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Fundamentals of Multinational Finance Sixth Edition

Chapter 10 Transaction Exposure

Learning Objectives 10.1 Examine the three major foreign exchange exposures experienced by firms

10.2 Explore why firms hedge foreign exchange exposure

10.3 Detail how transaction exposure is defined and measured

10.4 Describe how one company may hedge its transaction exposures

10.5 Evaluate how foreign exchange risk management is conducted by actual firms today

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Types of Foreign Exchange Exposure (1 of 2) • Foreign Exchange Exposure

– A measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates

• Transaction Exposure – Measures changes in the value of outstanding financial obligations

incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change

• Translation Exposure – Accounting-derived changes in owner’s equity to occur because of

the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements

Types of Foreign Exchange Exposure (2 of 2) • Operating Exposure

– Aka economic exposure, competitive exposure, or strategic exposure

– Measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates § While transaction exposure is concerned with future cash

flows already contracted for, operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates alters its international competitiveness

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Exhibit 10.1: The Foreign Exchange Exposures of the Firm

Why Hedge? (1 of 3) • Multinational firms possess a multitude of cash flows that are sensitive

to changes in exchange rates, interest rates, and commodity prices

• Hedging Defined – Hedging involves the taking of a position by acquiring either an

asset, a contract, or a derivative that will rise (fall) in value and offset a fall (rise) in the value of an existing position

– While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against § The value of a firm is the net present value of all expected

future cash flows § Hedging reduces the variation of the expected future cash

flows

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Exhibit 10.2: Hedging’s Impact on the Expected Cash Flows of the Firm

Why Hedge? (2 of 3) • The Pros and Cons of Hedging

– Pros § Reduction in risk of future cash flows improves the planning

capability of the firm § Reduction of risk in future cash flows reduces the likelihood

that the firm’s cash flows will fall below a level sufficient to make debt service payments required for continued operation

§ Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

§ Management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of single opportunities to enhance firm’s value through selective hedging

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Why Hedge? (3 of 3) • The Pros and Cons of Hedging

– Cons § Shareholders are more capable of diversifying currency risk than is

the management of the firm § Currency hedging does not increase the expected cash flows of the

firm § Management often conducts hedging activities that benefit

management at the expense of the shareholders § Managers cannot outguess the market § Management’s motivation to reduce variability is sometimes for

accounting reasons § Efficient market theorists believe that investors can see through the

“accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation

Transaction Exposure (1 of 2) • Transaction Exposure

– Measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency

• Purchasing and Selling – The most common example of transaction exposure arises when a

firm makes a sale and receives a promise of payment from the buyer (a receivable) or purchases an input and promises to pay in the future (a payable), and that transaction is denominated in a foreign currency

– Quotation Exposure – Backlog Exposure – Billing Exposure

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Exhibit 10.3: The Life Span of Transaction Exposure

Transaction Exposure (2 of 2) • Borrowing and Lending

– Transaction exposure arises when funds are borrowed or loaned, and the amount involved is denominated in a foreign currency

• Other Causes of Transaction Exposure – Acquiring assets or incurring liabilities of any kind

denominated in a foreign currency § When a firm enters into a forward exchange contract, it is

deliberately creating a transaction exposure

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Measurement of Transaction Exposure: The Case of Ganado (1 of 14) • Foreign exchange transaction exposure can be managed by:

– Contractual (Financial) Hedges § Utilize cash flows originating from the financing activities of the firm

and include specific types of debt and foreign currency derivatives – Operating Hedges

§ Utilize the cash flows originating from the operating activities of the firm and include risk-sharing agreements and payments strategies using leads and lags

– Natural Hedge § An offsetting operating cash flow, a payable arising from the conduct

of business – Financial Hedge

§ An offsetting debt obligation or some type of financial derivative such as an interest rate swap

Measurement of Transaction Exposure: The Case of Ganado (2 of 14) • Ganado’s Transaction Exposure

– Ganado has just concluded negotiations for the sale of a turbine generator to Regency, a British firm, for £1,000,000

– The spot rate on the date of sale was $1.7640/£ – Four alternatives are available to Ganado to manage this

transaction exposure: § Remain unhedged § Hedge in the forward market § Hedge in the money market § Hedge in the options market

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Exhibit 10.4: Ganado’s Transaction Exposure

Measurement of Transaction Exposure: The Case of Ganado (3 of 14) • Unhedged Position

– Ganado may decide to accept the transaction risk – Ganado expects to receive £1,000,000 × $1.76 = $1,760,000

in three months § If the pound should fall to $1.65/£, Ganado will receive

only $1,650,000 § If the pound strengthens even more than forecast,

Ganado will receive more than $1,760,000

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Measurement of Transaction Exposure: The Case of Ganado (4 of 14) • Forward Hedge

– Since the spot rate on the date of sale was $1.7640/£, the receivable was booked as $1,764,000

– Regency will pay £1,000,000 to Ganado in three months

– Ganado could hedge this transaction exposure with a forward hedge § Ganado can sell £1,000,000 forward today at the 3-month forward

rate of $1.7540/£ § In three months Ganado will receive £1,000,000 from Regency,

deliver that sum to the bank against its forward sale, and receive $1,754,000

§ This would be recorded on Ganado’s income statement as a foreign exchange loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled)

Measurement of Transaction Exposure: The Case of Ganado (5 of 14) • Money Market Hedge (Balance Sheet Hedge)

– A money market hedge (aka a balance sheet hedge) involves a contract and a source of funds to fulfill that contract

– Ganado can borrow pounds in London at once, immediately convert the borrowed pounds into dollars, and repay the pound loan in three months with the proceeds from Regency

– Ganado will need to borrow just enough to repay both the principal and interest with the sale proceeds § The borrowing interest rate will be 10% per annum, or 2.5% for three months § The amount to borrow now for repayment in three months is:

£1,000,000/(1 + 0.025) = £975,610 § Ganado would borrow £975,610 now, and in three months repay that amount

plus £24,390 of interest § Ganado would exchange the £975,610 loan proceeds for dollars at the current

spot exchange rate of $1.7640/£, receiving $1,720,976 at once

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Measurement of Transaction Exposure: The Case of Ganado (6 of 14) • Forward and Money Market Hedges Compared

– To compare the forward hedge with the money market hedge, one must analyze how Ganado’s loan proceeds will be utilized for the next three months § The loan proceeds are received today, but the forward contract

proceeds are received in three months § For comparison, one must either calculate the future value of the

loan proceeds or the present value of the forward contract proceeds § As both the forward contract proceeds and the loan proceeds are

relatively certain, it is possible to make a clear choice between the two alternatives based on the one that yields the higher dollar receipts

§ This result, in turn, depends on the assumed rate of investment or use of the loan proceeds

Measurement of Transaction Exposure: The Case of Ganado (7 of 14) • Options Market Hedge

– Ganado could purchase a 3-month put option on £1,000,000 at an at- the-money strike price of $1.75/£ with a premium cost of 1.50%

– The total cost of the option is calculated as follows: Size of option × Premium × Spot rate = Total cost of option

£1,000,000 × 0.015 × $1.7640 = $26,460 § It is necessary to project the premium cost of the option forward

three months. – The cost of capital of 12% per annum or 3% per quarter

§ Therefore the premium cost of the put option as of June would be: $26,460 × 1.03 = $27,254

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Measurement of Transaction Exposure: The Case of Ganado (8 of 14) • Options Market Hedge

– When the £1,000,000 is received in June, the value in dollars depends on the spot rate at that time

– The upside potential is unlimited § At any exchange rate above $1.75/£, Ganado would allow its option to

expire unexercised and would exchange the pounds for dollars at the spot rate

§ If the expected rate of $1.76/£ materializes, Ganado would exchange the £1,000,000 in the spot market for $1,760,000

– Net proceeds would be $1,760,000 minus the $27,254 cost of the option, or $1,732,746

– The downside risk is limited with an option § If the pound depreciates below $1.75/£, Ganado would exercise its option

to sell £1,000,000 at $1.75/£, receiving $1,750,000 gross, but $1,722,746 net of the $27,254 cost of the option

Measurement of Transaction Exposure: The Case of Ganado (9 of 14) • Hedging Alternatives Compared

– If the exchange rate is expected to move against Ganado, less than$1.76/£, the money market hedge is clearly the preferred alternative with a guaranteed value of $1,772,605

– If the exchange rate is expected to move in Ganado’s favor, above $1.76/£, then the preferred alternative is less clear-cut, lying between remaining unhedged, the money market hedge, or the put option

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Exhibit 10.5: Ganado’s A/R Transaction Exposure Hedging Alternatives

Measurement of Transaction Exposure: The Case of Ganado (10 of 14) • Hedging an Account Payable

– If Ganado had a £1,000,000 account payable due in 90 days, the hedging

choices would include the following:

§ Remain Unhedged

– Ganado could wait 90 days, exchange dollars for pounds at that

time, and make its payment

– If Ganado expects the spot rate in 90 days to be $1.7600/£, the

payment would be expected to cost $1,760,000

– This amount is, however, uncertain; the spot exchange rate in 90

days could be very different from that expected

§ Forward Market Hedge

– Ganado could buy £1,000,000 forward, locking in a rate of

$1.7540/£, and a total dollar cost of $1,754,000.

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Measurement of Transaction Exposure: The Case of Ganado (11 of 14) • Hedging an Account Payable

– If Ganado had a £1,000,000 account payable due in 90 days, the hedging choices would include the following: § Money Market Hedge

– The money market hedge is distinctly different for a payable as opposed to a receivable

– To implement a money market hedge in this case, Ganado would exchange U.S. dollars spot and invest them for 90 days in a pound-denominated interest-bearing account

– The principal and interest in British pounds at the end of the 90-day period would be used to pay the £1,000,000 account payable

Measurement of Transaction Exposure: The Case of Ganado (12 of 14) • Hedging an Account Payable

– If Ganado had a £1,000,000 account payable due in 90 days, the hedging choices would include the following: § Option Hedge

– Ganado could cover its £1,000,000 account payable by purchasing a call

– option on £1,000,000 – A June call option on British pounds with a near at-the-money

strike price of $1.75/£ would cost 1.5% (premium) or: £1,000,000 × 0.015 × $1.7640/£ = $26,460

– This premium must be paid up-front – Its value, carried forward 90 days at the WACC of 12%, would

raise its end of period cost to $27,254

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Measurement of Transaction Exposure: The Case of Ganado (13 of 14) • Hedging an Account Payable

– If Ganado had a £1,000,000 account payable due in 90 days, the hedging choices would include the following: § Option Hedge (cont.)

– If the spot rate in 90 days is less than $1.75/£, the option would be allowed to expire and the £1,000,000 for the payable would be purchased on the spot market

– If the spot rate in 90 days exceeds $1.75/£, the call option would be exercised

Measurement of Transaction Exposure: The Case of Ganado (14 of 14) • Hedging an Account Payable

§ Strategy Choice – As with Ganado’s account receivable, the final

hedging choice depends on exchange rate expectations and the firm’s willingness to bear risk

– The forward hedge provides the lowest cost of making the account payable payment

– If the dollar strengthens against the pound, ending up at a spot rate less than $1.75/£, the call option could potentially be the lowest cost hedge

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Exhibit 10.6: Ganado’s A/P Transaction Exposure Hedging Alternatives

Risk Management in Practice • Which Goals?

– The treasury function of most private firms is usually considered a cost center

– It is not expected to add profit to the firm’s bottom line

• Which Exposures?

– Transaction exposures exist before they are actually booked as foreign currency- denominated receivables and payables

– Conservative hedging policies dictate that contractual hedges be placed only on existing exposures

• Which Contractual Hedges?

– Many MNEs have established rather rigid transaction exposure risk management policies, which mandate proportional hedging

§ These policies generally require the use of forward contract hedges on a percentage of existing transaction exposures

§ The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance

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