1. Thanarerk Thanakijsombat
Transaction Exposure
Thanarerk Thanakijsombat

2. What is FX Exposure?
It is a measure of the potential change in the firm’s cash flows, market value, balance sheet and income statement because of a change in exchange rates.

3. Operating Exposure-Economic exposure, Competitive Exposure
Types of FX Exposure
Transaction Exposure
Operating Exposure-Economic exposure, Competitive Exposure
Accounting Exposure

4. What is Transaction Exposure?
It is the exposure arising from contractual cash flows denominated in foreign currencies.
The amount of future cash flows from contracted transactions that can be affected by exchange rate fluctuations is referred to as transaction exposure.
Accounts Receivable, Accounts Payable, Scheduled interest and principle payments
If we know the denomination, timing and amount of a cash flow, and there is little uncertainty about its realization (that is tied to a well defined contract such as a sales contract, interest and principal payment etc) we refer these cash flows as contractual cash flows. The extent of contractual cash flows depend on the nature of the business and firm’s operational strategy. While companies like Boeing, Raytheon or BAE Systems have sales and purchase contracts stretching to as far as 5-6 years, for other companies contractual cash flows may not stretch more than 3 to 6 months.

5. The amount is due in two months.
Example
ABC imports an equipment from Germany. The company is billed for €10,000,000 for the equipment.
The amount is due in two months.
Assuming that this is the only foreign currency denominated transaction that ABC has, the company’s transaction exposure is € 10,000,000.
Note that in this case exposure is the foreign currency denominated liability or payable.

6. This is a contracted cash outflow or A/P (Account Payable)
Exposure and FX Risk
This is a contracted cash outflow or A/P (Account Payable)
It is denominated in a foreign currency
Its USD value of the payable depends on EUR/USD exchange rate.
If EUR appreciates, the USD value of the liability goes up. If EUR depreciates it declines.
The FX risk arising from transaction exposure is the change in the dollar value of A/P for a given change in the spot rate.

7. Steps in FX Risk Management
Identify the exposure
Evaluate the FX risk
Decide if we should carry the risk or hedge it.
Choose the hedging instrument that is most compatible with the nature of the risk and our risk management objectives

8. What is Hedging?
Hedging is taking a position by acquiring either a cash flow, an asset or a contract that will offset the change in the value of an existing position as the exchange rates change.
Note that the definition of “hedging” here is context specific. The factor that changes the value of the asset or liability is determined to be exchange rate. The objective of hedging is to offset any changes in the value of the asset or liability caused by the changes in the factor.

9. Case Example: Dayton Manufacturing
Dayton concluded a turbine sale to Crown, a British firm for GBP1,000,000 in March
The payment is due in June (3-months)
The company earns the minimum acceptable margin at $1,700,000. Below this amount Dayton would be losing money.

10. June OTC Put Option: @$1.7500 strike is 1.5% for 1m
Data Sheet
Spot Rate: $1.7640
3-month Forward Rate: $1.7540
RUK= %pa
RUS= %pa
June OTC Put strike is 1.5% for 1m
June OTC Put strike is 1% for 1m
Dayton’s June spot forecast is $1.7600
Dayton’s cost of capital is 12%

11. Dayton’s Alternatives
Remain Unhedged
Hedge in the forward market
Hedge in the money market
Hedge in the options market

12. Remain Unhedged
This alternative allows Dayton to accept the transaction risk. Spot rate will determine the USD cash-flows.
If the spot rate in June is1.70 and above, Dayton earns the minimum acceptable margin.
If the spot rate in June is below 1.70, Dayton loses money in this transaction.

13. Unhedged

14. Forward Market Hedge
If Dayton sells GBP1,000,000 forward in March as soon as it concludes the for June delivery it receives USD1,754,000
This is about $6,000 less than the amount to be received if the forecasted spot rate were attained. However, this rate is uncertain.

15. Forward vs Unhedged
The chart above compares the forward hedge and the unhedged posistion. Forward hedge locks Dayton to $1,754,000 and regardless the spot rate company clears this amount. At any spot rate below per pound, Dayton is better off by using the forward contract. It will have a hedging gain at any spot price below If the spot exceeds , Dayton will have a hedging loss, and miss the opportunity to collect more dollars per pound.

16. Dayton can create a money market hedge by
Borrowing PV of GBP cash-flows
Converting GBP into spot rate
Rolling the USD for three
The resulting amount will be Dayton’s USD cash-flow
Please note that the price obtained through money market hedge is pretty much the same price obtained through forward pricing. It is the same process that produces the forward rate. However, in this case company replicates what a counterparty bank does to quote a forward rate. There are several important differences to note: 1) Company uses its own credit line 2)company most likely have access to inferior rates as compared to financial institutions. It is highly unlikely that a money market hedge beats a competitive forward quote offered by a bank.

17. Borrow 1,000,000/(1+0.1*(90/360)) Buy USD spot Rollover @6%
MMH
Borrow 1,000,000/(1+0.1*(90/360))
=GBP975,609.7
Buy USD spot
@1.7640*975,609.7=$1,720,975.61
$1,720,975.61*(1+0.06*(90/360))
$1,746,790.24
Note that the above MMH rate obtained is equal to forward bid rate (since Dayton delivers Pound in exchange for USD) which can be simply calculated as: F= x (1+(0.06/4))/(1+(0.1/4))=

18. Note
The proceeds from money market hedge depends on the Dayton’s capability to place the USD in the money market.
At the on going market rate of 6% pa, the hedge generated $1,746,790.
Dayton could generate
1,755,396 if it could place/invest
$1,772,605 if it could place/invest

19. Question
What would be the rate that would break-even money market and forward hedge? (In other words at what rate or return earned from investment amount cleared from money market hedge and the forward contract will be equal?)
Please do not get confused by the use of term break-even. It only suggest the rate at which both methods clear the same amount of USDs for Dayton.

20. Answer
1,720,976*(1+Rate)=1,754,000
Rate= [note that this earned in 90 days]
Annualized=0.0192*(360/90)*100=7.68%

21. Forward vs MMH

22. Hedging with Options
There are two Put options available to Dayton. Both options are out of the money (Check what out of the money option means)
Exercise Price 1.75 is near forward at the money with 1.5% premium
Exercise Price 1.71 is out of money with 1% premium
The term “at the money” in general implies a strike price equal to spot rate. In the context of currency options, “at the money forward” is a widely used term and it implies a strike price equal to forward rate. In this particular case Strike 1.75 is very close to forward rate ,therefore the term near forward at the money is used.

23. Premium at the purchase
Premium for strike 1.75 is =GBP15,000*1.7640=$26,460
At the expiration 26,460*(1+(0.12/4))=27,254
(if we account for the time value of premium paid at t=0)
Premium for strike 1.71 is
=GBP10,000*1.7640=$17,640
At the expiration 17,640*(1+(0.12/4))=18,169
Please note that throughout the options discussion we ignored the time value of the premium paid. Since premium is paid at time zero, and the settlement of the option occurs some time in the future (say time T), when we incorporate premium into our net cash flow calculations without adjusting it for the time value, we engage in an “apples to oranges” operation. In order to conduct an apples to apples operation, we need to make a time value adjustment for the premium paid. This requires using an opportunity cost. The most appropriate opportunity cost to make this adjustment in the cost of capital of the firm. Remember from the data slide that the cost of capital of the firm is 12%. Since the adjustment is for only three months, we need to use 0.12/4=0.03

24. Put Option Summary

25. Put Strike
As the above chart shows, at any price below 1.75, we exercise the option and clear $1,722,746. Note that we deliver the pounds at 1,750,000, but the premium paid reduces net amount cleared to 1, 722,746. At any price above 1.75, we do not exercise the option and sell the pounds in the spot market. But since we cannot escape the sunk cost of the premium, the amount received in the spot market should be adjusted for the premium paid. In other words net cleared amount will be =(Spot x 1,000,000)-27, Note that the chart indicates that option beats the unhedged position at any spot rate below ( = ). If the spot is above this rate, unhedged position performs better. If you recall, option use is justfied when there is a directional uncertainty. That is if the possibility of the spot slipping below 1.72 is high, premium paid for the option makes sense.

26. Put Strike
A similar case exist for the put option with 1.71 strike. Since the strike is set at a lower rate, the premium is smaller, but 1.71 strike also exposes Dayton to the risk of not being able to clear above the benchmark proceed of 1.7m. If the option is exercised, the net amoun cleared is $1.69m

27. Comparative
Chart shows clearly that 1.75 sets the floor for the receivables at a higher level than 1.71 put. The trade-off is the premium paid for the respective options.

28. Comparative Analysis
The above table is constructed under the assumption that resulting exchange rate at the expiration of the contract is At this spot rate neither of the options are exercised. Dayton deals at the spot market. The OTM put option performs better than the ATM put option since it required smaller premium. A comparative analysis of the four strategies explored indicates that at 1.76 f

29. Comparative Analysis : All Put Together
Forward
MMH
Put Option
1.71
Unhedged
Put Option
1.75

30. Another Comprehensive Example: TCAS
TCAS had bid Canadian dollar C$2,900,00 for the delivery and the installation of a new management information software system and an extensive local area network (LAN) computer system.
The bid had been put together by the accounting department and accurately reflected costs. The bid was tendered on March 21 by FAX and was accepted on May 15.
Please note that this example was compiled from a case analysis. All the data was extracted from case narrative and tables.

31. In accordance with the terms of the contract, the Canadian government agency (Canadian Crown Corporation) had telexed a letter of acceptance of the bid and wired 10% of the purchase price as a deposit on the morning of May 16.
Also under the terms of the contract, TCAS would have to secure a performance bond from a third-party vender if awarded the bid. The performance bond would cost .75% of the outstanding contract value.

32. The remainder of the purchase price was due at the time the system was to be delivered and installed, which under the terms of the contract was to be within 90 days (the Canadian company had insisted on the 90 days and TCAS needed the extra time over the normal 45-day credit period) after the bid was accepted.
The TCAS production manager had assured Mr. Christopher that there would be no problems in meeting this delivery schedule for the hardware, although the product was not currently in inventory.

33. The software was already developed and available. Consequently, Mr
The software was already developed and available. Consequently, Mr. Christopher expected to receive a certified check for C$2,610,000 on August 16.
In preparing the bid, TCAS allowed for a tight mark-up of only 5% to improve the chances of winning the bid. Through past experience, TCAS knew that once it made the first sale, the quality of its product usually ensured additional purchases by the same company.

34. Since the Canadian government agency had stipulated that the bid be in Canadian dollars, TCAS had used the opening spot rate existing on March 21, which was 1US$ = Canadian $

35. Receivable (C$2,610,000) in Canadian dollars in 90 days
Summary-Issues
Receivable (C$2,610,000) in Canadian dollars in 90 days
Problem: If USD appreciates CAD receipts will worth less in USD
What is the possibility of CAD devaluation?
How much it may devalue?
Is the opposite possible?
Can we tolerate FX risk? Should we hedge?
If yes, what are our alternatives?
The bottom-line in the case is that TCAS have CAD 2,610,0000 receivable and concerns about USD appreciation.

36. Our Advisors Provide the following List!
Plain Vanilla
Money Market Hedge:
Cost of CAD Borrowing:12.50%pa
Rollover
Forward
Buy Put Option on CAD
Strike CAD or ($0.72) Premium: $0.0225
Sell (write) a Call option on CAD
Strike $0.72, Premium $0.0356
Plain Vanilla is a term used for simple derivative products. These are single derivatives with straightforward charactersitics.

37. Futures Factoring Futures Contract
Futures Price:$0.735, CAD100,000 per contract
Round trip Commission:$50 per contract
We need 26 Contracts: Cost=$1,300
Factoring
Discount Rate:9.2%, Fee:0.5%
Factoring is a trade finance method where foreign currency denominated receivables are purchased by the factor at a discount. Discount factor reflects the riskiness of the trading partner, in this case Canadian client.

38. Exotic Option: Put-Call Combo
Tunnel Forward: Purchase of a Put Option at strike price and the Sale of a Call Option at strike price of
Strike prices are selected in a way that premium received and premium paid are equal to each other.
Therefore, there is no net premium cost at the outset. This product is also called zero cost range forward.
This is put-call combination that amounts to a forward contract. However, unlike a generic/plain vanilla forward, the combination in this example locks TCAS to a range of exchange rates. In the traditional forward we lock into a single rate. Here, the effective amount of USDs we will receive in exchange for CAD will fall into the range of and We will not get less than $ and not more than $

39. Review of Each Product

40. Forward Hedge: Contract Price: CAD1.3653/$
CAD2,610,000/CAD1.3653=$1,911,668
This is simple and straightforward. We receive get 1 USD in exchange for every CAD The dollars amount to 1,911,668.

41. Foreign Currency Loan (Money Market Hedge)
 CAD2,610,000/( /4)= CAD2,530,909 Bor. Now
Less Arrangement Fee: CAD2,530,909* =CAD3,164
Net Receipt from Borrowing =CAD2,527,745
Conversion into =USD 1,859,456
Roll 11% ( ) =USD 1,910,591
Roll 5.5% =USD1,885,023
MMH is also easy to figure out. The cost of CAD borrowing for TCAS is 12.5%. And TCAS can invest its dollars at 11%. The rollover rate 11% here reflects Prime +Spread= /8th = =0.11
The 5.5% is the yield on 3-month treasury. If dollars were invested at 5.5%, TCAS would be able to clear only 1,885,023 from its MMH.

42. Buy a Put Option on CAD
Premium Paid: CAD2,610,000*$0.0225=$58,725
Floor (worst case) for CAD Receivables: 2,610,000*0.72-$58,725=$1,820,475
This option breaks even with forward rate at Spot rate of $ In other words it will perform better (i.e will yield more than $1,911,668) only if the spot exceeds $ (or CAD appreciates to )
Proof: (2,610,000*X)-58,725=1,911,668
X=$ or CAD1.3246
Plain vanilla put option costs CAD2,610,000 x $0.0225=$58,725. If it is exercised, it will clear $1,820,475.
The put option will yield the same amount of USDs as the forward contract when spot rate hits or USD per CAD (simply figure out at what spot rate, the put option would clear the same amount of USDs as forward contract.

43. Write (Sell) a Call Option on CAD
Premium Received: CAD2,610,000*0.0356=$92,916
Ceiling (when TCAS is assigned the call) : 2,610,000* ,916=1,972,116
Break-even with forward:
2,610,000*X+92,916=1,911,668
X=$0.6969/CAD or CAD1.4349
At any spot price exceeding $0.72 per CAD, the buyer of the call option will exercise the option and TCAS will receive
2,610,000* ,916=$1,972, At any price below $0.72 per CAD, the call will not be exercised and we will have to sell the CAD in the spot market at a lower price. The dollars collected will depend on the spot price. Note that in this highly risky strategy provides a small buffer for the decline of CAD value as TCAS collects $92,916 of premium. Note that time value of the premium has been ignored in this calculation.

44. Brokers Fee: Based on 26 Contracts 26*50=$1,300
Futures Contract
CAD2,610,000*0.735=$1,918,350
Brokers Fee: Based on 26 Contracts 26*50=$1,300
Net Receipt: USD $1,917,050
Assuming that Futures contract expires at $0.7350, we take delivery of $1,918, 350. After taking commissions into account net amount collected is $1,

45. Pre Sale of Contract (Factoring)
CAD Loan Amount: 2,610,000/( /4)=CAD2,551,320
Arrangement Fee: ,610,000*0.005 =CAD13,050
Net Discounted CAD CF=2,538,270
Conversion to =USD1,867,199
11% =USD1,918,546
=USD1,892,873
In this case we pay an arrangement fee of 0.5% is charged on the face value of 2.6 million receivables. The net amount cleared from factoring is 1,918,546 assuming that the we can invest at 11%pa.

46. Tunnel Forward
This is a simple product. TCAS has CAD2,610,000 receivable. Tunnel Forward described in the case requires simultaneous Purchase of a Put Option at strike price and the Sale of a Call Option at a strike price of Since the premium received and paid are equal to each other, there is no net premium cost at the outset.
This is a combination of put and call. We buy a put (long put) and write a call at two different strikes. The key issue here is to set the strikes such that the net premium we pay is zero. We pay a certain premium to purchase the put. Then we figure out at what strike price call premium is equal to the put premium we paid. In this case the put premium paid for strike is the same as the call premium collected from Call with strike Hence no net premium!

47. Zero Cost Range Forward
Therefore this product is also called a Zero Cost Range Forward meaning that instead of locking into a point forward rate we lock into a forward rate range. In this case, we will be able to exchange CAD2,610,000 at an exchange rate between $ (lower limit) and $ (upper limit).

48. Spot<0.7133
Let say spot rate turns out to be $0.7000/CAD. If we use the spot market, we get less than what we could if we used the put option we bought! Therefore it makes sense to exercise the put option at and sell 2,610,000 at $ and get USD1,861,713.
At spot rate $0.7000/CAD, the call buyer will not exercise the option since he/she can buy the CAD at the spot market at 0.7 instead of the call strike of Therefore, call option that we sold is not exercised.
At any spot rate below the scenario above will be repeated. We will exercise the put and the call will go unexercised.

49. Spot>0.7533
Now assume that the spot is $ In this case we do not exercise the put option since we can get a better deal at the spot market by selling CADs at 0.76 instead of put strike of So, put is not exercised!
The call buyer that we sold the call option at find this price more attractive as compared to the spot rate of $0.76 and would like to exercise the call option. We have to deliver 2,610,000 at (remember a call writer or seller has an obligation to deliver if the call buyer wants to exercise the option, so we have no choice but go along with the discretion of the call buyer). This brings us $ for each CAD and we get (CAD2,610,000)*($0.7533/CAD)=$1,966,113.  

50. 1,861,713<Actual Amount of US Dollars<1,966,113
0.7133<Spot<0.7533
At any spot below we will end up getting 1,861,713 and at any spot above we will end up getting $1,966,113.
What happens if the spot is between $ and $ ? In between both options will expire unexercised. So we can sell CADs at the spot rate. Therefore what we get is a range:
1,861,713<Actual Amount of US Dollars<1,966,113

51. Tunnel Forward: Summary
 Best Case (Ceiling): 2,610,000*0.7533=$1,966,116
Worst Case (Floor): 2,610,000*0.7133=$1,861,713

52. Tunnel Forward $ Value of CAD2,610,000 Max: 1,966,116 Min: 1,861,713
Spot
USD/CAD
0.7533
0.7133