Management of Transaction Exposure

Chapter Eight
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 Chapter Outline
Three Types of Exposure
Should the Firm Hedge?
Hedging Foreign Currency Receivables
Hedging Foreign Currency Payables
Cross-Hedging Minor Currency Exposure
Hedging Contingent Exposure
Hedging Recurrent Exposure with Swap Contracts
Hedging through Invoice Currency
Hedging via Lead and Lag
Exposure Netting
What Risk Management Products Do Firms Use?
Summary
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 Three Types of Exposure 1

It is conventional to classify foreign currency exposures into

three types:
1. Transaction exposure is the potential change in the
value of financial positions due to changes in the
exchange rate between the inception of a contract and
the settlement of the contract.
2. Economic exposure is the possibility that cash flows
and the value of the firm may be affected by
unanticipated changes in the exchange rates.
3. Translation exposure is the effect of an unanticipated
change in the exchange rates on the consolidated
financial reports of an MNC.
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 Three Types of Exposure 2

Firm is subject to transaction exposure when it faces

contractual cash flows that are fixed in foreign currencies

Example
• Suppose a U.S. firm sold its product to a German client
on three-month credit terms and invoiced €1 million.
• When the U.S. firm receives €1 million in three months, it
will have to convert (unless it hedges) the euros into
dollars at the spot exchange rate prevailing on the
maturity date, which cannot be known in advance.

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 Hedging Transaction Exposure
This chapter focuses on alternative ways of hedging
transaction exposure using various financial contracts and
operational techniques

Financial contracts
• Forward contracts, money market instruments, options
contracts, and swap contracts.

Operational techniques
• Choice of the invoice currency, lead/lag strategy, and
exposure netting.

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 Should the Firm Hedge?
No consensus on the question of whether a firm should
hedge; Most arguments suggesting corporate exposure
management will not add value to the firm hold in the case
of a “perfect” capital market

While the above arguments against corporate risk

management may be valid in a “perfect” capital market, one
can make a case for it based on various market
imperfections:
1. Information asymmetry.
2. Differential transaction costs.
3. Default costs.
4. Progressive corporate taxes.
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Tax Savings from Hedging Exchange Risk
Exposure

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 Hedging Foreign Currency Receivables
Suppose Boeing Corporation exported a landing gear of
Boeing 737 aircraft to British Airways and billed £10 million
payable in one year, with money market interest rates and
foreign exchange rates given as follows:
• U.S. interest rate: 6.10% per annum.
• U.K. interest rate: 9% per annum.
• Spot exchange rate: $1.50/£.
• Forward exchange rate: $1.46/£ (1-year maturity).
When Boeing receives £10 million in one year, it will
convert the pounds into dollars at the spot exchange rate
prevailing at the time

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 Forward Market Hedge 1

Most direct and popular way of hedging transaction

exposure is by currency forward contracts
Sell (buy) foreign currency receivables (payables) forward
to eliminate exchange risk exposure
• Boeing may sell forward its pounds receivables, £10
million, for delivery in one year, in exchange for a given
amount of U.S. dollars.
• On the maturity date of the contract, Boeing will have to
deliver £10 million to the bank, which is the counterparty
of the contract, and, in return, take delivery of $14.6
million ($1.46/£ * £10 m), regardless of the spot
exchange rate that may prevail on the maturity date.
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Dollar Proceeds from the British Sale: Forward
Hedge versus Unhedged Position

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 Forward Market Hedge 2

Suppose that on the maturity date of the forward contract,

the spot rate turns out to be $1.40/£, which is less than the
forward rate, $1.46/£
• Boeing would have received $14 million instead of $14.6
million had it not entered the forward contract.
What if the spot rate had been $1.50/£ at maturity?
• Boeing would have received $15 million by remaining
unhedged.
• Ex post, forward hedging would have cost Boeing $0.4
million.
Gains and losses are computed by the following:
Gain  F  S T  £10 million
© McGraw Hill 8-1
 Gains/Losses from Forward Hedge

Receipts from the British Sale

Spot Exchange Rate
on the Maturity Date Unhedged Forward Gains/Losses
(ST) Position Hedge from Hedgeb
$1.30 $13,000,000 $14,600,000 $1,600,000
$1.40 $14,000,000 $14,600,000 $600,000
$1.46a $14,600,000 $14,600,000 0
$1.50 $15,000,000 $14,600,000 ‒$400,000
$1.60 $16,000,000 $14,600,000 ‒$1,400,000

a
The forward exchange rate (F) is $1.46/£ in this example.
b
The gains/losses are computed as the proceeds under the forward hedge minus the proceeds from the
unhedged position at the various spot exchange rates on the maturity date.

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Illustration of Gains and Losses from Forward
Hedging

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 Forward Market Hedge 3

Firm must decide whether to hedge ex ante

Consider the following scenarios:
1. T ≈ F.
• Expected gains or losses are approximately zero, but forward
hedging eliminates exchange exposure.
• Firm will be inclined to hedge if it is averse to risk.
2. T < F.
• Firm expects a positive gain from forward hedging and would
be even more inclined to hedge than in Scenario 1.
3. T > F.
• Firm would be less inclined to hedge under this scenario,
other things being equal.

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 Currency Futures versus Forwards
A firm could use a currency futures contract, rather than a
forward contract, for hedging purposes
A futures contract is not as suitable as a forward contract for
hedging purposes for two reasons:
1. 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, etc.
• Thus, in most cases, the firm can only hedge
approximately.
2. 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.
• Again, this makes exact hedging difficult.
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 Money Market Hedge 1

A firm may borrow (lend) in foreign currency to hedge its foreign

currency receivables (payables), thereby matching its assets and
liabilities in the same currency
• Boeing can eliminate the exchange exposure arising from the
British sale by first borrowing in pounds, then converting the
loan proceeds into dollars, which then can be invested at the
dollar interest rate.
• On the maturity date of the loan, Boeing is going to use the
pound receivable to pay off the pound loan.
• If Boeing borrows a particular pound amount so that the
maturity value of this loan becomes exactly equal to the
pound receivable from the British sale, Boeing’s net pound
exposure is reduced to zero.
• Then, Boeing will receive the future maturity value of the
dollar investment. © McGraw Hill 8-1
 Money Market Hedge 2

What amount of pounds should Boeing borrow?

• Amount to borrow may be computed as the discounted present
value of the pound receivable.
• £10 million/(1.09) = £9,174,312.
Step-by-step procedure of money market hedging:
1. Borrow £9,174,312.
2. Convert £9,174,312 into $13,761,468 at the current spot
exchange rate of $1.50/£.
3. Invest $13,761,468 in the United States.
4. After one year, collect £10 million from British Airways and use
it to repay the pound loan.
5. Receive the maturity value of the dollar investment, that is,
$14,600,918 = ($13,761,468)(1.061).
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Cash Flow Analysis of a Money Market Hedge

Current Cash Cash Flow at

Transaction Flow Maturity
1. Borrow pounds £9,174,312 ‒£10,000,000
2. Buy dollar spot with pounds $13,761,468
‒£9,174,312

3. Invest in the United States ‒$13,761,468 $14,600,918

4. Collect pound receivable £10,000,000
Net cash flow 0 $14,600,918

© McGraw Hill 8-1

 Options Market Hedge 1

One possible shortcoming of both forward and money

market hedges is that these methods completely eliminate
exchange risk exposure
• Ideally, Boeing would like to protect itself only if the
pound weakens, while retaining the opportunity to benefit
if the pound strengthens.

Currency options provide a flexible “optional” hedge against

exchange exposure
• Firm may buy a foreign currency call (put) option to
hedge its foreign currency payables (receivables).

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 Options Market Hedge 2

Suppose that in the OTC market, Boeing purchased a put option

on £10 million with an exercise price of $1.46/£ and a one-year
expiration, and assume the option premium (price) was $0.02 per
pound
• Boeing paid $200,000 ($0.02 × 10 million) for the option.
• Provides Boeing with the right, but not the obligation, to sell up
to £10 million for $1.46/£, regardless of the future spot rate.

Assume the spot exchange rate turns out to be $1.30 on the

expiration date
• Upfront cost is equivalent to $212,200 = ($200,000 × 1.061).
• Net dollar proceeds are $14,387,800 = $14,600,000 ‒
$212,200.
• Boeing is assured of “minimum” dollar receipt of $14,387,800.
© McGraw Hill 8-2
 Options Market Hedge 3

Consider an alternative scenario where the pound

appreciates against the dollar, and assume the spot rate
turns out to be $1.60 per pound at expiration
• Boeing will have no incentive to exercise the option.
• Rather, it would let the option expire and convert £10
million into $16 million at the spot rate.
• Subtracting $212,200 for the option cost, the net dollar
proceeds will become $15,787,800 under the option
hedge.
Options hedge allows the firm to limit downside risk while
preserving the upside potential, but firm must pay for this
flexibility in terms of the option premium
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 Comparison of Hedging Strategies
Money market hedge versus forward hedge
• Money market hedge dominates since the guaranteed dollar
proceeds from the British sale with the money market hedge
exceeds guaranteed proceeds with forward hedge.
Money market hedge versus options hedge
• Options hedge dominates money market hedge for future spot
rates greater than $1.4813/£, but money market hedge dominates
options hedge for spot rates lower than $1.4813/£.
Options hedge versus forward hedge
• Options hedge dominates the forward hedge for future spot rates
greater than $1.48 per pound, whereas the opposite holds for spot
rates lower than $1.48 per pound.
© McGraw Hill 8-2
 Boeing’s Alternative Hedging Strategies for a
Foreign Currency Receivable
EXHIBIT 8.8 Boeing’s Alternative Hedging Strategies for a Foreign Currency Receivable: A
Summary
Strategy Transactions Outcomes
Forward market hedge 1. Sell £10,000,000 forward for U.S. Assured of receiving $14,600,000
dollars now. in one year; future spot exchange
2. In one year, receive £10,000,000 rate becomes irrelevant.
from the British client and deliver
it to the counterparty of the
forward contract.
Money market hedge 1. Borrow £9,174,312, buy Assured of receiving $13,761,468
$13,761,468 spot, and invest in now or $14,600,918 in one year;
the United States now. future spot exchange rate
2. In one year, collect £10,000,000 becomes irrelevant.
from the British client and pay off
the pound loan using the amount.
Options market hedge 1. Buy a put option on £10,000,000 Assured of receiving at least
for an upfront cost of $200,000. $14,387,800 or more if the future
2. In one year, decide whether to spot exchange rate exceeds the
exercise the option upon exercise exchange rate; Boeing
observing the prevailing spot controls the downside risk while
exchange rate. retaining the upside potential.

© McGraw Hill 8-2

 Hedging Foreign Currency Payables
Suppose Boeing imported a Rolls-Royce jet engine for £5
million payable in one year
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).
Boeing is concerned about the future dollar cost of this
purchase, and it will try to minimize the dollar cost of paying
off the payable

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 Foreign Currency Payables: Alternatives
Forward market hedge
• If Boeing decides to hedge this payable exposure using a forward
contract, it only needs to buy £5 million forward in exchange for the
following dollar amount:
$8,750,000 = (£5,000,000)($1.75/£)
Money market hedge
• PV of foreign currency payable: £4,694,836 = £5 million/1.065
• Outlay of dollars today: $ 8,450,705 = (£4,694,836 )($1.80/£).
• Future value: $8,957,747 = ($8,450,705)(1.06).
Options market hedge
• Purchase a “call” on £5 million.

© McGraw Hill 8-2

 Boeing’s Alternative Hedging Strategies for a
Foreign Currency Payable
EXHIBIT 8.8 Boeing’s Alternative Hedging Strategies for a Foreign Currency Payable: A Summary
Strategy Transactions Outcomes
Forward market hedge 1. Agree today to buy £5,000,000 and Assured of paying $8,750,000
sell U.S. dollars forward in one in one year; future spot
year. exchange rate becomes
2. In one year, pay $8,750,000 and irrelevant.
receive £5.000.000 from the
counterparty of the forward
contract and deliver the pounds to
Rolls-Royce.
Money market hedge 1. Borrow $8,450,705 and use the Assured of paying $8,957,747
dollars to buy £4,694,836 now. in one year; future spot
Invest the pounds at the British exchange rate becomes
interest rate. irrelevant.
2. In one year, collect £5,000,000 and
deliver the pounds to Rolls-Royce.
Pay off the dollar loan with
$8,957,747.
Options market hedge 1. Buy a call option on £5,000,000 for Assured of paying at most
an upfront cost of $90,000. $9,095,400 or less if the future
2. In one year, decide whether to spot exchange rate falls below
exercise the option upon observing the exercise exchange rate;
the prevailing spot exchange rate. Boeing controls the downside
risk while retaining the upside
potential.

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Dollar Costs of Securing the Pound Payable:
Alternative Hedging Strategies

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 Cross-Hedging Minor Currency Exposure
If a firm has positions in major currencies (for example,
British pound, euro, and Japanese yen), it can easily use
forward, money market, or options contracts to manage its
exchange risk exposure
However, if the firm has positions in less liquid currencies
(for example, Indonesian rupiah, Thai bhat, and Czech
koruna), it may be either very costly or impossible to use
financial contracts in these currencies
• In this situation, firms may use cross-hedging, which
involves hedging a position in one asset by taking
position in another asset.

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 Hedging Contingent Exposure
Options contract can also provide an effective hedge against
what might be called contingent exposure
• Contingent exposure is the risk due to uncertain situations
in which a firm does not know if it will face exchange risk
exposure in the future.
• Example: Suppose GE is bidding on a hydroelectric project in
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. Since GE may or may not face exchange exposure, it
faces a typical contingent exposure situation.
• Difficult to manage contingent exposure using traditional
hedging tools like forward contracts, but an alternative is for
GE to buy a put option on C$100million.
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 Hedging Recurrent Exposure with Swap
Contracts
Firms often must deal with a “sequence” of accounts
payable or receivable in terms of a foreign currency, and
these recurrent cash flows can be best hedged using a
currency swap contract
• Currency swap contracts are agreements to exchange
one currency for another at a predetermined exchange
rate, that is, the swap rate, on a sequence of future
dates.
• Similar to a portfolio of forward contracts with different
maturities.
• Very flexible in terms of amount and maturity, with
maturity ranging from a few months to 20 years.
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 Hedging through Invoice Currency
Hedging through invoice currency is an operational technique
that allows the firm to shift, share, or diversify exchange risk
by appropriately choosing the currency of invoice
• Example: If Boeing invoices $150 million rather than £100
million for the sale of aircraft, it does not face exchange
exposure anymore. Though the exchange exposure has
not disappeared, it has been shifted to the British importer.
• Another option would be for Boeing to invoice half of the bill
in U.S. dollars and the remaining half in British pounds,
thereby sharing the exchange exposure.
• Finally, the firm can diversify exchange exposure to some
extent by using currency basket units, such as the SDR, as
the invoice currency.
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 Hedging via Lead and Lag
The lead/lag strategy reduces transaction exposure by paying or
collecting foreign financial obligations early (lead) or late (lag)
depending on whether the currency is hard or soft
• Challenges associated with this strategy:
• If we assume Boeing would like B A to prepay £100 million, we
can also assume BA would have no incentive to do so unless
it received a substantial discount to compensate for
prepayment.
• Pushing BA to prepay may hurt future sales efforts by Boeing.
• To the extent the original invoice price incorporated the
expected depreciation of the pound, Boeing is already partially
protected against depreciation of the pound.
• Strategy can be employed more effectively to deal with intrafirm
payables and receivables among subsidiaries.
© McGraw Hill 8-3
 Exposure Netting: Lufthansa
“In 1984, Lufthansa, a German airline, signed a contract to buy $3
billion worth of aircraft from Boeing and entered into a forward
contract to purchase $1.5 billion forward for the purpose of
hedging against the expected appreciation of the dollar against
the German mark. This decision, however, suffered from a major
flaw: A significant portion of Lufthansa’s cash flows was also
dollar-denominated.”
• Lufthansa had a so-called “natural hedge”.
• The following year, the dollar depreciated substantially against
the mark and Lufthansa experienced a major foreign exchange
loss from settling the forward contract.
• The lesson here is that, when a firm has both receivables and
payables in a given foreign currency, it should consider
hedging only its net exposure.
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 Exposure Netting
Realistically, typical multinational corporations are likely to
have a portfolio of currency positions
• In this case, firms should hedge residual exposure rather
than hedge each currency position separately.
Exposure netting is hedging only the net exposure by
firms that have both payables and receivables in foreign
currencies
• For firms that would like to apply this approach
aggressively, it helps to centralize the firm’s exchange
exposure management function in one location.
• Many MNCs are using a reinvoice center, a financial
subsidiary, as a mechanism for centralizing exposure
management functions.
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 What Risk Management Products Do Firms
Use?
Among U.S. corporations, based on a survey of Fortune
500 firms, the most popular product was the traditional
forward contract
• Jesswein, Kwok, and Folks (1995) found 93% of
respondents reported using forward contracts.
Kim and Chance (2018) study:
• Examined actual currency risk management practices of
101 largest nonfinancial corporations in South Korea.
• Authors document a great discrepancy between what
firms say they do versus what they actually do,
attributing the discord to attempts by companies to time
their hedges.
© McGraw Hill 8-3
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