used this amount for operational activity.

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If not used for
operational activity
than invest in money
market
Than convert $ to PKR, suppose the spot rate is presently
PKR159. When firm convert $ to PKR. It will receive :
Amount of rupee received from loan =$4754*159=755,943
So now these rupee will be invested in the money market. Assume
interest rate is 2%:
755,943.24*1+0.02= Rs 771,062

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Put option hedge
Based on contingency graph

It could do this by purchasing put option on 5000 dollars.

Assume that the out option have an exercise price of PKR
159, a premium of PKR5, and an expiration date of 180
from now (when the Receivables ariive).

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 Exercise price = PKR 159
Premium =PKR 5

190

180

170

160

150

140

130 140 150 160 170 180 190

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● Based on
Currency future
forcast
Considering previous example, national food purchasing a out
option contract on dollar ;the option has an exercise piece of PKR
161 and a premium of PKR5. The company has developed the
following Probability distribution for the spot rate of the dollar in
180 days:
╸ PKR 162 (30% Probability)
╸ PKR 163 (40%Probability)
╸ PKR 164(30%Probability)

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Contine…
Scenario Spot rate Premium per Amount Net amount PKR amount Probability Cash recive
when unit on put received per received per from (7) (6*7)=8
payments on options unit when unit (after hedging
Receivables (PKR) owing put accounting $5000
is received (3) options for premium Receivables
(PKR) (4) paid) with put
( 2) (5=4-3) option.
(6)
($5000*5)

1 162 05 163 158 790,000 30% 237,000

2 163 05 164 159 795,000 40% 318, 000

3 164 05 165 160 800,000 30% 240,000

Expected value of cash to be received = (237000+318000+240000= PKR 795000

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Optimal option

Cash flow from future hedging =800000 PKR

Cash flow from money market hedging = 771,062 PKR
Cash flow from PUT OPTION hedging = 795000 PKR.

So optimal option here is future contract but with camparing put

option there is little differcence so firm may be decide to go with
put option having let it expire option benefit here..

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If not hedge
Possible spot rate of Rupee payment when Probability Values = probability
$ in 180 days not hedging *rupee payments
=$5000*possible spot
rate

PKR 162 810000 30% 243, 000

PKR 163 815000 40% 326,000

PKR 164 820000 30% 246,000

Expected value of cash to be received =243000 +326,000

+246,000 =806000

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Contine... .

When camparing this expected value to the expected value of

cash that firm would received from its put option hedge
(795000), so national food decide to remain unhedged.
This decision reflect the hope of benefiting from appreciation
of dollar against rupee over the next 180 days..

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Evaluation of hedging
decisions after 180 days

after 180 days, when the Receivables arrived, the spot rate of
the $ is 165. Since National food did not hedge, it receives
Cash recieved =spot rate *amount recieved
=165 *$5000
PKR 8250000
So it's wise decision not to hedge..(825000-795000=PKR
30000

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Summary of hedging techniques

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