NPTEL

International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Module - 22
Transaction Exposure Management Part-1

Developed by: Dr. A.K.Misra

Assistant Professor, Finance

Vinod Gupta School of Management

Indian Institute of Technology

Kharagpur, India

Email: arunmisra@vgsom.iitkgp.ernet.in

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International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Transaction Exposure Management

Learning Objectives:

In this session, forward market and cross-currency forward contract for management of
transaction exposure are discussed in details.

Highlights & Motivation:

In this session, the following details about management of transaction exposure are discussed.

Forward Market
Cross-Currency Forward contract
Problems of forward contract market

The session would help readers to understand the currency forward, futures and options markets
and their applications for hedging currency risk.

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International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Introduction
As discussed in Session-21, transaction exposure refers to the change in the home currency value
of an item whose foreign currency value is contractually fixed. Many firms attempt to manage
their currency exposures through hedging by purchasing forward and future contracts.
These contracts eliminate the currency risk. With the liberalization of foreign exchange
market, companies are permitted to hedge their anticipated exposures by purchasing
forward contracts and future contracts. Both two ways forward quotes are available for major
world currencies upto six months. Currency Future market has been operating in many countries;
including India, where major world currencies are being traded and quotation are available for
one year.

The present session discussed about the management of transaction exposures using forward and
future contracts.

Management of Transaction Exposures: Forward Market

A typical MNC balance sheet, generally, has several contractual exposures in various currencies
and maturing in different dates.

Receivables/Payables Value Maturity Days

US$ Payable 900,00 40
Euro Receivable 250,00 60
US$ receivable 110,00 40
US$ Interest Payable 9,000 40
Euro Loan Payable 80,000 60
US$ export Receivable 875,00 40
Euro Export Receivable 700,00 60

Net Exposure in US$ at 40 days

Payable : US$99,000
Receivable : US$98,500
Net Exposure : US$ (-) 500

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International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Net Exposure in Euro at 60 days

Payable : Euro 80,000

Receivable : Euro 95,000
Net Exposure : Euro 15,000

In the above case, the MNC can hedge the open position of US$ and Euro by purchasing US$500
forward contract of 40 days and selling a 60-days forward contract of Euro 15,000.

However, if exposures are in different dates, then it is not possible to aggregate them. In this
case, for each transaction, separate forward contract need to be purchased. Before using the
forward market to hedge transaction exposure, let us discuss about the operation of forward
market.
Forward Market for Transaction Exposure Management

Any foreign currency transaction which takes place beyond spot transaction, i e, settlement
take place beyond 2 days, it is a forward transaction. Foreign currency forward market is
an over the counter unorganized market. Authorized dealers in foreign exchange market,
particularly commercial banks, provide quotation for forward transaction. It is not a standardized
market and pricing, size, delivery date etc., are customized by the authorized dealers as per the
requirement of customers.

A customer having exposure in forex market can buy/ sell forward currency. For this, he
has to pay a premium/discount which is known as forward charges. As discussed in earlier
session the forward charges are estimated taking into interest rate differential between two
countries whose currencies are in consideration.

Forward Exchange Rate = Spot Rate+ Forward Premium/Discount

If currency is appreciating = Premium currency
If currency is Depreciating = Discount currency
In case of direct quotation, Premium is added for depreciation and deduct for appreciation

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International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Forward Quotation in the Over the Counter Market

Spot rate at March 1st 2010 : US$1: Rs.48.8325/8650

Forward Premium / Discount: Spot/March: 0.1700/1800
Spot/April : 0.3500/3700
Estimate the Forward Rate after 2 months.

Buyer of forward currency:

Spot rate as on March 1, 2010: Rs.48.8650

Two month forward premium : 0.3700

Since the dollar is appreciating forward premium need to be added with the March spot rate to
arrive the forward rate after two month. Hence the 2 month forward rate is Rs.49.2350.

Seller of forward currency:

Spot rate as on March 1, 2010: Rs.48.8325
Two month forward premium : 0.3500

Since the dollar is appreciating forward premium need to be added with the March spot rate to
arrive at the forward rate after two month. Hence the 2 month forward rate is Rs.49.1825

Forward contract involves two parties; agree to sell/buy a specified amount of forex at a
specified rate at a specified date in future. Generally, no exchange of money takes place at
the time of entering forward agreement. At expiration, a forward contract can be settled
either by physical delivery of currency or cash settlement.

Forward contract between two banks is nothing more than a telephonic agreement on the price,
amount and delivery date. However, banks when enters forward contracts with corporation may
ask for margin or cash deposits.

Forward contract can be used for hedging or offsetting the risk arising out of transaction
exposure.

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International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Example:
A Company in India has shipped product to USA amounting to US$ 50,000 to be payable after 3
months. The spot rate US$ is Rs.48.2550. Since the cash settlement will take place after 3 months,
the open position of US$50,000 is a transaction risk for the Company. The Company asks for a
forward quotation to a bank for hedging the risk. The Bank has given following information
about the forward market.

Spot rate : US$1: 48.2550/3500

3 month forward rate : 2500/3000
Using the above information, prepare the hedging strategy for the Company.

The Company has open position for receivable of US$50,000 to be settled after 3 month. Any
appreciation of rupee against US$ is a risk for the company. Expecting appreciation of rupee the
Company planned to go for sell of forward contracts.

The Company would sell US$ 50,000, 3 month forward and the rate would be as follows:

Current Spot : Selling rate : Rs.48.2550

Add 3 month forward rate : Rs. 0.2500
3 month forward sell rate : Rs. 48.5050

After 3 months, the company would surrender the US$ 50,000 and get an exchange rate of
Rs.48.5050 per US$. If the rupee appreciated beyond 48.5050, then the company would be
profitable. However, if rupee depreciated to 48.6500, than the company would be the loser. In this
case the company may go for cancellation of forward contract by paying the required transaction
cost.

Forward Contract can be cancelled by the holder of the contract. In the case of cancellation, the
party needs to pay exchange margin.

Example
As on November 15, an exporter has booked a sell contract of US$50,000 to be delivered two
months forward at a rate Rs. 48.40. The delivery date is January 15. As on December 15, he
wanted to cancel the contract. The Bank charges an exchange margin of 0.15% and flat
cancellation charges of Rs.250. Estimate the cash flow, with the given information as at
December 15:

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Interbank spot as at December 15: 47.40- 47.42

1-Month Forward: 15/30
Prime Lending Rate: 11.50%
One month before the due date the customer is cancelling the forward contract. Hence, effectively
the bank can cover its position by buying one month forward.
Cancellation of forward sell contract can be done by one month forward TT selling rate.

December Spot US$ Purchase rate: Rs.47.40

1-Month Forward Premium: 0.15 Rs. 47.62
Exchange Margin: 0.15%

Amount to be paid to the customer: {(Rs.48.25 Rs.47.62)*US$ 50,000 } = Rs.39,000/-

This payment is due on January 15. Since the settlement is made one month before, the PLR of
11.50% would be used for discounting the January 15 so as to pay it on December 15 and the
amount would be Rs.34978/-

Cross-Currency Forward Contract

Forward cross rate can be computed in the as per Spot cross rates, however, the concept of option
period in the overseas forex markets is outdated and hence rates are estimated on a fixed date
basis.
Example:
An Indian Garment exporter will be receiving in September 30. Since the delivery of will be
after one month, the garment exporter is facing transaction exposure for against Indian Rupee.
He wanted to book a forward sell contract for against Indian Rupee. If the exchange rates, as on
1st August, are as follows, what rate the Bank would quote to him.

Mumbai Inter-bank Market :

Spot : US$1: Rs.47.2825/3275

Forward: Spot/August: 2500/2700
Spot/September:5200/5500
Spot/October:7700/8200

London Market :
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Vinod Gupta School of Management, IIT. Kharagpur.

Spot : 1: US$ 1.6184/6191

Forward: Spot August: 16/15
Spot September :34/32
Spot October :53/50

Solution

On 30th September, the Indian Exporter would received the . He would surrender the and
received US$ which he again convert into Indian Rupee.

Quotation for against US$ as on September 30 would be :

Spot rate : 1: US$ 1.6184

September Forward Premium :(-) 0.0034
US$ 1.6150
(Since is appreciating, hence premium will be deducted)

Quotation for US$ against Indian as on September 30 would be:

Spot rate : US1: Rs.47.2825

September Forward Premium : 0. 5200
Rs.47.8025
(Since Rupee is depreciating, hence premium will be added)

Forward rate for the September delivery contract of against Indian rupee will be

1= US$ 1.6150 and US$1=Rs.47.8025

Or 1= Rs.47.8025 * 1.6150
Or 1=Rs.77.2010

The Bank would quote 1: Rs.77.2010 to the customer for delivery of Contract on September 30.
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International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Problems in Forward Contracts

Credit Risk
It may happen that both the parties may not adhere to forward contract as promised in the
contract. This leads to credit risk. Since there is no counterparty to certify this
contract, it generally create credit risk.

Not Mark to Market (MTM)

Since the forward contracts are OTC product and are not subject to mark-to-
market, any significant change or volatility in exchange rate market, may make
difficult for one party in the contract to abide by the contract. MTM creates a sinking
fund for smoothly progress towards the exchange rate, which would be prevailed, in the
near future.

No Standardization
Forward contracts are the OTC products and customized as per the requirement of
customers.
No Liquidity
Since forward contracts are not listed and traded, there is no liquidity or market for
the same product. Once the contract signed, the holder of the contract need cannot sell it
and hence, the holder has to keep it till maturity or cancel it for getting out of it.

No Transparency for Prices, Volume, Delivery etc.

This OTC product generally has different prices for same currency and same
maturity primarily due to lack of transparency in pricing policy.

Difficult to Exit
Since forward contract is an OTC product and there is no secondary market for this,
it would be very difficult to exit from such contract once you hold it. Only way to exit
is cancellation by paying may be hefty cancellation charges.

No Standardization
Forward contracts are the OTC products and customized as per the requirement of
customers.

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International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

No Liquidity
Since forward contracts are not listed and traded, there is no liquidity or market for
the same product. Once the contract signed, the holder of the contract need cannot sell it
and hence, the holder has to keep it till maturity or cancel it for getting out of it.

No Transparency for Prices, Volume, Delivery etc.

This OTC product generally has different prices for same currency and same
maturity primarily due to lack of transparency in pricing policy.

Difficult to Exit
Since forward contract is an OTC product and there is no secondary market for this,
it would be very difficult to exit from such contract once you hold it. Only way to exit
is cancellation by paying may be hefty cancellation charges.

References
Sachs, J.D, Warner, A, Aslund, A & Fischer, S, Economic Reform and the Process of
Global Integration Brookings Papers on Economic Activity, Vo.1995, No.1, 25th
Anniversary Issue. 1995, pp.1-118.

Foreign Trade of India 1947-2007: Trends, Policies and Prospects, Vibha Mathur, New
Century Publication, 2006.

http://en.wikipedia.org/wiki/World_Trade_Organization

http://www.blackwellpublishing.com/content/BPL_Images/Content_store/Sample_chapter
/9780631229513/001.pdf

Model Questions

1. Write in brief various products for management of Transaction exposure.

2. Explain various features of Futures Market and bring out its distinctive advantages of over
the Forward Market.

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