TOPIC NINE

MANAGEMENT OF
EXPOSURE

TRANSACTION EXPOSURE
There are three types of exposures:
1. Transaction exposure
2. Translation exposure
3. Operation exposure

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 TRANSLATION EXPOSURE
• Changes in income statement items and the book value of
balance sheet assets and liabilities that are caused by an
exchange rate change.

OPERATION EXPOSURE
• Changes in the amount of future operating cash flows caused
by the exchange rate change.

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 TRANSACTION EXPOSURE
• Changes in the value of outstanding foreign currencies
denominated contract that brought about by an exchange rate
change

ALTERNATIVE CURRENCY TRANSLATION

METHODS
• Current/noncurrent method:
– current asset & liability are translated into HC at the current ER
– noncurrent asset & liability are translated into HC at the historical ER

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 ALTERNATIVE CURRENCY TRANSLATION
METHODS
• Monetary/nonmonetary method
– Monetary items (cash, account payables and receivable and long-term
debt) are translated at the current rate
– Nonmonetary items (inventory, fixed assets, and long –term investment)
are translated at the historical rates
– Income statement items are translated at average exchange rate during
the period, except for revenue, and expense items related to
nonmonetary assets and liability

ALTERNATIVE CURRENCY TRANSLATION

METHODS
• Temporal method
– This method appears to be a modified version of monetary/non-
monetary method.
– The only difference: inventory is always translated at the current rate

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 ALTERNATIVE CURRENCY
TRANSLATION METHODS
• Current rate method
– All balance sheet and income items are translated at the current rate

FINANCIAL STATEMENT IMPACT OF TRANSLATION

ALTERNATIVE
(FC 5=$1)
(FC4=$1) Monetary Temporal Current/non Current rate
Assets FC US$ US$ US$ US$ US$
Cash, mar.securities 2,600 650 520 520 520 520
Inventory (at market) 3,600 900 900 720 720 720
Prepaid expenses 200 50 50 50 40 40
total current assets 6,400 1,600 1,470 1,290 1,280 1,280
Fixed asset - Dep. 3,600 900 900 900 900 720
Goodwill 1,000 250 250 250 250 200
Total assets 11,000 2,750 2,620 2,440 2,430 2,200
Liabilities
Current liabilities 3,400 850 680 680 680 680
Long term debt 3,000 750 600 600 750 600
Deferred income taxes 500 125 100 100 125 100
Total liabilities 6,900 1,725 1,380 1,380 1,555 1,380
Capital stock 1,500 375 375 375 375 375
Retained earnings 2,600 650 865 685 500 445
Total equity 4,100 1,025 1,240 1,060 875 820
Total liabilities+ equity 11,000 2,750 2,620 2,440 2,430 2,200
Translation gain (loss) 215 35 (150) (205)
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 FINANCIAL STATEMENT IMPACT OF
TRANSLATION ALTERNATIVE
(FC 2.5=$1)
(FC4=$1) Monetary temporal Current/Non Current rate
Assets FC US$ US$ US$ US$ US$
Cash, mar.securities 2,600 650 1,040 1,040 1,040 1,040
Inventory (at market) 3,600 900 900 1,440 1,440 1,440
Prepaid expenses 200 50 50 50 80 80
total current assets 6,400 1,600 1,990 2,530 2,560 2,560
Fixed asset - Dep. 3,600 900 900 900 900 1,440
Goodwill 1,000 250 250 250 250 400
Total assets 11,000 2,750 3,140 3,680 3,710 4,400
Liabilities
Current liabilities 3,400 850 1,360 1,360 1,360 1,360
Longterm debt 3,000 750 1,200 1,200 750 1,200
Deferred income taxes 500 125 200 200 125 200
Total liabilities 6,900 1,725 2,760 2,760 2,235 2,760
Capital stock 1,500 375 375 375 375 375
Retained earnings 2,600 650 5 545 1,100 1,265
Total equity 4,100 1,025 380 920 1,475 1,640
Total liabilities+ equity 11,000 2,750 3,140 3,680 3,710 4,400
Translation gain (loss) (645) (105) 450 615
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FINANCIAL STATEMENT IMPACT OF

TRANSLATION ALTERNATIVE
Monetary temporal Current/N Current
Assets
Cash, market .securities
Inventory (at market)
Prepaid expenses
total current assets
Fixed asset - Dep.
Goodwill
Total assets
Liabilities
Current liabilities
Longterm debt
Deferred income taxes
Total liabilities
Capital stock
Retained earnings
Total equity
Total liabilities+ equity
Translation gain (loss)
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 MANAGING TRANSACTION EXPOSURE

• 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?

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BUSINESS SITUATION

Boeing Corporation exported a Boeing 737 to British Airways and billed

£10M payable in one year. The money market rate and foreign exchange
rates are given as follows:

˗ The U.S. interest rate: 6.10% per annum

˗ The U.K. interest rate: 9.00% per annum
˗ The spot exchange rate: $1.50/£
˗ The forward exchange rate: $1.46/£ (1year maturity)

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 FORWARD MARKET HEDGE
• If you are going to owe foreign currency in the future, agree to buy the
foreign currency now by entering into long position in a forward contract.

• If you are going to receive foreign currency in the future, agree to sell the
foreign currency now by entering into short position in a forward contract.

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MONEY MARKET HEDGE

• This is the same idea as covered interest arbitrage.

• To hedge a foreign currency payable, buy a bunch of that
foreign currency today and sit on it.
– It’s more efficient to buy the present value of the foreign currency
payable today.
– Invest that amount at the foreign rate.
– At maturity your investment will have grown enough to cover your
foreign currency payable.

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 OPTIONS MARKET HEDGE
Options provide a flexible hedge against the downside, while preserving the
upside potential.
• To hedge a foreign currency payable buy calls on the currency.
– If the currency appreciates, your call option lets you buy the currency at the
exercise price of the call.

• To hedge a foreign currency receivable buy puts on the currency.

– If the currency depreciates, your put option lets you sell the currency for the
exercise price.

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CROSS-HEDGING
MINOR CURRENCY EXPOSURE
• The major currencies are U.S. dollar, Canadian dollar, British
pound, Euro, Swiss franc, Mexican peso, and Japanese yen.
• Everything else is a minor currency, like the Polish zloty.
• It is difficult, expensive, or impossible to use financial
contracts to hedge exposure to minor currencies.

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 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 Vietnamese importer with liabilities in Czech
koruna hedging with long or short forward contracts on the euro. If the
koruna is expensive when the euro is expensive, or even if the koruna is
cheap when the euro is expensive it can be a good hedge. But they need to
co-vary in a predictable way.

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HEDGING CONTINGENT EXPOSURE

• If only certain contingencies give rise to exposure, then options

can be effective insurance.
– For example, if your firm is bidding on a hydroelectric dam project in
Canada, you will need to hedge the Canadian-U.S. dollar exchange rate
only if your bid wins the contract. Your firm can hedge this contingent
risk with options.

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 HEDGING RECURRENT EXPOSURE
WITH SWAPS
• Recall that swap contracts can be viewed as a portfolio of forward contracts.
• Firms that have recurrent exposure can very likely 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.

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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

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 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.

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EXPOSURE NETTING
• A multinational firm should not consider deals in isolation but should focus
on hedging the firm as a portfolio of currency positions.
– As an example, consider a U.S.-based multinational with Korean won
receivables and Japanese yen payables. Since the won and the yen tend to move
in similar directions against the U.S. dollar, the firm can just wait until these
accounts come due and just buy yen with won.
– Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge
each currency separately.

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 EXPOSURE NETTING
• Many multinational firms use a reinvoice center. Which is a
financial subsidiary that nets out the intrafirm transactions.
• Once the residual exposure is determined, then the firm
implements hedging.

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EXPOSURE NETTING: AN EXAMPLE

Bilateral Netting would reduce the number of foreign exchange
transactions by half:

$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
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 EXPOSURE NETTING: AN EXAMPLE
Consider simplifying the bilateral netting with multilateral netting:

$15

$40

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EXPOSURE NETTING: AN EXAMPLE

Clearly, multilateral netting can simplify things greatly.

$15

$40

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 EXPOSURE NETTING: AN EXAMPLE
Compare this:

$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
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EXPOSURE NETTING: AN EXAMPLE

With this:

$15

$40

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 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 helped when management hedges.

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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.

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