Lecture 12.

Management of Transaction
Exposure (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 ascertain and minimize the dollar cost of paying off the
payable.
Forward Market Hedge
• If Boeing decides to hedge this payable exposure using a forward
contract, it can take a long position on a forward contract and agree
to buy the foreign currency payable amount in the future.
• Boeing will buy £5 million forward at the forward rate of $1.75/£ in
one year in exchange for the following dollar amount:
• $8,750,000 = (£5,000,000) × ($1.75/£)
• With forward hedge, the dollar cost of this jet engine will be
$8,750,000 regardless of the future exchange rate.
Money Market Hedge
• Boeing can borrow in dollars, buy pounds today with the borrowed dollars,
and invest pounds in the U.K. against the foreign currency payable.
• The amount of pounds needed to invest in the U.K. today to receive £5 million
in one year:
£4,694,836 = £5 million/1.065
• Borrow dollars today to purchase £4,694,836 at the spot rate:
• $8,450,705 = (£4,694,836) × ($1.80/£).
• In one year, collect £5 million from the U.K. investment and deliver it to Rolls-
Royce. Repay the dollar loan with:
• $8,957,747 = ($8,450,705) × (1.06).
• With money market hedge, the dollar cost of the jet engine is $8,957,747
regardless of future exchange rate.
Options Market Hedge
• Suppose that Boeing purchased a call option on £5 million with an
exercise price of $1.80/£ and a one-year expiration, and assume the
option premium (price) was $0.018 per pound.
• Boeing paid $90,000 (= $0.018/£ × £5 million) for the option.
• Considering the time value of money, the upfront cost is equivalent to
$95,400 = ($90,000 × 1.06).
• Provides Boeing with the right, but not the obligation, to buy £5 million for
$1.80/£, regardless of the future spot rate.
Options Market Hedge
• At maturity, if spot exchange rate > $1.80/£:
• Boeing will exercise the call option and buy £5 million at the strike price of
$1.80/£ and pay the following dollar amount:
• $9,000,000 = $1.80/£ × £5 million
• Net proceeds = $9,000,000 + $95,400 = $9,095,400
• At maturity, if spot exchange rate =< $1.80/£:
• Boeing will let the call option expire and buy £5 million at the spot price.
• With options hedge, the dollar cost of the jet engine will not exceed
$9,095,400.
Boeing’s Alternative Hedging Strategies for a
Foreign Currency Payable
Strategy Transactions Outcomes
1. Agree today to buy £5,000,000 and
sell U.S. dollars forward in one year. Assured of paying $8,750,000 in one
Forward market 2. In one year, pay $8,750,000 and year; future spot exchange rate
hedge receive £5.000.000 from the becomes irrelevant.
counterparty of the forward contract
and deliver the pounds to Rolls-Royce.

1. Borrow $8,450,705 and use the dollars

to buy £4,694,836 now. Invest the Assured of paying $8,957,747 in one
Money market pounds at the British interest rate. year; future spot exchange rate
hedge 2. In one year, collect £5,000,000 and becomes irrelevant.
deliver the pounds to Rolls-Royce. Pay
off the dollar loan with $8,957,747.
1. Buy a call option on £5,000,000 for an Assured of paying at most
upfront cost of $90,000. $9,095,400 or less if the future spot
Options market exchange rate falls below the
2. In one year, decide whether to exercise exchange rate; Boeing
hedge exercise the option upon observing controls the downside risk while
the prevailing spot exchange rate. retaining the upside potential.
Dollar Costs of Securing the Pound Payable:
Alternative Hedging Strategies

$8,750,000 = $95,400 + £5,000,000 × 𝑆!

Summary of Hedging Strategies for
Transaction Exposure
Foreign Currency Receivable Foreign Currency Payable

Buy the foreign currency payable

Sell the foreign currency receivable
amount forward by entering into a
Forward Hedge amount forward by entering into a short
long position on a forward
position on a forward contract.
contract.

Borrow in foreign currency against the Borrow in domestic currency, buy

Money Market foreign currency receivable, buy U.S. foreign currency today with the
Hedge dollars with the loan, and invest in the loan, and invest abroad against the
U.S. foreign currency payable.

Buy put options on the foreign currency Buy call options on the foreign
Options Hedge
receivable. currency payable.
Problem 1
Solution 1
a)
• Total option premium = $0.05/SF × SF5000 = $250. In three months,
$250 is worth $253.75 = $250 × (1.015). (6%/4 = 1.5%)
• At the expected future spot rate of $0.63/SF, which is less than the
exercise price, you don’t expect to exercise options. Rather, you
expect to buy Swiss franc at $0.63/SF.
• Since you are going to buy SF5,000, you expect to spend $3,150
(=.63×5,000). Thus, the total expected cost of buying SF5,000 will be
the sum of $3,150 and $253.75, i.e., $3,403.75.
b)
• Future dollar cost of forward contract: $0.63/SF × SF5000 = $3,150
Solution 1
c)
• We know the future dollar cost of forward contract: $3,150
• The future dollar cost of option contract is: 253.75 + 𝑀𝑖𝑛(5000×
𝑆! , 5000×$0.64/𝑆𝐹)
• The Break-even point can be obtained in the following equation:
• 3,150 = 253.75 + 5000×𝑆"
• The break-even point: 𝑆! = $0.57925/SF
• The forward and option market hedges are indifferent at the spot rate of
$0.57925/SF.
Solution 1
d)
• With the forward contract, you
always pay $3,150.
• If the Swiss franc appreciates beyond
$0.64/SF, which is the exercise price
of call option, you will exercise the
option and buy SF5,000 for $3,200.
• The maximum cost of buying SF5,000
with options market hedge is
$3,453.75 ($3,200 + $253.75).
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 baht, 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.
Cross-Hedging Minor Currency Exposure
• Suppose a U.S. firm has an account receivable in Korean won and
would like to hedge its won position.
• Since the won/dollar exchange rate is highly correlated with the
yen/dollar exchange rate, the U.S. firm may sell a yen amount, which
is equivalent to the won receivable, forward against the dollar
thereby cross-hedging its won exposure.
• Obviously, the effectiveness of this cross-hedging technique would
depend on the stability and strength of the won/yen correlation.
• A study by Aggarwal and Demaskey (1997) indicates that Japanese
yen derivative contracts are fairly effective in cross-hedging
exposure to minor Asian currencies such as the Indonesian rupiah,
Philippine peso, and Thai bhat.
Cross-Hedging Minor Currency Exposure
• Commodity futures contracts may be used effectively to cross-hedge
some minor currency exposures. (Benet 1990)
• Suppose the dollar price of the Mexican peso is positively correlated
to the world oil price.
• Mexico is a major exporter of oil, accounting for roughly 5 percent of the
world market share.
• A firm may use oil futures contracts to manage its peso exposure.
• The firm can sell (buy) oil futures if it has peso receivables (payables).
• Soybean and coffee futures contracts may be used to cross-hedge a
Brazilian real exposure.
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.
Hedging Contingent Exposure
• An alternative approach is to buy a three-month put option on C$100
million. In this case, there are four possible outcomes:
• The bid is accepted, and the spot exchange rate turns out to be less than
the exercise rate: The firm will simply exercise the put option and convert
C$100 million at the exercise rate.
• The bid is accepted, and the spot exchange rate turns out to be greater
than the exercise rate: The firm will let the put option expire and convert
C$100 million at the spot rate.
• The bid is rejected, and the spot exchange rate turns out to be less than
the exercise rate: Although the firm does not have Canadian dollars, it will
exercise the put option and make a profit.
• The bid is rejected, and the spot rate turns out to be greater than the
exercise rate: The firm will simply let the put option expire.
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.
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.
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 BA 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.
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.
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.
What Risk Management Products Do Firms
Use?
• Giambona, Graham, Harvey and Bodnar (2018) study of 1,100
corporate risk managers around the world.
• FX forward contract is the most popular financial instrument to
manage the FX risk with 64% of firms using forward contracts.
• Followed by cross currency swaps (38%), futures contracts (32%), money
markets deposits/loans (31%), and foreign currency debt financing (27%).
• Pricing strategies are the most commonly used operational hedging
method with 55% of firms reported using it to deal with FX risk.
Problem 2
Solution 2
a. The implied exercise (price) rate is: $10,000/SF15,000=$0.6667/SF
b. If the Swiss client chooses to pay $10,000, it will cost SF16,129
(=10,000/0.62). Since the Swiss client has an option to pay
SF15,000, it will choose to do so. The value of this option is
obviously SF1,129 (=SF16,129-SF15,000).
c. Baltimore Machinery faces a contingent exposure in the sense that
it may or may not receive SF15,000 in the future. The firm thus can
hedge this exposure by buying a put option on SF15,000.