Management of

Transaction Exposure 8
Week Eight

Objective:

Today’s class discusses various methods available

for the management of one type of exchange
rate exposure—transaction exposure—faced by
multinational firms.

9-1
 Outline
• Forward Market Hedge
• Money Market Hedge
• Options Market Hedge
• Cross-Hedging Minor Currency Exposure
• Hedging Contingent Exposure

9-2
 Transaction Exposure
• Transaction exposure (Ch. 8)
– Measures how exchange rate changes affect the
domestic currency values of a firm’s contractual
cash flows denominated in foreign currency.

• Other types of exposure to be discussed in Ch.

9.

9-3
 Transaction exposure: An Example
You are a U.S. importer of British wool and have
just ordered next year’s inventory. Payment of
£100M is due in one year.

Question: How is the US$ value of the

importer’s payables affected by the $/£
exchange rate?

9-4
Transaction exposure: An Example
Payables
($)
Unhedged
$180m payable

$150m

$120m
Value of £1 in
$ in one year

$1.20/£ $1.50/£ $1.80/£

9-5
 Forward Market Hedge
• Question: How can you fix the cash outflow in
dollars using a forward contract?

What’s the answer?

(A) Buy pounds forward, or
(B) Sell pounds forward ?

9-6
 Forward Market Hedge
Payables
($) Unhedged
position

Assuming the $180m

forward Hedged
exchange rate $150m position
with
is $1.50/£.
Forward
$120m
Value of £1 in
$ in one year

$1.20/£ $1.50/£ $1.80/£

9-7
 Forward Market Hedge
• The forward market hedge fixes the amount of
dollar payables, i.e., it removes the
transaction exposure completely.

• Is this always desirable?

– Before the future spot rate is known:

– After the future spot rate is known:

9-8
 Forward Market Hedge: A
Summary
• If you are going to owe foreign currency in the
future, lock in the purchase price (in dollars)
of the foreign currency now by entering into a
long position of a forward contract.
• If you are going to receive foreign currency in
the future, lock in the sale price (in dollars) of
the foreign currency now by entering into a
short position of a forward contract.

9-9
 Money Market Hedge
• To hedge a foreign currency payable, buy a bunch of
that foreign currency today and sit on it.
– Buy today the present value of the foreign
currency payable, and invest that amount at the
foreign interest rate.
– At maturity your investment will have grown
enough to cover your foreign currency payable.

9-10
 Money Market Hedge
Suppose you want to hedge a payable in the
amount of £1, maturing in 1 year:
i. Borrow $x at t = 0 on a loan at a rate of i$ per year.
£1
$x = S($/£) × (1+ i )
£
Repay the loan in 1 year
$x –$x(1 + i$)

0 1

9-11
 Money Market Hedge
£1
ii. At t = 0, exchange the borrowed $x for
(1+ i£)
at the prevailing spot rate.
£1
iii. At t = 0, invest at i£ for 1 year.
(1+ i£)

iv. At maturity, your British investments will have grown

to £1. This amount will be just enough to service your
payable.

v. At the same time, you need to repay $x(1 + i$).

 Money Market Hedge: An Example
A U.S.–based importer of Italian bicycles
– In one year owes €100,000 to an Italian supplier.
– The spot exchange rate is $1.50 = €1.00
– The one-year interest rate in Italy is i€ = 4%
– The one-year interest rate in the U.S. is i$ = 3%
€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)
$1.50
Dollar cost today = $144,230.77 = €96,153.85 × €1.00

9-13
 Money Market Hedge: An Example
• With this money market hedge, we have
redenominated a one-year €100,000 payable into a
$144,230.77 payable due today.
• To convert it to a dollar payable due in one year, we
could borrow the $144,230.77 today and owe in one
year

$148,557.69 = $144,230.77 × (1.03)

€100,000
$148,557.69 = S($/€)× T × (1+ i$)T
(1+ i€)

9-14
 Money Market Hedge: An Example
• In sum, you have used a money market hedge to turn
your pound payable of £1 in one year’s time into a
dollar payable of $x(1 + i$) in one year’s time.
• In this sense, a money market hedge achieves the same
purpose as a forward market hedge—by turning a fixed
foreign currency payable into a fixed domestic currency
payable.
• But are the two different ways to hedge offered at the
same price?

9-15
 Forward Market vs.Money Market Hedges

• The forward market hedge locks in the future price of

£1at $F.
• For the money market hedge, recall that it turns a
pound payable of £1 at time T into a dollar payable of
$x(1 + i$) at time T,
– where £1
$x = S($/£) ×
(1+ i£)
– Thus, the money market hedge turns each pound of payable
at time T
into a dollar payable of $(1 + i$) S($/£)
(1+ i£)

9-16
 Forward Market vs.
Money Market Hedges
• Thus, each pound costs $F using the forward market

hedge, and each pound costs $(1 + i$) S($/£)

using the money market hedge. (1+ i£)

S($/£)
• What is the relationship between F and (1 + i$)
(1+ i£)
if the two different ways to hedge are to be offered at
the same cost?

9-17
 Options Market Hedge
• Options provide a flexible hedge against the
downside, while preserving the upside
potential (because you only exercise an option
when it is in the money).
• Of course, this flexibility comes at a cost (i.e.,
option premium).

9-18
 Options Market Hedge
Suppose the
forward exchange
rate is $1.50/£.
If an importer who
$30m
owes £100m does
not hedge the
payable, in one
$0
year his gain (loss) Value of £1 in
on the unhedged $1.20/£ $1.50/ $1.80/£$ in one year
position relative £
–$30m
to a forward
market hedge is Unhedged
shown in green. payable
9-19
 Options Market Hedge
• Surely, using a forward market hedge avoids
the possibility of loss when the pound
appreciates beyond $1.50/£.
• But it also eliminates the possibility of gain if
the pound depreciates below $1.50/£.
(Note: the gain/loss line for forward market
hedge is just a horizontal line at $0.)

9-20
 Options Markets Hedge
Profit Long call on
Suppose our
importer buys a £100m
call option on
£100m with an
exercise price of
$1.50 per pound.
He pays $.05 per –$5m Value of £1 in
pound for the call. $1.55/ $ in one year
$1.50/
£
£

loss

9-21
 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 depreciation
of the pound –$5m Value of £1 in
below $1.45/£. $1.20/£ $ in one year
$1.45
/£
$1.50/ Unhedged
loss £ payable
9-22
 Options Markets Hedge
But he also has a Profit Long call on
hedge against a £100m
pound
appreciation.
$25
The option price m
of $5m paid up
front can be –$5 m
thought of as an Value of £1 in
$1.80/£$ in one year
insurance $1.45/£
premium. –$30
m
$1.50/ Unhedged
loss £ payable
9-23
 Hedging Exports with Put Options
• Graph the unhedged gain/loss of an exporter who is
owed £1 million in one year, relative to a forward
market hedge. The current one-year forward rate is
$2/£.
• Suppose the exporter buys a put option written on
£1 million with a maturity of one year and a strike
price of $2/£. The cost of this option is $0.05 per
pound.
– Graph the profit/loss from this put option.
– Graph the gain/loss on the option market hedge of the
receivable, relative to a forward market hedge.

9-24
 Options Market Hedge:
Exporter buys a put option to protect the dollar
value of his receivable.

$1,950,000

S($/£)360
–$50k
Long put
$2 $2.05

–$2m
 Options Markets Hedge: Summary
IMPORTERS who OWE
foreign currency in the future
should BUY CALL OPTIONS.
– If the price of the foreign
currency goes up, his call will
lock in an upper limit on the
dollar cost of his imports.
– If the price of the foreign
currency goes down, he will
have the option to buy the
foreign currency (in the spot
market) at a lower price.
9-26
EXPORTERS with accounts
receivable denominated in foreign
currency should BUY PUT
OPTIONS.
– If the price of the foreign 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 (in the spot market)
at a higher price.
 Hedging Contingent Exposure
• Contingent exposure: whether or not a firm is
subject to exchange rate exposure depends on
the outcome of uncertain events.
• For example, if your firm is bidding on a
hydroelectric dam project in Canada, you will
need to hedge the Canadian dollar receivables
(C$100 million) only if your bid wins the
contract.

9-27
 Hedging Contingent Exposure
• Under such contingent exposure, should the
firm leave the exposure unhedged, use a
forward market hedge, or use an option
market hedge?

9-28
 Hedging Contingent Exposure

9-29
 Cross-Hedging
• Forward, furtures, or options contracts are
readily available for major currencies such as
the US$, Japanese yen, British pound, and the
euro.
• For other currencies, such contracts may not
be available. Even if they are, they may be
very costly.
• A potential solution: Cross-Hedging

9-30
 Cross-Hedging
• Cross-hedging: hedging a position in one asset
by taking a position in another asset.
• E.g. A U.S. company hedges a Korean won
receivable by selling Japanese yen forward.
– Rationale: the dollar/won and the dollar/yen
exchange rates are highly correlated with each
other.
– Limitation:

9-31
 Exercise 1
• You plan to visit Geneva, Switzerland, in three months to
attend an international business conference. You expect
to incur a total cost of SF5,000 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 an exercise price 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 three-
month interest rate is 6 percent per annum in the United
States and 4 percent per annum in Switzerland.

8-32
 Exercise 1 (Cont’d)
a. Calculate your expected dollar cost of buying SF5,000 if
you choose to hedge by a 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 cost of meeting the SF
payable against the future spot exchange rate under
both the options and forward market hedges.
8-33
 Exercise 2
• Suppose that Melbourne Industries sold a drilling machine
to a Swiss firm and gave the Swiss client a choice of paying
either A$11,000 or SF15,000 in three months.
a. In the example, Melbourne Industries effectively gave the
Swiss client a free option to buy up to A$11,000 using Swiss
francs. What is the “implied” exercise exchange rate?
b. If the spot exchange rate turns out to be A$0.70/SF, which
currency do you think the Swiss client will choose to use for
payment? What is the value of this free option for the Swiss
client?
c. What is the best way for Melbourne Industries to deal with
exchange exposure?

8-34
 End of Week 8

9-35