Managing Exposure

1. Transaction Exposure
• Transaction exposure exists when the
future cash transactions of a firm are
affected by exchange rate fluctuations.
• When transaction exposure exists, the firm
faces three major tasks:
 Identify its degree of transaction exposure,
 Decide whether to hedge its exposure, and
 Choose among the available hedging
techniques if it decides on hedging.
 Techniques to Eliminate
Transaction Exposure
• Hedging techniques include:
– Futures hedge,
– Forward hedge,
– Money market hedge, and
– Currency option hedge.
• MNCs will normally compare the cash flows
that could be expected from each hedging
technique before determining which
technique to apply.
 Techniques to Eliminate
Transaction Exposure
• A futures hedge involves the use of
currency futures.
• To hedge future payables, the firm may
purchase a currency futures contract for
the currency that it will be needing.
• To hedge future receivables, the firm may
sell a currency futures contract for the
currency that it will be receiving.
 Techniques to Eliminate
Transaction Exposure
• A forward hedge differs from a futures
hedge in that forward contracts are used
instead of futures contract to lock in the
future exchange rate at which the firm will
buy or sell a currency.
• Recall that forward contracts are common
for large transactions, while the
standardized futures contracts involve
smaller amounts.
 Techniques to Eliminate
Transaction Exposure
• An exposure to exchange rate movements
need not necessarily be hedged, despite
the ease of futures and forward hedging.
• Based on the firm’s degree of risk
aversion, the hedge-versus-no-hedge
decision can be made by comparing the
known result of hedging to the possible
results of remaining unhedged.
 Techniques to Eliminate
Transaction Exposure
• A forward hedge involves the use of
forward contract.
• To hedge forward payables, the firm may
purchase a currency forward contract for
the currency that it will be needing.
• To hedge future receivables, the firm may
sell a currency forward contract for the
currency that it will be receiving.
International Finance
 Techniques to Eliminate
Transaction Exposure
• Example:
• A U.S. firm needs to pay £200,000 in 180
days
• Spot rate of Pound today = $1.47
• 180 days forward rate of Pound = $1.50

International Finance
 Techniques to Eliminate
Transaction Exposure
• Purchase Pound 180 days forward
Dollar needed in 180 days
= Payable in £ X forward rate of £
= £200,000 X $1.50/ £
= $300,000

International Finance
 Techniques to Eliminate
Transaction Exposure
• A money market hedge involves taking
one or more money market position to
cover a transaction exposure.
• Often, two positions are required.
– Payables: Borrow in the home currency, and
invest in the foreign currency.
– Receivables: borrow in the foreign currency,
and invest in the home currency.

International Finance
 Techniques to Eliminate
Transaction Exposure
• Example: (Payable)
• A U.S. firm needs to pay NZD1,000,000 in
30 days
• Borrowing rate in US = 8.40% p.a.
• Deposit rate in NZ = 6.00% p.a.
• Spot rate of NZD today = $0.65

International Finance
 Techniques to Eliminate
Transaction Exposure
A U.S. firm needs to pay NZ$1,000,000 in 30 days.
Borrow home currency, invest foreign currency

Borrows at 8.40% p.a

1. Borrows For 30 days 4. Pays
$646,766 $651,293

Exchange at
$0.6500/NZ$
Lends at 6.00% p.a
For 30 days
2. Holds 3. Receives
NZ$995,025 NZ$1,000,000
International Finance
 Techniques to Eliminate
Transaction Exposure
• Amount in NZD to be invest
NZD1,000,000 / (1+0.5%) = NZD995,025
• Amount in $ needed to borrow & convert
into NZD
NZD995,025 X 0.65 = $646,766
• Interest and principal owed on $ loan after
30 days
$646,766 X (1+0.7%) = $651,293
International Finance
 Techniques to Eliminate
Transaction Exposure
• Example: (Receivable)
• A U.S. firm expects to receive
SGD400,000 in 90 days
• Borrowing rate in SG = 8.00% p.a.
• Deposit rate in US = 7.20% p.a.
• Spot rate of SGD today = $0.55

International Finance
 Techniques to Eliminate
Transaction Exposure
A U.S. firm expects to receive SGD400,000 in 90 days.
Borrow foreign currency, invest home currency
Borrows at 8.00% p.a
1. Borrows for 90 days 4. Pays
S$392,157 S$400,000

Exchange at
$0.5500/S$
Lends at 7.20% p.a
2. Holds for 90 days 3. Receives
$215,686 $219,568
International Finance
 Techniques to Eliminate
Transaction Exposure
• Amount to borrow in SG
SGD400,000 / (1+2%) = SGD392,157
• Convert SGD to US
SGD392,157 X 0.55 = $215,686
• Interest and principal proceeds after 90
days
$215,686 X (1+1.8%) = $219,568

International Finance
 Techniques to Eliminate
Transaction Exposure
• A currency option hedge involves the use of
currency call (buy) or put (sell) options to
hedge transaction exposure.
• Since options need not be exercised, firms
will be insulated from adverse exchange rate
movements, and may still benefit from
favorable movements.
• However, the firm must assess whether the
premium paid is worthwhile.
International Finance
 Techniques to Eliminate
Transaction Exposure
• Example:
• A U.S. firm needs to pay £100,000 in 90
days
• Call option exercise price $1.60/ £,
Premium $0.04
• Expected spot rate:
$1.58, $1.62 & $1.66

International Finance
Using Currency Call (buy) Options for
Hedging Payables
British Pound Call Option:
Exercise Price = $1.60, Premium = $0.04.

For each £ :

Spot Rate Cost Total Amt.

= (Spot or $1.60)+$.04 =Cost x £100,000

$1.58 (x) $1.62 $162,000

$1.62 (√) $1.64 $164,000

$1.66 (√) $1.64 $164,000

International Finance
 Techniques to Eliminate
Transaction Exposure
• Example:
• A U.S. firm expects to receive
NZD600,000 in 90 days
• Put option exercise price $0.50/ NZD,
Premium $0.03
• Expected spot rate:
$0.44, $0.46 & $0.51

International Finance
 Using Put (sell) Options for
Hedging Receivables
New Zealand Dollar Put Option:
Exercise Price = $0.50, Premium = $.03.

For each NZ$ :

Spot Rate Cost Total Amt.

= (Spot or $0.50)-$.03
=Cost x NZD600,000

$0.44(√) $0.47 $282,000

$0.46(√) $0.47 $282,000

$0.51(x) $0.48
International Finance $288,000
 Techniques to Eliminate
Transaction Exposure
Hedging Payables Hedging
Receivables
Futures Purchase currency Sell currency
hedge futures contract(s). futures contract(s).
Forward Negotiate forward Negotiate forward
hedge contract to buy contract to sell
foreign currency. foreign currency.
Money Borrow local Borrow foreign
market currency. Convert currency. Convert
hedge to and then invest to and then invest
in foreign currency. in local currency.
Currency Purchase currency Purchase currency
option call option(s). put option(s).
Alternative Hedging Techniques
• Sometimes, a perfect hedge is not
available (or is too expensive) to eliminate
transaction exposure.
• To reduce exposure under such a
condition, the firm can consider:
– leading and lagging,
– cross-hedging, or
– currency diversification.
Alternative Hedging Techniques
• The act of leading and lagging refers to an
adjustment in the timing of payment
request or disbursement to reflect
expectations about future currency
movements.
• Expediting a payment is referred to as
leading, while deferring a payment is
termed lagging.
 2. Economic Exposure
• Economic exposure refers to the impact
exchange rate fluctuations can have on a
firm’s future cash flows.
• Exchange rate changes are often linked to
variability in real growth, inflation, interest
rates, governmental actions,… If material,
the changes may cause firms to adjust
their financing and operating strategies
 Economic Exposure
• A firm can assess its economic exposure
by determining the sensitivity of its
expenses and revenues to various
possible exchange rate scenarios.
• The firm can then reduce its exposure by
restructuring its operations to balance its
exchange-rate-sensitive cash flows.
 Economic Exposure
• Restructuring may involve:
 increasing/reducing sales in new or existing
foreign markets,
 increasing/reducing dependency on foreign
suppliers,
 establishing or eliminating production facilities
in foreign markets, and/or
 increasing or reducing the level of debt
denominated in foreign currencies.
 3. Translation Exposure
• Translation exposure results when an
MNC translates each subsidiary’s financial
data to its home currency for consolidated
financial reporting.
• Translation exposure does not directly
affect cash flows, but some firms are
concerned about it because of its potential
impact on reported consolidated earnings.
 Translation Exposure
• An MNC may attempt to avoid translation
exposure by matching its foreign liabilities
with its foreign assets.
• To hedge translation exposure, forward or
futures contracts can be used. Specifically,
an MNC may sell the currency that its
foreign subsidiary receive as earnings
forward, thus creating an offsetting cash
outflow in that currency.