1. Managing Transaction Exposure
CHAPTER 11
Managing Transaction Exposure
© 2000 South-Western College Publishing 1

2. Chapter Objectives
To identify the commonly used techniques for hedging transaction exposure;
To explain how each technique can be used to hedge future payables and receivables;
To compare the advantages and disadvantages among hedging techniques; and
To suggest other methods of reducing exchange rate risk when hedging techniques are not available.

3. Transaction Exposure
Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations.
However, on the average, hedging may not reduce the MNC’s costs.
If transaction exposure exists, the MNC should
identify the degree of transaction exposure,
decide whether to hedge and how much to hedge based on its degree of risk aversion and exchange rate forecasts, and
choose among the various hedging techniques available if it decides to hedge.

4. Transaction Exposure
MNCs that adopt a centralized approach to hedging must identify the net transaction exposure in each currency for all its subsidiaries.
Note that sometimes, a firm can reduce its transaction exposure by pricing its exports in the same currency that will be needed to pay for imports.

5. Techniques to Eliminate Transaction Exposure
A futures hedge involves the use of currency futures to hedge transaction exposure.
Recall that futures contracts represent a standardized number of units for each currency.
A futures hedge is not always beneficial, but some firms may be more comfortable locking in their exchange rates than remaining exposed to exchange rate fluctuations.

6. Techniques to Eliminate Transaction Exposure
A forward hedge involves the use of forward contracts by large corporations to hedge transaction exposure.
Based on the firm’s degree of risk aversion, the decision about whether to hedge can be made by comparing the known result of hedging to the possible results of remaining unhedged.

7. Techniques to Eliminate Transaction Exposure
For payables :
real nominal cost nominal cost
cost of = of payables – of payables
hedging with hedging without hedging
For receivables :
nominal nominal
real home currency home currency
cost of = revenues – revenues
hedging received received
without hedging with hedging
If the real cost is negative, then hedging is more favorable than not hedging.

8. Techniques to Eliminate Transaction Exposure
To estimate the real cost, the probability distribution of the exchange rates is needed:
expected probability real cost
real cost = S that exchange x of hedging
of hedging i rate is i when rate is i
The overall probability that hedging will be more costly can also be computed.
Note that to avoid distortion, the real cost of hedging for each currency should be expressed as a percentage of their respective hedged amounts if they are to be compared.

9. Text book example

10. Cost of hedging

11. Techniques to Eliminate Transaction Exposure
A money market hedge involves taking one or more money market position to cover a future payables or receivables position.
Often, two positions are required:
For payables, (1) borrow the home currency representing future payables, and (2) invest in the foreign currency.
For receivables, (1) borrow the foreign currency representing future receivables, and (2) invest in the home currency.

12. Money market hedge - own funds

13. Money market hedge - borrowed funds

14. Money market - receivables

15. Techniques to Eliminate Transaction Exposure
If interest rate parity (IRP) exists, and transaction costs do not exist, the money market hedge will yield the same results as the forward hedge.
This is so because the forward premium on the forward rate reflects the interest rate differential between the two currencies.

16. Techniques to Eliminate Transaction Exposure
A currency option hedge involves the use of currency call or put options to hedge transaction exposure.
Recall that the option owner can choose not to exercise the contract.
Hence, the firm will be insulated from adverse exchange rate movements, but may benefit from favorable movements.
However, the firm must assess whether the advantages are worth the premium paid for the option.

17. Option - example Clemson has a payable of £ 100 000 in 90 d
Call option with exercise price $1.60 is avaialbe, premium $0.04
Spot rate forecast is either $1.58, $1.60 or $ 1.62
What is the amount paid in the various scenarios with respect to the future pound rate ?

18. Option example

19. Techniques to Eliminate Transaction Exposure
Most MNCs determine which hedging technique is optimal on a case-by-case basis.
Note that when using a futures, forward, or money market hedge, the firm can determine its future cash flows with certainty. However, this is not the case when using a currency option hedge or when remaining unhedged.
A further complication for many firms is that the amount of foreign currency to be received at the end of the period being analyzed is uncertain.

20. Comparison - example
Fresno Corp will need $ in 30 d. It considers using
forward hedge
money market hedge
option hedge
no hedge

21. Comparison - example

22. Comparison - example

23. Forward and money market

24. Option hedge

25. Unhedged

26. Hedging Long-Term Transaction Exposure
Over the long run, the continual hedging of repeated transactions that are expected in the near future has limited effectiveness.
Hence, MNCs that are certain of their future cash flows may attempt long-term hedging.
The commonly used techniques are long-term forward contracts, currency swaps, and parallel loans.
Long-term forward contracts, or long forwards, with maturities of ten years or more, can be set up for very creditworthy customers.

27. Hedging Long-Term Transaction Exposure
Currency swaps can take many forms. In one form, two parties, with the aid of brokers, agree to exchange specified amounts of currencies on specified dates in the future.
A parallel loan, or back-to-back loan, involves an exchange of currencies between two parties, with a promise to re-exchange the currencies at a specified exchange rate on a future date.

28. Alternative Hedging Techniques
Sometimes, a firm may not be able to eliminate its transaction exposure completely because it cannot accurately predict its cash flows, or because the costs of hedging are too high.
To reduce exposure under such conditions, the firm can consider leading and lagging, cross-hedging, or currency diversification.
The act of leading and lagging refers to an adjustment in the timing of payment request or disbursement to reflect expectations about future currency movements.

29. Alternative Hedging Techniques
When a currency cannot be hedged, cross-hedging may be practiced. With cross-hedging, a currency that is highly correlated with the currency of concern is hedged instead. The stronger the positive correlation, the more effective the strategy will be.
With currency diversification, the firm diversifies its business among numerous countries whose currencies are not highly correlated.

30. Impact of Hedging Transaction Exposure
on an MNC’s Value
Hedging decisions on
transaction exposure
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent

31. Chapter Review Transaction Exposure
Selective Hedging of Transaction Exposure
Identifying the Net Transaction Exposure
Adjusting the Invoice Policy to Manage Exposure

32. Chapter Review Techniques to Eliminate Transaction Exposure
Futures Hedge
Forward Hedge
Money Market Hedge
Currency Option Hedge
Calculating the Real Cost of Hedging
Determining the Optimal Hedge
Limitation of Repeated Short-Term Hedging

33. Chapter Review Hedging Long-Term Transaction Exposure
Long-Term Forward Contract
Currency Swap
Parallel Loan
Alternative Hedging Techniques
Leading and Lagging
Cross-Hedging
Currency Diversification
How Transaction Exposure Management Affects an MNC’s Value