Transaction Exposure Questions - Pearson Education

CHAPTER 10 TRANSACTION EXPOSURE 10.1 Foreign Exchange Exposure. Define the three types of foreign exchange exposure. The three main types of foreign exchange exposure are transaction, translation, and operating:  Transaction exposure measures changes in the value of outstanding...

CHAPTER 10 TRANSACTION EXPOSURE 10.1 Foreign Exchange Exposure. Define the three types of foreign exchange exposure. The three main types of foreign exchange exposure are transaction, translation, and operating:  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 rates change. Thus, it deals with changes in cash flows that result from existing contractual obligations.  Translation 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.  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. The change in value depends on the effect of the exchange rate change on future sales volume, prices, and costs. 10.2 Currency Exposure and Contracting. Which of the three currency exposures relate to cash flows already contracted for, and which of the exposures do not? Transaction exposures are existing exposures of the firm, resulting from identifiable transaction. Operating exposures are exposures which are likely—anticipated—but not yet existing or contracted. 10.3 Currency Risk. Define currency risk. Currency risk is the variance in expected cash flows arising from unexpected exchange rate changes. 10.4 Hedging. What is a hedge? How does that differ from speculation? A hedge is the acquisition of a contract or a physical asset that will offset a change in value of some other contract or physical asset. Hedges are entered into to reduce or eliminate risk, as opposed to speculation, which is the taking of a position for the purposes of potential profit. 10.5 Value of the Firm. What—according to financial theory—is the value of a firm? According to financial theory, the value of a firm is the net present value of all expected future cash flows. 10.6 Cash Flow Variability. How does currency hedging theoretically change the expected cash flows of the firm? Hedging reduces the variability of expected cash flows. In some cases hedging may also bound or limit the variability of expected cash flows on an absolute basis. Copyright © 2023 Pearson Education, Inc.  54 Eiteman/Stonehill/Moffett  Multinational Business Finance, Sixteenth Edition 10.7 Arguments for Currency Hedging. Describe four arguments in favor of a firm pursuing an active currency risk management program? 1. Reduction in risk of future cash flows improves the planning capability of the firm. If the firm can more accurately predict future cash flows, it may be able to undertake specific investments or activities that it might otherwise not consider. 2. Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a level sufficient to make debt-service payments in order for it to continue to operate. This minimum cash flow point, often referred to as the point of financial distress, lies left of the center of the distribution of expected cash flows. Hedging reduces the likelihood of the firm’s cash flows falling to this level. 3. Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Regardless of the level of disclosure provided by the firm to the public, management always possesses an advantage in the depth and breadth of knowledge concerning the real risks. 4. Markets are usually in disequilibrium because of structural and institutional imperfections, as well as unexpected external shocks (such as an oil crisis or war). Management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of opportunities to enhance firm value through selective hedging (the hedging of exceptional exposures or the occasional use of hedging when management has a definite expectation of the direction of rates). 10.8 Arguments against Currency Hedging. Describe six arguments against a firm pursuing an active currency risk management program. 1. Shareholders are more capable of diversifying currency risk than the management of the firm. If stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage the risk in a way that satisfies their individual preferences and risk tolerance. 2. Currency risk management does not increase the expected cash flows of the firm. Currency risk management does, however, consume firm resources and so reduces cash flow. The impact on value is a combination of the reduction of cash flow (which lowers value) and the reduction in variance (which increases value). 3. Management often conducts hedging activities that benefit management at the expense of the shareholders. The field of finance called agency theory frequently argues that management is generally more risk-averse than shareholders. 4. Managers cannot outguess the market. If and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging should be zero. 5. 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 than for incurring similar or even higher cash costs in avoiding the foreign exchange loss. Foreign exchange losses appear in the income statement as a highly visible separate line item or as a footnote, but the higher costs of protection are buried in operating or interest expenses. Copyright © 2023 Pearson Education, Inc.  Chapter 10: Transaction Exposure 55 6. 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. Hedging would only add cost. 10.9 Transaction Exposure. What are the four main types of transactions from which transaction exposure arises? Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. Transaction exposure arises from any of the following: 1. Purchasing or selling on credit, on open account, goods or services when prices are stated in foreign currencies 2. Borrowing or lending funds when repayment is to be made in a foreign currency 3. Being a party to an unperformed foreign exchange forward contract 4. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies 10.10 Life Span of a Transaction Exposure. Diagram the life span of an exposure arising from selling a product on open account. On the diagram define and show quotation, backlog, and billing exposures. See Chapter Exhibit 10.3 for the entire life span. 10.11 Unperformed Contracts. Which contract is more likely not to be performed, a payment due from a customer in foreign currency (a currency exposure) or a forward contract with a bank to exchange the foreign currency for the firm’s domestic currency at a contracted rate (the currency hedge)? The forward contract agreement with a financial service provider—a bank—is much more “certain” than is the receipt of cash in payment on an outstanding receivable. 10.12 Cash Balances. Why do foreign currency cash balances not cause transaction exposure? A transaction exposure is defined as a foreign currency denominated cash flow occurring at a future date in time. Since cash balances are in the present, not a future cash flow, they are not defined as transaction exposures. 10.13 Contractual Currency Hedges. What are the four main contractual instruments used to hedge transaction exposure? The four main contractual instruments or hedges used to hedge transaction exposure are foreign currency forwards, foreign currency futures, money market derivatives, and foreign currency options. 10.14 Money Market Hedges. How does a money market hedge differ for an account receivable versus that of an account payable? Is it really a meaningful difference? A money market hedge for an account receivable is the use of the A/R as collateral against a foreign currency loan (the A/R is not being sold, only posted as collateral for a loan). This creates a short- term loan or debt obligation on the hedger’s balance sheet which “matches” the foreign currency receivable. Copyright © 2023 Pearson Education, Inc.  56 Eiteman/Stonehill/Moffett  Multinational Business Finance, Sixteenth Edition A money market hedge for an account payable requires the company to exchange money now to be placed on deposit in a foreign currency financial account in an amount which, upon maturity, will satisfy the account payable in-full. Whether there is a meaningful difference between the two is both debatable in somewhat situational. A heavily indebted firm will not find taking on additional debt obligations (hedging the A/R), since that will increase all debt-based financial metrics and ratios. A firm that does not enjoy ready access to affordable capital will find the foreign currency deposit (hedging the A/P) difficult, as it means putting scarce capital into an account for earning nothing but interest when capital is hard to come by. 10.15 Balance Sheet Hedging. What is the difference between a balance sheet hedge, a financing hedge, and a money market hedge?  A balance sheet hedge is any foreign currency denominated asset or liability created to offset a similar foreign currency denominated liability or asset.  A financing or financial hedge is any financial position, a deposit or loan obligation, created to offset a matching foreign currency denominated exposure.  A money market hedge is one type of financial hedge, where a foreign currency loan is acquired to hedge a foreign currency denominated account receivable, or a foreign currency deposit is created to hedge a foreign currency denominated account payable. 10.16 Forward versus Money Market Hedging. Theoretically, shouldn’t forward contract hedges and money market hedges have the same identical outcome? Don’t they both use the same three specific inputs—the initial spot rate, the domestic cost of funds, and the foreign cost of funds? On a theoretical basis, both structures do indeed include the same three basic components. What differs, however, is the rates of interest utilized in constructing the positions. The forward contract uses eurocurrency deposit rates (effectively the same as LIBOR rates) in the construction of the forward rate. The money market hedge, however, uses a deposit rate (for an A/P) or a borrowing rates (for an A/R) for the execution of the structure. Borrowing rates will include the lender’s credit assessment of the borrower. In both cases the firm’s weighted average cost of capital, which will obviously differ across firms, is needed for the estimation of the time value of money either used/accessed as part of the money market hedge. 10.17 Foreign Currency Option Premia. Why do many firms object to paying for foreign currency option hedges? Do firms pay for forward contract hedges? How do forwards and options differ if at all? Consider the traditional alternative to the option—the forward contract. A firm does not exchange any cash flow up-front for a forward. It does, however, have its available line of credit with the financial institution reduced by the amount of the forward, but that is not an out-of-pocket cash obligation. An option, however, is purchased—the option premium—and that is an explicit cost of acquiring the derivative whether it is used or not in the end. (Option premiums are not necessarily settled up- front, as many banks will simply combine the option premium settlement with the regular clearing of Copyright © 2023 Pearson Education, Inc.  Chapter 10: Transaction Exposure 57 the firm’s settlements with the bank, or combine it with the final settlement on the over the counter option at option maturity). Option premiums may also be significant in size. If a firm is purchasing a number of large options, this may require a larger amount of capital than the firm has budgeted for treasury and currency operations. Many firms simply object to spending money, option premiums, for a risk product that may or may not be ultimately used. 10.18 Decision Criteria. Ultimately, a treasurer must choose among alternative strategies to manage transaction exposure. Explain the two main decision criteria that must be used. A treasurer must select on the basis of two decision criteria: (1) the risk tolerance of the firm, as expressed in its stated policies, and (2) the treasurer’s own view, or expectation of the direction (and distance) the exchange rate will move over the exposure period. 10.19 Risk Management Hedging Practices. According to surveys of corporate practices, which currency exposures do most firms regularly hedge? Transaction exposures, once booked (recorded on the financial statements as an account receivable or payable), are the most frequently hedged exposure. Conservative hedging policies dictate that contractual hedges be placed only on existing exposures. 10.20 Hedging Booked Exposures. Why do many firms only allow hedging of existing exposures and not allow the hedging of anticipated exposures? Until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100%. Conservative hedging policies dictate that contractual hedges be placed only on existing exposures. Copyright © 2023 Pearson Education, Inc.