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Managing Transaction ExposureManaging Transaction Exposure

1111ChapterChapter

South-Western/Thomson Learning 2003

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Chapter Objectives

To identify the commonly usedtechniques for hedging transaction

exposure;

To explain how each technique can beused to hedge future payables and

receivables; To compare the advantages and

disadvantages of the identified hedging

techniques; and

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Chapter Objectives

To suggest other methods ofreducing exchange rate risk when

hedging techniques are not available.

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Transaction exposure exists when thefuture cash transactions of a firm are

affected by exchange rate fluctuations.

When transaction exposure exists, thefirm faces three major tasks:

Identify its degree of transaction exposure,

Decide whether to hedge its exposure, and

Choose among the available hedging

techniques if it decides on hedging.

Transaction Exposure

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Identifying Net Transaction Exposure

Centralized Approach - A centralizedgroup consolidates subsidiary reports to

identify, for the MNC as a whole, theexpected net positions in each foreign

currency for the upcoming period(s).

Note that sometimes, a firm may be able toreduce its transaction exposure by pricingsome of its exports in the same currency

as that needed to pay for its imports.

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Techniques to Eliminate


Hedging techniques include: Futures hedge,

Forward hedge, Money market hedge, and

Currency option hedge.

MNCs will normally compare the cashflows that could be expected from each

hedging technique before determining

which technique to apply.

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Afutures hedge involves the use ofcurrency futures.

To hedge future payables, the firm maypurchase a currency futures contract for

the currency that it will be needing.

To hedge future receivables, the firm maysell a currency futures contract for the

currency that it will be receiving.



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Aforward hedge differs from a futureshedge in that forward contracts are used

instead of futures contract to lock in thefuture exchange rate at which the firm will

buy or sell a currency.

R

ecall that forward contracts are commonfor large transactions, while the

standardized futures contracts involve

smaller amounts.



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An exposure to exchange rate movementsneed not necessarily be hedged, despite

the ease of futures and forward hedging.

Based on the firms degree of riskaversion, the hedge-versus-no-hedge

decision can be made by comparing theknown result of hedging to the possible

results of remaining unhedged.



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Real cost ofhedging payables (RCHp) =

+ nominal cost of payables with hedging

nominal cost of payables withouthedging

Real cost ofhedging receivables (RCHr) =

+

nominal home currency revenuesreceived without hedging

nominal home currency revenuesreceived with hedging



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If the real cost of hedging is negative, thenhedging is more favorable than not

hedging.

To compute the expected value of the realcost of hedging, first develop a probability

distribution for the future spot rate, andthen use it to develop a probability

distribution for the real cost of hedging.



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If the forward rate is an accurate predictorof the future spot rate, the real cost of

hedging will be zero.

If the forward rate is an unbiased predictorof the future spot rate, the real cost of

hedging will be zero on average.



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Amoneymarket hedge involves takingone or more money market position to

cover a transaction exposure.

Often, two positions are required. Payables: Borrow in the home currency,

and

invest in the foreign currency. Receivables: borrow in the foreign

currency, and invest in the home

currency.



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Note that taking just one money marketposition may be sufficient.

A firm that has excess cash need notborrow in the home currency when hedging

payables.

Similarly, a firm that is in need of cashneed not invest in the home currency

money market when hedging receivables.



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The known results of money markethedging can be compared with the known

results of forward or futures hedging todetermine which the type of hedging that

is preferable.



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If interest rate parity (IRP) holds, andtransaction costs do not exist, a money

market hedge will yield the same result asa forward hedge.

This is so because the forward premium

on a forward rate reflects the interest ratedifferential between the two currencies.



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Acurrency option hedge involves the useof currency call or put options to hedge

transaction exposure.

Since options need not be exercised, firmswill be insulated from adverse exchange

rate movements, and may still benefit fromfavorable movements.

However, the firm must assess whetherthe premium paid is worthwhile.



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Hedging Payables HedgingReceivables

Futures Purchase currency Sell currency

hedge futures contract(s). futures contract(s).Forward Negotiate forward Negotiate forwardhedge contract to buy contract to sell

foreign currency. foreign currency.

Money Borrow local Borrow foreign

market currency. Convert currency. Converthedge to and then invest to and then invest

in foreign currency. in local currency.

Currency Purchase currency Purchase currencyoption call option(s). put option(s).



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A comparison of hedging techniquesshould focus on minimizing payables, or

maximizing receivables.

Note that the cash flows associated withcurrency option hedging and remaining

unhedged cannot be determined with

certainty.



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In general, hedging policies vary with theMNC managements degree of risk

aversion and exchange rate forecasts.

The hedging policy of an MNC may be tohedge most of its exposure, none of its

exposure, or to selectively hedge its

exposure.



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Limitations ofHedging

Some international transactions involvean uncertain amount of foreign currency,

such that overhedging may result.

One way of avoiding overhedging is tohedge only the minimum known amount in

the future transaction(s).

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Limitations ofHedging

In the long run, the continual hedging ofrepeated transactions may have limited

effectiveness.

For example, the forward rate often movesin tandem with the spot rate. Thus, an

importer who uses one-period forward

contracts continually will have to pay

increasingly higher prices during a strong-

foreign-currency cycle.

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Hedging Long-Term


MNCs that are certain of having cashflows denominated in foreign currencies

for several years may attempt to use long-term hedging.

Three commonly used techniques forlong-term hedging are:

long-term forward contracts,

currency swaps, and

parallel loans.

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Hedging Long-Term


Long-termforward contracts, or longforwards, with maturities of ten years or

more, can be set up for very creditworthycustomers.

Currency swaps can take many forms. Inone form, two parties, with the aid of

brokers, agree to exchange specified

amounts of currencies on specified dates

in the future.

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Aparallel 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.

Hedging Long-Term


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Alternative Hedging Techniques

Sometimes, a perfect hedge is notavailable (or is too expensive) to eliminate

transaction exposure.

To reduce exposure under such acondition, the firm can consider:

leading and lagging,

cross-hedging, or

currency diversification.

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The act ofleading and laggingrefers to anadjustment in the timing of payment

request or disbursement to reflectexpectations about future currency

movements.

Expediting a payment is referred to asleading, while deferring a payment is

termed lagging.

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When a currency cannot be hedged, acurrency that is highly correlated with the

currency of concern may be hedgedinstead.

The stronger the positive correlationbetween the two currencies, the more

effective this cross-hedgingstrategy will

be.

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With currency diversification, the firmdiversifies its business among numerous

countries whose currencies are not highlypositively correlated.

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Impact ofHedging Transaction Exposureon an MNCs Value

? A

v!

n

tt

m

j

tjtj

k1=

1

,,

1

ERECFE

=Value

E (CFj,t) = expected cash flows in currencyjto be received

by the U.S. parent at the end of period t

E (ERj,t) = expected exchange rate at which currencyjcan

be converted to dollars at the end of period t

k=

weighted average cost of capital of the parent

Hedging Decisions onTransaction Exposure

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