1. Transaction Exposure
(or chapter 8)

2. Agenda Types of forex exposures? Causes of transaction exposure?
Pros & cons of hedging transaction exposure?
How to manage transaction exposure?
Forward Market Hedge
Money Market Hedge
Option Market Hedge
Institutional practices of forex risk management.

3. Types of forex exposure
potential change in profitability, net cash flow, market value due to change in forex rate.
Transaction Exposure
changes in value of outstanding financial obligations incurred prior to change in forex, not due to settle until after forex change.
Operating (Economic) Exposure
change in firm PV resulting from change in expected future operating cash flows due to unexpected forex change
Translation (Accounting) Exposure
accounting-derived changes in owner equity due to consolidation in single currency.
Tax Exposure
varies by country, general rule only realized foreign losses are deductible for calculating income taxes

4. Why Hedge? Pros & Cons… Improves planning.
Reduces likelihood of bankruptcy.
Management better knows actual risks.
vs.
Currency risk management costly, may not increase expected cash flows.
Shareholders more capable diversifying risk.
Investors already factored forex exposure into valuation.
Conducts hedging to benefit management. 
Managers cannot outguess efficient market .
Management criticized for forex losses but not for cost in avoiding forex losses.

5. Why Hedge? Hedged Unhedged NCF Net Cash Flow (NCF) Expected Cash Flow
Reduction of risk?
Increase/decrease in expected cash flow?
Increase in value?
Unhedged
NCF
Net Cash Flow (NCF)
Expected Cash Flow

6. What causes transaction exposure?
Purchasing or selling on credit.
Borrowing or lending in foreign currency.
Being party to unperformed forward contract.
Acquiring assets/ incurring liabilities in foreign currency.

7. Open Account Purchasing/ Selling
Seller quotes price t1
Buyer places order t2
Seller ships product t3
Buyer settles A/R t4
Quotation Exposure
Time b/n quoting price & reaching sale.
Backlog Exposure
Contract Signed.
Time to fill order.
Billing Exposure
Time to get paid.
Anticipa-tion Exposure

8. Borrowing &Lending Grupo Embotellador de Mexico (Gemex)
Dollar debt mid-December, 1994:
$ 264 m  PS 3.45/$ = PS 910,800,000.
Dollar debt in mid-January, 1995:
$ 264 m  PS 5.50/$ = PS 1,452,000,000 (59% up!)

9. How to manage transaction exposure?
Contractual hedge
Operating hedges
Risk-sharing agreements.
Leads and lags in payment terms.
Swaps.
Natural hedge
Financial hedge
offsetting debt obligation.
financial derivative such as swap.

10. Hedging Account Receivable
Suppose October sale for £1,000,000, A/R January.
Spot $1.764/£
3m-forward $1.754/£ (2.27% discount)
Cost of capital 12.0% annual
British 3m borrowing rate 10% annual
British 3m lending rate 8% annual
US 3m borrowing rate is 8% annual
US 3m lending rate is 6% annual
Jan. put on £1,000,000 w/ strike $1.75/£; 1.5% premium.
Forecasts 3m future spot $1.76/£.
Budget rate (lowest acceptable amount) $1.70/£

11. Hedging Account Receivable
Unhedged position: £1,000,000 x $1.76/£ = $1.76 m.
Forward hedge:
Forward contract & source of funds to fulfill the contract.
Forward time A/R created (October).
A/R spot $1.764/£, so $1,764,000.
Covered (perfect) vs. uncovered (open) forward hedge.
Money market hedge:
creates liability offset w/ asset in £: balance sheet hedge.
borrow PV of £1,000,000: £1,000,000/1.025 = £975,610.
exchange £975,610 at spot $1.764/£ for $1,720,976.
Received today Invested in Rate Future value in 3 months
$1,720,976 Treasury bill 6% annual or 1.5%/qtr $1,746,791
$1,720,976 Debt cost 8% annual or 2.0%/qtr $1,755,396
$1,720,976 Cost of capital 12% annual or 3.0%/qtr $1,772,605

12. Option Market Hedge Purchase put option. Breakeven price, option hedge
3 month put ATM strike $1.75/£, premium 1.5%:
Premium as of Jan $26,460  1.03 = $27,254.
Unlimited upside, limited downside.
Breakeven price, option hedge
Upper bound:
If pound appreciate above $1.754/£ + $0.0273/£ = $1.7813/£.
Lower bound
If pound depreciates below $1.75/£ - $0.0273/£ = $1.722/£.

13. A / R Hedges Uncovered ATM put option Money market $1,772,605 @ 12%
1.68
1.70
1.74
1.76
1.72
1.82
1.80
1.78
1.86
1.84
US$ value of
£1,000,000 A/R
Ending spot (US$/£)
Uncovered
Forward
$1.7540/£
ATM put option
min $1,722,746
Put strike
$1.75/£
Money market
12%
Forward contract
$1,754,000

14. Account Payable Hedge Assume £1,000,000 A/P in 90 days
Unhedged position: expected pay $1,760,000.
Forward market hedge: purchase $1.754/£, cost locked $1,754,000.
Money market hedge:
Offset £ obligation by £ asset w/ matching maturity.
Exchange US$ spot & invest for 90 days in £.
Carry the cost forward 90 days

15. Account Payable Hedge Option hedge: purchase call option on payable.
ATM call option w/ strike $1,75/£ would be 1.5% premium.
If spot less $1.75/£ option expire & £1,000,000 purchased on spot market.
If spot above $1.75/£ option exercised: exchange $1.75/£ less option premium:
Carried forward 90 12% p.a. premium $27,254.
Exercise call option (£1,000,000  $1.75/£ $1,750,000
Call premium (carried forward 90 days) $27,254
Total maximum expense of call option hedge $1,777,254

16. A / P Hedges Uncovered Money market $1,781,294 Forward contract
1.68
1.70
1.74
1.76
1.72
1.82
1.80
1.78
1.86
1.84
US$ value of
£1,000,000 A/R
Ending spot (US$/£)
Uncovered
Forward
$1.754/£
Call strike
$1.75/£
Call option:
$1,777,254
Money market
$1,781,294
Forward contract
$1,754,000

17. Forex Risk Management for Real
Goals?
cost center vs. profit center.
Exposures?
backlog exposure?
selectively hedge backlog & anticipated exposures?
Contractual Hedges?
Amount of risk covered, proportional hedges?
Currency options?

18. Things to remember Types of forex exposures
Transaction
Operating
Translation
Tax
How to hedge A/R & A/P transaction exposure?
Money market?
Forward market?
Option market?