Chapter 8

Transaction Exposure
 Chapter Outline
• Forward Market Hedge
• Money Market Hedge
• Options Market Hedge
• 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
• Should the Firm Hedge?
• What Risk Management Products Do Firms Use?

8-2
 Techniques for Hedging Transaction
Exposure
Hedging Technique Payables Receivables

Future Hedge Purchase a currency future contract Sell a currency futures contract (or
(or contracts) representing the contracts) representing the currency
currency and amount related to the and amount related to the receivables
payables

Forward Hedge Negotiate a forward contract to Negotiate a forward contract to sell the
purchase the amount of foreign amount of foreign currency that will be
currency needed to cover the payables received as a result of the receivables

Money Market Hedge Borrow local currency and convert to Borrow the currency dominating the
currency dominated payables. Invest receivables convert it to the local
these funds until they ate needed to currency and invest it. Then pay off the
cover the payables loan with cash inflow from the
receivables

Currency Option Hedge Purchase a currency call option (or Purchase a currency put option (or
options) representing the currency and options) representing the currency and
amount related to the payables amount related in the receivables

8-3
 Forward Market Hedge: Imports
• If you expect to owe foreign currency in the future, you can hedge by
agreeing today to buy the foreign currency in the future at a set price by
entering into a long position in a forward contract.

Importer Go
nc c
rre sti

Se od
y
Cu m e

rv s o
Do

ic e r
s

Forward
rre ign

Fo rren
y

cu
re cy
cu re

Foreign
nc

Contract
Fo

ign
Counterparty Supplier
8-4
 Forward Market Hedge: Exports
• If you are going to receive foreign currency in the future, agree to sell the
foreign currency in the future at a set price by entering into short position
in a forward contract.

Exporter

Fo rren
rre ign

Cu
re cy
y

ign
Cu re
nc
Fo

nc c
rre sti

Go rvi
y
Cu m e

od ces
Se
Do

Forward
so
Foreign
r
Contract Customer
Counterparty
8-5
 Importer’s Forward Market Hedge
A U.S.-based importer of Italian shoes has just ordered next year’s inventory. Payment of
€100M is due in one year. If the importer buys €100M at the forward exchange rate of $1.50/€,
the cash flows at maturity look like this:

U.S.
Importer
00

Sh
,0

oe
00

s
,5
$1

0 0 €1
0
0, ,0
00
00
€ 1, ,0
00
Forward
Italian
Contract
Counterparty Supplier
8-6
 Exporter’s Futures Market Cross-Currency Hedge
Your firm is a U.K.-based exporter of bicycles. You have sold €750,000 worth of bicycles to an Italian retailer.
Payment (in euros) is due in six months. Your firm wants to hedge the receivable into pounds.

Country U.S. $ equiv. Currency per U.S. $

Britain (£62,500) $2.0000 £0.5000
1 Month Forward $1.9900 £0.5025
3 Months Forward $1.9800 £0.5051
6 Months Forward $2.0000 £0.5000
12 Months Forward $2.1000 £0.4762
Euro (€125,000) $1.4700 €0.6803
1 Month Forward $1.4800 €0.6757
3 Months Forward $1.4900 €0.6711
6 Months Forward $1.5000 €0.6667
12 Months Forward $1.5100 €0.6623
Sizes of forwards on this exchange are £62,500 and €125,000.
8-7
 Exporter’s Futures Market Cross-Currency Hedge
• The exporter has to convert the €750,000 receivable first into dollars and then
into pounds.
• If we sell the €750,000 receivable forward at the six-month forward rate of
$1.50/€, we can do this with a SHORT position in 6 six-month euro futures
contracts. €750,000
6 contracts =
€125,000/contract
 Selling the €750,000 forward at the six-month forward rate of $1.50/€ generates
$1,125,000: $1.50
$1,125,000 = €750,000 ×
€1
 At the six-month forward exchange rate of $2/£, $1,125,000 will buy £562,500. We
can secure this trade with a LONG position in 9 six-month pound futures contracts:
£562,500
9 contracts =
£62,500/contract
8-8
 Exporter’s Futures Market Cross-Currency
Hedge: Cash Flows at Maturity
Short position
in 6 six-month
euro futures on €750,000
€125,000
at $1.50/€1 $1,125,000 Exporter Bicycles Customer
Long position
€750,000
in 9 six-month
$1,125,000
pound futures £562,500
on £62,500 at
$2.00/£1

8-9
 Importer’s Money Market Hedge
• This is the same idea as covered interest arbitrage.
• To hedge a foreign currency payable, buy the present
value of that foreign currency payable today and put
it in the bank at interest.
– Buy the present value of the foreign currency payable
today at the spot exchange rate.
– Invest that amount at the foreign rate.
– At maturity your investment will have grown enough to
cover your foreign currency payable.

8-10
 Importer’s Money Market Hedge
A U.S.–based importer of Italian bicycles owes €100,000 to an
Italian supplier in one year.
– The spot exchange rate is $1.50 = €1.00.
– The one-year interest rate in Italy is i€ = 4%.
– The importer can hedge this payable by buying

€100,000
€96,153.85 = 1.04
and investing €96,153.85 at 4% in Italy for one year. At maturity, he
will have €100,000 = €96,153.85 × (1.04).

$1.50
Dollar cost today = $144,230.77 = €96,153.85 ×
€1.00

8-11
 Importer’s Money Market Hedge
• With this money market hedge, we have redenominated a
one-year €100,000 payable into a $144,230.77 payable due
today.
• If the U.S. interest rate is i$ = 3%, we could borrow the
$144,230.77 today and owe $148,557.69 in one year.

$148,557.69 = $144,230.77 × (1.03)

€100,000
$148,557.69 = S($/€)× × (1+ i ) T
(1+ i€)T $

8-12
 Importer’s Money Market Hedge: Cash Flows Now
and at Maturity
deposit i = 4% €
Spot Foreign €96,153.85 Importer
Exchange
€96,153.85 Italia Bank
Market $144,230.77 €100,000
T= 1 cash

$148,557.69
$144,230.77

€1
flows

00
,00
bic

0
yc
l es
Supplier
U.S Bank

8-13
 Exporter’s Money Market Hedge
Spot Foreign €95,238.10 €95,238.10 Crédit
Exporter Agricole
Exchange Borrow i€ = 5%
Market $119,047.62 €100,000
An American exporter has
T= 1 cash
deposit i$ = 7.10%
just sold €100,000 worth of

$127,500.00
$119,047.62
shoes to a French customer. flows

€1
0
Payment is due in one year.

0,0
Interest rates in dollars are

00
sh
7.10 percent in the U.S. and

oe
s
5 percent in the euro zone.
The spot exchange rate is Customer
$1.25/€1.00. Use a money U.S Bank
market hedge to eliminate
the exporter’s exchange rate
risk.
8-14
 Importer’s Money Market Cross-Currency
Your firm is a U.K.-basedHedge
importer of bicycles. You have
bought €750,000 worth of bicycles from an Italian firm.
Payment (in euros) is due in one year. Your firm wants
to hedge the payable into pounds.
– Spot exchange rates are $2/£ and $1.55/€
– The interest rates are 3% in €, 6% in $ and 4% in £, all
quoted as an APR.
What should you do to redenominate this 1-year €-
denominated payable into a £-denominated payable
with a 1-year maturity?

8-15
 Importer’s Money Market Cross-Currency
Hedge
• Sell pounds for dollars at spot exchange rate, buy euro at spot
exchange rate with the dollars, invest in the euro zone for one
year at i€ = 3%, all such that the future value of the investment
equals €750,000. Using the numbers we have:
– Step 1: Borrow £564,320.39 at i£ = 4%.
– Step 2: Sell pounds for dollars, receive $1,128,640.78.
– Step 3: Buy euro with the dollars, receive €728,155.34.
– Step 4: Invest in the euro zone for 12 months at 3% APR (the future
value of the investment equals €750,000).
– Step 5: Repay your borrowing with £586,893.20.
(see next slide for where the numbers come from)

8-16
 Where Do the Numbers
The present value of the euro payable =
Come From?
€750,000
€728,155.34 =
(1.03)
The dollar cost of buying
the present value of the = $1,128,640.78 = €728,155.34 × $1.55
euro payable today €1

Cost today in pounds of the £1

present dollar value of the £564,320.39 = $1,128,640.78 × $2
euro payable
FV in pounds of the cost in
pounds of being able to pay £586,893.20 = £564,320.39 × (1.04)
the supplier €750,000
8-17
 Importer’s Money Market Cross-Currency Hedge: Cash
Flows Now and at Maturity
Spot Foreign $1,128,640.77
Exchange €728,155.34
Market €728,155.34 Importer deposit i€ = 3% Italia Bank
Spot Foreign €750,000
Exchange
£564,320.39
T= 1 cash

£586,893.20
£564,320.39
Market

€7
$1,128,640.77 flows

50
,00
bic

0
yc
l es
Supplier
U.K Bank

8-18
 Options
• A motivated financial engineer can create
almost any risk-return profile that a company
might wish to consider.
• An important consideration when using
options is the hedge ratio that we covered in
the last chapter.
• Without due consideration of the hedge ratio,
the careless use of options can undo attempts
at hedging.
8-19
 Using Options to Hedge: Exports
• A British exporter who is owed €100,000 in one period has many choices:
– Buy call options on the pound with a strike in dollars while also buying
put options on the euro with a strike in dollars.
– Buy call options on the pound with a strike in euros.
– Buy put options on the euro with a strike in pounds.
• For any options market hedge, the exporter should use the hedge ratio to
know how many options are needed.
– Spot rates are S0(£/€) = £0.80/€, S0($/€) = $2.00/€,
S0($/£) = $2.50/£; i£ = 15½% and i€ = 5%.
– In the next year, suppose that there are two possibilities:
• S1(£/€) = £1.00/€ or
• S1(£/€) = £0.75/€

8-20
 Options Market Cross-Currency Hedge

At first it seems logical that a British exporter with a €100,000 receivable should buy
10 put options on €10,000—but that doesn’t work well. £10,000
10 × p0 = £2,077.92 (strike price of £.80/€) up
The hedge ratio of this option is − 1/5
p1 = £0
S1(£/€) = £1.00/€
p1up – p down
1
€10,000 = £8,000
H= p0 = £207.79
S1up – S1 down

£7,500
£0 – £500 –£500
pdown
1
= = =−/ 1 = £500
£10,000 – £7,500 £2,500 5
S1(£/€) = £0.75/€
With a hedge ratio of –0.20 our exporter would actually be better hedged with a long position in
50 PHLX puts.
8-21
 10 Puts on €10,000 (Strike £8,000) is Not a Hedge
Out-of-the-Money:
Put T = 1 Spot Market
Option S1(£/€) = £1.00/€ £100,000 Sell €100,000
Dealer K0(£/€) = £0.80/€ Buying
d s Exporter €100,000 S (£/€) = £1.00/€.
1

o o
G 0 0
0 ,0
1 0 Notice that our exporter doesn’t have
customer €
a hedge when he buys 10 put options.
Go
od £80,000
€1 s Put Option
00 S (£/€) = £0.75/€
10×p0 = £2,077.92 ,00 Buying 1

0 Exporter K (£/€) = £0.80/€ Dealer

0

The future value of the €100,000

receivable net of the cost of 10 options is either
£97,600 = £100,000 − £2,077.92 × 1.155
or £77,600 = £80,000 − £2,077.92 × 1.155
8-22
 50 × p0 = £10,389.61
Long 50 Puts = Perfect Hedge
Out-of-the-Money: T = 1 Spot Market
Option Put
S1(£/€) = £1.00/€ £100,000 Sell €100,000
Dealer Buying
K0(£/€) = £0.80/€
€100,000 S (£/€) = £1.00/€.
s Exporter
1

o d
Go 0 T = 1 Spot Market
,0 0 Buy €400,000
0 0 0
customer € 1 , 0 S1(£/€) = £0.75/€.
0 0
£ 3 0 0 In-the-Money Puts
Go 0 ,0 S (£/€) = £0.75/€
0 40 1

€1 o d s Put € K (£/€) = £0.80/€

0

00 Buying £400,000
,00 Option
The future value of the 0 Exporter
receivable net of the cost of 50 puts is €500,000 Dealer
£88,000 = £100,000 − £10,389.61 × 1.155 or
£88,000 = £400,000 − £10,389.61 × 1.155 − £300,000
8-23
 Options Hedges and Money Market Hedges and
Forward Market Hedges
• The next two slides show that the hedge of buying 50
puts has the exact same payoffs as a forward market
hedge and a money market hedge.
• Recall the story: A British exporter is owed €100,000 in one
period.
• S0(£/€) = £0.80/€, S0($/€) = $2.00/€, S0($/£) = $2.50/£
– i£ = 15½% and i€ = 5%
– In the next year, there are two possibilities:
• S1(£/€) = £1.00/€ or
• S1(£/€) = £0.75/€

8-24
 Money Market Cross-Currency Hedge
Perfect hedge whether S1(£/€) = £1.00/€ or S1(£/€) = £0.75/€.
Spot Foreign
Exchange
€95,238.10 Borrow PV of €100,000 at i€ = 5%

Market Exporter €95,238.10

$190,476.19 Italia Bank

Spot Foreign €100,000

Exchange
$190,476.19

£76,190.48
T= 1 cash

£88,000
Market flows
£76,190.48

Go ,00
€1

od 0
00
S0(£/€) = £0.80/€,

s
i£ = 15½% Customer
U.K Bank
i€ = 5%
8-25
 Forward Market Cross-Currency Hedge
A U.K.-based exporter sold a €100,000 order to an
Italian retailer. Payment is due in 1 year and the
exporter used a forward hedge. S0(£/€) = £0.80/€, S0($/€) = $2.00/€,
Euro S0($/£) = $2.50/£
Forward €100,000 i£ = 15½% i€ = 5% i$ = 10%
Contract
Counterparty $209,523.81 Exporter Goods Customer
Pound
€100,000
Forward
$209,523.81
Contract £88,000
Counterparty

Perfect hedge whether S1(£/€) = £1.00/€ or S1(£/€) = £0.75/€.

8-26
 Call-Buying Importer
Consider a British importer who owes €100,000 in one year.
The importer can use a money market or forward market hedge to £10,000
redenominate this into a £88,000 liability. up
He could also use OTC call options on the euro c1 = £2,000
with a pound strike.
£8,000
c0 = £900.43
With a hedge ratio of .80 our importer can hedge with a long
position in 1 OTC call on €125,000. £7,500
down
c1 = £0
cup1 –c1down £2,000– £0 £2,000 4
H= = = =
S1up – S1 down £10,000 – £7,500 £2,500 5
8-27
 1 Call on €125,000 = Perfect Import Hedge
Out-of-the-Money: T = 1 Spot Market
Option S1(£/€) = £0.75/€
Call £75,000
Buying Buy €100,000
Dealer K0(£/€) = £0.80/€
Importer €100,000 S1(£/€) = £0.75/€.

d s
o 0
Go ,0 0
T = 1 Spot Market
00
Supplier €1 0
Sell €25,000
0 0 0 S1(£/€) = £1.00/€.
5, 0 0
G

£2 5,
oo

€1 €2
ds

00 Call
,00 £100,000 Option
0 Buying
€125,000 Dealer
The future value of the Importer
receivable net of the cost of the call is In-the-Money Calls:
S1(£/€) = £1.00/€
£88,000 = £75,000 + £13,000 or K0(£/€) = £0.80/€
£88,000 = £100,000 + £13,000 − £25,000 8-28
 Cross-Hedging Minor Currency Exposure
• The major world currencies are the U.S. dollar,
Canadian dollar, British pound, euro, Swiss franc,
Mexican peso, and Japanese yen.
• Everything else is a minor currency (for example, the
Swedish krona).
• It is difficult, expensive, and sometimes even
impossible to use financial contracts to hedge
exposure to minor currencies.

8-29
Cross-Hedging Minor Currency Exposure
• Cross-hedging involves hedging a position in one
asset by taking a position in another asset.
• The effectiveness of cross-hedging depends upon
how well the assets are correlated.
– An example would be a U.S. importer with liabilities in
Swedish krona hedging with long or short forward
contracts on the euro. If the krona is expensive when the
euro is expensive, or even if the krona is cheap when the
euro is expensive, it can be a good hedge. But they need to
co-vary in a predictable way.

8-30
 Hedging Recurrent Exposure with Swaps

• Recall that swap contracts can be viewed as a

portfolio of forward contracts.
• Firms that have recurrent exposure can usually hedge
their exchange risk at a lower cost with swaps than
with a program of hedging each exposure as it comes
along.
• It is also the case that swaps are available in longer-
terms than futures and forwards.

8-31
 Exposure Netting
• A multinational firm should not consider deals in isolation, but should
focus on hedging the firm as a portfolio of currency positions.
• Once the residual exposure is determined, we hedge that.
• Multilateral netting is an efficient and cost-effective mechanism for
settling interaffiliate foreign exchange transactions and thus determining
the firm’s residual exposure.
• In the following slides, a firm faces the following exchange rates:

£1.00 = $2.00
€1.00 = $1.50
SFr 1.00 = $0.90
8-32
 SFr150
$150

5 0
€ 1

£150
€150

£1
50

SFr150
$1
$150

50
5 0
r 1
S F

€150
£150
8-33
Exposure Netting
SFr150 = $135
$150

5 0
€ 1

SFr150=$135
=

£150
$225 = €150

2 5
2 5
£1
$ 1 3
$
50

$1
$3
$150

$300
50
0
00
1 5
F r
S

$225 = €150
£150 = $300
8-34
Exposure Netting
SFr150 = $135
$150

5 0
€ 1

SFr150=$135
=

£150
$225 = €150

2 5
2 5
£1
$ 1 3
$
50

$1
$3
$150

$300
50
0
00
1 5
F r
S

$225 = €150
£150 = $300
8-35
 $135
$15
$150

2 5

$165
$75

$ 2 0
9
$1
$

$300
$225

50
$3
00

$1
$150

$135
50
3 5
$ 1

$225
$75
$300
8-36
 Exposure Netting: How to Double
Check Your Answer

• It’s always good practice to check your work.

• It’s better for you to find your mistakes than for your
professor to (or your boss!).
• You can check your work in exposure netting by
adding up each subsidiary’s debits and credits.
• When you’re done, check that you haven’t destroyed
or “created” any money.
• A new example follows for practice checking
answers.
8-37
 $100
$125 +$125
+$80 $80 +$155
+$155 –$240
–$300 $100
$140
$60
2 5
$ 1

$155
$125

$1
55

$1
$100

00

$80
8 0
$100 $ $80
+$80 +$100
+$155 $125 +$125
–$375 –$465
–$40 –$160
$155
8-38
 $25 $20
+$55 +$45
–$20 $20 +$75
$60 $140

5
$5

$75
$25

$ 4
5

–$30
+$30 –$75
–$45 –$55
–$25 $30 –$160
–$40
8-39
 $100
$60 +$40
$140

$6 0

$100
0 $ 4

–$100
–$60
–$40 –$160
8-40
 Alternative Solution

$60
$140

$2

$140
0
$40

–$140
–$20
–$40 –$160
8-41
Netting with Central Depository
Some firms use a central depository as a cash pool to
facilitate funds mobilization and reduce the chance of
misallocated funds.

$6 4 0
0 $1
Central
depository
$1
4 0 60
$

8-42
 Other Hedging Strategies
• Hedging through invoice currency.
– The firm can shift, share, or diversify:
• Shift exchange rate risk by invoicing foreign sales in home currency
• Share exchange rate risk by pro-rating the currency of the invoice between
foreign and home currencies
• Diversify exchange rate risk by using a market basket index
• Hedging via lead and lag.
– If a currency is appreciating, pay those bills denominated in that currency
early; let customers in that country pay late as long as they are paying in that
currency.
– If a currency is depreciating, give incentives to customers who owe you in that
currency to pay early; pay your obligations denominated in that currency as
late as your contracts will allow.

8-43
 Should the Firm Hedge?
• Not everyone agrees that a firm should hedge.
– Hedging by the firm may not add to shareholder
wealth if the shareholders can manage exposure
themselves.
– Hedging may not reduce the non-diversifiable risk
of the firm. Therefore, shareholders who hold a
diversified portfolio are not benefitted when
management hedges.

8-44
What Risk Management Products do Firms
Use?

• Most U.S. firms meet their exchange risk

management needs with forward, swap, and
options contracts.
• The greater the degree of international
involvement, the greater the firm’s use of
foreign exchange risk management.

8-45
 Questions
• 1. Discuss and compare hedging transaction
exposure using the forward contract vs.
money market instruments. When do the
alternative hedging approaches produce the
same result?

5-46
 Questions
• 2. Discuss and compare the costs of hedging
via the forward contract and the options
contract.

5-47
 Questions
• 3. What are the advantages of a currency
options contract as a hedging tool compared
with the forward contract?

5-48
 Questions
• 4. Should a firm hedge? Why or why not?

5-49