Chapter 10

Transaction
Exposure
Management
 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.
• Exhibit 10.1 shows schematically the three main
types of foreign exchange exposure: transaction,
translation, and operating.

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 Exhibit 10.1 Corporate Foreign
Exchange Exposure

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 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.
• Thus, this type of exposure deals with
changes in cash flows the result from
existing contractual obligations.

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 Types of Foreign
Exchange Exposure

• 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.

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 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,
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.

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 Types of Foreign
Exchange Exposure

• 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.

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 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.

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 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.
• 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.

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 Why Hedge?

• The value of a firm, according to financial theory, is

the net present value of all expected future cash
flows.
• The fact that these cash flows are expected
emphasizes that nothing about the future is certain.
• Currency risk is defined roughly as 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 10.2 illustrates the distribution of
expected net cash flows of the individual firm.

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 Exhibit 10.2 Hedging’s Impact on
the Expected Cash Flows of the Firm

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 Why Hedge?

• However, 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

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 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

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 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.
• The most common example of transaction
exposure arises when a firm has a receivable
or payable denominated in a foreign
currency. Exhibit 10.3 demonstrates how
this exposure comes about.

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 Exhibit 10.3 The Life Span of
Transaction Exposure

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 Measurement
of Transaction Exposure
• 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.

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 Measurement
of Transaction Exposure

• 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.

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 Trident’s Transaction Exposure

• 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.
• See Exhibit 10.4
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 Exhibit 10.4 Trident’s Transaction
Exposure

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 Trident’s Transaction Exposure

• A forward hedge involves a forward (or futures) contract and

a source of funds to fulfill the contract.
• In some situations, funds to fulfill the forward exchange
contract are not already available or due to be received later,
but must be purchased in the spot market at some future
date.
• 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.
• The purchase of such funds at a later date is referred to as
covering.

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 Trident’s Transaction Exposure

• 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.
• 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).

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 Trident’s Transaction Exposure

• Hedging with options allows for participation in any

upside potential associated with the position while
limiting downside risk.
• The choice of option strike prices is a very important
aspect of utilizing options as option premiums, and
payoff patterns will differ accordingly.
• Exhibit 10.5 shows the value of Trident’s £1,000,000
account receivable over a range of possible ending
spot exchange rates and hedging alternatives.
• Exhibit 10.6 shows alternatives for an account
payable

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 Exhibit 10.5 Valuation of Cash Flows Under
Hedging Alternatives for Trident with Option

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 Exhibit 10.6 Valuation of Hedging
Alternatives for an Account Payable

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 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.

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 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, however, are actively
hedging not only backlog exposures, but also selectively
hedging quotation and anticipated exposures.
– Anticipated exposures are transactions for which there
are – at present – no contracts or agreements between
parties

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 Risk Management in Practice

• 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.

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 Risk Management in Practice

• Many MNEs have established rather rigid

transaction exposure risk management policies that
mandate proportional hedging.
• 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, view of exchange rate movements, and
confidence level.

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