Managing Transaction Exposure
Managing Transaction Exposure
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Managing Transaction Exposure
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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 this exposure.
Choose a hedging technique if it decides
to hedge part or all of the exposure.
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Transaction Exposure
• To identify net transaction exposure, a
centralized group consolidates all
subsidiary reports to compute the
expected net positions in each foreign
currency for the entire MNC.
• Note that sometimes, a firm may be able to
reduce its transaction exposure by pricing
its exports in the same currency that it will
use to pay for its imports.
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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 would be expected from each hedging
technique before determining which
technique to apply.
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Futures and Forward Hedges
• A futures hedge uses currency futures,
while a forward hedge uses forward
contracts, to lock in the future exchange
rate.
• Recall that forward contracts are
commonly negotiated for large
transactions, while the standardized
futures contracts tend to be used for
smaller amounts.
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Futures and Forward Hedges
• To hedge future payables (receivables), a
firm may purchase (sell) currency futures, or
negotiate a forward contract to purchase
(sell) the currency forward.
• The hedge-versus-no-hedge decision can be
made by comparing the known result of
hedging to the possible results of remaining
unhedged, and taking into consideration the
firm’s degree of risk aversion.
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Futures and Forward Hedges
• The real cost of hedging measures the
additional expenses beyond those incurred
without hedging.
• Real cost of hedging payables (RCHp) =
nominal cost of payables with hedging –
nominal cost of payables without hedging
• Real cost of hedging receivables (RCHr) =
nominal revenues received without hedging
– nominal revenues received with hedging
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Futures and Forward Hedges
• If the real cost of hedging is negative, then
hedging is more favorable than not
hedging.
• To compute the expected value of the real
cost of hedging, first develop a probability
distribution for the future spot rate. Then
use it to develop a probability distribution
for the real cost of hedging.
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The Real Cost of Hedging for Each £ in Payables
Nominal Cost Nominal Cost Real Cost
Probability With Hedging Without Hedging of Hedging
5% $1.40 $1.30 $0.10
10 $1.40 $1.32 $0.08
15 $1.40 $1.34 $0.06
20 $1.40 $1.36 $0.04
20 $1.40 $1.38 $0.02
15 $1.40 $1.40 $0.00
10 $1.40 $1.42 – $0.02
5 $1.40 $1.45 – $0.05
20%
Probability
15%
10%
5%
0%
-$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10
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Futures and Forward Hedges
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Money Market Hedge
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Money Market Hedge
A firm needs to pay NZ$1,000,000 in 30 days.
Borrows at 8.40%
1. Borrows for 30 days 3. Pays
$646,766 $651,293
Effective
Exchange at exchange rate
$0.6500/NZ$ $0.6513/NZ$
Lends at 6.00%
2. Holds for 30 days 3. Receives
NZ$995,025 NZ$1,000,000
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Money Market Hedge
A firm expects to receive S$400,000 in 90 days.
Borrows at 8.00%
1. Borrows for 90 days 3. Pays
S$392,157 S$400,000
Effective
Exchange at exchange rate
$0.5500/S$ $0.5489/S$
Lends at 7.20%
2. Holds for 90 days 3. Receives
$215,686 $219,568
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Money Market Hedge
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Currency Option Hedge
• A currency option hedge uses currency call
or put options to hedge transaction
exposure.
• Since options need not be exercised, they
can insulate a firm from adverse exchange
rate movements, and yet allow the firm to
benefit from favorable movements.
• Currency options are also useful for
hedging contingent exposure.
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Hedging with Currency Options
Hedging Payables with Hedging Receivables with
Currency Call Options Currency Put Options
Strike price = $1.60 Strike price = $0.50
Premium = $ .04 Premium = $ .03
Nominal Cost for each £ Nominal Income for each NZ$
$1.66 $.52
With Hedging
With
$1.62 $.48 Hedging
$1.58 $.44
Without Hedging Without Hedging
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Hedging Policies of MNCs
• In general, an MNC’s hedging policy varies
with the management’s degree of risk
aversion.
• An MNC may choose to hedge most of its
exposure or none of its exposure.
• The MNC may also choose to hedge
selectively, such as hedging only when it
expects the currency to move in a certain
direction.
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Limitations of Hedging
• Some international transactions involve
an uncertain amount of foreign currency,
such that overhedging may result.
¤ One solution is to hedge only the minimum
known amount. Additionally, the uncertain
amount may be hedged using options.
• In the long run, the continual short-term
hedging of repeated transactions may
have limited effectiveness too.
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Limitation of Repeated Short-Term Hedging
Repeated Hedging of Foreign Payables
When the Foreign Currency is Appreciating
although there
are savings
from hedging.
0 1 2 3 Year
The forward rate often moves in tandem with the spot rate.
Thus, an importer who uses one-period forward contracts continually
will have to pay increasingly higher prices during a strong-foreign-
currency cycle.
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Hedging Long-Term Transaction Exposure
Long-Term Hedging of Foreign Payables
when the Foreign Currency is Appreciating
Spot Rate
Savings from
hedging
3-yr
2-yr forward
1-yr forward
forward
0 1 2 3 Year
If the hedging techniques can be applied to longer-term periods, they can more
effectively insulate the firm from exchange rate risk over the long run.
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Hedging Long-Term
Transaction Exposure
• MNCs that can accurately estimate foreign
currency cash flows for several years may
use long-term hedging techniques.
Long-term forward contracts, or long
forwards, with maturities of up to five
years or more, can be set up for very
creditworthy customers.
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Hedging Long-Term
Transaction Exposure
In a currency swap, two parties, with the
aid of brokers, agree to exchange
specified amounts of currencies on
specified dates in the future.
A parallel loan, or back-to-back loan,
involves an exchange of currencies
between two parties, with a promise to re-
exchange the currencies at a specified
exchange rate and future date.
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Alternative Hedging Techniques
• Sometimes, a perfect hedge is not
available (or is too expensive) to eliminate
transaction exposure.
• To reduce exposure under such
conditions, the firm can consider:
¤ leading and lagging,
¤ cross-hedging, or
¤ currency diversification.
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Leading and Lagging
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Cross-Hedging
• When a currency cannot be hedged,
another currency that can be hedged and
is highly correlated may be hedged
instead.
• The stronger the positive correlation
between the two currencies, the more
effective the cross-hedging strategy will
be.
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Currency Diversification
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