Management of

Transaction Exposure

Chapter Objective:

This chapter discusses various methods available

for the management of transaction exposure facing
multinational firms.
 Chapter Outline
 Forward Market Hedge
 Futures Market Hedge
 Money Market Hedge
 Options Market Hedge
 Cross-Hedging Minor Currency Exposure
 Hedging Contingent Exposure
 Hedging Recurrent Exposure with Swap Contracts
 Chapter Outline (continued)
 Hedging Through Invoice Currency
 Hedging via Lead and Lag
 Exposure Netting
 Should the Firm Hedge?
 What Risk Management Products do Firms Use?
 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.
 Forward Market Hedge: an Example
You are a U.S. importer of British woolens and have
just ordered next year’s inventory. Payment of
£100M is due in one year.

Question: How can you fix the cash outflow in

dollars?
Answer: One way is to put yourself in a position
that delivers £100M in one year—a long
forward contract on the pound.
 Forward Market Hedge
Suppose the The importer will be better off if
forward exchange the pound depreciates: he still
rate is $1.50/£. buys £100m but at an exchange
$30m rate of only $1.20/£ he saves
If he does not $30 million relative to $1.50/£
hedge the £100m
$0
payable, in one Value of £1 in $
year his gain $1.20/£ $1.50/£ $1.80/£ in one year
(loss) on the –$30m
unhedged position But he will be worse off if Unhedged
is shown in green. the pound appreciates. payable
 Forward Market Hedge
If you agree to buy £100 Long
If he agrees
million at a price of forward
to buy £100m $1.50 per pound, you
in one year at will make $30 million if
$30m
$1.50/£ his the price of a pound
gain (loss) on reaches $1.80.
the forward $0
Value of £1 in $
are shown in $1.20/£ $1.50/£ $1.80/£ in one year
blue.
–$30m If you agree to buy £100 million at a
price of $1.50 per pound, you will lose
$30 million if the price of a pound is
only $1.20.
 Forward Market Hedge
Long
The red line
forward
shows the
payoff of the
$30 m
hedged
payable. Note Hedged payable
that gains on $0
Value of £1 in $
one position are $1.20/£ $1.50/£ $1.80/£ in one year
offset by losses
–$30 m
on the other
position. Unhedged
payable
 Futures Market Hedge
 As an exporter you expect to receive 3 months
from now US $ 20,000. The spot price of US $ is
Rs 50.00 while 3-m futures at NSE is trading at Rs
49.30 indicating depreciation of US dollar.
 Under what circumstances would you like to
hedge?
 What would be the hedging strategy?
 Futures Market Hedge
 If as exporter one believe that in 3 months' time
US dollar would depreciate below the futures
price of Rs 49.30 one must hedge else not.
 For hedging with futures market the exporter
being long on the underlying asset would go short
on futures. Close to expiry of futures when
exporter receives the funds he would buy back the
futures contract hoping to nullify the gains/losses
and realise close to target rate of Rs 49.30
 Futures Market Hedge
 Assume that the exporter hedges with the futures
contract. One futures contract at NSE is for US $
1,000 and it is cash settled.
 Find out the exchange rate realised by the exporter
when prior to maturity
 a) spot rate is Rs 50.50 and futures is selling for Rs
50.42
 b) spot rate is Rs 48.40 and futures is selling for Rs
48.48.
 Futures Market Hedge
 The exporter has receivable of US $ 20,000. With contract size of US $ 1,000 the
exposure shorts 20 futures contract at Rs 49.30 now and buys back later. He sells the
foreign currency in the spot market.
 The effective exchange rate realized by the exporter under two different scenarios is
worked out as below:
Scenario “a” Scenario “b”
Futures contract sold at 49.30 49.30
Futures contract bought at 50.42 48.48
Profit/loss in cash from futures position (1.12) 0.82
Spot rate realized 50.50 48.40
Effective exchange rate realized 49.38 49.22
Effective price can also be found by adding basis at the end to the futures price.
Futures price at inception 49.30 49.30
Basis at end 0.08 (0.08)
Effective exchange rate realized 49.38 49.22
 Futures Market Hedge
 Impex Limited has to make a payment of US $ 25,000 after 3 months.
The spot exchange rate is Rs 46 and it has been increasing in the
recent past. The appreciation of dollar is expected to continue as
reflected in the 3-m futures quotation of Rs 47.50. The management of
Impex Limited believes that US dollar is expected to go beyond Rs
47.50 in 3 months' time.
1. How can Impex Limited hedge its foreign currency exposure?
2. Assume that Impex Limited takes position in futures and at the time of
making payment after 3 months it unwinds the position in futures.
Find out the effective exchange rate paid by them if
a) spot rate is Rs 49.10 and futures price is Rs 49.20, and
b) spot price is Rs 46.75 and futures price is Rs 46.80.
 Futures Market Hedge
Impex limited has payable of US $ 25,000. With contract size of US $ 1,000 they buy 25
futures contract at Rs 47.50 now and sell the futures later. Impex Limited fulfils the foreign
exchange requirement from the spot market. The effective exchange rate paid by Impex
Limited under two different scenarios is worked out as below:
Scenario "a" Scenario "b"
Futures contract bought at 47.50 47.50
Futures contract sold at 49.20 46.80
Profit/loss in cash from futures position 1.70 (0.70)
Spot rate paid 49.10 46.75
Effective exchange rate paid 47.40 47.45
Effective price can also be found by adding basis at the end to the futures price.
Futures price at inception 47.50 47.50
Basis at end (0.10) (0.05)
Effective exchange rate paid 47.40 47.45
 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.
 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.
 Money Market Hedge
A U.S.–based importer of Italian bicycles
 In one year owes €100,000 to an Italian supplier.
 The spot exchange rate is $1.25 = €1.00
 The one-year interest rate in Italy is i€ = 4%
€100,000
Can hedge this payable by buying €96,153.85 = 1.04
today and investing €96,153.85 at 4% in Italy for one year.
At maturity, he will have €100,000 = €96,153.85 × (1.04)

Dollar cost today = $120,192.31 = €96,153.85 × $1.25

€1.00
 Money Market Hedge
 With this money market hedge, we have
redenominated a one-year €100,000 payable into a
$120,192.31 payable due today.
 If the U.S. interest rate is i$ = 3% we could borrow
the $120,192.31 today and owe in one year

$123,798.08 = $120,192.31 ×(1.03)

€100,000
$123,798.08 = S($/€)× T × (1+ i$)
T
(1+ i€)
 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.
 Options Market Hedge
Suppose the
The importer will be better off if
forward exchange
the pound depreciates: he still
rate is $1.50/£.
buys £100m but at an exchange
If an importer who $30m rate of only $1.20/£ he saves
owes £100m does $30 million relative to $1.50/£
not hedge the
payable, in one $0
Value of £1 in $
year his gain (loss) $1.20/£ $1.50/£ $1.80/£ in one year
on the unhedged
position is shown –$30m
in green. But he will be worse off if Unhedged
the pound appreciates. payable
 Options Markets Hedge
Profit Long call on
Suppose our £100m
importer buys a
call option on
£100m with an
exercise price
of $1.50 per –$5m Value of £1 in $
pound. $1.55/£ in one year
$1.50/£
He pays $.05
per pound for
loss
the call.
 Options Markets Hedge
Profit Long call on
The payoff of the
portfolio of a call £100m
and a payable is
shown in red. $25m
He can still profit
from decreases in
the exchange rate –$5m Value of £1 in $
below $1.45/£ but $1.20/£ in one year
has a hedge against $1.45 /£
unfavorable
increases in the $1.50/£ Unhedged
exchange rate. loss payable
 Options Markets Hedge
If the exchange Profit Long call on
rate increases to £100m
$1.80/£ the
importer makes
$25 m
$25 m on the call
but loses $30 m on
the payable for a
maximum loss of –$5 m Value of £1 in $
$5 million. $1.80/£ in one year
$1.45/£
This can be –$30 m
thought of as an $1.50/£ Unhedged
insurance loss payable
premium.
 Options Markets Hedge
IMPORTERS who OWE
foreign currency in the
future should BUY
CALL OPTIONS.
 If the price of the currency
goes up, his call will lock in
an upper limit on the dollar
cost of his imports.
 If the price of the currency
goes down, he will have the
option to buy the foreign
currency at a lower price.
EXPORTERS with accounts
receivable denominated in
foreign currency should BUY
PUT OPTIONS.
 If the price of the currency goes
down, puts will lock in a lower
limit on the dollar value of his
exports.
 If the price of the currency goes
up, he will have the option to sell
the foreign currency at a higher
price.
Hedging Exports with Put Options
 Show the portfolio payoff of an exporter who
is owed £1 million in one year.
 The current one-year forward rate is £1 = $2.
 Instead of entering into a short forward
contract, he buys a put option written on £1
million with a maturity of one year and a
strike price of £1 = $2.
 The cost of this option is $0.05 per pound.
 Options Market Hedge:
Exporter buys a put option to protect the dollar
value of his receivable.
$1,950,000

e
bl
va
ei
c
re
d
ge
ed
H
S($/£)360
–$50k
Long put
le
ab

$2 $2.05
iv
ce
re
gn
Lo

–$2m
 The exporter who buys a put option to protect
the dollar value of his receivable
has essentially purchased a call.

le
v ab
ei
c
re
d
ge
ed
H
S($/£)360
–$50k

$2 $2.05
 Hedging Imports with Call
Options
 Show the portfolio payoff of an importer who owes
£1 million in one year.
 The current one-year forward rate is £1 = $1.80; but
instead of entering into a short forward contract,
 He buys a call option written on £1 million with an
expiry of one year and a strike of £1 = $1.80 The
cost of this option is $0.08 per pound.
 Forward Market Hedge:
GAIN
Importer buys £1m forward.
(TOTAL)
Long
currency
forward

This forward hedge

fixes the dollar value S($/£)360
of the payable at
$1.80m.
$1.80

Accounts Payable =
LOSS
Short Currency position
(TOTAL)
 Options Market Hedge:
$1.8m Importer buys call option on £1m.
$1,720,000
Call
Call option limits
the potential cost of
servicing the payable.

S($/£)360
–$80k
$1.80
$1.72 $1.88

U
nh
ed
ge
d
ob
l ig
at
io
n
 Our importer who buys a call to protect himself
from increases in the value of the pound creates a
$1,720,000 synthetic put option on the pound.
He makes money if the pound falls in value.

S($/£)360
–$80k
$1.80
$1.72

The cost of this “insurance policy” is $80,000

 Taking it to the Next Level
 Suppose our importer can absorb “small” amounts
of exchange rate risk, but his competitive position
will suffer with big movements in the exchange
rate.
 Large dollar depreciations increase the cost of his
imports
 Large dollar appreciations increase the foreign currency
cost of his competitors exports, costing him customers
as his competitors renew their focus on the domestic
market.
Our Importer Buys a Second Call Option
This position is called a straddle
$1,720,000
2nd
$1,640,000 Call

S($/£)360
–$80k Importers synthetic put
$1.64 $1.80 $1.96
–$160k
$1.72 $1.88
 Suppose instead that our importer is willing to
risk large exchange rate changes but wants to
profit from small changes in the exchange rate,
$1,720,000 he could lay on a butterfly spread.

Sell 2 puts $1.90 strike.

butterfly spread

S($/£)360
–$80k Importers synthetic put
$1.80 $1.90
$1.72 $2 buy a put $2 strike

A butterfly spread is analogous to an interest rate collar; indeed it’s

sometimes called a zero-cost collar. Selling the 2 puts comes close
to offsetting the cost of buying the other 2 puts.
 Options
 A motivated financial engineer can create almost
any risk-return profile that a company might wish
to consider.
 Straddles and butterfly spreads are quite common.
 Notice that the butterfly spread costs our importer
quite a bit less than a naïve strategy of buying call
options.
 Cross-Hedging
Minor Currency Exposure
 The major currencies are the: U.S. dollar,
Canadian dollar, British pound, Euro, Swiss franc,
Mexican peso, and Japanese yen.
 Everything else is a minor currency, like the Thai
bhat.
 It is difficult, expensive, or impossible to use
financial contracts to hedge exposure to minor
currencies.
 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 U.S. importer with liabilities in
Swedish krona hedging with long or short forward
contracts on the euro. If the krona is expensive when
the euro is expensive, or even if the krona is cheap
when the euro is expensive it can be a good hedge. But
they need to co-vary in a predictable way.
 Cross Hedging: Example
 Apex Company, a computer chip manufacturer, has sold
computer chips to customers in Thailand on March 1 and
will receive Thai baht (THB) 5 million on April 28. The
exchange rates on March 1 are THB 1 = INR 1.4092 and
USD 1 = INR 45.3462. The correlation between the Thai
baht and the U.S. dollar is estimated as 0.97. The standard
deviation of THB–INR exchange rate is 0.53 and that of
USD–INR futures is 2.35. Explain how you would hedge
the Thai baht exchange rate risk? The USD–INR futures
with expiry on April 28 are priced at INR 45.5387
 Solution

Apex should sell 1,094 USD-INR futures with expiry on April 28 at 45.5387
 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.
 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.
 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
 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.
 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.
 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.
 Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:

$20
$30
$40
$10 $35 $10 $30 $40
$25
$60
$20
$30
 Exposure Netting: an Example
Bilateral Netting would reduce the number of
foreign exchange transactions by half:
$20
$10
$30
$40
$20 $15 $10
$10$25$35 $30$10$40
$25
$60
$20
$10
$30
 Multilateral Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:

$10
$15

$20
$30
$40
$40 $15
$15$25
$15 $10 $10
$10
$10
 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.
 Should the Firm Hedge?
 In the presence of market imperfections, the firm
should hedge.
 Information Asymmetry
 Themanagers may have better information than the
shareholders.
 Differential Transactions Costs
 Thefirm may be able to hedge at better prices than the
shareholders.
 Default Costs
 Hedging may reduce the firms cost of capital if it reduces the
probability of default.
 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.
 Quiz Time
 How would you define transaction exposure? How is it
different from economic exposure?
 Discuss and compare the costs of hedging via the forward
contract and the options contract.
 What are the advantages of a currency options contract as
a hedging tool compared with the forward contract?
 What is exposure netting?
 What is cross hedging? Discuss the factors determining its
effectiveness.
 Should a firm hedge? Why or why not?
 Quiz Time: Practical Problem
You plan to visit Geneva, Switzerland in three months to attend an international business
conference. You expect to incur the total cost of SF 5,000 for lodging, meals and
transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the
three-month forward rate is $0.63/SF. You can buy the three-month call option on SF
with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your
expected future spot exchange rate is the same as the forward rate. The interest rate is 6
percent per annum in the United States and 4 percent per annum in Switzerland.
(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call
option on SF.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge
using a forward contract.
(c) At what future spot exchange rate will you be indifferent between the forward and option
market hedges?
(d) Illustrate the future dollar costs of meeting the SF payable against the future spot
exchange rate under both the options and forward market hedges.
 Solution
 (a) Total option premium = (.05)(5000) = $250. In three months, $250 is
worth $253.75 = $250(1.015). At the expected future spot rate of $0.63/SF,
which is less than the exercise price, you don’t expect to exercise options.
Rather, you expect to buy Swiss franc at $0.63/SF. Since you are going to buy
SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected
cost of buying SF5,000 will be the sum of $3,150 and $253.75, i.e., $3,403.75.
 (b) $3,150 = (.63)(5,000).
 (c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot
rate. Solving for x, we obtain x = $0.57925/SF. Note that at the break-even
future spot rate, options will not be exercised.
 (d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price
of call option, you will exercise the option and buy SF5,000 for $3,200. The
total cost of buying SF5,000 will be $3,453.75 = $3,200 + $253.75. This is the
maximum you will pay.
 Case Study: Airbus Exposure
Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company, and billed $30 million
payable in six months. Airbus is concerned with the euro proceeds from international
sales and would like to control exchange risk. The current spot exchange rate is
$1.05/euro and six-month forward exchange rate is $1.10/euro at the moment. Airbus
can buy a six-month put option on U.S. dollars with a strike price of euro 0.95/$ for a
premium of euro0.02 per U.S. dollar. Currently, six-month interest rate is 2.5% in the
euro zone and 3.0% in the U.S.
a. Compute the guaranteed euro proceeds from the American sale if Airbus decides to
hedge using a forward contract.
b. If Airbus decides to hedge using money market instruments, what action does Airbus
need to take? What would be the guaranteed euro proceeds from the American sale in
this case?
c. If Airbus decides to hedge using put options on U.S. dollars, what would be the
‘expected’ euro proceeds from the American sale? Assume that Airbus regards the
current forward exchange rate as an unbiased predictor of the future spot exchange rate.
d. At what future spot exchange rate do you think Airbus will be indifferent between the
option and money market hedge?
 Solution
a. Airbus will sell $30 million forward for EURO
27,272,727 = ($30,000,000) / ($1.10/EURO).
b. Airbus will borrow the present value of the
dollar receivable,
i.e., $29,126,214 = $30,000,000/1.03,
and then sell the dollar proceeds spot for euros:
EURO 27,739,251.
This is the euro amount that Airbus is going to keep.
 Solution
c. Since the expected future spot rate is less than the strike
price of the put option, i.e., EURO 0.9091< EURO 0.95,
Airbus expects to exercise the option and receive EURO
28,500,000 = ($30,000,000)(EURO 0.95/$). This is gross
proceeds.
Airbus spent EURO 600,000 (=0.02x30,000,000) upfront
for the option and its future cost is equal to EURO 615,000
= EURO 600,000 x 1.025.
Thus the net euro proceeds from the American sale is
EURO 27,885,000, which is the difference between the
gross proceeds and the option costs.
 Solution
d. At the indifferent future spot rate, the following will hold:
EURO 28,432,732 = ST (30,000,000) – EURO 615,000.
Solving for ST, we obtain the indifference future spot
exchange rate, i.e., EURO 0.9683/$, or $1.0327/EURO.
Note that EURO 28,432,732 is the future value of the
proceeds under money market hedging:
EURO 28,432,732 = (EURO 27,739,251) (1.025).