CH 08

Chapter 8
Transaction Exposure
Prepared by Shafiq Jadallah
To Accompany
Fundamentals of Multinational Finance
Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman
Copyright © 2003 Pearson Education, Inc. Slide 8-1
Chapter 8
Transaction Exposure
 Learning Objectives
• Distinguish between the three major foreign exchange
exposures experienced by firms
• Identify foreign exchange transaction exposure
• Analyze the pros and cons of hedging foreign
exchange transaction exposure
• Identify the alternatives available to a firm for
managing a large and significant transaction exposure
• Evaluate the institutional practices and concerns of
foreign exchange risk management

Foreign Exchange Exposure
 Foreign exchange exposure is a measure of the
potential for a firm’s profitability, net cash flow, and
market value to change because of a change in
exchange rates
• These three components are the key financial elements
of how we view a firm’s success, thus a financial
manager must know how to limit the firm’s exposure
to changes in exchange rates

 Types of foreign exchange exposure
• Transaction Exposure – measures changes in the
value of outstanding financial obligations incurred
prior to a change in exchange rates but not due to be
settled until after the exchange rate changes
• Operating Exposure – also called economic exposure,
measures the change in the present value of the firm
resulting from any change in expected future operating
cash flows caused by an unexpected change in
exchange rates

• Translation Exposure – also called accounting
exposure, is the potential for accounting derived
changes in owner’s equity to occur because of the need
to “translate” financial statements of foreign
subsidiaries into a single reporting currency for
consolidated financial statements
• Tax Exposure – the tax consequence of foreign
exchange exposure varies by country, however as a
general rule only realized foreign losses are deductible
for purposes of calculating income taxes

Moment in time when exchange rate changes
Accounting exposure Operating exposure

Changes in reported owners’ equity Change in expected future cash flows
in consolidated financial statements arising from an unexpected change in
caused by a change in exchange rates exchange rates
Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates
Time

Why Hedge - the Pros & Cons
 Opponents of hedging give the following reasons:
• Shareholders are more capable of diversifying risk
than the management of a firm; if stockholders do not
wish to accept the currency risk of any specific firm,
they can diversify their portfolios to manage that risk
• Currency risk management does not increase the
expected cash flows of a firm; currency risk
management normally consumes resources thus
reducing cash flow
• Management often conducts hedging activities that
benefit management at the expense of shareholders

 Opponents of hedging give the following reasons (continued):
• Managers cannot outguess the market; if and when markets are in
equilibrium with respect to parity conditions, the expected NPV of
hedging is zero
• 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
statements than for incurring similar or even higher cash cost in
avoiding the foreign exchange loss
• 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

 Proponents of hedging give the following reasons:
• Reduction in the risk of future cash flows improves the
planning capability of the firm
• Reduction of risk in future cash flows reduces the
likelihood that the firm’s cash flows will fall below a
necessary minimum
• Management has a comparative advantage over the
individual investor in knowing the actual currency risk
of the firm
• Markets are usually in disequilibirum because of
structural and institutional imperfections

Hedged
Unhedged
NCF Expected Value, E(V) Net Cash Flow (NCF)
Hedging reduces the variability of expected cash flows about the mean of the distribution.
This reduction of distribution variance is a reduction of risk.

Measurement of Transaction Exposure
 Transaction exposure measures gains or losses that
arise from the settlement of existing financial
obligations, namely
• Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
• Borrowing or lending funds when repayment is to be
made in a foreign currency
• Being a party to an unperformed forward contract and
• Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies

Purchasing or Selling on Open Account
 Suppose Trident Corporation sells merchandise on open
account to a Belgian buyer for €1,800,000 payable in 60 days
 Further assume that the spot rate is $0.9000/€ and Trident
expects to exchange the euros for €1,800,000 x $0.9000/€ =
$1,620,000 when payment is received
• Transaction exposure arises because of the risk that Trident will
something other than $1,620,000 expected
• If the euro weakens to $0.8500/€, then Trident will receive
$1,530,000
• If the euro strengthens to $0.9600/€, then Trident will receive
$1,728,000

 Trident might have avoided transaction exposure by
invoicing the Belgian buyer in US dollars, but this
might have lead to Trident not being able to book the
sale
 Even if the Belgian buyer agrees to pay in dollars,
however, Trident has not eliminated transaction
exposure, instead it has transferred it to the Belgian
buyer whose dollar account payable has an unknown
euro value in 60 days

Life Span of a Transaction Exposure
t1 t2 t3 t4
Seller quotes a Buyer places Seller ships Buyer settles
price to buyer firm order with product and A/R with cash
seller at bills buyer in amount of
offered price currency
quoted at t1
Quotation Exposure Backlog Exposure Billing Exposure

Time between quoting Time it takes to fill the Time it takes to get
a price and reaching a order after contract is paid in cash after A/R
contractual sale signed is issued

Borrowing and Lending
 A second example of transaction exposure arises
when funds are loaned or borrowed
 Example: PepsiCo’s largest bottler outside the US is
located in Mexico, Grupo Embotellador de Mexico
(Gemex)
• On 12/94, Gemex had US dollar denominated debt of
$264 million
• The Mexican peso (Ps) was pegged at Ps$3.45/US$
• On 12/22/94, the government allowed the peso to float
due to internal pressures and it sank to Ps$4.65/US$

Borrowing and Lending
 Gemex’s peso obligation now looked like this
• Dollar debt mid-December, 1994:
– US$264,000,000  Ps$3.45/US$ = Ps$910,800,000
• Dollar debt in mid-January, 1995:
– US$264,000,000  Ps$5.50/US$ = Ps$1,452,000,000
• Dollar debt increase measured in Ps
– Ps$541,200,000
 Gemex’s dollar obligation increased by 59% due to
transaction exposure

Other Causes of Transaction Exposure
 When a firm buys a forward exchange contract, it
deliberately creates transaction exposure; this risk is
incurred to hedge an existing exposure
• Example: US firm wants to offset transaction exposure
of ¥100 million to pay for an import from Japan in 90
days
• Firm can purchase ¥100 million in forward market to
cover payment in 90 days

Contractual Hedges
 Transaction exposure can be managed by contractual,
operating, or financial hedges
 The main contractual hedges employ forward, money, futures
and options markets
 Operating and financial hedges use risk-sharing agreements,
leads and lags in payment terms, swaps, and other strategies
 A natural hedge refers to an offsetting operating cash flow, a
payable arising from the conduct of business
 A financial hedge refers to either an offsetting debt obligation
or some type of financial derivative such as a swap

Trident’s Transaction Exposure
 Maria Gonzalez, CFO of Trident, has just concluded a
sale to Regency, a British firm, for £1,000,000
 The sale is made in March for settlement due in three
months time, June
• Assumptions
– Spot rate is $1.7640/£
– 3 month forward rate is $1.7540/£ (a 2.2676% discount)
– Trident’s cost of capital is 12.0%
– UK 3 month borrowing rate is 10.0% p.a.
– UK 3 month investing rate is 8.0% p.a.

• Assumptions
– US 3 month borrowing rate is 8.0% p.a.
– US 3 month investing rate is 6.0% p.a.
– June put option in OTC market for £1,000,000; strike
price $1.75; 1.5% premium
– Trident’s foreign exchange advisory service forecasts
future spot rate in 3 months to be $1.7600/£
 Trident operates on thin margins and Maria wants to
secure the most amount of US dollars; her budget
rate (lowest acceptable amount) is $1.7000/£

 Maria faces four possibilities:
• Remain unhedged
• Hedge in the forward market
• Hedge in the money market
• Hedge in the options market

 Unhedged position
• Maria may decide to accept the transaction risk
• If she believes that the future spot rate will be $1.76/£,
then Trident will receive £1,000,000 x $1.76/£ =
$1,760,000 in 3 months time
• However, if the future spot rate is $1.65/£, Trident will
receive only $1,650,000 well below the budget rate

 Forward Market hedge
• A forward hedge involves a forward or futures contract
and a source of funds to fulfill the contract
• The forward contract is entered at the time the A/R is
created, in this case in March
• When this sale is booked, it is recorded at the spot rate.
• In this case the A/R is recorded at a spot rate of
$1.7640/£, thus $1,764,000 is recorded as a sale for
Trident
• If Trident does not have an offsetting A/P in the same
amount, then the firm is considered uncovered

 Forward Market hedge
• Should Maria want to cover this exposure with a forward
contract, then she will sell £1,000,000 forward today at the 3
month rate of $1.7540/£
• She is now “covered” and Trident no longer has any transaction
exposure
• In 3 months, Trident will received £1,000,000 and exchange
those pounds at $1.7540/£ receiving $1,754,000
• This sum is $6,000 less than the uncertain $1,760,000 expected
from the unhedged position
• This would be recorded in Trident’s books as a foreign exchange
loss of $10,000 ($1,764,000 as booked, $1,754,000 as settled)

 Money Market hedge
• A money market hedge also includes a contract and a
source of funds, similar to a forward contract
• In this case, the contract is a loan agreement
– The firm borrows in one currency and exchanges the
proceeds for another currency
– Hedges can be left “open” (i.e. no investment) or
“closed” (i.e. investment)

• To hedge in the money market, Maria will borrow
pounds in London, convert the pounds to dollars and
repay the pound loan with the proceeds from the sale
– To calculate how much to borrow, Maria needs to
discount the PV of the £1,000,000 to today
– £1,000,000/1.025 = £975,610
– Maria should borrow £975,610 today and in 3 months
time repay this amount plus £24,390 in interest
(£1,000,000) from the proceeds of the sale

– Trident would exchange the £975,610 at the spot rate of
$1.7640/£ and receive $1,720,976 at once
– This hedge creates a pound denominated liability that is
offset with a pound denominated asset thus creating a
balance sheet hedge
Assets Liabilities and Net Worth
Account receivable £1,000,000 Bank loan (principal) £ 975,610

Interest payable 24,390
£1,000,000 £1,000,000

 In order to compare the forward hedge with the
money market hedge, Maria must analyze the use of
the loan proceeds
• Remember that the loan proceeds may be used today,
but the funds for the forward contract may not
• Because the funds are relatively certain, comparison is
possible in order to make a decision
• Three logical choices exist for an assumed investment
rate for the next 3 months

 First, if Trident is cash rich the loan proceeds might be
invested at the US rate of 6.0% p.a.
 Second, Maria could use the loan proceeds to substitute an
equal dollar loan that Trident would have otherwise taken for
working capital needs at a rate of 8.0% p.a.
 Third, Maria might invest the loan proceeds in the firm itself
in which case the cost of capital is 12.0% p.a.
Received today Invested in Rate Future value in 3 months
$1,720,976 Treasury bill 6% p.a. or 1.5%/quarter $1,746,791
$1,720,976 Debt cost 8% p.a. or 2.0%/quarter $1,755,396
$1,720,976 Cost of capital 12% p.a. or 3.0%/quarter $1,772,605

 Because the proceeds in 3 months from the forward
hedge will be $1,754,000, the money market hedge is
superior to the forward hedge if Maria used the
proceeds to replace a dollar loan (8%) or conduct
general business operations (12%)
 The forward hedge would be preferable if Maria were
to just invest the loan proceeds (6%)
 We will assume she uses the cost of capital as the
reinvestment rate

 A breakeven investment rate can be calculated in
order to forgo numerous calculations and still aid
Maria in her decision
(Loan proceeds) (1  rate)  (forward proceeds)
$1,720,976 (1  r)  $1,754,000
r  0.0192
 To convert this 3 month rate to an annual rate,
360
0.0192 x x 100  7.68%
90

 In other words, if Maria can invest the loan proceeds
at a rate equal to or greater than 7.68% p.a. then the
money market hedge will be superior to the forward
hedge
 The following chart shows the value of Trident’s A/R
over a range of possible spot rates both uncovered
and covered using the previously mentioned
alternatives

Value in US dollars of
Trident’s £1,000,000 A/R Uncovered yields
whatever the ending
1.84 Forward rate spot rate is in 90 days
is $1.7540/£
1.82
1.80
Money market hedge
yields $1,772,605
1.78
1.76
1.74
Forward contract hedge
yields $1,754,000
1.72
1.70
1.68
1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86
Copyright © 2003 Pearson Education, Inc.

Ending spot exchange rate (US$/£) Slide 8-33
 Option market hedge
• Maria could also cover the £1,000,000 exposure by
purchasing a put option. This allows her to speculate
on the upside potential for appreciation of the pound
while limiting her downside risk
– Given the quote earlier, Maria could purchase 3 month
put option at an ATM strike price of $1.75/£ and a
premium of 1.5%
– The cost of this option would be
(Size of option) x (premium) x (spot rate)  cost of option
£1,000,000 x 0.015 x $1.7640  $26,460
 Because we are using future value to compare the various
hedging alternatives, it is necessary to project the cost of the
option in 3 months forward
 Using a cost of capital of 12% p.a. or 3.0% per quarter, the
premium cost of the option as of June would be
– $26,460  1.03 = $27,254
 Since the upside potential is unlimited, Trident would not
exercise its option at any rate above $1.75/£ and would
purchase pounds on the spot market
 If for example, the spot rate of $1.76/£ materializes, Trident
would exchange pounds on the spot market to receive
£1,000,000  $1.76/£ = $1,760,000 less the premium of the
option ($27,254) netting $1,732,746

 Unlike the unhedged alternative, Maria has limited
downside with the option
 Should the pound depreciate below $1.75/£, Maria
would exercise her option and exchange her
£1,000,000 at $1.75/£ receiving $1,750,000
• Less the premium of the option, Maria nets $1,722,746
• Although this downside is less than that of the forward
or money market hedge, the upside potential is not
limited

 As with the forward and money market hedges, Maria
can also calculate her breakeven price on the option
• The upper bound of the range is determined by
comparison of the forward rate
– The pound must appreciate above $1.754/£ forward rate
plus the cost of the option, $0.0273/£, to $1.7813/£
• The lower bound of the range is determined in a
similar manner
– If the pound depreciates below $1.75/£, the net proceeds
would be $1.75/£ less the cost of $0.0273/£ or $1.722/£

Value in US dollars of
Trident’s £1,000,000 A/R
Uncovered
1.84 Forward rate
is $1.7540/£
1.82
ATM put option
1.80
Money market
1.78
1.76
1.74
Forward contract
1.72
1.70
1.68
1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86
Copyright © 2003 Pearson Education, Inc.

Ending spot exchange rate (US$/£) Slide 8-38
Put Option Strike Price ATM Option $1.75/£
Option cost (future cost) $27,254
Proceeds if exercised $1,750,000
Minimum net proceeds $1,722,746
Maximum net proceeds unlimited
Breakeven spot rate (upside) $1.7813/£
Breakeven spot rate (downside) $1.7221/£

Strategy Choice and Outcome
 Trident, like all firms, must decide on a strategy to
undertake before the exchange rate changes but how
will Maria choose among the strategies?
 Two criteria can be utilized to help Maria choose her
strategy
• Risk tolerance - of the firm,as expressed in its stated
policies and
• Viewpoint – Maria’s own view on the expected
direction and distance of the exchange rate

 After all the strategies have been explained, Trident
now needs to compare the alternatives and their
outcomes in order to choose a strategy
 There were four alternatives available to manage this
account receivable and Maria has a budget rate at
which she cannot fall below on this transaction

Hedging Strategy Outcome/Payout
Remain uncovered Unknown
Forward Contract hedge @ $1.754/£ $1,754,000
Money market hedge @ 8% p.a. $1,755,396
Money market hedge @ 12% p.a. $1,772,605
Put option hedge @ strike $1.75/£

Minimum if exercised $1,722,746
Maximum if not exercised Unlimited

Managing an Account Payable
 Just as Maria’s alternatives for managing the
receivable, the choices are the same for managing a
payable
• Assume that the £1,000,000 was an account payable in
90 days
 Remain unhedged – Trident could wait the 90 days
and at that time exchange dollars for pounds to pay
the obligation
• If the spot rate is $1.76/£ then Trident would pay
$1,760,000 but this amount is not certain

 Use a forward market hedge – Trident could purchase
a forward contract locking in the $1.754/£ rate
ensuring that their obligation will not be more than
$1,754,000
 Use a money market hedge – this hedge is distinctly
different for a payable than a receivable
• Here Trident would exchange US dollars spot and
invest them for 90 days in pounds
• The pound obligation for Trident is now offset by a
pound asset for Trident with matching maturity

 Using a money market hedge –
• To ensure that exactly £1,000,000 will be received in
90 days time, Maria discounts the principal by 8% p.a.
£1,000,000
 £980,392.16
  90 
1   .08 x 360 
  
• This £980,392.16 would require $1,729,411.77 at the

current spot rate
£980,392.16 x $1.7640/£  $1,729,411.77
 Using a money market hedge –
• Finally, carry the cost forward 90 days in order to
compare the payout from the money market hedge
  90 
$1,729,411.77 x 1   0.12 x   $1,781,294.12
  360 
• This is higher than the forward hedge of $1,754,000

thus unattractive

 Using an option hedge – instead of purchasing a put
as with a receivable, Maria would want to purchase a
call option on the payable
• The terms of an ATM call option with strike price of
$1,75/£ would be a 1.5% premium
£1,000,000 x 0.015 x $1.75/£  $26,460

• Carried forward 90 days the premium amount is comes
to $27,254

 Using an option hedge –
• If the spot rate is less than $1.75/£ then the option
would be allowed to expire and the £1,000,000 would
be purchased on the spot market
• If the spot rate rises above $1.75/£ then the option
would be exercised and Trident would exchange the
£1,000,000 at $1.75/£ less the option premium for the
payable
Exercise call option (£1,000,000  $1.75/£ $1,750,000
Call option premium (carried forward 90 days) $27,254
Total maximum expense of call option hedge $1,777,254

Risk Management in Practice
 Which Goals?
• The treasury function of most firms is usual considered a cost
center; it is not expected to add to the bottom line
• However, in practice some firms’ treasuries have become
aggressive in currency management and act as profit centers
 Which Exposures?
• Transaction exposures exist before they are actually booked yet
some firms do not hedge this backlog exposure
• However, some firms are selectively hedging these backlog
exposures and anticipated exposures

Risk Management in Practice
 Which Contractual Hedges?
• Transaction exposure management programs are
generally divided along an “option-line;” those which
use options and those that do not
• Also, these programs vary in the amount of risk
covered; these proportional hedges are policies that
state which proportion and type of exposure is to be
hedged by the treasury

Summary of Learning Objectives
 MNEs encounter three types of currency exposure: (1)
transaction; (2) operating; and (3) translation exposure
 Transaction exposure measures gains or losses that arise from
the settlement of financial obligations whose terms are stated
in a foreign currency
 Operating exposure measures the change in the present value
of the firm resulting from any change in future operating cash
flows caused by an unexpected change in exchange rates
 Translation exposure is the potential for accounting-oriented
changes in owner’s equity when a firm translates foreign
subsidiaries’ financial statements to consolidated financial
statements

 Transaction exposure arises from (1) purchasing or
selling on credit and prices are stated in foreign
currencies; (2) borrowing or lending funds when
repayment is to be made in a foreign currency; (3)
being party to an unperformed forward contract; and
(4) otherwise acquiring assets or liabilities
denominated in foreign currencies
 Considerable theoretical debate exists as to whether
or not firms should hedge currency risk

• Transaction exposure can be managed by
contractual techniques and certain operating
strategies. Contractual techniques include forward
contracts, money market and option hedges
• The choice of which hedge to use depends on the
individual firm’s currency risk tolerance and its
expectations of the probable movement of
exchange rates over the transaction exposure
period

 In general, if an exchange rate is expected to move in
a firm’s favor, the preferred contractual hedges are
those which allow the firm to participate in some of
the upside potential, but protect it against adverse
exchange rate movements
 In general, if an exchange rate is expected to move
against the firm, the preferred contractual hedge is
one which locks-in an exchange rate

 Risk management in practice requires a firm’s
treasury department to identify its goals. Is the
treasury a cost or a profit center?
 Treasury must also choose which contractual hedges
it wishes to use and what proportion of the currency
risk should be hedged. Additionally, treasury must
determine whether the firm should buy and/or sell
currency options, a strategy that has historically been
risky for some firms and banks

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Chapter 8

Prepared by Shafiq Jadallah

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Accounting exposure Operating exposure

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NCF Expected Value, E(V) Net Cash Flow (NCF)

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Quotation Exposure Backlog Exposure Billing Exposure

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Account receivable £1,000,000 Bank loan (principal) £ 975,610

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$1,720,976 Treasury bill 6% p.a. or 1.5%/quarter $1,746,791

$1,720,976 Debt cost 8% p.a. or 2.0%/quarter $1,755,396

$1,720,976 Cost of capital 12% p.a. or 3.0%/quarter $1,772,605

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Put Option Strike Price ATM Option $1.75/£

Option cost (future cost) $27,254

Proceeds if exercised $1,750,000

Minimum net proceeds $1,722,746

Maximum net proceeds unlimited

Breakeven spot rate (upside) $1.7813/£

Breakeven spot rate (downside) $1.7221/£

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Remain uncovered Unknown

Forward Contract hedge @ $1.754/£ $1,754,000

Money market hedge @ 8% p.a. $1,755,396

Money market hedge @ 12% p.a. $1,772,605

Put option hedge @ strike $1.75/£

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