11 Managing Transaction Exposure

Chapter Objectives

▪ Compare the techniques commonly used to hedge

payables
▪ 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

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 Policies for Hedging Transaction Exposure

Hedging Most of the Exposure

▪ Hedging most of the transaction exposure allows MNCs to
more accurately forecast future cash flows (in their home
currency) so that they can make better decisions regarding
the amount of financing they will need.
Selective Hedging
▪ MNC must identify its degree of transaction exposure.
▪ MNC must consider the various techniques to hedge the
exposure so that it can decide which hedging technique is
optimal and whether to hedge its transaction exposure.

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 Hedging Exposure to Payables

An MNC may decide to hedge part or all of its

known payables transactions using:
▪ Forward or futures hedge
▪ Money market hedge
▪ Currency option hedge

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 Hedging Exposure to Payables

Forward or Futures Hedge on Payables

▪ Allows an MNC to lock in a specific exchange rate at which
it can purchase a currency and hedge payables. A forward
contract is negotiated between the firm and a financial
institution. The contract will specify the:
▪ currency that the firm will pay
▪ currency that the firm will receive
▪ amount of currency to be received by the firm
▪ rate at which the MNC will exchange currencies (called the
forward rate)
▪ future date at which the exchange of currencies will occur

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 Hedging Exposure to Payables - Example

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 Hedging Exposure to Payables

Money Market Hedge on Payables

▪ Involves taking a money market position to cover a future
payables position.
▪ If a firm prefers to hedge payables without using its cash
balances, then it must
▪ Borrow funds in the home currency and
▪ Invest in
▪ Money market hedge versus forward hedge
▪ Since the results of both hedges are known beforehand, the
firm can implement the more feasible one.
▪ If IRP holds, then both yield the same results.

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 Hedging Exposure to Payables - Example

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 Hedging Exposure to Payables

Call Option Hedge on Payables

▪ A currency call option provides the right to buy a specified
amount of a particular currency at a specified strike price
or exercise price within a given period of time.
▪ The currency call option does not obligate its owner to buy
the currency at that price. The MNC has the flexibility to
let the option expire and obtain the currency at the existing
spot rate when payables are due.

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 Hedging Exposure to Payables

Call Option Hedge on Payables (cont.)

▪ Cost of call options based on contingency graph (Exhibit 11.1)
▪ Advantage: provides an effective hedge
▪ Disadvantage: premium must be paid
▪ Cost of call options based on currency forecasts (Exhibit 11.2)
▪ MNC can incorporate forecasts of the spot rate to more accurately
estimate the cost of hedging with call options.
▪ Consideration of Alternative Call Options
▪ Several different types of call options may be available, with
different exercise prices and premiums for a given currency and
expiration date.
▪ Whatever call option is perceived to be most desirable for hedging
a particular payables position would be analyzed, so that it could
then be compared to the other hedging techniques.
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 Exhibit 11.1 Contingency Graph for Hedging Payables With
Call Options

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 Exhibit 11.2 Use of Currency Call Options to Hedge Euro
Payables (exercise price = $1.20, premium = $.03)

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 Hedging Exposure to Payables

Comparison of Techniques to Hedge Payables

(Exhibit 11.3)
▪ The cost of the forward hedge or money market hedge
can be determined with certainty
▪ The currency call option hedge has different outcomes
depending on the future spot rate at the time payables
are due.

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 Hedging Exposure to Payables

Comparison of Techniques to Hedge Payables

▪ Optimal Technique for Hedging Payables (Exhibit 11.4)
▪ Select optimal hedging technique by:
▪ Consider whether futures or forwards are preferred.
▪ Consider desirability of money market hedge versus futures/forwards
based on cost.
▪ Assess the feasibility of a currency call option based on estimated
cash outflows.
▪ Choose optimal hedge versus no hedge for payables
▪ Even when an MNC knows what its future payables will be, it
may decide not to hedge in some cases.
Evaluate the hedge decision by estimating the real cost of
hedging versus the cost if not hedged.
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 Exhibit 11.3 Comparison of Hedging Alternatives for
Coleman Co.

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 Exhibit 11.4 Graphic Comparison of techniques to
Hedge Payables

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 Evaluating past decisions on Hedging
Payables

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 Hedging Exposure to Receivables

Forward or futures hedge on receivables allows the

MNC to lock in the exchange rate at which it can sell a
specific currency.

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 Hedging Exposure to Receivables

Money market hedge on receivables involves borrowing

the currency that will be received and using the receivables
to pay off the loan.

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 Hedging Exposure to Receivables

Put option hedge on receivables provides the right to sell a

specified amount of a particular currency at a specified strike
price by a specified expiration date.
▪ Cost of Put Options Based on Contingency Graph (Exhibit 11.5)
▪ Advantage: provides an effective hedge
▪ Disadvantage: premium must be paid
▪ Cost of Put Options Based on Currency Forecasts (Exhibit 11.6)
▪ MNC can use currency forecasts to more accurately estimate the
dollar cash inflows to be received when hedging with put options.
▪ Consideration of Alternative Put Options
▪ Several different types of put options may be available that feature
different exercise prices and premiums for a given currency and
expiration date.
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 Exhibit 11.5 Contingency Graph for Hedging Receivables with
Put Options

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 Exhibit 11.6 Use of Currency Put Options for Hedging Swiss
Franc Receivables (exercise price = $.72; premium = $.02)

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 Hedging Exposure to Receivables

Comparison of Techniques for Hedging Receivables

(Exhibit 11.7)
▪ Optimal Technique for Hedging Receivables: (Exhibit 11.8)
▪ Consider whether futures or forwards are preferred.
▪ Consider desirability of money market hedge versus
futures/forwards based on cost.
▪ Assess the feasibility of a currency put option based on estimated
cash outflows.
▪ Optimal hedge versus no hedge on receivables
▪ An MNC may know what its future receivables will be yet still
decide not to hedge. In that case, the MNC needs to determine the
probability distribution of its revenue from receivables when not
hedging

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 Exhibit 11.7 Comparison of Hedging Alternatives for Viner Co.

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 Exhibit 11.8 Graphic Comparison of Techniques to
Hedge Receivables

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 Evaluating past decisions on Hedging
Receivables

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 Hedging Exposure to Receivables

Evaluating the hedge decision by estimating the real cost of

hedging receivables versus the cost of receivables if not
hedged.
Summary of Hedging Techniques (Exhibit 11.9)

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 Exhibit 11.9 Review of Techniques for Hedging Transaction
Exposure

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 Limitations of Hedging

Limitation of Hedging an Uncertain Payment

▪ Some international transactions involve an uncertain amount
of foreign currency, leading to overhedging.

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 Limitations of Hedging

Limitation of Repeated Short-Term Hedging

▪ The continual short-term hedging of repeated transactions
may have limited effectiveness. (Exhibits 11.10 and 11.11)
▪ Long-term Hedging as a Solution
▪ Some banks offer forward contracts for up to 5 or 10 years on
some commonly traded currencies.
▪ Repeated short-term hedging is a parallel loan (also called a
“back-to-back loan”), which involves an exchange of
currencies between two parties with a promise to re-exchange
currencies at a specified exchange rate on a future date.

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 Exhibit 11.10 Repeated Hedging of Foreign Payables When
the Foreign Currency Is Appreciating

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 Exhibit 11.11 Long-Term Hedging of Payables When the
Foreign Currency Is Appreciating

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 Alternative Hedging Techniques

Leading and Lagging: adjusting the timing of a payment or

disbursement to reflect expectations about future currency
movements.

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 Alternative Hedging Techniques

Cross-Hedging: hedging by using a currency that serves as a

proxy for the currency in which the MNC is exposed.

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 Alternative Hedging Techniques

Currency Diversification: reduce exposure by diversifying

business among numerous countries.

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 Question 7

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 Question 7 - Answer

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 Question 11

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 Question 11 - Answer

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 Question 12

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 Question 12 - Answer

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 Question 19

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 Question 19 - Answer

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 Question - 32

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 Question – 32 – part (a) answer

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 Question – 32 – part (b) answer

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 Question 36

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 Question 36 - answer

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