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Chapter 8

Transaction Exposure

  End-of-Chapter Questions
1. Definitions.
(a) Define the term foreign exchange exposure.
Answer: In its most general sense, foreign exchange exposure is the possibility of either beneficial
or harmful effects on a company caused by a change in foreign exchange rates. The effect
on the company may be on its profits, its cash flows, or its market value.
(b) Define the four types of foreign exchange exposure.
Answer: (1) Transaction exposure is the potential for a gain or loss in contracted-for near term
cash flows caused by a foreign exchange rate-induced change in the value of amounts
due to the MNE or amounts that the MNE owes to other parties. As such, it is a
change in the home currency value of cash flows that are already contracted for.
(2) As such, it is a change in expected long-term cash flows; i.e., future cash flows
expected in the course of normal business but not yet contracted for.
(3) Translation exposure is the possibility of a change in the equity section (common
stock, retained earnings, and equity reserves) of a MNE’s consolidated balance sheet,
caused by a change (expected or not expected) in foreign exchange rates. As such it is
not a cash flow change, but is rather the result of consolidating into one parent
company’s financial statement the individual financial statements of related
subsidiaries and affiliates.
(4) Tax exposure. The tax consequence of foreign exchange exposure varies by country.
As a general rule, however, only realized foreign exchange losses are deductible for
purposes of calculating income taxes. Similarly, only realized gains create taxable
income. “Realized” means that the loss or gain involves cash flows.

2. Hedging and currency risk.


(a) Define the term hedging.
Answer: Hedging is the taking of a position, either acquiring a cash flow, an asset, or a contract
(including a forward contract) that will rise (fall) in value and offset a fall (rise) in the
value of an existing position. Hedging therefore protects the owner of the existing asset
from loss. However it also eliminates any gain from an increase in the value of the asset
hedged against.
(b) Define the term currency risk.
54  Eiteman/Stonehill/Moffet • Multinational Business Finance, Eleventh Edition
Answer: Currency risk can be roughly defined as the variance in expected cash flows arising from
exchange rate changes.
Chapter 8 Transaction Exposure  55
3. Arguments against currency risk management. What are six arguments against a firm pursuing an
active currency risk management program?
Answer: (1) Currency risk management does not increase the expected cash flows of the firm.
(2) Currency risk management normally consumes some of a firm’s resources and so
reduces cash flow. The impact on value is a combination of the reduction of cash flow
(which by itself lowers value) and the reduction in variance (which by itself increases
value).
(3) Management often conducts hedging activities that benefit management at the
expense of the shareholders. The field of finance called agency theory frequently
argues that management is generally more risk-averse than shareholders. If the firm’s
goal is to maximize shareholder wealth, then hedging activity is probably not in the
best interest of the shareholders.
(4) Managers cannot outguess the market. If and when markets are in equilibrium with
respect to parity conditions, the expected net present value of hedging is zero.
(5) Management’s motivation to reduce variability is sometimes driven by accounting
reasons. Management may believe that it will be criticized more severely for incurring
foreign exchange losses in its financial statements than for incurring similar or even
higher cash costs in avoiding the foreign exchange loss. Foreign exchange losses
appear in the income statement as a highly visible separate line item or as a footnote,
but the higher costs of protection are buried in operating or interest expenses.
(6) 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.

4. Arguments for currency risk management. What are four arguments in favor of a firm pursuing an
active currency risk management program?
Answer: (1) Reduction in risk in future cash flows improves the planning capability of the firm. If
the firm can more accurately predict future cash flows, it may be able to undertake
specific investments or activities that it might otherwise not consider.
(2) Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows
will fall below a necessary minimum. A firm must generate sufficient cash flows to
make debt-service payments in order for it to continue to operate. This minimum cash
flow point, often referred to as the point of financial distress, lies left of the center of
the distribution of expected cash flows. Hedging reduces the likelihood of the firm’s
cash flows falling to this level.
(3) Management has a comparative advantage over the individual shareholder in knowing
the actual currency risk of the firm. Regardless of the level of disclosure provided by
the firm to the public, management always possesses an advantage in the depth and
breadth of knowledge concerning the real risks and returns inherent in any firm’s
business.
56  Eiteman/Stonehill/Moffet • Multinational Business Finance, Eleventh Edition
(4) Markets are usually in disequilibrium because of structural and institutional
imperfections, as well as unexpected external shocks (such as an oil crisis or war).
Management is in a better position than shareholders to recognize disequilibrium
conditions and to take advantage of one-time opportunities to enhance firm value
through selective hedging. “Selective hedging” refers to the hedging of large, singular,
exceptional exposures or the occasional use of hedging when management has a
definite expectation of the direction of exchange rates.
Chapter 8 Transaction Exposure  57
5. Transaction exposure. What are the four main types of transactions from which transaction exposure
arises?
Answer: (1) Purchasing or selling on credit goods or services when prices are stated in foreign
currencies,
(2) Borrowing or lending funds when repayment is to be made in a foreign currency,
(3) Being a party to an unperformed foreign exchange forward contract, and
(4) Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.

6. Life span of a transaction exposure. Diagram the life span of an exposure arising from selling a
product on open account. On the diagram define and show quotation, backlog, and billing exposures.
Answer:
Exhibit 8.3 The Life Span of a Transaction Exposure

Time and Events

t1 t2 t3 t4
Seller quotes Buyer places Seller ships Buyer settles A/R
a price to buyer firm order with product and with cash in
(in verbal or seller at price bills buyer amount of currency
written form) offered at time t1 (becomes A/R) quoted at time t1

Quotation Backlog Billing


Exposure Exposure Exposure

Time between quoting Time it takes to Time it takes to


a price and reaching a fill the order after get paid in cash after
contractual sale contract is signed A/R is issued

7. Borrowing exposure; Give an example of a transaction exposure that arises from borrowing in a
foreign currency.
Answer: A second example of transaction exposure arises when funds are borrowed or loaned, and
the amount involved is denominated in a foreign currency. For example, PepsiCo’s largest
bottler outside of the United States in 1994 was Grupo Embotellador de Mexico (Gemex).
In mid-December, 1994, Gemex had U.S. dollar debt of $264 million. At that time
Mexico’s new peso (“Ps”) was traded at Ps3.45/US$, a pegged rate that had been
maintained with minor variations since January 1, 1993, when the new currency unit had
been created. On December 22, 1994, the peso was allowed to float because of economic
and political events within Mexico, and in one day it sank to Ps4.65/US$. For most of the
following January it traded in a range near Ps5.50/US$.
58  Eiteman/Stonehill/Moffet • Multinational Business Finance, Eleventh Edition
Debt In Pesos In Pesos
In US$ (at Ps5.50/$) (at Ps3.45/$)
Chapter 8 Transaction Exposure  59
Gemex dollar-denominated debt $264,000,000 Ps910,800,000 Ps1,452,000,000
60  Eiteman/Stonehill/Moffet • Multinational Business Finance, Eleventh Edition
The pesos needed to repay the dollar debt increased by Ps541,200,000 (Ps1,452,000,000 –
Ps910,800,000), or 59%! In U.S. dollar terms the drop in the value of the pesos caused
Gemex to need the peso-equivalent of an additional US$98,400,000 (Ps541,200,000 ÷
Ps5.50/$) to repay. This increase in debt was the result of transaction exposure.

8. Cash balances. Explain why foreign currency cash balances do not cause transaction exposure.
Answer: Foreign currency cash balances do not create transaction exposure, even though their
home currency value changes immediately with a change in exchange rates. No legal
obligation exists to move the cash from one country and currency to another. If such an
obligation did exist, it would show on the books as a payable (e.g., dividends declared and
payable) or receivable and then be counted as part of transaction exposure. Nevertheless,
the foreign exchange value of cash balances does change when exchange rates change.
Such a change is reflected in the consolidated statement of cash flows and the
consolidated balance sheet.

9. Contractual hedges. What are the four main contractual instruments used to hedge transaction
exposure?
Answer: Foreign exchange transaction exposure can be managed by contractual, operating, and
financial hedges. The main contractual hedges employ the forward, money, futures, and
options markets. Operating and financial hedges employ the use of risk-sharing agreements,
leads and lags in payment terms, swaps, and other strategies to be discussed in later chapters.

10. Decision criteria. Ultimately a treasurer must chose among alternative strategies to manage
transaction exposure. Explain the two main decision criteria that must be used.
Answer: The two main decision criteria are: (1) is treasury a cost center or a profit center?, and
(2) what is the tolerance for risk?

11. Proportional hedge. Many MNEs have established transaction exposure risk management policies
that mandate proportional hedging. Explain and give an example of how proportional hedging can be
implemented.
Answer: 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 (e.g., 50, 60, or 70%) of existing transaction exposures.
As the maturity of the exposures lengthens, the percentage forward-cover required
decreases. The remaining portion of the exposure is then selectively hedged on the basis
of the firm’s risk tolerance, view of exchange rate movements, and confidence level.
In addition to having required minimum forward-cover percentages, many firms also
require full forward-cover when forward rates “pay them the points.” The points on the
forward rate is the forward rate’s premium or discount.

For example, using the same situation and financial assumptions as in the Dayton case, the
forward rate of $1.7540/£ could be the result of the following 90-day Eurocurrency
interest rates on U.S. dollars (6.80% per annum) and British pounds (9.12% per annum):
  90  
1 +  0.0680 × 360  
   = $ 1.7540/ú .
Forward 90 = $ 1.7640/ú × 
  90  
 1 +  0.0912 × 360  
  
Chapter 8 Transaction Exposure  61
Because British pound interest rates are higher than U.S. dollar interest rates, the pound is
selling forward at a discount. A firm purchasing a forward contract to sell pounds forward
would itself be paying the points.
If U.S. dollar interest rates (6.80% per annum) were higher than British pound interest
rates (6.00% per annum), the pound would be selling forward at a premium:
  90  
1 +  0.0680 × 360  
   = $ 1.7675/ú .
Forward 90 = $ 1.7640/ú × 
  90  
 1 +  0.0600 × 360  
  

A forward rate of $1.7675/£ would allow Dayton to lock-in an exchange rate for 90 days
in the future which is better than the exchange rate which would be realized even if
Dayton received the British pounds today.
Many firms require that when the firm earns the forward points (as shown in this example)
that full forward-cover be put in place. Not only is the exchange rate in the firm’s favor, it
also allows the firm to earn a U.S. dollar effective rate which meets its budget exchange
rate, and a hedge choice which is independent of the firm’s exchange rate view. Although
the favorable forward rate is a result only of interest rate differences, many firms view this
as riskless profit.

  Mini-Case: Lufthansa’s Purchase of Boeing 737s


1. Do you think Heinz Ruhnau’s hedging strategy made sense?
Answer: Although Ruhnau was correct in his assessment that the dollar was too high
(“overvalued”), the position he constructed to manage the position was not really
effective. By hedging half the DM 7.6 million exposure, he basically divided the exposure
in half, hedging half and leaving half uncovered. The resulting positions will move
opposite in their valuation as the exchange rate moves (in either direction).

2. To what degree did he limit the upside and downside exposure of the transaction by hedging one-half
of it? Do you agree with his critics that he was speculating?
Answer: Ruhnau did not effectively manage his exchange rate risk. A completely uncovered
position would have no upper or lower limit to its exposure. A position which is one-half
covered would still have no limit to it upside or downside, only half the slope or rate of
movement as the totally uncovered position. A call option on dollars (or put option on
marks) would have placed an absolute upper limit on how much Ruhnau and Lufthansa
would have to pay to settle the Boeing purchase.
It is difficult to truly agree with the argument that he was speculating. Ruhnau was indeed
trying to manage or hedge the exposure, but his strategy was definitely flawed. To accuse
him of speculating on the component which was covered with the forward contract is to
not understand the concept of transaction exposure and how a short position in a foreign
currency could potentially cause severe monetary losses or excessive expenses in the
event the foreign currency appreciated significantly before cash settlement.
62  Eiteman/Stonehill/Moffet • Multinational Business Finance, Eleventh Edition
3. Is it fair to judge transaction exposure management effectiveness with 20-20 hindsight?
Answer: Although most would agree it is not “fair” to judge exposure management effectiveness
with perfect hindsight, it is a common practice in industry. Managerial behavior and
results must always be interpreted on the basis of both decision-making at specific points
in time—recognizing the risks and uncertainties of decisions made about the future—and
the eventual results and outcomes of those decisions. Outcomes cannot be ignored, but
management decision-making to protect the firm, its shareholders and creditors against
adverse impacts of exchange rate movements, is a necessary part of risk management.
A more effective and fair measure of performance is probably to measure outcomes as
hedged against corporate benchmarks which are agreed upon prior to the hedging.
Common benchmarks are a full forward cover outcome, or an average of the full forward
and completely uncovered position (which is indeed what Ruhnau did!).

  Mini-Case: Xian-Janssen Pharmaceutical (China) and the Euro


1. How significant an impact do foreign exchange gains and losses have on corporate performance at
XJP? What is your opinion of how they structure and manage their currency exposures?
Answer: The income statement for the business unit shows foreign exchange losses of Rmb 60
million in 2003 and another Rmb 75 million forecast for 2004, about 5.7% and 6.9%,
respectively. Although many people may first see these as relatively small losses, a
reduction in the operating earnings of an individual business unit from foreign exchange
changes alone like this would be considered significant. One way to note this is to
consider that the average return on sales (ROS) for the Fortune 500 in the second quarter
of 2005 was about 7.7%. If these bottom line profits were chopped an additional 6%-7%
on a consolidated basis, a lot of companies—and shareholders—would be considerably
upset.
The pure use of foreign exchange forwards is most likely the result of a series of factors:
1) limited availability of other foreign exchange derivatives or risk management
alternatives; 2) corporate policy on the part of J&J; 3) regulatory restrictions in China on
the use of derivative and currency products; and 4) the unwillingness of the parent
company to either carry the risk itself or allow more breadth in management (including
remaining uncovered as the euro seemingly peaks) of the foreign exchange exposures of
its Chinese unit.

2. J& J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized
organizational structure, in which the individual units are responsible for their own performance from
the top to the bottom line of the income statement. How is this reflected in the situation XJP finds
itself?
Answer: Although it is not unusual for a multinational firm to make foreign exchange gains and
losses the responsibility of its foreign subsidiaries, it is not typically considered very
efficient. The subsidiary business unit is typically just that, a business unit, and does not
ordinarily possess the resources of skills sets necessary for good exchange rate risk
management. That said, the strongest argument for placing foreign exchange
responsibilities on the subsidiary unit is that it creates those exposures, and who better to
charge with their minimization and management?
Chapter 8 Transaction Exposure  63
3. What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the
forward rate, and the expectations for the Chinese subsidiary’s financial results by the U.S. parent
company?
Answer: Nearly all multinational companies, like all organizations, operate off of budgets. The
Chinese subsidiary of J&J is no different. Paul Young must put together a strategic
business and marketing plan, combined with a budget, for Xian-Janssen’s coming year.
That is the reality of the situation. The forecast exchange rate for the coming year, the
budget rate, is typically either generated exclusively by corporate or in combination with
input from the specific business unit. Regardless of the process, the final budgeted rate
will be used for all planning, purchasing, and worst of all—formation of expectations. As
is the case with all forecasts, it will prove wrong. Paul Young just hopes it will not be “too
wrong,” and that the direction of the error prove in his business unit’s favor. Once the
budget was set and accepted by the U.S. parent, Paul Young and Xian-Janssen’s results
for the coming year would be carved in stone. They would then be managing the business
to meet the parent company’s expectations, in this case, of 20% growth.
The forward rate is calculated by financial service providers from the current spot rate and
interest differentials. Since the Rmb was fixed to the dollar at this time, and the euro was
continuing to appreciate versus the dollar, Xian-Janssen’s financial results were looking at
weaker and weaker euro results. The forward rate was costing Xian-Janssen more and
more money. Paul Young would feel increasing pressure to forego the hedging in order to
reduce the cost.

4. If you were Paul Young, what would you do?


Answer: This is a very interesting situation. If Paul Young actually has the ability to not hedge his
European cost of good sold, many students will argue that it is worth “the risk” of going
unhedged. One might argue, however, that there should be greater risk associated with
running a business unit without hedging its primary cost of goods old as opposed to the
declining margins on properly hedged purchases. In the case of going hedged and
suffering the higher costs, the primary downside is the wrath of not meeting the parent
company’s expected sales or profits for the year. The downside of going unhedged, and
then suffering some significant adverse exchange rate changes, could very well be much
much worse.