Chapter 9

Managing Transaction Exposure

JOUHARA G. SAN JUAN DR. VIRGILIO V. SALENTES

DBA Student
Professor Lecturer
 Chapter Objectives
• Compare the techniques commonly used to
hedge payable.
• Compare the techniques commonly used to
hedge receivables.
• Describe limitations of hedging .
• Suggest other methods of reducing exchange
rate risk when hedging techniques are not
available.
 Transaction Exposure
• Transaction exposure exists there are
contractual transactions that cause
the MNC to either need or received a
specified amount of foreign currency
at a specified point in the future.
 Hedging Most
of the Selective
Exposure Hedging
• MNC hedge most of their • Involves MNC
exposure so that their considering each type of
value is not highly transaction separately.
influenced by exchange
rates. • They believe that a
• It allows MNC’s to diversified set of
accurately forecast future exposure will limit the
cash flow so that they can actual impact the
make better decisions
regarding the amount of exchange rate will have
financing they will need. on their cash flow during
any period.
 HEDGING EXPOSURE TO PAYABLE
Techniques to Eliminate Transaction Exposure on payables

• Hedging techniques include:

1. Futures hedge, Allows the MNC to lock in a specific exchange rate
at which it can purchase a specific currency and
therefore , allow it to hedge payables denominated
2. Forward hedge, in foreign currency

3. Money market hedge, and

4. Currency option hedge.
• MNCs will normally compare the cash flows that
would be expected from each hedging technique
before determining which technique to apply.
Futures and Forward Hedges on payables
1.Future Hedge on 2. Forward Hedge on
Payable Payable
• A futures hedge uses • forward hedge uses forward
contracts, to lock in the
currency futures.
future exchange rate.
• standardized futures • forward contracts are
contracts tend to be commonly negotiated for
used for smaller large transactions (i.e. MNC
and a commercial bank)
amounts and would
be purchased in an
exchange
 Example:
• Coleman company is a U.S. based MNC that will
need 100,000 euros in 1 year. It could obtain a
forward contract to purchase the euros in 1 year.
The 1 year forward rate is 1.20, the same rate as
currency futures contracts on euros. If Coleman
purchases euros 1 year forward , its dolla cost in
1 year is:
Cost in $=Payable x Forward rate
=100,000 euros x $1.20
=$ 120,000
 3. Money Market Hedge on Payables

• A money market hedge on payables

involves taking a money market position
to cover a future payables position.
• For payables:
1. Borrow in the home currency
(optional)
2. Invest in the foreign currency
Example:
 Money Market Hedge (3)
A firm expects to receive S$400,000 in 90 days.
NOW Borrows at 8.00% 90 days
for 90 days
1. Borrows 3. Owes S$400,000
S$392,157

Effective
exchange rate
Exchange at £0.30/S$ $0.5489/S$ repays

Lends at 7.20% for 90

days
2. Can spend 3. Receives S$400,000
£117,647
 Money Market Hedge VS
Forward hedge
• If interest rate parity (IRP) holds, and
transaction costs do not exist, a money market
hedge will yield the same results as a forward
hedge.
• This is so because the forward premium on a
forward rate reflects the interest rate
differential between the two currencies.
 4. Call option Hedge on Payables
• Provides the right to buy a specified amount of a particular
currency at a specified price (called strike price , or
exercise price within a given period of time)
• A currency call option does not obligate its owner to buy
the currency at that price.
• MNC has the flexibility to let the option expire and obtain
the existing currency at the existing spot rate when
payables are due.
• Currency options are also useful for hedging contingent
exposure.
 4.1 Cost of Call option Based on Contingency Graph
-Contingency graph determine the cost of hedging for various
possible spot rates when payables are due.
 4.2 Cost of Call option Based on Currency Forecast

-An MNC incorporating its own forecasts of the spot rate at the time the
payable are due, so that it can more accurately estimate the cost of
hedging with all call options.
 Comparison of Hedging Techniques
• Hedging techniques are compared to
identify the one that minimizes payables
or maximizes receivables.
• Note that the cash flows associated with
currency option hedging are not known
with certainty but have to be forecasted.
• Several alternative currency options with
different exercise prices are also usually
available.
Comparison of Hedging Techniques for
payables
 Evaluating hedge decision
• Formula:
 HEDGING EXPOSURE TO RECEIVABLES
Techniques to Eliminate Transaction Exposure on receivables

• Hedging techniques include:

Allows the MNC to lock in a specific
1. Futures hedge, exchange rate at which it can sell a specific
currency and therefore , allow it to hedge
2. Forward hedge, receivables denominated in foreign
currency

3. Money market hedge, and

4. Currency option hedge.
 Futures and Forward Hedges on
receivables
1.Future Hedge on 2. Forward Hedge on
Receivables Receivables
• standardized futures • forward contracts are
contracts tend to be used commonly negotiated for
for smaller amounts and large transactions (i.e. MNC
would be sold in an and a commercial bank)
exchange
 3. Money Market Hedge on
Receivables

• A money market hedge on receivables

involves taking a money market
position to cover a future receivables
position.
• For receivables:
1. Borrow in the foreign currency
2. Invest in the home currency (optional)
 4. Put option Hedge on Receivables
• Put options provide an MNC to sell a
specific amount of currency at a specified
exercise price by a specified expiration date.
• MNC can purchase a put option on the
currency denominating its receivables and
lock in the minimum amount that it would
receive when converting the receivables
into its home currency
• An option and not an obligation
 4.1 Cost of Put option Based on Contingency Graph
-Contingency graph illustrates the advantages and disadvantages
of a put option for hedging receivables.
 4.2 Cost of Put option Based on Currency Forecast

-An MNC incorporating its own forecasts of the spot rate at the
time the receivables arrive, so that it can more accurately
estimate the dollar cash inflows to be received when hedging
with put options.
Comparison of Hedging Techniques for
receivables
 Evaluating hedge decision
• Formula:
Summary of hedging techniques
 Limitations of Hedging
• Limitation of Hedging an Uncertain Payment
Some international transactions involve an uncertain
amount of foreign currency, such that over hedging
may result.
– One solution is to hedge only the minimum known amount.
Additionally, the uncertain amount may be hedged using
options.
• Limitation of Repeated Short Term Hedging
In the long run, the continual short-term hedging of
repeated transactions may have limited effectiveness
too.
 Long Term Hedging as a solution

• MNCs that can accurately estimate

foreign currency cash flows for several
years may use long-term hedging
techniques.
1. Long-term forward contracts, or long
forwards, with maturities of up to five
years or more, can be set up for very
creditworthy customers.
 Cont…Solution
2. In a currency swap, two parties, with the aid of
brokers, agree to exchange specified amounts of
currencies on specified dates in the future.
3. A parallel loan, or back-to-back loan, involves an
exchange of currencies between two parties, with a
promise to re-exchange the currencies at a specified
exchange rate and future date.
 Alternative Hedging Techniques

• Sometimes, a perfect hedge is not available (or

is too expensive) to eliminate transaction
exposure.
• To reduce exposure under such conditions, the
firm can consider:
1. leading and lagging
2. cross-hedging
3. currency diversification
 1. Leading and Lagging

• Leading and lagging strategies involve

adjusting the timing of a payment request or
disbursement to reflect expectations about
future currency movements.
• Expediting a payment is referred to as leading,
while deferring a payment is termed lagging.
 2. Cross-Hedging

• When a currency cannot be hedged,

another currency that can be hedged and
is highly correlated may be hedged
instead.
• The stronger the positive correlation
between the two currencies, the more
effective the cross-hedging strategy will
be.
 3. Currency Diversification
• An MNC may reduce its exposure to
exchange rate movements when it
diversifies its business among
numerous countries.
• Currency diversification is more
effective when the currencies are not
highly positively correlated.

***Thank you and God Bless****

 Assessment of Exchange Rate
Exposure by the Sport Exports
Company
• At the current time, Sport Exports Company is
willing to receive in British Pounds for the
monthly export is sends to the United
Kingdom. While all of its receivables are
denominated in pounds, it has no payable in
pounds or in any