GROUP NO: 01 1

TOPIC: Managing and Measuring

Transaction Exposure.

Presented By: Arooj Fatima , Shazma,

Hina Farooq , Farwa Nawaz.

Presented To: Prof Asad Abbas.

 2

▪ Outlines

▪ Compare the techniques commonly used to

hedge payable

▪ Compare the techniques commonly used to

hedge receivables

▪ Describe limitations of hedging

▪ Suggest others methods of reducing exchange rate

risk when hedging
▪ techniques are not available
Transaction Exposure
3

The degree to which the value of future cash transactions (inflow

& outflow) can be affected by exchange rate fluctuations is
referred to as transaction exposure.
To measure transaction exposure: 2 steps
 project the net amount of inflows or outflows in each foreign
currency, and
 determine the overall risk of exposure to those currencies.
Transaction Exposure – Estimating
4

Net CF
When estimating net cash flow MNC can use
 Point estimate
 Range estimate
Transaction Exposure – Estimating 5

Net CF
Consolidated Net cash flow assessment of Miami Co.
Transaction Exposure – Estimating 6

Net CF
Consolidated Net cash flow assessment of Miami Co.
Transaction Exposure – Use of Corr. 7

& S.D.
An MNC’s overall exposure can be assessed by considering each
currency position together with the correlations among the
currencies.
Transaction Exposure – Using
8

Correlations
 The correlations among currency
movements can be measured by their
correlation coefficients, which indicate
the degree to which two currencies
move in relation to each other.
coefficient
 perfect positive correlation 1.00
 no correlation 0.00
 perfect negative correlation -1.00
Transaction Exposure – Using 9

Correlations
Correlations Among Exchange Rate Movements
Transaction Exposure – Using 10

Correlations
 The point in considering correlations is to detect positions
that could somewhat offset each other.
 For example, if currencies X and Y are highly correlated,
the exposures of a net X inflow and a net Y outflow will
offset each other to a certain degree.
 Note that the correlations among currencies may change
over time.
 Factors that affect the maximum 1-day
11

loss
The maximum 1- day loss of a currency is dependent on three
factors.
First, it is dependent on the expected percentage change in
currency for the next day . If the expected outcome in the
previous example is -.2 percent instead of 0 percent, the maximum
loss over the 1-day period is
Maximum 1-day loss = E(𝑒𝑡 )- (1.65Х𝜎𝑀𝑋𝑃 )
= -.2% - (1.65×1.2%)
= -.0218, or -2.18%
Second, the maximum 1-day loss on the confidence level used . A
higher confidence level will cause a more pronounced maximum
1-day loss, holding other factors constant. If the confidence level in
the example is 97.5 percent instead of 95 percent, the lower
boundary is 1.96 standard deviations from the expected
percentage change in the present thus, the maximum 1-day loss is
 12

Maximum 1-day loss = E (𝑒𝑡 ) – ( 1.96× 𝜎𝑀𝑋𝑃 )

= 0% - ( 1.96 × 1.2%)
= -.02352, or – 2.352%
Third, the maximum 1-day loss is depenent on the standard
deviation of the daily percentage changes in the currency over
a previous period. If the Peso’s standard deviation on the 95
percent instead of 1.2 percent , the maximum 1-day loss 9
based on the 95 percent confidence interval ) is
Maximum 1-day loss = E (𝑒𝑡 ) – 9 1.65× 𝜎𝑀𝑋𝑃 )
=0% - ( 1.65 × 1 %)
= -.0165, or – 1.65%
Movements of Selected Currencies Against
US$ 13
Managing Transaction at 14
Exposure

The process of controlling and

overseeing transactions that are
exposed to various risks, such as
credit, market, operational, and
liquidity risks, to minimize
potential losses and ensure
regulatory compliance.
Policies for Hedging Transaction Exposure 15

 Hedging Most of the Exposure

Hedging most of the transaction exposure allows
MNCs to more accurately forecast future cash
flows (in their home currency) so that they can
make better decisions regarding the amount of
financing they will need.
 Selective Hedging
▪ MNC must identify its degree of transaction
exposure.
▪ MNC must consider the various techniques to
hedge the exposure so that it can decide which
hedging technique is optimal and whether to
hedge its transaction exposure.
Hedging Exposure to Payables 16

An MNC may decide to hedge part or all

of its known payables transactions using:
▪ Futures hedge
▪ Forward hedge
▪ Money market hedge
▪ Currency option hedge
Forward or Futures Hedge on Payables 17

Allows an MNC to lock in a specific exchange rate at

which it can purchase a currency and hedge payables.
A forward contract is negotiated between the firm and a
financial institution. The contract will specify the:
▪ currency that the firm will pay
▪ currency that the firm will receive
▪ amount of currency to be received by the firm
▪ rate at which the MNC will exchange currencies
(called the forward rate)
▪ future date at which the exchange of currencies
will occur
Money Market Hedge on Payables 18

 Involves taking a money market position to

cover a future payables position.

 If a firm prefers to hedge payables without

using its cash balances, then it must
▪ Borrow funds in the home currency and
▪ Invest in a short-term instrument in the
foreign currency
Call Option Hedge on Payables 19

 A currency call option provides the right to

buy a specified amount of a particular
currency at a specified strike price or
exercise price within a given period of time.
 The currency call option does not obligate
its owner to buy the currency at that price.
The MNC has the flexibility to let the option
expire and obtain the currency at the
existing spot rate when payables are due.
Cost of Call Options 20

 Based on contingency graph (Exhibit 11.1)

▪ Advantage: provides an effective hedge
▪ Disadvantage: premium must be paid
 Based on currency forecast (Exhibit 11.2)
▪ MNC can incorporate forecasts of the spot rate to more
accurately estimate the cost of hedging with call options.
 Consideration of Alternative Call Options
▪ Several different types of call options may be available,
with different exercise prices and premiums for a given
currency and expiration date.
▪ Whatever call option is perceived to be most desirable for
hedging a particular payables position would be analyzed,
so that it could then be compared to the other hedging
techniques.
 Exhibit 11.1 Contingency Graph for Hedging Payables
With Call Options 21

21
 Exhibit 11.2 Use of Currency Call Options for Hedging Euro
Payables (Exercise Price = $1.20, Premium = $.03) 22

22
Comparison of Techniques to Hedge Payables 23

 The cost of the forward hedge or

money market hedge can be
determined with certainty
 The currency call option hedge has
different outcomes depending on the
future spot rate at the time payables
are due.
 Exhibit 11.3 Comparison of Hedging Alternatives for
Coleman Co. 24

24
Optimal Technique for Hedging Payables 25

1. Select optimal hedging technique by:

a. Consider whether futures or forwards are preferred.
b. Consider desirability of money market hedge versus
futures/forwards based on cost.
c. Assess the feasibility of a currency call option based on
estimated cash outflows.
2. Choose optimal hedge versus no hedge for
payables
a. Even when an MNC knows what its future payables will
be, it may decide not to hedge in some cases.
3. Evaluate the hedge decision by estimating the
real cost of hedging versus the cost if not
hedged.
 Exhibit 11.4 Graphic Comparison of Techniques to
Hedge Payables 26

26
Hedging Exposure to Receivables 27

1. Forward or futures hedge allows the MNC

to lock in the exchange rate at which it
can sell a specific currency.
2. Money market hedge involves borrowing
the currency that will be received and
using the receivables to pay off the loan.
3. Put option hedge on receivables provides
the right to sell a specified amount of a
particular currency at a specified strike
price by a specified expiration date.
Cost of Put Options 28

1. Based on Contingency Graph (Exhibit

11.5)
a. Advantage: provides an effective hedge
b. Disadvantage: premium must be paid
2. Based on Currency Forecasts (Exhibit
11.6)
a. MNC can use currency forecasts to more
accurately estimate the dollar cash inflows to
be received when hedging with put options.
 Exhibit 11.5 Contingency Graph for Hedging Receivables
with Put Options 29

29
 Exhibit 11.6 Use of Currency Put Options for Hedging Swiss
Franc Receivables (Exercise Price = $.72; Premium 30
= $.02)

30
Comparison of Techniques for Hedging Receivables
31

1. Optimal Technique for Hedging

Receivables:
a. Consider whether futures or forwards are
preferred.
b. Consider desirability of money market hedge
versus futures/forwards based on cost.
c. Assess the feasibility of a currency put option
based on estimated cash outflows.
2. Choose optimal hedge versus no hedge for
receivables
3. Evaluate the hedge decision by estimating
the real cost of hedging receivables versus
the cost of receivables if not hedged.
 Exhibit 11.7 Comparison of Hedging Alternatives for Viner
Co. 32

32
 Exhibit 11.8 Graph Comparison of Techniques to Hedge
Receivables 33

33
 Exhibit 11.9 Review of Techniques for Hedging Transaction
Exposure 34

34
Limitations of Hedging 35

 Limitation of Hedging an Uncertain Payment

Some international transactions involve an
uncertain amount of foreign currency, leading to
overhedging.
 Limitation of Repeated Short-Term Hedging
The continual short-term hedging of repeated
transactions may have limited effectiveness.
 Long-term Hedging as a Solution
Some banks offer forward contracts for up to 5
years or 10 years on some commonly traded
currencies.
 Exhibit 11.10 Illustration of Repeated Hedging of Foreign
Payables When the Foreign Currency Is Appreciating 36

36
 Exhibit 11.11 Long-Term Hedging of Payables When the
Foreign Currency Is Appreciating 37

37
Alternative Hedging Techniques 38

 Leading and Lagging: adjusting the timing of

a payment or disbursement to reflect
expectations about future currency
movements.
 Cross-Hedging: hedging by using a currency
that serves as a proxy for the currency in
which the MNC is exposed.
 Currency Diversification: reduce exposure
by diversifying business among numerous
countries.