1. Chapter 8 Transaction Exposure

2. Three Types of Exposures
Transaction exposure:
the sensitivity of “realized” domestic currency values of the firm's contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. 
Economic exposure:
the extent to which the value of the firm would be affected by unanticipated changes in exchange rates.
Translation exposure:
the potential that the firm's consolidated financial statements can be affected by changes in exchange rates.

3. Transaction Exposure
A firm is subject to transaction exposure whenever it has foreign-currency denominated receivables or payables.
The magnitude of transaction exposure is the same as the amount of foreign currency that is receivable or payable.

4. Ways for hedging transaction exposure
Financial contracts:
Forward market hedge
Money market hedge
Option market hedge
Swap market hedge
Operational techniques:
Choice of the invoice currency
Lead/lag strategy
Exposure netting

5. Example
Suppose that Boeing Corporation exported a Boeing 737 to British Airways and billed £10 million payable in one year. The money market interest rates and foreign exchange rates are given as follows:
Lets look at the ways for managing this transaction exposure.
The U.S. interest rate:
6.10% per annum.
The U.K. interest rate:
9.00% per annum.
The spot exchange rate:
$1.50/£.
The forward exchange rate:
$1.46/£ (1-year maturity)

6. Forward Market Hedge
The firm may sell (buy) its foreign currency receivables (payables) forward to eliminate its exchange risk exposure.
Boeing may simply sell forward its pounds receivable, £10 million for delivery in one year.
Once Boeing enters into the forward contract, exchange rate uncertainty becomes irrelevant for Boeing.

7. Dollar Proceeds from the British Sale: Forward Hedge versus Unhedged Position

9. Futures or forward contract?
A futures contract is not as suitable as a forward contract for hedging purpose for two reasons.
Unlike forward contracts that are tailor-made to the firm's specific needs, futures contracts are standardized instruments in terms of contract size, delivery date, and so forth.
Due to the marking-to-market property, there are interim cash flows prior to the maturity date of the futures contract that may have to be invested at uncertain interest rates.

10. Money Market Hedge
Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money markets.
The firm may borrow in foreign currency to hedge its foreign currency receivables .
The firm may lend in foreign currency to hedge its foreign currency payables.

11. Money Market Hedge
The step-by-step procedure of money market hedging can be illustrated as follows:
Borrow £9,174,312.
Convert £9,174,312 into $13,761,468 at the current spot exchange rate of $1.50/£.
Invest $13,761,468 in the United States.
Collect £10 million from British Airways and use it to repay the pound loan.
Receive the maturity value of the dollar investment, that is, $14,600,918 = ($13,761,468)(1.061), which is the guaranteed dollar proceeds from the British sale.

13. Options Market Hedge
One possible shortcoming of both forward and money market hedges is that these methods completely eliminate exchange risk exposure. 
Boeing ideally would like to protect itself only if the pound weakens, while retaining the opportunity to benefit if the pound strengthens.

14. Options Market Hedge
A firm may buy a foreign currency call option to hedge its foreign currency payables.
A firm may buy a foreign currency put option to hedge its foreign currency receivables.

15. Options Market Hedge
suppose that in the over-the-counter market Boeing purchased a put option on 10 million British pounds with an exercise price of $1.46 and a one-year expiration.
Assume that the option premium (price) was $0.02 per pound.
Boeing thus paid $200,000 (= $0.02 × 10 million) for the option. 
Boeing has the right, but not the obligation, to sell up to £10 million for $l.46/£, regardless of the future spot rate.

16. Options Market Hedge
Considering the time value of money, this upfront cost is equivalent to $212,200 (= $200,000 × 1.061) as of the expiration date. 

17. The break-even spot rate can be found by solving the following:
$10,000,000*ST - $212,200 = $14,600,000

18. Options Market Hedge
The options hedge allows the firm to limit the downside risk while preserving the upside potential. 

19. Options Market Hedge
Choice of the exercise price for the options contract ultimately depends on the extent to which the firm is willing to bear exchange risk.
If the firm's objective is only to avoid very unfavorable exchange rate changes then it should buy an out-of-money put option with a low exercise price, saving option costs. 

21. Hedging Foreign Currency Payables
So far, we have discussed hedging Boeing's receivables now let consider hedging payables.
Suppose Boeing imported a Rolls-Royce jet engine for £5 million payable in one year. The market condition is summarized as follows:
The U.S. interest rate:
6.00% per annum.
The U.K. interest rate:
6.50% per annum.
The spot exchange rate:
$1.80/£.
The forward exchange rate:
$1.75/£ (1-year maturity)

22. Forward Contracts
Buy £5 million forward in exchange for the following dollar amount: $8,750,000 = £5,000,000*$1.75/£
Regardless of the spot exchange rate that may prevail in one year, Boeing's foreign currency payable is fully hedged.

23. Money Market Instruments
the present value of its foreign currency payable:
£4,694,836=£5,000,000/1.065
immediately invests £4,694,836 at the British interest rate of percent per annum to guarantee having £5,000,000 in one year.
This would cost $8,450,705 = £4,694,836*$1.8/£
The future value of this dollar cost is $8,957,747 = $8,450,705*1.06
This exceeds the forward cost. forward would be preferred over money market hedge in this case.

24. Currency Options Contracts
It needs to buy “call” options on £5,000,000. 
It has to decide on the exercise or strike price for the call options.
Assume that Boeing chooses the exercise price at $1.80/£ with the premium of $0.018 per pound. 
he total cost of options as of the maturity date (considering the time value of money):
$95,000 = $0.018/£*$5,000,000*1.06

25. Currency Options Contracts
Boeing will be able to secure £5,000,000 for a maximum of $9,095,400 (= $9,000,000 + $95,400), or less.
The break-even spot exchange rate, that is, ST*, can be computed from the following equation:
$8,750,000 = 5,000,000*ST + $95,400
ST*= 1.731

27. Cross-Hedging Minor Currency Exposure
If the firm has positions in a less liquid currencies such as the Korean won, Thai bhat, and Czech koruna, it may be either very costly or impossible to use financial contracts in these currencies.
Financial markets of developing countries are relatively underdeveloped and often highly regulated.
Could use cross-hedging.

28. Cross-Hedging Minor Currency Exposure
Cross-hedging involves hedging a position in one asset by taking a position in another asset.
The effectiveness of cross-hedging depends upon how well the assets are correlated.
An example would be a U.S. importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive, it can be a good hedge. But they need to co-vary in a predictable way.

29. Hedging Contingent Exposure
Option contracts can provide an effective hedge against contingent exposure.
Contingent exposure refers to a situation in which the firm may or may not be subject to exchange exposure. 
Suppose General Electric (GE) is bidding on a hydroelectric project in Quebec Province, Canada. If the bid is accepted, which will be known in three months, GE is going to receive C$100 million to initiate the project. 

31. Hedging Recurrent Exposure with Swap Contracts
A swap 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.
The swap contracts can be viewed as a portfolio of forward contracts.
Firms that have recurrent exposure can usually hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along.
It is also the case that swaps are available in longer-terms than futures and forwards.

32. Hedging through Invoice Currency
The firm can shift, share, or diversify:
Shift exchange rate risk by invoicing foreign sales in home currency
Share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies
Diversify exchange rate risk by using a market basket index

33. Hedging via Lead and Lag
If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency.
If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.

34. Exposure Netting
A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.
Once the residual exposure is determined, we hedge that.
Multilateral netting is an efficient and cost-effective mechanism for settling interaffiliate foreign exchange transactions and thus determining the firm’s residual exposure.

35. Should the firm hedge?

36. What Risk Management Products do Firms Use?
Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts.
The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.

38. Summary
The firm is subject to a transaction exposure when it faces contractual cash flows denominated in foreign currencies.
Transaction exposure can be hedged by financial contracts like forward, money market, and options contracts, as well as by such operational techniques as the choice of invoice currency, lead/lag strategy, and exposure netting.
If the firm has a foreign-currency-denominated receivable (payable), it can hedge the exposure by selling (buying) the foreign currency receivable (payable) forward.
The firm can expect to eliminate the exposure without incurring costs as long as the forward exchange rate is an unbiased predictor of the future spot rate.
The firm can achieve equivalent hedging results by lending and borrowing in the domestic and foreign money markets.

39. Summary
currency options provide flexible hedges against exchange exposure. With the options hedge, the firm can limit the downside risk while preserving the upside potential.
Currency options also provide the firm with an effective hedge against contingent exposure.
The firm can shift, share, and diversify exchange exposure by appropriately choosing the invoice currency.
The firm can reduce transaction exposure by leading and lagging foreign currency receipts and payments, especially among its own affiliates.

40. Summary
When a firm has a portfolio of foreign currency positions, it makes sense only to hedge the residual exposure rather than hedging each currency position separately.
In a perfect capital market where stockholders can hedge exchange exposure as well as the firm, it is difficult to justify exposure management at the corporate level. In reality, capital markets are far from perfect, and the firm often has advantages over the stockholders in implementing hedging strategies. There thus exists room for corporate exposure management to contribute to the firm’s value.

41. Problem 1
Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10 million payable in six months. Currently, the six-month forward exchange rate is $1.10/€ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/€ in six months.
What is the expected gain/loss from the forward hedging?
If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? Why or why not?
Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?
Suppose now that the future spot exchange rate is forecast to be $1.17/€. Would you recommend hedging? Why or why not?

42. Problem 2
IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-month forward rate is ¥100/$. The three- month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable.
Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

43. Problem 3
You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three- month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.
(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.
(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?