Lecture 11.

Management of Transaction
Exposure
Three Types of Exposure
1. Transaction exposure is the sensitivity of realized domestic currency
values of firm’s contractual cash flows (that is, accounts receivables
or payables) denominated in foreign currencies to unexpected
changes in exchange rates.
2. Economic exposure is the extent to which the value of the firm may
be affected by unanticipated changes in the exchange rates.
3. Translation exposure is the potential that the firm’s consolidated
financial statements can be affected by changes in the exchange
rates.
Should the Firm Hedge?
• No consensus on the question of whether a firm should hedge.
• Some would argue that exchange exposure management at the
corporate level is redundant when stockholders can manage the
exposure themselves.
• Others would argue that what matters in the firm valuation is only
systematic risk; corporate risk management may only reduce the total
risk.
• These arguments suggest that corporate exposure management
would not necessarily add to the value of the firm.
• However, these arguments against corporate risk management may
be valid in a "perfect" capital market.
Should the Firm Hedge?
• One can make a case for corporate risk management based on various
market imperfections:
• Information asymmetry: The managers may have better information than the
shareholders
• Differential transaction costs: The firm may be able to hedge at better prices
than the shareholders
• Default costs: Hedging may reduce the firm’s cost of capital if it reduces the
probability of default.
• Progressive corporate taxes: Stable earnings may lead to lower corporate
taxes than volatile earnings due to progressive tax rates.
Transaction Exposure
• 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.
Hedging Transaction Exposure
• There are various 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.
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.
Hence, the dollar proceeds from this foreign sale is uncertain without
hedging.
Forward Market Hedge
• Most direct and popular way of hedging transaction exposure is by
currency forward contracts.
• Sell foreign currency receivables forward to eliminate exchange risk
exposure.
Forward Market Hedge
• Boeing may take a short position on a pounds forward contract and
sell forward £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.
• With forward hedge, the dollar proceeds from the sale of landing gear
becomes $14.6 million regardless of future exchange rate.
Dollar Proceeds from the British Sale: Forward
Hedge versus Unhedged Position
Forward Market Hedge
• 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 - ST ) ´ 10 million
Gains/Losses from Forward Hedge
Receipts from the British Sale

Spot Exchange Rate on Unhedged Forward Gains/Losses

the Maturity Date (ST). Position Hedge from Hedge
$1.30 $13,000,000 $14,600,000 $1,600,000
$1.40 $14,000,000 $14,600,000 $600,000
$1.46 $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
Note:
The forward exchange rate (F) is $1.46/£ in this example.
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.
Illustration of Gains and Losses from Forward
Hedging
Forward Market Hedge
• Firm must decide whether to hedge ex ante
• Consider the following scenarios:
• Scenario 1 (𝑆!̅ ≈ 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.
• Scenario 2 (𝑆!̅ < 𝐹)
• Firm expects a positive gain from forward hedging and would be even more inclined to
hedge than in Scenario 1.
• Scenario 3 (𝑆!̅ > 𝐹)
• Firm would be less inclined to hedge under this scenario, other things being equal.
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:
• 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.
• 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.
Money Market Hedge
• A firm may borrow in foreign currency against its foreign currency
receivables, 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.
Money Market Hedge
• What amount of pounds should Boeing borrow?
• Amount to borrow is the discounted present value of the pound receivable.
• £10 million/(1.09) = £9,174,312.
• Step-by-step procedure of money market hedging:
• Borrow £9,174,312. Must pay back £10 million in one year.
• Convert £9,174,312 into $13,761,468 today at the current spot exchange rate of $1.50/£.
• Invest $13,761,468 in the United States.
• After one year, 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).
• With money market hedge, the dollar proceeds from the sale of landing gear
becomes $14,600,918 regardless of future exchange rate.
Cash Flow Analysis of a Money Market Hedge

Transaction Current Cash Flow Cash Flow at Maturity

1. Borrow pounds £9,174,312 −£10,000,000
2. Buy dollar spot with $13,761,468
pounds −£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 $14,600,918
Options Market Hedge
• 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.
• 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.
• Firm may buy a foreign currency put option to hedge its foreign currency
receivables.
Options Market Hedge
• 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.
• Considering the time value of money, the upfront cost is equivalent to
$212,200 = ($200,000 × 1.061).
• Provides Boeing with the right, but not the obligation, to sell £10 million for
$1.46/£, regardless of the future spot rate.
Options Market Hedge
• At maturity, if spot exchange rate < $1.46/£:
• Boeing will exercise the put option and sell £10 million at the strike price of
$1.46/£.
• For example, assume the spot exchange rate turns out to be $1.30/£
on the expiration date.
• Boeing will exercise the put option and sell £10 million at the strike price of
$1.46/£ and receive $14.6 million.
• Option premium was 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.
Options Market Hedge
• At maturity, if spot exchange rate >= $1.46/£:
• Boeing will have no incentive to exercise the option. It would let the option
expire and convert £10 million into dollars at the spot rate.
• For example, assume the spot exchange rate turns out to be $1.60/£
on the expiration date.
• Boeing will let the option expire and sell £10 million at the spot rate of
$1.60/£ and receive $16 million.
• Option premium was equivalent to $212,200 = ($200,000 × 1.061).
• Net dollar proceeds are $15,787,800 = $16,000,000 − $212,200.
Dollar Proceeds from Options Hedge
Future Spot Exercise Gross Dollar Option Net Dollar
Exchange Rate (ST) Decision Proceeds Cost Proceeds
$1.30 Exercise $14,600,000 $212,200 $14,387,800
$1.40 Exercise $14,600,000 $212,200 $14,387,800
$1.46 Neutral $14,600,000 $212,200 $14,387,800
$1.50 Not exercise $15,000,000 $212,200 $14,787,800
$1.60 Not exercise $16,000,000 $212,200 $15,787,800

Note: The exercise exchange rate (E) is $1.46 in this example.

Boeing’s Alternative Hedging Strategies for a
Foreign Currency Receivable
Strategy Transactions Outcomes
• Sell £10,000,000 forward for U.S. Assured of receiving $14,600,000
Forward market • dollars now. in one year; future spot exchange
In one year, receive £10,000,000 from rate becomes irrelevant.
hedge the British client and deliver it to the
counterparty of the forward contract.

• Borrow £9,174,312, buy $13,761,468

spot, and invest in the United States Assured of receiving $13,761,468
Money market now. now or $14,600,918 in one year;
hedge • In one year, collect £10,000,000 from future spot exchange rate
the British client and pay off the becomes irrelevant.
pound loan using the amount.

• Buy a put option on £10,000,000 for Assured of receiving at least

an upfront cost of $200,000. $14,387,800 or more if the future
Options market • In one year, decide whether to spot exchange rate exceeds the
hedge exercise the option upon observing exercise exchange rate; Boeing
the prevailing spot exchange rate. controls the downside risk while
retaining the upside potential.
 Comparison of Hedging Strategies
Dollar Proceeds from the British Sale:
Alternative Hedging Strategies

$14,600,918= 𝑆! × £10 million - $212,200

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.