Management of Transaction Exposure

Chapter Eight
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Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights
 Three Types of Exposure
• It is conventional to classify foreign currency
exposures into three types:
1. Transaction exposure is the potential
change in the value of financial positions due
to changes in the exchange rate between the
inception of a contract and the settlement of
the contract
2. Economic exposure is the possibility that
cash flows and the value of the firm may be
affected by unanticipated changes in the
exchange rates
3. Translation exposure is the effect of an
unanticipated change in the exchange rates on
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Three Types of Exposure (Continued)
• 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 received €1m 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
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 Hedging Transaction Exposure
• This chapter focuses on alternative 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
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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 £10m in one year, it
will convert the pounds into dollars at the
spot exchange rate prevailing at the time
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 Forward Market Hedge
• Most direct and popular way of hedging
transaction exposure is by currency forward
contracts
• Sell (buy) foreign currency receivables
(payables) forward to eliminate exchange risk
exposure
– Boeing may sell forward its pounds receivables,
£10m, 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 £10m to the bank, which is the
counterparty of the contract, and, in return, take
delivery of $14.6m ($1.46/£ * £10m), regardless of
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 Dollar Proceeds from the British Sale:
Forward Hedge versus Unhedged Position

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 Forward Market Hedge (Continued)
• 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 $14m instead of
$14.6m had it not entered the forward contract
• What if the spot rate had been $1.50/£ at
maturity?
– Boeing would have received $15m by remaining
unhedged
– Ex post, forward hedging would have cost Boeing
$0.4m
• Gains and losses are computed by the
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Gains/Losses from Forward Hedge

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Illustration of Gains and Losses from Forward
Hedging

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 Forward Market Hedge (Concluded)
• Firm must make decision whether to hedge ex
ante
• Consider the following scenarios:
1. T ≈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
2. T <F
• Firm expects a positive gain from forward hedging
and would be even more includes to hedge than in
Scenario 1
3. T >F Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 8-11
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 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:
1. 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.
• Thus, in most cases, the firm can only hedge
approximately
2. Due to the marking-to-market property, there are
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 Money Market Hedge
• A firm may borrow (lend) in foreign currency to
hedge its foreign currency receivables
(payables), 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,
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 Money Market Hedge (Continued)
• What amount of pounds should Boeing borrow?
– Amount to borrow may be computer as the
discounted present value of the pound receivable
– £10m / (1.09) = £9,174,312
• Step-by-step procedure of money market
hedging:
1. Borrow £9,174,312
2. Convert £9,174,312 into $13,761,468 at the current
spot exchange rate of $1.50/£
3. Invest $13,761,468 in the U.S.
4. After one year, collect £10m from British Airways
and use it to repay the pound loan
5. Receive the maturity value of the dollar investment,
that is, $14,600,918 = ($13,761,468)(1.061)
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Cash Flow Analysis of a Money
Market Hedge

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 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

• Currency options provide a flexible “optional”

hedge against exchange exposure
– Firm may buy a foreign currency call (put) option to
hedge its foreign currency payables (receivables)

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 Options Market Hedge (Continued)
• Suppose that in the OTC market, Boeing
purchased a put option on £10m 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
– Provides Boeing with the right, but not the obligation,
to sell up to £10m for $1.46/£, regardless of the
future spot rate
• Assume the spot exchange rate turns out to be
$1.30 on the expiration date
– Upfront cost is equivalent to $212,200 = ($200,000 *
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 Options Market Hedge (Concluded)
• Consider an alternative scenario where the
pound appreciates against the dollar, and
assume the spot rate turns out to be $1.60 per
pound at expiration
– Boeing will have no incentive to exercise the option
– Rather, it would let the option expire and convert
£10m into $16m at the spot rate
– Subtracting $212,200 for the option cost, the net
dollar proceeds will become $15,787,800 under the
option hedge
• 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
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Boeing’s Alternative Hedging Strategies
for a Foreign Currency Receivable

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 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 they will try to
minimize the dollar cost of paying off the
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 Foreign Currency Payables: Alternatives
• Forward market hedge
– If Boeing decides to hedge this payable exposure using
a forward contract, it only needs to buy £5m forward in
exchange for the following dollar amount:
$8,750,000 = (£5,000,000) ($1.75/£)
• Money market hedge
– PV of foreign currency payable: £4,694,836 = £5m /
1.065
– Outlay of dollars today: $8,957,747 = ($8,450,705)
($1.80/£)
– Future value: $8,957,747 = ($8,450,705) (1.06)
• Options market hedge
– Purchase a “call” on £5m Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
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Boeing’s Alternative Hedging Strategies
for a Foreign Currency Payable

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 Dollar Costs of Securing the Pound
Payable: Alternative Hedging Strategies

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 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$100m 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, but8-24
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