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Chapter 5

Managing Transaction Exposure

Objectives
A primary objective of the chapter is to provide an overview of hedging techniques . Yet, transaction exposure cannot always be hedged in all cases. Even when it can be hedged, the firm must decide whether a hedge is feasible. While a firm will only know for sure whether hedging is worthwhile after the period of concern, it can incorporate its expectations about future exchange rates, future inflows and outflows, as well as its degree of risk aversion to make hedging decisions. The specific objectives are to:
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Objectives
identify the commonly used techniques for hedging transaction exposure; explain how each technique can be used to hedge future payables and receivables; compare the advantages and disadvantages of the identified hedging techniques; suggest other methods of reducing exchange rate risk when hedging techniques are not available.
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Transaction Exposure
Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. When transaction exposure exists, the firm 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.


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Identifying Net Transaction Exposure


Centralized Approach - A centralized group consolidates subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency for the upcoming period(s). Note that sometimes, a firm may be able to reduce its transaction exposure by pricing some of its exports in the same currency as that needed to pay for its imports.
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Techniques to Eliminate Transaction Exposure


Hedging techniques include:
Futures hedge, Forward hedge, Money market hedge, Currency option hedge.

MNCs will normally compare the cash flows that could be expected from each hedging technique before determining which technique to apply.
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Techniques to Eliminate Transaction Exposure


* Futures Hedge A futures hedge involves the use of currency futures. To hedge future payables, the firm may purchase a currency futures contract for the currency that it will be needing. To hedge future receivables, the firm may sell a currency futures contract for the currency that it will be receiving.
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Techniques to Eliminate Transaction Exposure


* Forward Hedge A forward hedge differs from a futures hedge in that forward contracts are used instead of futures contract to lock in the future exchange rate at which the firm will buy or sell a currency. Recall that forward contracts are common for large transactions, while the standardized futures contracts involve smaller amounts.
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Techniques to Eliminate Transaction Exposure


Forward Hedge versus No Hedge An exposure to exchange rate movements need not necessarily be hedged, despite the ease of futures and forward hedging. Based on the firms degree of risk aversion, the hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged.
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Techniques to Eliminate Transaction Exposure


Real cost of hedging payables (RCHp) =
nominal cost of payables with hedging nominal cost of payables without hedging

Real cost of hedging receivables (RCHr) =


nominal home currency revenues received without hedging nominal home currency revenues received with hedging

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Techniques to Eliminate Transaction Exposure


If the real cost of hedging is negative, then hedging is more favorable than not hedging. To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate, and then use it to develop a probability distribution for the real cost of hedging.
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Techniques to Eliminate Transaction Exposure


Example:
Durham Co. will need 100,000 in 90 days to pay for British imports. Todays 90-day forward rate of the British pound is $1.40. To assess the future value of British pound, Durham may develop a probability distribution, as shown in the following exhibit. This exhibit can be used to determine the probability that a forward hedge will be more costly than no hedge. This is achieved by estimating the real cost of hedging payables.
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Techniques to Eliminate Transaction Exposure


Feasibility Analysis for Hedging
Possible Nominal Cost Amounts in $ Needed Real Cost Spot Rate of of hedging to Buy 100,000 if of hedging in 90 days Probability 100,000 Firm Remains Unhedged 100,000 $1.30 5% $140,000 $1.30*100,000 =$130,000 $10,000 1.32 10 140,000 1.32*100,000 = 132,000 8,000 1.34 15 140,000 1.34*100,000 = 134,000 6,000 1.36 20 140,000 1.36*100,000 = 136,000 4,000 1.38 20 140,000 1.38*100,000 = 138,000 2,000 1.40 15 140,000 1.40*100,000 = 140,000 0 1.42 10 140,000 1.42*100,000 = 142,000 - 2,000 1.45 5 140,000 1.45*100,000 = 145,000 - 5,000

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Techniques to Eliminate Transaction Exposure


The date indicate there is a 15% chance that the RCHp will be negative . Using the information in the exhibit, Durham can estimate the expected value of the RCHp, which is determined by E(RCHp) = PiRCHi ( where Pi represent the probability that the ith outcome will occur.)
= 5%($10,000) + 10%($8,000)+15%($6,000) + 20%($4,000) + 20%($2,000) + 15%(0) + 10%(-$2,000) + 5%(-$5,000) = $500 +$800 +$900 + $800 +$400 +0 $200 - $250 = $2950.

So, Durham may decide not to hedge.

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Techniques to Eliminate Transaction Exposure


If the forward rate is an accurate predictor of the future spot rate, the real cost of hedging will be zero. If the forward rate is an unbiased predictor of the future spot rate, the real cost of hedging will be zero on average.

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Techniques to Eliminate Transaction Exposure


* Money Market Hedge A money market hedge involves taking one 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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Techniques to Eliminate Transaction Exposure


Note that taking just one money market position may be sufficient.
A firm that has excess cash need not borrow in the home currency when hedging payables. Similarly, a firm that is in need of cash need not invest in the home currency money market when hedging receivables.

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Techniques to Eliminate Transaction Exposure


Example : Ashland ,Inc., needs NZ$1,000,000 in 30 days, and it can earn 6% annualized (.5% for 30 days) on a New Zealand security over this period. In this case, the amount needed to purchase a New Zealand one-month security is NZ$1,000,000 1+ .005 Assume that the New Zealand dollars spot rate is $.65, then $646,766 is needed to purchase the New Zealand security (computed as NZ995,025 * $.65). In 30 days, the security will mature and provide NZ$1,000,000 to Ashland, Inc., which can use this money to cover its payables.
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Techniques to Eliminate Transaction Exposure


For the two examples shown, the known results of money market hedging can be compared with the known results of forward or futures hedging to determine which type of hedging is preferable.

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Techniques to Eliminate Transaction Exposure


If interest rate parity (IRP) holds, and transaction costs do not exist, a money market hedge will yield the same result as a forward hedge. This is so because the forward premium on a forward rate reflects the interest rate differential between the two currencies.

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Techniques to Eliminate Transaction Exposure


* Currency Option Hedge
A currency option hedge involves the use of currency call or put options to hedge transaction exposure. Since options need not be exercised, firms will be insulated from adverse exchange rate movements, and may still benefit from favorable movements. However, the firm must assess whether the premium paid is worthwhile.
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Techniques to Eliminate Transaction Exposure


Example 1:
Clemson Corp. has payables of 100,000 90 days from now. Assume there is a call option available with the exercise price of $1.60. Assume that the option premium is $.04 per unit. Clemson expects the spot rate of the pound to be either $1.58, $1.62, or $1.66 when the payables are due. The effect of each of these scenarios on Clemsons cost of payables is shown in the following exhibit.
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Techniques to Eliminate Transaction Exposure


Use of Currency Call Options for Hedging British Pound Payables (Exercise Price = $1.60; Premium = $.04) (1) (2) (3) (4) (5) = (4) + (3) (6)
Spot Rate Premium Amount Total Amount Paid $ Amount Paid When per Unit Paid per per Unit (Including for 100,000 Payables Paid on Unit When the Premium ) When Owing Are Call Owing Call When Owing Call Scenario Due Options Options Call Options Options 1 $1.58 $.04 $1.58 $ 1.62 $ 162,000 2 1.62 .04 1.60 1.64 164,000 3 1.66 .04 1.60 1.64 164,000

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Techniques to Eliminate Transaction Exposure


Example 2:
Knoxville, Inc., transport goods to New Zealand and expects to receive NZ$600,000 in about 90 days. Because it is concerned that the New Zealand dollar may depreciate against the U.S. dollar, Knoxville is considering purchasing put options to cover its receivables. The New Zealand dollar put options considered here have an exercise price of $.50 and a premium of $.03 per unit. Knoxville anticipates that the spot rate in 90 days will be either $.44, $.46, or $.51. The amount to be received as a result of owing currency put options is shown in the following exhibit.
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Techniques to Eliminate Transaction Exposure


Use of Currency Put Options for Hedging New Zealand Dollar Receivable (Exercise Price = $0.50; Premium = $.03) (1) (2) (3) (4) (5) = (4)-(3) (6)
Spot Rate Premium Amount Net Amount $ Amount Received When per Unit Received Received from Hedging Payment on on Per Unit Per Unit NZ$600,000 Receivables Put When (after Accounting Receivables Scenario Is Options Owning for Premium with Received Put Options Paid) Put Options

1 2 3

$.44 .46 .51

$.03 .03 .03

$.50 .50 .51

$ .47 .47 .48

$ 282,000 282,000 288,000

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Techniques to Eliminate Transaction Exposure


Summary of Hedging Techniques
Hedging Payables
Futures hedge Forward hedge Purchase currency futures contract(s).

Hedging Receivables
Sell currency futures contract(s). Negotiate forward contract to sell foreign currency. Borrow foreign currency. Convert to and then invest in local currency. Purchase currency put option(s)
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Negotiate forward contract to buy foreign currency. Money Borrow local market currency. Convert hedge to and then invest in foreign currency. Currency Purchase currency option call option(s).

Techniques to Eliminate Transaction Exposure


A comparison of hedging techniques should focus on minimizing payables, or maximizing receivables. Example: Assume that Fresno Corp. will need 200,000 in 180 days. It considers using (1) a forward hedge, (2) a money market hedge, (3) an option hedge, or (4) no hedge. Its analysts develop the following information, which can be used to assess the alternative solutions:
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Techniques to Eliminate Transaction Exposure


* Spot rate of pound = $1.50 * 180-day forward rate of pound = $1.47 Interest rates are as follows: U.K. U.S. 180-day deposit rate 4.5% 4.5% 180-day borrowing rate 5.0% 5.0% * A call option on pounds that expires in 180 days has an exercise price of $1.48 and a premium of $.03 * A put option on pounds that expires in 180 days has an exercise price of $1.49 and a premium of $.02

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Techniques to Eliminate Transaction Exposure


Fresno Corp. forecasted the future spot rate in 180 days as follows: Possible Outcome Probability $ 1.43 20% $ 1.46 70% $ 1.52 10% Fresno Corp. then assess the alternative solutions, as shown in the following exhibit. Each alternative is analyzed to estimate the nominal dollar cost of paying for the payables denominated in pound.
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Techniques to Eliminate Transaction Exposure


Comparison of Hedging Alternatives for Fresno Corp:
Forward Hedge Purchase pounds 180 days forward. Dollar needed in 180 days = payables in * forward rate of = 200,000* $1.47 = $294,000 Money Market Hedge Borrow $, convert to , invest , repay $ loan in 180 days. Amount in to be invested = 200,000 / (1 + .045) = 191,388 Amount in $ needed to convert into for deposit = 191,388* $1.50 = $287,082

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Techniques to Eliminate Transaction Exposure


Interest and principal owed on $ loan after 180 days = $287,082*(1+ .05) = $301,436 Call Option
Purchase call option (Exercise price = $.1.48, Premium = $.03)
Possible Spot Premium Exercise Total Price Total Price Probability Rate in per Unit Option? (Including Paid for 180 days Paid for Option Premium) 200,000 Option Paid per Unit $ 1.43 $.03 No $1.46 $ 292,000 20% 1.46 .03 No 1.49 298,000 70% 1.52 .03 Yes 1.51 302,000 10%

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Techniques to Eliminate Transaction Exposure


Remain Unhedged Purchase 200,000 in the spot market 180 days from now.
Future Spot Rate Expected in 180 days Dollars Needed to to Purchase 200,000 Probability

$1.43 1.46 1.52

$286,000 292,000 304,000

20% 70 10

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Techniques to Eliminate Transaction Exposure


Conclusion: A review of this exhibit shows that Fresno Corp. is likely to perform best if it remains unhedged, but if it prefers to hedge, it should choose forward hedge.

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Techniques to Eliminate Transaction Exposure


Note that the cash flows associated with currency option hedging and remaining unhedged cannot be determined with certainty. In general, hedging policies vary with the MNC managements degree of risk aversion and exchange rate forecasts. The hedging policy of an MNC may be to hedge most of its exposure, none of its exposure, or to selectively hedge its exposure.
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Limitations of Hedging
Some international transactions involve an uncertain amount of foreign currency, such that overhedging may result. One way of avoiding overhedging is to hedge only the minimum known amount in the future transaction(s).

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Limitations of Hedging
In the long run, the continual hedging of repeated transactions may have limited effectiveness. For example, the forward rate often moves in 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 Transaction Exposure


MNCs that are certain of having cash flows denominated in foreign currencies for several years may attempt to use long-term hedging. Three commonly used techniques for long-term hedging are:
long-term forward contracts, currency swaps, and parallel loans.

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Hedging Long-Term Transaction Exposure


Long-term forward contracts, or long forwards, with maturities of ten years or more, can be set up for very creditworthy customers. Currency swaps can take many forms. In one 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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Hedging Long-Term Transaction Exposure


A parallel loan, or back-to-back loan, involves an exchange of currencies between two parties, with a promise to reexchange the currencies at a specified exchange rate and future date.

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Alternative Hedging Techniques


Sometimes, a perfect hedge is not available (or is too expensive) to eliminate transaction exposure. To reduce exposure under such a condition, the firm can consider:
leading and lagging, cross-hedging, or currency diversification.

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Alternative Hedging Techniques


The act of leading and lagging refers to an adjustment in the timing of payment request or disbursement to reflect expectations about future currency movements. Expediting a payment is referred to as leading, while deferring a payment is termed lagging.
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Alternative Hedging Techniques


When a currency cannot be hedged, a currency that is highly correlated with the currency of concern may be hedged instead. The stronger the positive correlation between the two currencies, the more effective this cross-hedging strategy will be.
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Alternative Hedging Techniques


With currency diversification, the firm diversifies its business among numerous countries whose currencies are not highly positively correlated.

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Questions and Applications


1.Assume that Stevens Point Co. has net receivables of 100,000 Singapore dollars in 90 days. The spot rate of the S$ is $.50, and the Singapore interest rate is 2 percent over 90 days. Suggest how the U.S. Firm could implement a money market hedge. Be precise.
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Questions and Applications


2. Assume that Citadel Co. purchases some goods in Chile that are denominated in Chilean pesos. It also sells goods denominated in U.S. dollars to some firms in Chile. At the end of each month, it has a large net payables position in Chilean pesos. How can this U.S. firm use an invoicing strategy to reduce this transaction exposure? List any limitations on the effectiveness of this strategy.

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Questions and Applications


3. Would Montana Co.s real cost of hedging Japanese yen receivables have been positive, negative, or about zero on average over a period in which the dollar weakened consistently ? Explain.

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Questions and Applications


4. Cornell Co. purchases computer chips denominated in euros on a monthly basis from a Dutch supplier. To hedge its exchange rate risk, this U.S. firm negotiates a three-month forward contract three months before the next order will arrive. In other words, Cornell is always covered for the next three monthly shipments. Because Cornell consistently hedges in this manner, it is not concerned with exchange rate movements. Is Cornell insulated from exchange rate movements? Explain.

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Questions and Applications


5. Malibu, Inc., is a U.S. company that imports British goods. It plans to use call options to hedge payables of 100,000 in 90 days. Three call options are available that have an expiration date 90 days from now. Fill in the number of dollars needed to pay for the payables ( including the option premium paid) for each option available under each possible scenario.

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Questions and Applications


Spot Rate Exercise Price of Pound = $1.74; 90 days Premium Scenario from Now = $.06 1 $1.65 2 1.70 3 1.75 4 1.80 5 1.85 Exercise Price Exercise Price = $1.76; = $1.79; Premium Premium = $.05 = $.03

If each of the five scenarios had an equal probability of occurrence, which option would you choose? Explain.

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Questions and Applications


6. a. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows: Future Spot Rate Probability $.61 20% .63 50 .67 30

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Questions and Applications


Assume that one-year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates: U.S. Singapore Deposit Rate 8% 5% Borrowing Rate 9 6

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Questions and Applications


Given this information, determine whether a forward hedge, money market hedge, or currency option hedge would be most appropriate. Then, compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position.
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Questions and Applications


b. Assume that Baton Rouge, Inc., expects to need S$1 million in one year. Using any relevant information in part(a) of this question, determine whether a forward hedge, money market hedge, or a currency option hedge would be most appropriate. Then, compare the most appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its payables position.
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