Transaction Exposure Management

Types of Exposure

• There are three types of exposure that firms face.
• Economic exposure (or operating exposure) relates to a firm's competitive position and overall value, but it isn't covered
• Translation exposure arises from currency effects on a company's consolidated financial statements, especially with foreign subsidiaries and is closely tied to accounting regulations and isn't covered
• Transaction exposure stems from exchange rate fluctuations impact on a company's obligations for foreign currency payments and receipts.
  • Transaction exposure reflects how sensitive a firm's domestic currency value is to contractual cash flows in foreign currencies.

Transaction Exposure Management

• Firms address three main tasks when transaction exposure exists.
  • Identification of the degree of transaction exposure.
  • Deciding whether or not to hedge that exposure.
  • Selecting hedging techniques
• Effective comparison of hedging methods requires considering the time value of money

Importance of Time Value of Money

• Money's worth today is greater than the same amount in the future.
• Money today is more valuable than the same amount in the future, due to opportunity cost.
• Opportunity cost reflects using money now versus later.
• The difference helps calculate the present value of future cash flows when using hedging contracts.
• Interest is earned or paid to compensate for the time lenders forgo using their money

Boeing Example

• Boeing exports a 737 to British Airways, billing them £10 million payable in one year.
• The money market interest rates and foreign exchange rates are:
  • US interest rate: 6.10% per annum
  • UK interest rate: 9.00% per annum
  • Spot exchange rate: $1.50/£
  • The forward exchange rate: $1.46/£

Option 1: Forward Market Hedge

• Firms can sell or buy foreign currency receivables or payables forward to eliminate exchange risk exposure.
• If payment is expected in a foreign currency, agree to sell the foreign currency now via a short position in a forward contract.
• If a future foreign currency payment is due, agree to buy the foreign currency now via a long position in a forward contract.
• Boeing sells its pounds receivable forward
  • £10 million x $1.46/£ = $14.6 million.
• Exchange rate uncertainty no longer exists upon entering the forward contract.
• A disadvantage of forwards, exchange risk exposure is eliminated entirely, there is no opportunity to benefit

Option 2: Money Market Hedge

• Hedging can be achieved via lending and borrowing in domestic and foreign money markets.
• Firms can borrow or lend in foreign currency to hedge foreign currency receivables or payables.
• Procedure:
  • Borrow the present value of £10 million using a 9% interest rate:
  • £10,000,000 / 1.09 = £9,174,312.
  • Convert £9,174,312 into $13,761,468 at the spot exchange rate of $1.50/£.
  • Invest $13,761,468 in the US at 6.10% for one year.
  • Collect £10 million from British Airways and use it to repay the pound loan.
  • Receive the dollar investment's maturity value: $13,761,468 x 1.061 = $14,600,918.
  • $14,600,918 is the guaranteed dollar proceeds from the British sale.
• Money market hedges eliminate upside exposure.
  • Boeing may desire to protect itself if the pound weakens.
  • Retain the opportunity to benefit if the pound strengthens

Option 3: Options Market Hedge

• A firm may buy a foreign currency call option to hedge its foreign currency payables.
• A firm may buy a foreign currency put option to hedge its foreign currency receivables.
• Boeing purchases put options on £10 million with an exercise price of $1.46/£, expiring in one year.
  • The option premium price is $0.02/£.
    • Boeing pays $0.02/£ x £10 million = $200,000.
  • $200,000 x 1.061 = $212,000 is the upfront cost at expiration date
• Boeing can sell up to £10 million for $1.46/£, regardless of the future spot rate.
• Option markets hedges offer higher proceeds than the forward hedge if the future spot price is > $1.48/£
• The options hedge limits downside risk while allowing for upside potential.
• Option contract exercise price depends on the extent of a firm's willingness to bear exchange risk.
  • If the aim is to avoid unfavorable exchange rate changes, an out-of-money put option (low exercise price) would save option costs

Boeing's Hedging Strategy Summary

• Forward Market Hedge:
  • Transactions: Sell £10,000,000 forward for U.S. dollars now and receive £10,000,000 from the British client in one year
  • Outcome: Receiving $14,600,000 in one year is assured, future spot exchange becomes irrelevant.
• Money Market Hedge:
  • Transactions: Borrow £9,174,312 and buy $13,761,468 now.
  • Outcome: Assured of receiving $13,761,468 now or $14,600,918 in one year, future spot exchange rate is negated.
• Options Market Hedge:
  • Transactions: Buy a put option on £10,000,000 for an upfront cost of $200,000.
  • Decide whether to exercise the option in one year and observe the prevailing spot exchange rate.
  • Outcome: Receiving at least $14,387,800 is assured and there is opportunity for more profit if the future spot rate exceeds the exercise rate

Rolls Royce Example

• Boeing imported a Rolls-Royce jet engine for £5 million payable after one year.
• Market conditions:
  • US interest rate: 6.00% per annum.
  • UK interest rate: 6.50% per annum.
  • Spot exchange rate: $1.80/£.
  • Forward exchange rate: $1.75/£ (1-year maturity).

Forward Contract Hedge Example

• Boeing buys £5 million forward for £5,000,000 x $1.75/£ = $8,750,000.
• This fully hedges Boeing's foreign currency payable.

Money Market Hedge Example

• The firm can lend in foreign currency to hedge its foreign currency payables
• £5,000,000 / 1.065 = £4,694,836 is the present value of the foreign currency payable.
• Boeing can lend £4,694,836 at the British interest rate of 6.5% per annum and be guaranteed of having £5,000,000 in one year.
• £4,694,836 x $1.80/£ = $8,450,705 (future value of dollar cost), totaling $8,450,705 x 1.06 = $8,957, 747.

Options Market Hedge Example

• Secure £5,000,000 for a maximum of $9,095,400
  • $9,000,000 for exercising the options at $1.80/£
  • $95,400 for buying the options
• A firm may buy a foreign currency call option to hedge its foreign currency payables.
• Boeing buys call options for £5,000,000
  • Assume the exercise price is at $1.80/£ with a $0.018 per £ premium.
  • Total cost of options as of the maturity date:
    • $0.018/£ x £5,000,000 x 1.06 = $95,400.

Hedging Recurrent Exposure

• Firms with recurrent exposure can hedge their currency exposure at a lower cost using swaps.
• Swaps are available in longer-terms than futures and forwards.

Currency Risk Management

• Most firms use forward, swap, and option contracts to manage currency risk.
• The greater the degree of international involvement, the greater the firm's use of foreign exchange risk management.
• Currency risk is complex and hedging or predicting can be troublesome and costly so you might not want to