Transaction

Exposure
2013 Pearson Education, Inc. All rights reserved. 10-2
Exposure
Foreign exchange exposure is a measure of the
potential for a firms profitability, net cash flow, and
market value to change because of a change in
exchange rates.
An important task of the financial manager is to
measure foreign exchange exposure and to manage
it so as to maximize the profitability, net cash flow,
and market value of the firm.
The effect on a firm when foreign exchange rates
change can be measured in several ways.
Next slide shows schematically the three main
types of foreign exchange exposure: transaction,
translation, and operating.

2013 Pearson Education, Inc. All rights reserved. 10-4
Types of Foreign
Exchange Exposure
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, this type of exposure deals with
changes in cash flows the result from
existing contractual obligations.
2013 Pearson Education, Inc. All rights reserved. 10-5
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.
2013 Pearson Education, Inc. All rights reserved. 10-6
Types of Foreign
Exchange Exposure
Transaction exposure and operating
exposure exist because of unexpected
changes in future cash flows.
The difference between the two is that
transaction exposure is concerned with
future cash flows already contracted for,
while operating exposure focuses on
expected (not yet contracted for) future
cash flows that might change because a
change in exchange rates has altered
international competitiveness.
2013 Pearson Education, Inc. All rights reserved. 10-7
Types of Foreign
Exchange Exposure
Translation exposure, also called accounting
exposure, is the potential for accounting-
derived changes in owners 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.
2013 Pearson Education, Inc. All rights reserved. 10-8
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.
Many firms attempt to manage their
currency exposures through hedging.

2013 Pearson Education, Inc. All rights reserved. 10-9
Why Hedge?
Hedging is the taking of a position, acquiring
either a cash flow, an asset, or a contract
(including 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 gain
from an increase in the value of the asset
hedged against.
2013 Pearson Education, Inc. All rights reserved. 10-10
Measurement
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 most common example of transaction
exposure arises when a firm has a receivable
or payable denominated in a foreign
currency. Next slide demonstrates how this
exposure comes about.

2013 Pearson Education, Inc. All rights reserved. 10-12
Measurement
of Transaction Exposure
Foreign exchange transaction exposure can be
managed by contractual, operating, and financial
hedges.
The main contractual hedges employ the forward,
money, futures, and options markets.
Operating and financial hedges employ the use of
risk-sharing agreements, leads and lags in payment
terms, swaps, and other strategies.

2013 Pearson Education, Inc. All rights reserved. 10-13
Measurement
of Transaction Exposure
The term natural hedge refers to an off-
setting operating cash flow, a payable
arising from the conduct of business.
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.
Care should be taken to distinguish
operating hedges from financing hedges.
2013 Pearson Education, Inc. All rights reserved. 10-14
Tridents Transaction Exposure
Trident, US based co. sells 1,000,000GBP worth
generator to a UK based company. Payment due in
three months.

With reference to Tridents Transaction Exposure,
the CFO, Maria Gonzalez, has four alternatives:
Remain unhedged;
hedge in the forward market;
hedge in the money market; or
hedge in the options market.
2013 Pearson Education, Inc. All rights reserved. 10-16
Tridents Transaction Exposure
A forward hedge involves a forward (or futures) contract and
a source of funds to fulfill the contract.
In some situations, funds to fulfill the forward exchange
contract are not already available or due to be received later,
but must be purchased in the spot market at some future
date.
This type of hedge is open or uncovered and involves
considerable risk because the hedge must take a chance on
the uncertain future spot rate to fulfill the forward contract.
The purchase of such funds at a later date is referred to as
covering.
2013 Pearson Education, Inc. All rights reserved. 10-17
Tridents Transaction Exposure
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.
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.
Alternatively, funds to repay the loan may be purchased in
the foreign exchange spot market when the loan matures
(uncovered or open money market hedge).
2013 Pearson Education, Inc. All rights reserved. 10-18
Tridents Transaction Exposure
Hedging with options allows for participation in any
upside potential associated with the position while
limiting downside risk.
The choice of option strike prices is a very important
aspect of utilizing options as option premiums, and
payoff patterns will differ accordingly.
Next slide shows the value of Tridents 1,000,000
account receivable over a range of possible ending
spot exchange rates and hedging alternatives.
Valuation of Cash Flows Under Hedging Alternatives for
Trident with Option
2013 Pearson Education, Inc. All rights reserved. 10-20
Risk Management in Practice
The treasury function of most private firms,
the group typically responsible for
transaction exposure management, is
usually considered a cost center.
The treasury function is not expected to add
profit to the firms bottom line.
Currency risk managers are expected to err
on the conservative side when managing
the firms money.
2013 Pearson Education, Inc. All rights reserved. 10-21
Risk Management in Practice
Firms must decide which exposures to hedge:
Many firms do not allow the hedging of quotation
exposure or backlog exposure as a matter of policy
Many firms feel that 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%
An increasing number of firms, however, are actively
hedging not only backlog exposures, but also selectively
hedging quotation and anticipated exposures.
Anticipated exposures are transactions for which there
are at present no contracts or agreements between
parties

2013 Pearson Education, Inc. All rights reserved. 10-22
Risk Management in Practice
As might be expected, transaction exposure
management programs are generally
divided along an option-line, those that
use options and those that do not.
Firms that do not use currency options rely
almost exclusively on forward contracts and
money market hedges.

2013 Pearson Education, Inc. All rights reserved. 10-23
Risk Management in Practice
Many MNEs have established rather rigid
transaction exposure risk management policies that
mandate proportional hedging.
These contracts generally require the use of
forward contract hedges on a percentage of existing
transaction exposures.
The remaining portion of the exposure is then
selectively hedged on the basis of the firms risk
tolerance, view of exchange rate movements, and
confidence level.

2013 Pearson Education, Inc. All rights reserved. 10-24
Proctor and Gambles affiliate in India, P & G India,
procures much of its toiletries product line from a
Japanese company. Because of the shortage of
working capital in India, payment terms by Indian
importers are typically 180 days or longer. P & G India
wishes to hedge a 8.5 million Japanese yen payable.
Although options are not available on the Indian rupee
(Rs), forward rates are available against the yen.
Additionally, a common practice in India is for
companies like P & G India to work with a currency
agent who will, in this case, lock in the current spot
exchange rate in exchange for a 4.85% fee. Using the
following exchange rate and interest rate data,
recommend a hedging strategy.

2013 Pearson Education, Inc. All rights reserved. 10-25
Assumptions Values
180-day account payable, Japanese yen
()

85,00,000
Spot rate (/$)

120.60
Spot rate, rupees/dollar (Rs/$)

47.75
Implied (calculated) spot rate (/Rs)

2.5257

(120.60 /
47.75)
180-day forward rate (/Rs)

2.4000
Expected spot rate in 180 days (/Rs)

2.6000
180-day Indian rupee investing rate 8.000%
180-day Japanese yen investing rate 1.500%
Currency agent's exchange rate fee 4.850%
P & G India's cost of capital 12.00%