Chapter 11

Managing
Transaction
Exposure

1
 Transaction
Exposure
exists when future cash transactions
of a firm are affected by exchange
rate fluctuations

2
Is hedging worthwhile?

3
Should the firm’s hedging strategy be to use
forward contracts for all of its future foreign
exchange transactions?

If the forward rate is an unbiased estimate of

the future spot rate 

Sometimes it is higher and other times it is

lower but it balances out over the long run 
Firm does not bear the cost of hedging
4
By hedging, MNC knows with certainty what its
future cash outflows and inflows will be. This
makes planning much easier for the MNC.
Should the firm hedge a future foreign
exchange transaction if it feels the exchange
rate will move in an unfavorable direction?

If it is fairly good at forecasting

exchange rate movements
5
 Conclusions
The MNC’s level of risk aversion, and its
ability (and desire) to forecast
exchange rates determine:

 If it will hedge
 How much it will hedge
 How it will hedge
6
 The Company uses foreign currency debt and
derivatives to hedge the foreign currency risk associated
with certain royalties, intercompany financings and long-
term investments in foreign subsidiaries and affiliates. In
2005, the Company used foreign currency debt to hedge
the foreign currency risk associated with foreign
currency denominated cash and equivalents related to
HIA. This reduces the impact of fluctuating foreign
currencies on cash flows and shareholders’ equity. Total
foreign currency denominated debt, including the effects
of foreign currency exchange agreements, was $8.1
billion and $6.6 billion for the years ended 2005 and 2004,
respectively. In addition, where practical, the Company’s
restaurants purchase goods and services in local
currencies resulting in natural hedges.
2005 Financial Report, McDonald’s Corporation, p 18
http://www.mcdonalds.com/corp/invest/pub/2005_Financial_Report.RowPar.0002.ContentPar.0001.ColumnPar.0003.DownloadFiles.0001.File.tmp/Financial_Report_2005.pdf

7
 Identifying Net
Transaction
Exposure
Do this on a currency-by-currency basis

8
 U.S. Based MNC
(millions of $)
Subsidiary £ How could the
London + $100 MNC use forward
Munich - $110 contracts to hedge
Toronto + $30 against its
Consolidated + $20 transaction
exposure to £’s?
London and Toronto subsidiaries could
sell £’s forward and Munich subsidiary
could buy £’s forward

OR
MNC could sell $20m worth of £’s forward
9
 (millions of $)
Subsidiary £ C$ € ¥
London + $100 -$60 -$80 - $30
Munich - $110 -$80 +$120 + $80
Toronto + $30 +$70 -$10 - $50
Consolidated + $20 -$70 +$30 + $0

What could the MNC do about its

transaction exposure to the ¥?

It may decide it has no

transaction exposure to the ¥

10
 Should “net” exposure be viewed from
the subsidiary level or be centralized
(from the view of the entire MNC)?

Favoring Centralized
Control

Goal of financial decision maker is to

maximize the value of the overall MNC, not
the value of individual subsidiaries
11
 Implications
If exposure of subsidiaries nets out 
no hedge is necessary
Subsidiary ¥ If all three subsidiaries
London - $30 hedge, MNC
Munich + $80 experiences
Toronto - $50 unnecessary
Consolidated +$0 expenses

If a single subsidiary hedges, then the

MNC overall becomes exposed
12
Favoring Decentralized (Subsidiary)
Control
1. Local creditors may look unfavorably
toward subsidiary’s exposure if it doesn’t
handle its own exposure
2. Subsidiary’s management may feel
more comfortable handling their own
exposure so they will not be hurt by
adverse movements in exchange rates
which make them look bad on their job
record
13
 In the past Kodak would bill its
subsidiaries in $’s for supplies it
provided so each subsidiary had to deal
with its own transaction exposure

Now Kodak bills its subsidiaries in

their local currencies and Kodak’s
main headquarters handles any
transaction exposure

14
 Fiat (Italian auto maker) has a centralized system for 421
subsidiaries in 55 countries, uses a comprehensive reporting
system to keep track of cash flows in each currency, and its main
headquarters does any necessary hedging

15
Techniques for Managing
Transaction Exposure
 Invoicing Strategy
 Pricing Strategy
 Futures (Forward) Contracts
 Money Market Hedge
 Options Hedge
 Go Uncovered

16
Today G.E. is awarded a contract to
supply turbine blades to Lufthansa (German
company). The blades will be delivered to
Lufthansa one year from today and G.E. will
receive €25,000,000 for the blades. Currently
the spot rate is $0.55/€ and the 1-year futures
rate is $0.54/€. The size of a futures contract is
€125,000. German annual interest rates are 6%
on deposits and 8% on borrowed funds and
U.S. annual interest rates are 5% on deposits
and 7% on borrowed funds. 1-year € call
options with a strike price of $0.51/€ have a
premium of 6¢ /€ and put options with a strike
price of $0.58/€ have a premium of 5¢ /€.
17
 Is G.E. long or short in €’s?

LONG
because they will receive €25,000,000 in the future
0 1

+ €25,000,000
- €25,000,000
€0
If G.E. decides it wants to offset this long position,
it will set up a situation which will require it to pay
€25,000,000 one year from today

HEDGING 18
 Invoicing Strategy
If G.E. is buying parts from a German
firm for delivery in one year, it could
agree to pay for them in €’s
(i.e. Invoice price is in €’s)

Pricing Strategy
When negotiating the contract with
Lufthansa, G.E. could have insisted on
being paid in U.S. $’s rather than €’s

Could this cause problems for G.E.?

Lufthansa may award the contract to a
company that prices their blades in €’s 19
Futures Contract Hedge
Should G.E. buy or sell a futures contract?
Since it will receive €’s in the future and
wants to convert them to $’s, it should sell
€ Futures Contracts

Today
1. G.E. sells 25,000,000
 200 contracts
125,000

at $0.54/€

20
One Year from Today
1. G.E. receives €25,000,000 from Lufthansa

2. G.E. delivers €’s on Futures Contract

G.E. receives (25,000,000)(0.54) = $13,500,000

Should G.E. hedge with a Futures Contract or

maintain its long position in €’s?

That depends on what G.E. thinks

the future spot rate will be

21
 Develop a probability distribution for what
the spot rate will be one year from today

Possible Future
Spot Rates Probability
$0.53/€ 15%
$0.54/€ 40%
$0.55/€ 45%

Calculate the expected spot rate

E[spot] = (15%)($0.53) + (40%)($0.54) + (45%)($0.55)
=$0.542/€
Since E[spot] > Future Rate, do not hedge

22
 If GE doesn’t hedge, what is the
probability it made the correct choice?
40% + 45% = 85%
What is GE’s expected
revenue without hedging?

(25,000,000)($0.542) = $13,550,000
Compare this to GE’s revenue if it hedges
(25,000,000)($0.54) = $13,500,000

GE will have to decide if the extra “expected”

revenue of $50,000 is worth the
risk of going unhedged
23
Money Market Hedge
Take a money market position to offset a
future foreign currency payables or
receivables position

EXAMPLE #1
Suppose GE needs to borrow $15,000,000
to build a new plant in the U.S.
GE can borrow €’s today instead of $’s with
the idea of using the €25,000,000 it receives
from Lufthansa to repay this loan
24
 Should GE borrow €25,000,000?

It should borrow less than €25,000,000

€Borrowed(1 + iGer) = €25,000,000 

25,000,000
€Borrowed =  €23,148,148
1  8%
25
 Today
1. GE borrows €23,148,148 from
German bank at 8% for 1 year

2. Convert €’s to $’s at current spot rate

(23,148,148)($0.55) = $12,731,481

3. Use the $’s to help build the

new plant in the U.S.

26
 One Year from Today

1. GE receives €25,000,000 from

Lufthansa
2. Use the €25,000,000 to repay
loan from the German bank
(23,148,148)(1 + 8%) = €25,000,000

27
 EXAMPLE #2
GE does not need to borrow $’s to help
finance construction of a new plant

Today
1. GE borrows €23,148,148 from
German bank at 8% for 1 year
2. Convert €’s to $’s at spot rate
(23,148,148)($0.55) = $12,731,481
3. Deposit $’s in U.S. bank for 1 year
at 5%
28
One Year from Today
1. GE receives €25,000,000 from
Lufthansa
2. Use these €’s to repay loan
from German bank
(23,148,148)(1 + 8%) = €25,000,000
3. GE receives $’s from U.S. bank
(12,731,481)(1 + 5%) = $13,368,055

29
 Which is better for GE, the
Money Market hedge or the
Futures hedge?

GE gets $13,500,000 with the

Futures hedge compared to
$13,368,055 with this
Money Market hedge

30
 Suppose GE must pay €203,000 to a German
company three months from today. The 90-day
interest rate on borrowed funds in the U.S. is
1.75% and on deposits in Germany is 1.5%.
Use a Money market hedge.
How many €’s should GE deposit
in a German bank?
203,000
 €200,000
1.015

EXAMPLE #1
GE has excess $’s it does not need
during the next 90 days
31
 Today
1. GE converts appropriate amount of $’s to €’s
200,000(0.55) = $110,000
2. GE deposits €200,000 in a German bank
at 1.5% for 90 days

Three Months from Today

1. GE receives €’s from German bank
200,000(1.015) = €203,000
2. GE uses these €’s to pay German company
32
 EXAMPLE #2
GE does not have excess cash (or has excess
but doesn’t want to use it for this purpose)

Today
1. GE borrows the right amount of $’s for 90
days at 1.75% from U.S. bank
200,000(0.55) = $110,000

2. Convert $110,000 to €200,000

3. GE deposits €’s in German bank for 90
days at 1.5%
33
Three Months from Today
1. GE receives €’s from German bank
200,000(1.015) = €203,000

2. GE uses these €’s to pay German company

3. GE repays loan
110,000(1.0175) = $111,925

Compare the amount repaid to the U.S. bank

to the cost of getting the needed £’s with a
Futures Contract to determine which is best
34
 Consider the €’s GE will receive from
Lufthansa. What “bad” could happen
which would cause GE to be interested in
buying a Futures Contract?
That one year from today the spot rate will be

BELOW
$0.54/€ (the Futures rate today)
i.e. that the € will depreciate
below the current Futures rate
A Futures Contract and a Money Market
Hedge will protect GE from the bad
effects of this occurring
35
 What would GE like to see happen
to the spot rate over the next 12
months if it did not hedge?
One year from today the spot rate to be

ABOVE
$0.54/€ (the futures rate today)
Would a Futures Contract or a Money
Market Hedge allow GE to benefit from
this situation occurring?

What would allow GE to benefit

from this situation occurring?
36
Currency Option Hedge
Should GE use a Put or a Call?

Put Option
Should GE buy or sell a € Put?

BUY
37
 Today
1. GE buys 200 Put Options to sell
€25,000,000 with a strike price of
$0.58/€ and a premium of 5¢/€

Cost: (25,000,000)(5¢) = $1,250,000

GE is now guaranteed that the minimum

they will receive for the turbine blades is
(25,000,000)($0.58 - 5¢) = $13,250,000

38
 One Year from Today
1. GE receives €25,000,000 from Lufthansa
How does GE decide if it
should exercise the Put?

Compare the spot rate to the strike price

If spot $0.58

GE should exercise the Put 

receives 25,000,000($0.58) = $14,500,000 
clears $14,500,000 - $1,250,000 = $13,250,000
39
 If spot $0.58

GE should not exercise the Put 

GE sells the €’s in the spot market 
GE receives 25,000,000(spot rate) 
clears 25,000,000(spot rate) - $1,250,000

Note:
If $0.58 < spot < $0.63  GE recoups
some of the 5¢ premium
If $0.63 < spot  GE recoups all of the
5¢ premium plus more
40
 Which would have been better for GE?
Sell Futures Buy Put Option strike
Contract $0.54/€ $0.58/€ 5 cent premium

That depends on what the

spot rate is one year from today
If spot rate is $0.52/€?

Futures Contract
If spot rate is $0.58/€?

Futures Contract
41
 If spot rate is $0.65/€?

Put Option
If spot rate is $0.595/€?

Put Option

Futures Contract is better if

spot < $0.59 = $0.54 + 5¢
Futures rate Put premium
Put Option is better if spot > $0.59
42
 NOTE
NOTE
If the spot rate is greater than $0.54 one year
from today, the best course of action for GE
to take today would be not to hedge at all

GE will not know this until after

it had to make a decision

Not hedging would leave GE unprotected

if € depreciated below $0.54/€
43
 GE’s Future (Forward) hedge, Money Market
hedge, Put Option hedge, and going uncovered
can be compared visually.

Possible Future
Spot Rates Probability
$0.50/€ 10%
$0.53/€ 30%
$0.60/€ 60%

44
 Future's Contract Hedge
100%
80%
60%
40%
20%

$13,500,000

Money Market Hedge

100%
80%
60%
40%
20%

$13,368,055

45
 Put Option Hedge
Strike price $0.58 and premium 5¢
100%

80%

60%

40%

20%

$13,250,000 $13,750,000
spot is 50¢ or 53¢ spot is 60¢
exercise put don’t exercise put

46
 Uncovered Position
100%

80%

60%

40%

20%

$12,500,000 $13,250,000 $15,000,000

spot is 50¢ spot is 53¢ spot is 60¢

47
Hedging Long-term Transaction Exposure
Some MNC’s know they will
be exposed for many years
into the future
(Disney with theme parks in
France & Japan)

48
 Long-term Forward
Contracts
Many large international banks offer terms
up to five years on British pounds, Canadian dollars,
Japanese yen, and Swiss francs.

Because forward contracts are tailored to

the needs of the customer, maturities up to
10 years or more are sometimes available
for the major currencies.
49
 Currency Swaps
There are many forms of Currency Swaps

EXAMPLE
A Japanese firm is doing business in England
and will receive £’s over the next few years.
It gets together with a British firm which is doing
business in Japan and will receive ¥’s
over the next few years.
50
 They agree to exchange their foreign
currency cash flows at a specific rate

¥’s ¥’s
¥’s ¥’s
¥’s
£’s
£’s £’s
£’s £’s

Brokers employed by large banks will

act as middlemen and will charge a fee
for their services
51
Alternative Hedging
Techniques

Leading & Lagging

Adjust timing of payables and
receivables depending on expectation
of exchange rate movement

52
 EXAMPLE
French firm ships supplies to its subsidiary
in Switzerland and will be paid in SF’s

What should the French firm do if it thinks

the SF will depreciate against the €?

Speed up the payment Leading

What should the French firm do if it thinks
the SF will appreciate against the €?
Slow down the payment Lagging
53
 Cross-Hedging
Suppose a firm has transaction exposure
against a currency where a hedge does
not exist
Identify another foreign currency which
is highly positively correlated with the
currency needed (relative to movements
against the home currency) and for
which a hedge does exist

54
 Building Blocks for FINC 445
Skills: Hedging:
Communication Invoicing strategy, pricing strategy, futures contract hedge,
money market hedge, currency option hedge, uncovered
Problem Solving position, leading & lagging hedging technique, cross-hedging

International Fisher Purchasing Power Measuring Exposure

Effect: Parity: to Exchange Rate
Interest rates inflation Fluctuations
Locational Arbitrage Triangular Arbitrage Interest Rate Parity Covered Interest
Arbitrage

Exchange Rate Systems: fixed, European Fiscal Policy: budget Monetary Policy: Fed
Bretton Woods, floating, managed Monetary deficit money supply Intervention: direct,
float, pegged, Asian Crisis System: Euro inflation sterilized, indirect

Forward Contracts: Futures Contracts Arbitrage Put Call Contingency

Forward Premium margin Options Options Graph

MNC’s and consumers Exchange Rate Determination: Adjustment of Market Equilibrium: Speculating on
Investors Exports and imports Inflation, interest rates, income levels, anticipated exchange
Central Banks pair of currency markets expectations about future exchange rates rate movement
Speculators supply, demand, equilibrium

Motives: Familiar Setting: Currency Conversion: Spot Market: Bank participation in

Involved in foreign U.S. grocery store The basics, value, appreciate, Bid & ask rates, direct & foreign exchange
financial markets Buyer vs seller depreciate, purchasing power indirect, cross rates, markets
arbitrage

Trade Agreements: FX Systems: Balance of Payments: Trade Issues: Economic Factors: Intl
U.S.-Canada, NAFTA, Euro, Dollarization, Current Account Japan & China, Inflation, national income, Agencies:
Mercosur, FTAA, CAFTA, Floating Exchange Capital Account deficits, surpluses, interest rates, trade barriers, World Bank
Mexico, EU, GATT, WTO Rate System Official Reserve Acct trading partners capital controls IMF

Problem of Scarcity: Economic Goal of Corp: Ethical Perfect MNC vs Risk of doing PV of
Comparative Advantage Systems: Max. wealth of Considerations Markets: domestic business MNC’s
Interdependence Capitalism, Socialism shareholders labor firm internationally
Communism
cashflows
interest
55
Image created by: Ralph A. Clevenger 56