Lecture 5
Transaction
Exposure
Multinational Business Finance
Global Economy
Corporate Ownership, Goal, and Governance
International Monetary System
Balance of Payments
Foreign Exchange Market
International Parity Conditions
Foreign Exchange Forecasting
Foreign Currency Derivatives and Swaps
Transaction Exposure
Translation Exposure
Operating Exposure
Global Cost of Capital
Raising Capital Globally
Multinational Tax Management
International Trade Finance
Foreign Direct Investments
Multinational Capital Budgeting
Foreign Exchange Exposure
• Foreign exchange exposure is a measure of the potential for a
firm’s profitability, net cash flow, and market value to change
because of a change in exchange rates.
• Time
– Existing contracts – transaction, translation
– Future contracts – economic
• Money
– Realized – transaction, economic
– Unrealized - translation
• An important task of the financial manager is to
– measure foreign exchange exposure and to
– manage it so as to maximize the profitability, net cash flow,
and market value of the firm.
5-3 © 2013 Pearson Education, Inc. All rights reserved.
Hedging
• Hedging is the taking of a position, acquiring either
a cash flow, an asset, or a contract (including a
forward contract) that will rise (fall) in value and
offset a fall (rise) in the value of an existing
position.
• While hedging can protect the owner of an asset
from a loss, it also eliminates any gain from an
increase in the value of the asset hedged against.
Transaction Exposure
• Transaction exposure measures gains or losses that
arise from the settlement of existing financial
obligations whose terms are stated in a foreign
currency.
• Can be managed by contractual, operating, and
financial hedges.
• Contractual hedge - forward, money, futures, and
options markets. (Lecture 5 today)
• Operating and financial hedges - risk-sharing
agreements, leads and lags in payment terms,
swaps, and other strategies. (Lectures 6-8, 10-11
and Strategy classes )
• Natural hedge offsetting operating cash flow, a
payable arising from the conduct of business.
Transaction Exposure Example
• US exporter sells merchandize to Belgian importer for
EUR1,800,000. Contract is signed when St=0 =1.12 $/
€, payment is received when St=1= 1.10 $/€
• Cash inflow = 1.8M EUR x 1.10 $/€ = $1.980 million
• Recorded = 1.8M EUR x 1.12 $/€ = $2.016 million
• Foreign exchange gain (loss) =-$0.036 million
Managing Receivable
Do nothing
• Expect
£1,000,000 x 1.76 $/£
= $1,760,000
Forward hedge
• Sell Forward
£1,000,000 x 1.7540 $/£ =
$1,754,000
Money market hedge
• Borrow £1,000,000 / (1+0.025) = £ 975,610
• Convert in $: £975,610 x 1.7640 $/£ = $1,720,976
• Invest at WACC
• $1,720,976 x (1+0.03) = $1,772,605
Options hedge for the
£1,000,000 receivable
• Concern: depreciation of GBP use put options
• Put option on GBP
– Strike = $1.75/£, premium 1.5% of the amount
• Option cost = £1,000,000x0.015x1.7640=$26,460
• Recall that delivery is in 90 days
– Best available rate is WACC 12% p.a.
– FV of option cost in 90 days $26,460(1+0.12/4)=$27,254
– $27,254/£1,000,000 = $0.027254 per 1£
• If FX90 > 1.75 put not excised,
• payoff = FX90 x £1,000,000 - $27,254
• If FX90 < 1.75 put excised,
• payoff = 1.75/£ x £1,000,000 - $27,254
5-8 © 2013 Pearson Education, Inc. All rights reserved.
Hedging the Receivable
Transactions Side by Side
Managing Payable
• Do nothing alternative – risk to have to pay more, as
opposed of receiving less in previous example
• Forward hedge – buy GBP forward at $1.7540/£
• Money market hedge - $£ at spot rate, invest in UK
so that after 90 days there will be £1,000,000 in the
UK account
• Invest in UK: 1,000,000/(1+0.08/4)= £980,392.16
• $ equivalent of £, 90 days before payment:
£980,392.16 x $1.7640/£=$1,729,411.77
• $FV at best available rate, WACC = 12% in this case,
on payment date
$1,729,411.77x(1+0.12/4)=$1,781,294.12
Options hedge for payable
• Concern: appreciation of GBP - use call options
• Call option on GBP
• Strike = $1.75/£, premium 1.5% of the amount
• Option cost = £1,000,000x0.015x1.7640=$26,460
• Recall that delivery is in 90 days
• Best available rate is WACC 12% p.a.
• FV of option cost in 90 days
$26,460(1+0.12/4)=$27,254
• $27,254/£1,000,000 = $0.027254 per 1£
• If FX90 < 1.75 - call not excised,
total cost = FX90 x £1,000,000 + $27,254
• If FX90 > 1.75 - call excised,
total cost = 1.75/£ x £1,000,000 + $27,254
Hedging the Payable
Transactions Side by Side
Derivatives hedges with reduced cost
• Concern: forwards limit upside, options cost money
• Objective: reduce cost of hedging strategy
– Less cost but more risk
• Forwards – over and under-hedging based on specific
market expectation for FX rates
• Options
– Use of OTM options instead of ATM options, cheaper
strategy
– Taking opposite position or complex options
strategies: collars (risk reversals), spreads
• Exotic features
– Knock in/out features
– Digital options
Risk Management in Practice
• Typically firms do not hedge 100% of exposure in
order to cut costs
• Companies manage risks in areas where they do not
have expertise, and leave exposure unhedged in areas
where they do have expertise.
• Risk management is performed using mostly forward,
swap, and options contracts.
• The greater the degree of international involvement,
the greater the firm’s use of foreign exchange risk
management.
• Risk management is a process to efficiently allocate
risk
