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Transaction Exposure
Types of Foreign
Exchange Exposure
11-2
Types of Foreign Exchange
Exposure
• Foreign exchange exposure is a measure of the
potential change for a firm’s profitability, net cash
flow, and market value because of a change in
exchange rates
• An important task for the financial manager is to
measure foreign exchange exposure and to manage it
so as to maximize or stabilize the profitability, net
cash flow, and market value of the firm
• The impact on a firm when foreign exchange rates
change can be classified into three kinds of exposure:
transaction, operating, and translation exposure
11-3
Types of Foreign Exchange
Exposure
• Transaction exposure measures changes in the
value of existing foreign-currency-denominated
obligations, which incurred prior to an exchange
rate change but are not due to be settled until after
the exchange rate change
– According to the above definition, the exchange rate
changes cause the transaction exposure for existing
obligations, which start in the past and end in the
future
• In general, this type of exposure can be defined as
changes in cash flows of current existing
contractual obligations due to the movement of
the exchange rates
11-4
Types of Foreign Exchange
Exposure
• Operating exposure, also called economic exposure,
competitive exposure, or strategic exposure,
measures the change in the present value of the
firm resulting from any change in future operating
cash flows of the firm caused by an unexpected
change in exchange rates
• More specifically, the change in firms’ value
depends on the impact of the exchange rate change
on future sales volume, product prices, and costs in
the following years
11-5
Types of Foreign Exchange
Exposure
• 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” foreign currency financial statements of
foreign subsidiaries into a single reporting currency to
prepare worldwide consolidated financial statements
• This risk arises from that the exchange rates for
acquiring assets, liabilities, and equities are different
from that for generating consolidated financial
statements
• So, comparing to time points of acquiring assets,
liabilities, and equities, changes of the exchange rate at
later time points cause the translation exposure
11-6
Exhibit 11.1 Comparison of Occurrence Time of the
Three Foreign Exchange Exposures on the Time Line
Transaction exposure
Impact of settling existing obligations, which entered into before changes
in exchange rates but to be settled after changes in exchange rates
Time
11-7
Types of Foreign Exchange
Exposure
• Transaction exposure vs. Operating exposure
– Both transaction exposure and operating exposure exist
because of unexpected changes in future cash flows
– The difference between them:
• Transaction exposure is concerned with the uncertainty of
future cash flows which are already contracted
• Operating exposure focuses on expected future cash flows
(not yet contracted) that might change because a change in
exchange rates could alter international competitiveness
11-8
Types of Foreign Exchange
Exposure
• Tax consequence of foreign exchange exposures
– As a general rule, only realized foreign exchange losses are
deductible for calculating income taxes; Similarly, only
realized foreign exchange gains create taxable income
– Losses from transaction exposure usually reduce taxable
income in that year, but losses from operating exposure may
maintain for several years and thus reduce taxable income
over a series of future years
– Note that translation exposure could affect the parent
company’s net worth or net income, but it will not generate
cash losses in practice, i.e., both the parent company and
subsidiaries will not lose any money physically during the
translation of financial statements
– Since losses from translation exposure are only “paper”
losses, involving no cash flows, they are not deductible from
pretax income 11-9
Reasons for Hedging
Foreign Exchange Risk
11-10
Why Hedge?
• MNEs possess a multitude of cash flows that are
sensitive to changes in exchange rates, interest rates,
and commodity prices
– These three financial price risks are the subject of the
growing field of financial risk management
– Here we focus only on the sensitivity of the individual
firm’s future cash flows to exchange rates
• Many firms attempt to manage their currency (foreign
exchange) exposures through hedging
– Hedging is the taking of a position, acquiring either a cash
flow, an asset, or a contract (e.g., a forward contract) that
will rise (fall) in value and offset a fall (rise) in the value of
an existing position
– While hedging can protect the owner of an asset from a loss,
it also eliminates any gains from an increase in the value of
that asset 11-11
Why Hedge?
• What is to be gained by the firm from hedging?
– The major motive for firms to hedge is to increase the present
value of firms
– The value of a firm, according to financial theories, is the
present value of all expected future cash flows
– For expected cash flows with higher uncertainty (or risk), a
higher discount rate should be applied to calculating the
present value and thus a lower present value for these cash
flows is generated
– A firm that hedges these foreign exchange exposures reduces
the variance (or risk) in the value of future expected cash
flows (see Exhibit 11.2 on the next slide)
– Thus, a lower discount rate is employed to calculate the
present value of expected future cash flows, which implies
the increase of the present value of the firm
11-12
Exhibit 11.2 Impact of Hedging on the
Expected Cash Flows of the Firm
※ Hedging will not increase the expected value for a cash flow. Actually, if taking the
hedging cost into account, hedge transactions will decrease the expected cash flow
※ Hedging reduces the variability of future cash flows about the expected value of the
distribution. This reduction of distribution variance is a reduction of risk
11-13
Why Hedge?
• However, is a reduction in the variability of future
cash flows to be a sufficient reason for currency risk
management? Opponents of currency hedging
commonly make the following arguments
– Shareholders are much more capable of diversifying
currency risk according to their individual preferences and
risk tolerance than the management of the firm
– Although currency risk management can reduce the variance,
it reduces the expected cash flow due to hedging costs.
• So, the net benefit of hedge depends on the trade-off between
these two effects
– Hedging activities are sometimes conducted to benefit the
management at the expense of the shareholders
• For instance, the true goal of hedging the variance of the
company’s income is to ensure the bonus of the management
11-14
Why Hedge?
– Management may overuse the expensive hedge
• Management may believe that it will be criticized more
severely for incurring foreign exchange losses than for
incurring similar or even higher hedge costs in avoiding the
foreign exchange loss
• Possibly due to the accounting rules: because the foreign
exchange losses appear in the income statements as a highly
visible item or as a footnote, but the hedging costs are buried
in operating or interest expenses
– 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
• Although the translation exposure are only “paper” losses,
there are still some firms to hedge this risk
• However, the above argument implies that it is not necessary
to hedge the translation (accounting) exposure 11-15
Why Hedge?
• Proponents of hedging cite the following arguments:
– Hedge can reduce the variance of future cash flows and
thus may increase the firm’s present value by reducing
the discount rate
– Firms should focus on the main business they are in and
take activities to minimize risks arising from interest rates,
exchange rates, and other market variables
– Management is in better position than shareholders to
recognize disequilibrium conditions quickly and to
undertake the hedging activities immediately
– Management has a comparative advantage over individual
shareholders in estimating the actual currency risk of the
firm and taking the correct hedging strategy
11-16
Why Hedge?
– Reduction in risk in future cash flows improves the
planning capability of the firm. Therefore, the firm can
undertake more investment projects that it might not
consider before
– Since a firm must generate sufficient cash flows to
make debt-service payments, reduction of risk in
future cash flows reduces the likelihood that the firm’s
cash flows will fall below a necessary minimum (This
minimum level of cash flows is also termed as the point
of financial distress)
11-17
Sources of Transaction
Exposure
11-18
Sources of Transaction Exposure
• Transaction exposure measures gains or losses that
arise from the settlement of existing financial
obligations whose terms are stated in a foreign
currency
• The sources of transaction exposure include
– Purchasing or selling goods and services in foreign
currencies through credit accounts (to form the A/P or
A/R on the balance sheet)
– Borrowing or lending funds in foreign currencies
– Entering into foreign exchange or foreign currency
derivative contracts
11-19
Purchasing or Selling through
Credit Account
• The most common example of transaction exposure
arises when a firm has a receivable or payable
denominated in foreign currencies
• For each trade of goods and services, the total
transaction exposure consists of quotation, backlog,
and billing exposures (see Exhibit 11.3)
• Suppose that a U.S. firm sells merchandise on credit
account to a Belgian buyer for €1,000,000 to be made
in 60 days. The current exchange rate is $1.12/€, so the
seller expects to receive $1,120,000
– If the exchange rate becomes $1.08/€ ($1.15/€), the seller will
receive $1,080,000 ($1,150,000)
– Thus exposure (or risk) means not only the probability of
some losses but also the probability of some gains 11-20
Exhibit 11.3 The Life Span of the Transaction
Exposure for Trades of Goods and Services
Time and Events
t1 t2 t3 t4
Seller quotes a price Buyer places Seller ships Buyer settles A/R
in foreign currency to firm order with products and with cash in
buyer (in verbal or seller at price bills buyer foreign currency
written form) offered at time t1 (becomes A/R) quoted at time t1
11-22
Entering into Foreign Exchange or
Foreign Currency Derivative Contracts
• Suppose a U.S. firm purchases ¥100 million through
a foreign exchange forward contract at the forward
exchange rate ¥100/$ after 90 days
– When a firm enters into a foreign exchange derivatives
contract, it deliberately creates a transaction exposure
– The motive to create transaction exposure could be the need
to hedge the account payable of ¥100 million after 90 days
– If the spot exchange rate becomes ¥110/$ (¥90/$) after 90
days, the U.S. firm will have a transaction loss (gain)
through this foreign exchange forward contract
– On the other hand, if the spot exchange rate is ¥110/$
(¥90/$) after 90 days, the account payable of ¥100
million after 90 days have a transaction gain (loss)
11-23
Sources of Transaction Exposure
※ Note that cash balances in foreign currency DO
NOT create transaction exposure, even though their
domestic currency value changes immediately with a
change in exchange rates
– Since the firm does not have the obligation to transfer cash
in foreign currency into cash in domestic currency, there is
no transaction exposure for the cash in foreign currency
– This kind of risk is reflected in the consolidated statement
and thus classified as the translation exposure
11-24
Management of
Transaction Exposure
11-25
Management of Transaction
Exposure
• Transaction exposure can be managed by operating,
financial, and contractual hedges
• The term operating hedge refers to an off-setting
operating cash flow arising from the conduct of
business
– For example, the payments in a foreign currency could be
offset by the foreign currency cash inflow generated from
operating activities, e.g., from sales. This kind of hedge for
the transaction exposure is also termed natural hedge
– Operating hedge could also employ the use of risk-sharing
agreements, leads and lags in payment terms, and other
strategies
11-26
Management of Transaction
Exposure
Leading and Lagging
• Leading and lagging strategies involve adjusting
the timing of a payment request or disbursement to
reflect expectations about future currency
movements.
• General Electric and other well-known MNCs
commonly use leading and lagging strategies in
countries that allow them.
11-27
Management of Transaction
Exposure
Leading and Lagging
• In some countries, the government limits the length
of time involved in leading and lagging strategies
so that the flow of funds into or out of the country
is not disrupted. Consequently, an MNC must be
aware of government restrictions in any countries
where it conducts business before using these
strategies.
11-28
Management of Transaction
Exposure
• Corvalis Co. is based in the United States and has
subsidiaries dispersed around the world. The focus
here will be on a subsidiary in the United Kingdom
that purchases some of its supplies from a
subsidiary in Hungary. These supplies are
denominated in Hungary’s currency (the forint).
• If Corvalis Co. expects that the pound will soon
depreciate against the forint, it may attempt to
expedite the payment to Hungary before the pound
depreciates. This strategy is referred to as leading.
11-29
Management of Transaction
Exposure
• As a second scenario, assume that the British
subsidiary expects the pound to appreciate against
the forint soon. In this case, the British subsidiary
may attempt to stall its payment until after the
pound appreciates. In this way it could use fewer
pounds to obtain the forint needed for payment.
This strategy is referred to as lagging.
11-30
Management of Transaction
Exposure
Cross-Hedging
• Cross-hedging is a common method of reducing
transaction exposure when the currency cannot be
hedged.
• This type of hedge is sometimes referred to as a
proxy hedge because the hedged position is in a
currency that serves as a proxy for the currency in
which the MNC is exposed.
• The effectiveness of this strategy depends on the
degree to which these two currencies are positively
correlated. The stronger the positive correlation, the
more effective will be the cross-hedging strategy.
11-31
Management of Transaction
Exposure
Cross-Hedging- Example
• Greeley Co., a U.S. firm, has payables in zloty
(Poland’s currency) 90 days from now. Because it
is worried that the zloty may appreciate against the
U.S. dollar, it may desire to hedge this position. If
forward contracts and other hedging techniques are
not possible for the zloty, Greeley may consider
cross-hedging.
• In this case, it needs to first identify a currency that
can be hedged and is highly correlated with the
zloty.
11-32
Management of Transaction
Exposure
Cross-Hedging- Example (contd.)
• Greeley notices that the euro has recently been
moving in tandem with the zloty and decides to set
up a 90-day forward contract on the euro.
• If the movements in the zloty and euro continue to
be highly correlated relative to the U.S. dollar (that
is, they move in a similar direction and degree
against the U.S. dollar), then the exchange rate
between these two currencies should be somewhat
stable over time.
• By purchasing euros 90 days forward, Greeley Co.
can then exchange euros for the zloty
11-33
Strategic Management
9
-
3
of Operating Exposure
4
Currency Diversification
• limits the potential effect of any single
currency’s movements on the value of an
MNC.
• Some MNCs, such as The Coca-Cola Co.,
PepsiCo, and Altria, claim that their exposure
to exchange rate movements is significantly
reduced because they diversify their business
among numerous countries.
Strategic Management
of Operating Exposure
• The dollar value of future inflows in foreign
currencies will be more stable if the foreign
currencies received are not highly positively
correlated.
• The reason is that lower positive correlations or
negative correlations can reduce the variability
of the dollar value of all foreign currency
inflows.
• If the foreign currencies were highly correlated
with each other, diversifying among them
would not be a very effective way to reduce
risk. If one of the currencies substantially
depreciated, the others would do so as well,
given that all these currencies move in tandem.
Management of Transaction
Exposure
• A financial hedge refers to either an off-setting debt
obligation (such as a loan) or some type of financial
derivative such as an interest rate swap
– To eliminate the transaction exposure, firms can borrow
foreign currencies today to prepare for the settlement of
A/Rs in foreign currencies in the future
– Due to the borrowing activities, this kind of hedge is
classified as financial hedge
• Contractual hedges employ the forward, futures, and
options contracts to hedge transaction exposures
• The Trident case as follows illustrates how contractual
and financial hedging techniques may be used to
protect against transaction exposure
11-36
Trident’s Transaction Exposure
• Trident company just concludes negotiations for the
sale of telecommunication equipments to Regency, a
British firm, for £1,000,000
– The sale is made in March with payment due three months
later in June
– The financial and market information is as follows
‧Spot exchange rate: $1.7640/£
‧Three-month forward rate: $1.7540/£
‧Cost of capital for Trident company: 12%
‧U.K. three-month deposit (borrowing) interest rate: 8% (10%)
‧U.S. three-month deposit (borrowing) interest rate: 6% (8%)
‧Put option expired in June for £1,000,000 with the strike price
$1.75/£ ($1.71/£) is quoted as 1.5% (1.0%) premium
‧Trident’s foreign exchange advisory service forecasts that the
spot rate after three months will be $1.76/£
11-37
Trident’s Transaction Exposure
• Trident’s minimum acceptable margin is at a sales
price of $1,700,000, which implies the budget rate,
the lowest acceptable dollar per pound exchange
rate, is at $1.70/£
• Trident company has four alternatives to deal with
the transaction exposure:
– Remain unhedged
– Hedge in the forward market
– Hedge in the money market
– Hedge in the options market
• These choices can be applied to both an account
receivable (in this case) and an account payable
11-38
Trident’s Transaction Exposure
• Unhedged position
11-39
Trident’s Transaction Exposure
– It would be recorded on Trident’s income statement as a
foreign exchange loss of $10,000 ($1,764,000 as booked,
$1,754,000 as settled)
– Different from the above case, if funds to fulfill the forward
exchange contract are not already available or due to be
received later, funds to fulfill the forward contract must be
purchased in the spot market at some future time points
– This type of hedge is “open” or “uncovered” and involves
considerable risk because of the uncertain future spot rate to
obtain funds to fulfill the forward contract
– In this chapter, only the covered hedge is considered
11-40
Trident’s Transaction Exposure
• Money Market Hedge
– A money market hedge also involves a contract and a source
of funds to fulfill that contract
– In this instance, the contract is a loan agreement, so the
money market hedge is a kind of financial hedge
– The firm seeking the money market hedge borrows in one
currency and exchanges the proceeds for another currency
– Funds to fulfill the contract–to repay the loan–may be
generated from business operations, in which case the money
market hedge is covered
11-43
Trident’s Transaction Exposure
– For the ATM put, the cost of put is £1,000,000 × 1.5% =
£15,000 = $26,460 (= £15,000 × $1.7640/£)
1.74
Forward contract hedge
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
-1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86
-1.70
Forward contract hedge locks
-1.72
in a payment of $1,754,000
-1.74
-1.76
-1.78
Money market hedge locks
Call option hedge
-1.80 in a payment of $1,764,000
-1.82
-1.84
Uncovered payment
Call option strike whatever the ending
price of $1.75/£ spot rate is in 90 days
11-50