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Chapter 11

Transaction Exposure
Types of Foreign
Exchange Exposure

Types of Foreign Exchange
• Foreign exchange exposure is a measure of the
potential change for a firm’s profitability, net cash
flow, and market value because of a change in
exchange rates
• An important task for the financial manager is to
measure foreign exchange exposure and to manage it
so as to maximize or stabilize the profitability, net
cash flow, and market value of the firm
• The impact on a firm when foreign exchange rates
change can be classified into three kinds of exposure:
transaction, operating, and translation exposure

Types of Foreign Exchange
• Transaction exposure measures changes in the
value of existing foreign-currency-denominated
obligations, which incurred prior to an exchange
rate change but are not due to be settled until after
the exchange rate change
– According to the above definition, the exchange rate
changes cause the transaction exposure for existing
obligations, which start in the past and end in the
• In general, this type of exposure can be defined as
changes in cash flows of current existing
contractual obligations due to the movement of
the exchange rates
Types of Foreign Exchange
• 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
• More specifically, the change in firms’ value
depends on the impact of the exchange rate change
on future sales volume, product prices, and costs in
the following years

Types of Foreign Exchange
• Translation exposure, also called accounting 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
• This risk arises from that the exchange rates for
acquiring assets, liabilities, and equities are different
from that for generating consolidated financial
• So, comparing to time points of acquiring assets,
liabilities, and equities, changes of the exchange rate at
later time points cause the translation exposure
Exhibit 11.1 Comparison of Occurrence Time of the
Three Foreign Exchange Exposures on the Time Line

Time point when the

exchange rate changes

Translation exposure Operating exposure

Changes in reported owners’ equity Change in expected future cash flows
in consolidated financial statements for following years arising from an
caused by a change in exchange rates unexpected change in exchange rates

Transaction exposure
Impact of settling existing obligations, which entered into before changes
in exchange rates but to be settled after changes in exchange rates

Types of Foreign Exchange
• Transaction exposure vs. Operating exposure
– Both transaction exposure and operating exposure exist
because of unexpected changes in future cash flows
– The difference between them:
• Transaction exposure is concerned with the uncertainty of
future cash flows which are already contracted
• Operating exposure focuses on expected future cash flows
(not yet contracted) that might change because a change in
exchange rates could alter international competitiveness

Types of Foreign Exchange
• Tax consequence of foreign exchange exposures
– As a general rule, only realized foreign exchange losses are
deductible for calculating income taxes; Similarly, only
realized foreign exchange gains create taxable income
– Losses from transaction exposure usually reduce taxable
income in that year, but losses from operating exposure may
maintain for several years and thus reduce taxable income
over a series of future years
– Note that translation exposure could affect the parent
company’s net worth or net income, but it will not generate
cash losses in practice, i.e., both the parent company and
subsidiaries will not lose any money physically during the
translation of financial statements
– Since losses from translation exposure are only “paper”
losses, involving no cash flows, they are not deductible from
pretax income 11-9
Reasons for Hedging
Foreign Exchange Risk

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
– Here we focus only on the sensitivity of the individual
firm’s future cash flows to exchange rates
• Many firms attempt to manage their currency (foreign
exchange) exposures through hedging
– Hedging is the taking of a position, acquiring either a cash
flow, an asset, or a contract (e.g., 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 gains from an increase in the value of
that asset 11-11
Why Hedge?
• What is to be gained by the firm from hedging?
– The major motive for firms to hedge is to increase the present
value of firms
– The value of a firm, according to financial theories, is the
present value of all expected future cash flows
– For expected cash flows with higher uncertainty (or risk), a
higher discount rate should be applied to calculating the
present value and thus a lower present value for these cash
flows is generated
– A firm that hedges these foreign exchange exposures reduces
the variance (or risk) in the value of future expected cash
flows (see Exhibit 11.2 on the next slide)
– Thus, a lower discount rate is employed to calculate the
present value of expected future cash flows, which implies
the increase of the present value of the firm
Exhibit 11.2 Impact of Hedging on the
Expected Cash Flows of the Firm

※ Hedging will not increase the expected value for a cash flow. Actually, if taking the
hedging cost into account, hedge transactions will decrease the expected cash flow
※ Hedging reduces the variability of future cash flows about the expected value of the
distribution. This reduction of distribution variance is a reduction of risk

Why Hedge?
• However, is a reduction in the variability of future
cash flows to be a sufficient reason for currency risk
management? Opponents of currency hedging
commonly make the following arguments
– Shareholders are much more capable of diversifying
currency risk according to their individual preferences and
risk tolerance than the management of the firm
– Although currency risk management can reduce the variance,
it reduces the expected cash flow due to hedging costs.
• So, the net benefit of hedge depends on the trade-off between
these two effects
– Hedging activities are sometimes conducted to benefit the
management at the expense of the shareholders
• For instance, the true goal of hedging the variance of the
company’s income is to ensure the bonus of the management
Why Hedge?
– Management may overuse the expensive hedge
• Management may believe that it will be criticized more
severely for incurring foreign exchange losses than for
incurring similar or even higher hedge costs in avoiding the
foreign exchange loss
• Possibly due to the accounting rules: because the foreign
exchange losses appear in the income statements as a highly
visible item or as a footnote, but the hedging costs are buried
in operating or interest expenses
– 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
• Although the translation exposure are only “paper” losses,
there are still some firms to hedge this risk
• However, the above argument implies that it is not necessary
to hedge the translation (accounting) exposure 11-15
Why Hedge?
• Proponents of hedging cite the following arguments:
– Hedge can reduce the variance of future cash flows and
thus may increase the firm’s present value by reducing
the discount rate
– Firms should focus on the main business they are in and
take activities to minimize risks arising from interest rates,
exchange rates, and other market variables
– Management is in better position than shareholders to
recognize disequilibrium conditions quickly and to
undertake the hedging activities immediately
– Management has a comparative advantage over individual
shareholders in estimating the actual currency risk of the
firm and taking the correct hedging strategy

Why Hedge?
– Reduction in risk in future cash flows improves the
planning capability of the firm. Therefore, the firm can
undertake more investment projects that it might not
consider before
– Since a firm must generate sufficient cash flows to
make debt-service payments, reduction of risk in
future cash flows reduces the likelihood that the firm’s
cash flows will fall below a necessary minimum (This
minimum level of cash flows is also termed as the point
of financial distress)

Sources of Transaction

Sources 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
• The sources of transaction exposure include
– Purchasing or selling goods and services in foreign
currencies through credit accounts (to form the A/P or
A/R on the balance sheet)
– Borrowing or lending funds in foreign currencies
– Entering into foreign exchange or foreign currency
derivative contracts

Purchasing or Selling through
Credit Account
• The most common example of transaction exposure
arises when a firm has a receivable or payable
denominated in foreign currencies
• For each trade of goods and services, the total
transaction exposure consists of quotation, backlog,
and billing exposures (see Exhibit 11.3)
• Suppose that a U.S. firm sells merchandise on credit
account to a Belgian buyer for €1,000,000 to be made
in 60 days. The current exchange rate is $1.12/€, so the
seller expects to receive $1,120,000
– If the exchange rate becomes $1.08/€ ($1.15/€), the seller will
receive $1,080,000 ($1,150,000)
– Thus exposure (or risk) means not only the probability of
some losses but also the probability of some gains 11-20
Exhibit 11.3 The Life Span of the Transaction
Exposure for Trades of Goods and Services
Time and Events

t1 t2 t3 t4
Seller quotes a price Buyer places Seller ships Buyer settles A/R
in foreign currency to firm order with products and with cash in
buyer (in verbal or seller at price bills buyer foreign currency
written form) offered at time t1 (becomes A/R) quoted at time t1

Time between quoting Time it takes to Time it takes to

a price and reaching a fill the order after get paid in cash after
contractual sale contract is signed A/R is issued

Quotation Backlog Billing

Exposure Exposure Exposure
※After the price is quoted at t1, if the exchange rate changes against the seller at t2, the
seller may earn less or even suffer losses. So the transaction exposure starts from t1
※At t3, the seller books foreign-currency-denominated receivables at the exchange rate
of that time point, but changes in exchange rate between t3 and t4 will affect the
received cash flow in domestic dollars at t4, that is the billing exposure
※The transaction exposure on credit account is actually the billing exposure 11-21
Borrowing or Lending Foreign
• A true case for the transaction exposure over foreign
debt is about the Grupo Embotellador de Mexico
• Gemex, the largest bottler of PepsiCo outside the U.S.,
had U.S. dollar debt of $264 million in 1994
• The Mexico’s new peso was pegged at Ps3.45/$ since
Jan. 1, 1993, but the peso was forced to float in Dec.
1994 because of economic and political events and the
exchange rate stabilized near Ps5.5/$
• So, the debt in pesos is from Ps910 million to Ps1452
million, which increases by 59%

Entering into Foreign Exchange or
Foreign Currency Derivative Contracts
• Suppose a U.S. firm purchases ¥100 million through
a foreign exchange forward contract at the forward
exchange rate ¥100/$ after 90 days
– When a firm enters into a foreign exchange derivatives
contract, it deliberately creates a transaction exposure
– The motive to create transaction exposure could be the need
to hedge the account payable of ¥100 million after 90 days
– If the spot exchange rate becomes ¥110/$ (¥90/$) after 90
days, the U.S. firm will have a transaction loss (gain)
through this foreign exchange forward contract
– On the other hand, if the spot exchange rate is ¥110/$
(¥90/$) after 90 days, the account payable of ¥100
million after 90 days have a transaction gain (loss)

Sources of Transaction Exposure
※ Note that cash balances in foreign currency DO
NOT create transaction exposure, even though their
domestic currency value changes immediately with a
change in exchange rates
– Since the firm does not have the obligation to transfer cash
in foreign currency into cash in domestic currency, there is
no transaction exposure for the cash in foreign currency
– This kind of risk is reflected in the consolidated statement
and thus classified as the translation exposure

Management of
Transaction Exposure

Management of Transaction
• Transaction exposure can be managed by operating,
financial, and contractual hedges
• The term operating hedge refers to an off-setting
operating cash flow arising from the conduct of
– For example, the payments in a foreign currency could be
offset by the foreign currency cash inflow generated from
operating activities, e.g., from sales. This kind of hedge for
the transaction exposure is also termed natural hedge
– Operating hedge could also employ the use of risk-sharing
agreements, leads and lags in payment terms, and other

Management of Transaction
Leading and Lagging
• Leading and lagging strategies involve adjusting
the timing of a payment request or disbursement to
reflect expectations about future currency
• General Electric and other well-known MNCs
commonly use leading and lagging strategies in
countries that allow them.

Management of Transaction
Leading and Lagging
• In some countries, the government limits the length
of time involved in leading and lagging strategies
so that the flow of funds into or out of the country
is not disrupted. Consequently, an MNC must be
aware of government restrictions in any countries
where it conducts business before using these

Management of Transaction
• Corvalis Co. is based in the United States and has
subsidiaries dispersed around the world. The focus
here will be on a subsidiary in the United Kingdom
that purchases some of its supplies from a
subsidiary in Hungary. These supplies are
denominated in Hungary’s currency (the forint).
• If Corvalis Co. expects that the pound will soon
depreciate against the forint, it may attempt to
expedite the payment to Hungary before the pound
depreciates. This strategy is referred to as leading.

Management of Transaction
• As a second scenario, assume that the British
subsidiary expects the pound to appreciate against
the forint soon. In this case, the British subsidiary
may attempt to stall its payment until after the
pound appreciates. In this way it could use fewer
pounds to obtain the forint needed for payment.
This strategy is referred to as lagging.

Management of Transaction
• Cross-hedging is a common method of reducing
transaction exposure when the currency cannot be
• This type of hedge is sometimes referred to as a
proxy hedge because the hedged position is in a
currency that serves as a proxy for the currency in
which the MNC is exposed.
• The effectiveness of this strategy depends on the
degree to which these two currencies are positively
correlated. The stronger the positive correlation, the
more effective will be the cross-hedging strategy.
Management of Transaction
Cross-Hedging- Example
• Greeley Co., a U.S. firm, has payables in zloty
(Poland’s currency) 90 days from now. Because it
is worried that the zloty may appreciate against the
U.S. dollar, it may desire to hedge this position. If
forward contracts and other hedging techniques are
not possible for the zloty, Greeley may consider
• In this case, it needs to first identify a currency that
can be hedged and is highly correlated with the

Management of Transaction
Cross-Hedging- Example (contd.)
• Greeley notices that the euro has recently been
moving in tandem with the zloty and decides to set
up a 90-day forward contract on the euro.
• If the movements in the zloty and euro continue to
be highly correlated relative to the U.S. dollar (that
is, they move in a similar direction and degree
against the U.S. dollar), then the exchange rate
between these two currencies should be somewhat
stable over time.
• By purchasing euros 90 days forward, Greeley Co.
can then exchange euros for the zloty
Strategic Management

of Operating Exposure

Currency Diversification
• limits the potential effect of any single
currency’s movements on the value of an
• Some MNCs, such as The Coca-Cola Co.,
PepsiCo, and Altria, claim that their exposure
to exchange rate movements is significantly
reduced because they diversify their business
among numerous countries.
Strategic Management
of Operating Exposure
• The dollar value of future inflows in foreign
currencies will be more stable if the foreign
currencies received are not highly positively
• The reason is that lower positive correlations or
negative correlations can reduce the variability
of the dollar value of all foreign currency
• If the foreign currencies were highly correlated
with each other, diversifying among them
would not be a very effective way to reduce
risk. If one of the currencies substantially
depreciated, the others would do so as well,
given that all these currencies move in tandem.
Management of Transaction
• 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
– To eliminate the transaction exposure, firms can borrow
foreign currencies today to prepare for the settlement of
A/Rs in foreign currencies in the future
– Due to the borrowing activities, this kind of hedge is
classified as financial hedge
• Contractual hedges employ the forward, futures, and
options contracts to hedge transaction exposures
• The Trident case as follows illustrates how contractual
and financial hedging techniques may be used to
protect against transaction exposure
Trident’s Transaction Exposure
• Trident company just concludes negotiations for the
sale of telecommunication equipments to Regency, a
British firm, for £1,000,000
– The sale is made in March with payment due three months
later in June
– The financial and market information is as follows
‧Spot exchange rate: $1.7640/£
‧Three-month forward rate: $1.7540/£
‧Cost of capital for Trident company: 12%
‧U.K. three-month deposit (borrowing) interest rate: 8% (10%)
‧U.S. three-month deposit (borrowing) interest rate: 6% (8%)
‧Put option expired in June for £1,000,000 with the strike price
$1.75/£ ($1.71/£) is quoted as 1.5% (1.0%) premium
‧Trident’s foreign exchange advisory service forecasts that the
spot rate after three months will be $1.76/£
Trident’s Transaction Exposure
• Trident’s minimum acceptable margin is at a sales
price of $1,700,000, which implies the budget rate,
the lowest acceptable dollar per pound exchange
rate, is at $1.70/£
• Trident company has four alternatives to deal with
the transaction exposure:
– Remain unhedged
– Hedge in the forward market
– Hedge in the money market
– Hedge in the options market
• These choices can be applied to both an account
receivable (in this case) and an account payable

Trident’s Transaction Exposure
• Unhedged position

• Forward Market Hedge

– A forward hedge involves a forward (or futures) contract
and a source of funds to fulfill the contract in the future
– If funds to fulfill the forward contract are on hand or are
due because of a business operation, the hedge is considered
“covered,” since no residual foreign exchange risk exists

Trident’s Transaction Exposure
– It would be recorded on Trident’s income statement as a
foreign exchange loss of $10,000 ($1,764,000 as booked,
$1,754,000 as settled)
– Different from the above case, if funds to fulfill the forward
exchange contract are not already available or due to be
received later, funds to fulfill the forward contract must be
purchased in the spot market at some future time points
– This type of hedge is “open” or “uncovered” and involves
considerable risk because of the uncertain future spot rate to
obtain funds to fulfill the forward contract
– In this chapter, only the covered hedge is considered

Trident’s Transaction Exposure
• Money Market Hedge
– 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, so the
money market hedge is a kind of financial hedge
– 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

※ £975,610 =£1,000,000 / (1+10%×90/360)

Trident’s Transaction Exposure
– The money-market hedge actually creates a pound-
denominated liability (the pound loan) to offset the pound-
denominated asset (the account receivable)
– So, the money-market hedge is also a kind of balance sheet
– Money market hedge vs. forward market hedge
Received today Invested in Rate (annual) FV after 3 months

$1,720,976 Deposit 6% $1,746,791

$1,720,976 Dollar loans 8% $1,755,396
$1,720,976 Operations of the firm 12% $1,772,605

※ A break-even investment rate can be calculated that would make Trident

indifferent between the forward market hedge and the money market hedge
$1, 720,976 (1  r )  $1, 754, 000  r  1.92% (7.68% annually)
※ If Trident can invest the loan proceeds at a rate higher than 7.68% per annum,
it would prefer the money market hedge
Trident’s Transaction Exposure
• Option Market Hedge
– Trident could also cover £1,000,000 exposure by
purchasing a put option to acquire the right to sell British
pounds forward at the strike price
– Hedging with purchasing options allows for participation
in any upside potential associated with the position while
limiting downside risk
– The choice of option strike prices is an important aspect
of utilizing options for hedging because option premiums
and payoff patterns will differ accordingly
– Trident consider (1) a nearly ATM put with the strike
price of $1.75/£ and the premium of 1.5%, or (2) an
OTM put with the strike price of $1.71/£ and the
premium of 1%

Trident’s Transaction Exposure
– For the ATM put, the cost of put is £1,000,000 × 1.5% =
£15,000 = $26,460 (= £15,000 × $1.7640/£)

– The minimal dollar receipts in June is $1,750,000 –

$26,460×(1 + 12%×90/360) = $1,750,000 – $27,254 =
$1,722,746 when the spot exchange rate is below $1.75/£
(The opportunity cost of $26,460 is the cost of capital of
Trident, i.e., 12%)
– The maximal dollar receipts in June is unlimited and
increasing with the appreciation of the pounds
Trident’s Transaction Exposure
– Compare the ATM put and the OTM put
Put option with strike price ATM put at $1.75/£ OTM put at $1.71/£
Option cost (FV in June) $27,254 $18,169
Proceeds if exercised $1,750,000 $1,710,000
Minimum net proceeds $1,722,746 $1,691,831
Maximum net proceeds Unlimited Unlimited

※ The option premium for the OTM put is £1,000,000 × 1% = £10,000 =

$17,640 (= £10,000 × $1.7640/£)
※ The minimal dollar receipts in June is $1,710,000 – $17,640×(1 +
12%×90/360) = $1,710,000 – $18,169 = $1,691,831 when the spot exchange
rate is below $1.71/£
※ The OTM put is much cheaper today, but the minimum net proceeds of the
OTM put is smaller than those of the ATM put, i.e., the OTM put provides a
lower level of protection
※ In the Trident’s case, the OTM put cannot meet its budgeted exchange rate
of $1.70/£ after taking the premium expenses into consideration
Trident’s Transaction Exposure
• Comparison of alternative hedging strategies for Trident
Unhedged position Result
Wait three months then sell the received Receipt in US$ in June
£1,000,000 for dollars in the spot market 1.An unlimited maximum
2.An expected $1,760,000
3.A zero minimum
Forward market hedge Result
Sell £1,000,000 forward for dollars Certain receipts of $1,754,000 in June

Money market hedge Result

1.Borrow £975,610 at the interest rate of 1.The received £1,000,000 is for the repayment
10% of the interest and principal of the borrowed
2.Exchange for $1,720,976 at the spot amount of £975,610
exchange rate 2.The FV of $1,720,976 in June depends on the
3.Invest $1,720,976 in US markets for US$ investment rate (The break-even rate of
three months 7.68% generates the same payment as the
forward contract, i.e., $1,754,000)
Options market hedge Result
Purchase a three-month put option of Receipt in US$ in June
£1,000,000 with the strike price of 1.An unlimited maximum less $27,254
$1.75/£ and premium cost of $27,254 (FV 2.An expected $1,760,000 less $27,254
after 3 months)
3.A minimum of $1,750,000 less $27,254 11-46
Exhibit 11.5 Valuation of Cash Flows
Under Hedging Alternatives for Trident
Value of Trident’s £1,000,000 A/R Uncovered
(in million US dollars)
Put option strike
1.84 price of $1.75/£ OTM put
option hedge
1.82 Put option strike
price of $1.71/£
ATM put
option hedge

1.76 Money market hedge

Forward contract hedge


1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86

Ending spot exchange rate (US$/£)

Trident’s Transaction Exposure
• The final choice among hedges depends on the firm’s
risk tolerance, its view of the future exchange rate,
and its confidence in its view
– Thus, transaction exposure management with contractual or
financial hedges requires managerial judgment
• For an account payable, where the firm would be
required to make a foreign currency payment at a
future date, it is possible to apply similar techniques
to hedging this transaction exposure
• Suppose that Trident had a £1,000,000 account
payable which will be settled in 90 days, the possible
hedge alternative are summarized in the table on the
next slide
Trident’s Transaction Exposure
Unhedged position Result
Wait 90 days, exchange dollars for Total payment for £1,000,000 in June
£1,000,000 at that time, and make its 1.Unlimited US$
payment 2.Expected amount of $1,760,000
3.Minimal zero US$ payment
Forward market hedge Result
Buy £1,000,000 forward for dollars Certain payments of $1,754,000 in June

Money market hedge Result

1.Borrow $1,729,411.77 at the interest rate 1.The interest and principal of £980,392.16 is
of 8% £1,000,000, which is just enough for the
2.Exchange for £980,392.16 at the spot payment after 90 days
exchange rate of $1.764/£ 2.The repayment amount of $1,729,411.77 in
3.Deposit £980,392.16 in the British 90 days is $1,764,000 (This cost is higher than
pound money market at the interest rate of the forward hedge and therefore unattractive)
8% for 90 days
Options market hedge Result
Purchase a three-month call option of Total payment for £1,000,000 in June
£1,000,000 with a nearly at-the-money 1.A limited maximum of $1,750,000 +
strike price of $1.75/£ and premium is $27,254 = $1,777,254
assumed to be 1.5%, which implies a cost of 2.A minimum of $0 plus $27,254
$27,254 (FV after 3 months)
Exhibit 11.6 Valuation of Hedging
Alternatives for an Account Payable
Value of Trident’s £1,000,000 A/P Ending spot exchange rate (US$/£)
in million US dollars

-1.68 1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86

Forward contract hedge locks
in a payment of $1,754,000


Money market hedge locks
Call option hedge
-1.80 in a payment of $1,764,000


Uncovered payment
Call option strike whatever the ending
price of $1.75/£ spot rate is in 90 days