Exposure)and)Hedging)

International)Business)and)Finance)
Individual)Assignment)

Name: Akta Gupta

GDGWI ID: 100100
Course: BBA Business Studies
Module: International Business and Finance
Module Code: ECON334
Module Leader: Mrs. Anuradha Tiwari / Mr. Prawesh Singh
Cohort: 2010-2013

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Exposures)and)Hedging))
In this globalised economy many companies have moved boarders in order to
expand and attain international recognition. These companies that trade in the
international market have their business valued in terms of foreign currencies. As the
foreign currency fluctuates, so does the value of the firm, thus there is a level of risk
involved. This currency risk is known as exposure. A business operating in the
international market would have to give importance to the type and level of exposure
and how it would hedge it (Eun & Resnick, 2001) as hedging would protect them
from unforeseen fluctuations in the foreign currency thus minimizing the possibility
of volatile cash flows (Moffet et al, 2003). This currency exposure is categorized into
three types, which are, the transaction exposure, the translation exposure and the
operating exposure.

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Transaction Exposure
Transaction exposure can be defined as the prospective changes in the
financial circumstance of the business due to the changes in the exchange rate
between the initiation of the contract and its settlement (McCarthy. S & Ispriani. A,
2004). Thus, when a firm buys a forward contract it results in the transaction
exposure, which can be hedged using the right tools. Suppose George Corporation, a
U.S. company sells products to its British buyer worth 1,500,000 that is to be paid at
the end of 3 months. The present spot rate is $1.5/ and George expects to receive
1,500,000$1.5/= $2,250,000 at the end of 3 months. But if the transaction
exposure arises, George receives higher or lower than the expected value. If the value
of the Euro falls (rises) to $1.3/ ($1.8/) it would result in George receiving
$1.950,000 ($2,700,000) which is lower (higher) than the expected value. This change
in the exchange rate can affect the cash flow of the company, thus the companies
would have acquire another cash flow, contract or asset which may offset the
volatility through a medium known as hedging.

Assuming that in the above scenario, the spot rate falls and this position is not
hedged, George will result in having a lower inflow than expected, thus if it wishes to
have a higher or certain inflow, it would have to hedge its investments. George in
order to protect his investments can hedge in the forward market, money market,
breakeven investment or the options market.
Spot rate: $1.50/
Forward rate: $1.40/
U.S. interest rate (3 months) = 6%
U.K. interest rate (3 months) = 8%

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In the forward market, a forward contract is entered into when the accounts
receivable is formed. This sale can be recorded at a spot exchange rate of $1.5/. If
George does not have an accounts payable at the same value, the firm will be
considered uncovered. Hedging in the forward market suggests that George would
have to sell 1,500,000 in the forward market today at a 3 month forward rate which
in this case is $1.40/ which means that at the end of 3 months George would
certainly receive $2.1million. If the value of falls to $1.30 which is what worries
George, he would receive $1.95million from the order but the profit made in the
futures market is $0.15 million thus giving George a net profit of $2.1million.
Similarly, if the value of the rises to $1.60, George would receive $2.4million in the
contract as well as loss $0.3million in the futures contract thus making a net profit of
$2.1million. Thus through investing in the forward currency, George could minimize
his risks of the transaction exposure.
Options market is the hedging strategy where the company can limit the risk
of falling along with protecting the upside risk of rising, for which it would have
to buy put option. Assume that put options is selling for 3, or $0.03/, with a
strike price of $1.45/, and 3 months expiration. George purchases 1.5million worth
of put options for $45,000 (1.5m x $0.03/), giving it the right to sell for
$2.175million (=1.5m @ $1.45/). The option premium is due, so considering the
time value of money; the future cost (three months) of the put options at 6% is
$47700 (= $45,000 1.06).
Suppose S=$1.35/ in 3 months. George exercises the option,
1. Spot: 1.5m x $1.35/ =$2.025m (Converting 1.5m to $ @ S=$1.35/).
2. ($1.45/ - $1.35/) x 1.5m = $0.15m Gross Profit on Options Contract Total
gross proceeds is $2.175million
3. Net proceeds= Gross proceeds options cost
$2.175million-$0.0447million
=$2.1303million
Thus the effective exercise rate is $2.1303million1.5million= $1.4202/. By using
the options market hedging method it can be seen that George get an investment
return on $2.1303m at the end of 3 months.
Another hedging strategy is the money market hedge where George would
borrow in one currency and exchange its earnings for another currency. He could
borrow in UK for 3 months at 8% with a 1.5million payoff, further convert the to
$ at the spot rate, invest in US at 6% and use the $ from the British buyer to pay of the
loan in the U.K in three months along with keeping the $ from the payoff in the US
money market.

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Borrow in UK at 8%
Borrow 1388889 (=1.5 m/1.08) today for 3 months @8%, 1.5m to be paid back in 3 months

Convert pounds into Dollars

the borrowed are converted into $ at the current spot rate of $1.50/ thus having $2083333 (=
$1.50/ x 1388889 )

Invest in US
invest the $2083333 in US at 6%

Collect from the British buyer and payback the loan

1.5million is received from the british buyer after 3 months and the loan of 1388889 with interest
of 111111, total 1.5million is paid off.

Receive return on investment in US

George can receive the return on investment in US of $2208332 as final return on investment)))))

In the above scenario, it can be seen that with the use money market hedging,
George Corporation was able to reduce the affect of the transaction exposure on his
investments.

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Translation Exposure
Translation exposure is the affect on the financial statements and balance
sheets of the firm due to fluctuations in the exchange rate. This happens in the case
when the accounts of the subsidiary of a company are compiled at the head office
where the exchange rate differs (Ajami et al, 2006). A simple example to elucidate
this is, a domestic division of an MNC makes a loss of $4 million while its subsidiary
makes a profit of 9million. Assuming that the exchange rate between the two
countries is in the ratio of 1:0.7, i.e., loss of $4million with a profit of $6.3million,
thus the overall profit of the firm will be $2.3million. Thus profit of the subsidiary
neutralizes the loss of the domestic branch. But there exists a currency risk due to
which if the value of the currency falls to 1:0.3, then the company would incur a net
loss of $2.3million. Due to this risk, companies try to hedge translation exposure
which otherwise would be reflected in the books of accounts.
To hedge translation risk, some of the methods are,
o Adjusting flow of funds by exporting to countries with appreciating currency and
importing from countries with depreciating currency, investing the hard-currency
and then replacing hard currency with the local currency loans.
o Companies experiencing the translation exposure can indulge in forward or future
contracts similar to the transaction exposure to avoid any unforeseen changes in
the returns.
o The firm could indulge in exposure netting where it could offset the exposure in
one currency with the exposure of another or same currency, when the exchange
rates are anticipated to move in ways such that the gains or losses in the first
currency would offset the losses or gains in the other (Nasdaq, 2011).
o Hedging using balance sheet hedge which aims to eliminate the mismatch
between the net liabilities and net assets which are denoted in the same currency.
This though may create transaction exposure but that would be hedged using the
forward contract.
o Derivative hedging where the translation exposure can be controlled using
speculation in the foreign exchange rate.
Using the appropriate method for a situation can increase the returns or reduce the
unexpected losses that the firm would have incurred.

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Economic Exposure
In contrast to the transaction and the translation exposure, Economic
exposure measures the change in the current value of the firm due to the future
operating cash flows resulted from any change in the exchange rates. It takes into
account the competitive position of the firm along with the expected sales of the
company in foreign currency (Duangploy et al, 1997). The other two exposures would
only affect companies dealing in the foreign market while economic exposure could
affect a company who deals only in the domestic market also as due to changes in the
value of the domestic currency, the competitive position of the firm may change.
To manage the economic exposure, it is important for a firm to know the
market in which it operates, its structure and its ability to diminish the effect of
currency fluctuations (Eun & Resnick, 2001). To avoid economic exposure, the
company could hedge in the following that would improve their financial position.
o The company could invest in the futures market similar to that of the transaction
exposure.
o Investing in tailor-made forward contracts that are not generally traded in the
organized sector but can cover the receivables and payables.
o Trading in options like the transaction exposure.
o Using swaps where two or more players exchange their streams of payments for a
limited period of time.
o Netting of the exposure.
o Using the appropriate marketing initiatives such as the selection of the targeted
market, the product strategy and pricing and promotional activities.
o Working on making the operations effective and efficient by using the right
combination of product sourcing, the products mix, location of the plant and
machinery and methods to raise productivity.
According to a research conducted on the Indian firms by Dr. Manisha Goel (2012),
on the method used for hedging economic exposure, the following was the response
from the researched firms.

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It is observed that varied types of exposures affect different firms, but in cases
when two or more exposures affect the company at the same time, which exposure to
be given more importance is the question. Theoretically, translation exposure affects
the figures in the books of accounts while transaction exposure affects the actual gain
or loss of cash during exchange rates fluctuation (Moffett, 2005). Thus, hedging of
transaction exposure should be considered more vital for a firm. Translation exposure
exists only firms operate in various countries i.e., have subsidiaries while transaction
exposure could exist for a firm operating in one country but dealing with countries.
Also, at times when firms aim to hedge translation exposure, it may result in
transaction exposure thus; hedging of transaction exposure is more preferable as in
certain circumstances, it results in the hedging of translation exposure as well.

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