Management of
Transaction Exposure
8
Chapter Eight
Chapter Objective:
This chapter discusses various methods available
for the management of transaction exposure facing
multinational firms.
This chapter ties together chapters 5, 6, and 7.
8-0

sdfb
Chapter Outline






8-2
Forward Market Hedge
Money Market Hedge
Options Market Hedge
Cross-Hedging Minor Currency Exposure
Hedging Contingent Exposure
Hedging Recurrent Exposure with Swap
Contracts
Chapter Outline (continued)





Hedging Through Invoice Currency
Hedging via Lead and Lag
Exposure Netting
Should the Firm Hedge?
What Risk Management Products do Firms Use?
3
8-3
Forward Market Hedge


8-4
If you are going to owe foreign currency in the
future, agree to buy the foreign currency now by
entering into long position in a forward contract.
If you are going to receive foreign currency in the
future, agree to sell the foreign currency now by
entering into short position in a forward contract.
Forward Market Hedge: an Example
You are a U.S. importer of Italian shoes and have
just ordered next year’s inventory. Payment of
€100M is due in one year.
Question: How can you fix the cash outflow in
dollars?
Answer: One way is to put yourself in a position
that delivers €100M in one year—a long
forward contract on the euro.
8-5
Forward Market Hedge
Suppose the
forward exchange
rate is $1.50/€.
$30m
If he does not
hedge the €100m
$0
payable, in one
year his gain
(loss) on the –$30m
unhedged position
is shown in green.
The importer will be better off if
the euro depreciates: he still
buys €100m but at an exchange
rate of only $1.20/€ he saves
$30 million relative to $1.50/€
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
But he will be worse off if
the pound appreciates.
Unhedged
payable
6
8-6
Forward Market Hedge
If he agrees
to buy €100m
in one year at
$30m
$1.50/€ his
gain (loss) on
the forward
$0
are shown in
blue.
–$30m
8-7
If you agree to buy €100
million at a price of
$1.50/€, you will make
$30 million if the price of
the euro reaches $1.80.
Long
forward
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
If you agree to buy €100 million at a
price of $1.50 per pound, you will lose
$30 million if the price of the euro falls
7
to $1.20/€.
Forward Market Hedge
The red line
shows the
payoff of the
$30 m
hedged
payable. Note
that gains on
$0
one position are
offset by losses
–$30 m
on the other
position.
8-8
Long
forward
Hedged payable
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
Unhedged
payable
Futures Market Cross-Currency Hedge
Your firm is a U.K.based exporter of
bicycles. You have sold
€750,000 worth of
bicycles to an Italian
retailer. Payment (in
euro) is due in six
months. Your firm
wants to hedge the
receivable into pounds.
Sizes of forward
contracts are shown.
8-9
Country
U.S. $
equiv.
Currency
per U.S. $
Britain (£62,500)
$2.0000
£0.5000
1 Month Forward
$1.9900
£0.5025
3 Months Forward
$1.9800
£0.5051
6 Months Forward
$2.0000
£0.5000
12 Months Forward
$2.1000
£0.4762
Euro (€125,000)
$1.4700
€0.6803
1 Month Forward
$1.4800
€0.6757
3 Months Forward
$1.4900
€0.6711
6 Months Forward
$1.5000
€0.6667
12 Months Forward
$1.5100
€0.6623
Futures Market Cross-Currency Hedge:
Step One


8-10
You have to convert the €750,000 receivable first
into dollars and then into pounds.
If we sell the €750,000 receivable forward at the
six-month forward rate of $1.50/€ we can do this
with a SHORT position in 6 six-month euro
futures contracts.
€750,000
6 contracts =
€125,000/contract
Futures Market Cross-Currency Hedge:
Step Two
Selling the €750,000 forward at the six-month
forward rate of $1.50/€ generates $1,125,000:
$1.50
$1,125,000 = €750,000 ×
€1
 At the six-month forward exchange rate of $2/£,
$1,125,000 will buy £562,500.
 We can secure this trade with a LONG position in
9 six-month pound futures contracts:

9 contracts =
8-11
£562,500
£62,500/contract
Money Market Hedge


This is the same idea as covered interest arbitrage.
To hedge a foreign currency payable, buy a bunch
of that foreign currency today and sit on it.



8-12
Buy the present value of the foreign currency payable
today.
Invest that amount at the foreign rate.
At maturity your investment will have grown enough to
cover your foreign currency payable.
Money Market Hedge
A U.S.–based importer of Italian bicycles



In one year owes €100,000 to an Italian supplier.
The spot exchange rate is $1.50 = €1.00
The one-year interest rate in Italy is i€ = 4%
€100,000
Can hedge this payable by buying €96,153.85 = 1.04
today and investing €96,153.85 at 4% in Italy for one year.
At maturity, he will have €100,000 = €96,153.85 × (1.04)
Dollar cost today = $144,230.77 = €96,153.85 × $1.50
€1.00
8-13
Money Market Hedge


With this money market hedge, we have
redenominated a one-year €100,000 payable into
a $144,230.77 payable due today.
If the U.S. interest rate is i$ = 3% we could borrow
the $144,230.77 today and owe in one year
$148,557.69 = $144,230.77 × (1.03)
€100,000
T
$148,557.69 = S($/€)×
×
(1+
i
)
$
(1+ i€)T
8-14
Money Market Hedge: Step One
Suppose you want to hedge a payable in the amount
of £y with a maturity of T:
i. Borrow $x at t = 0 on a loan at a rate of i$ per year.
£y
$x = S($/£)× (1+ i )T
£
$x
0
8-15
Repay the loan in T years
–$x(1 + i$)T
T
Money Market Hedge: Step Two
£y
ii. Exchange the borrowed $x for
(1+ i£)T
at the prevailing spot rate.
£y
Invest
at i£ for the maturity of the payable.
T
(1+ i£)
At maturity, you will owe a $x(1 + i$)T.
Your British investments will have grown to £y. This
amount will service your payable and you will have no
exposure to the pound.
8-16
Money Market Hedge
£y
1. Calculate the present value of £y at i£
(1+ i£)T
2. Borrow the U.S. dollar value of receivable at the spot rate.
3. Exchange $x = S($/£)×
4. Invest
£y
(1+ i£)T
£y
at i£ for T years.
T
(1+ i£)
for
£y
(1+ i£)T
5. At maturity your pound sterling investment pays your
receivable.
6. Repay your dollar-denominated loan with $x(1 + i$)T.
8-17
Money Market Cross-Currency Hedge
Your
firm is a U.K.-based importer of bicycles.
You have bought €750,000 worth of bicycles from
an Italian firm. Payment (in euro) is due in one year.
Your firm wants to hedge the payable into pounds.


Spot exchange rates are $2/£ and $1.55/€
The interest rates are 3% in €, 6% in $ and 4% in £,
all quoted as an APR.
should you do to redenominate this 1-year €denominated payable into a £-denominated payable
with a 1-year maturity?
What
8-18
Money Market Cross-Currency Hedge
Sell pounds for dollars at spot exchange rate, buy euro at spot
exchange rate with the dollars, invest in the euro zone for one
year at i€ = 3%, all such that the future value of the investment
equals €750,000. Using the numbers we have:
Step 1: Borrow £564,320.39 at i£ = 4%,
Step 2: Sell pounds for dollars, receive $1,128,640.78
Step 3: Buy euro with the dollars, receive €728,155.34
Step 4: Invest in the euro zone for 12 months at 3% APR
(the future value of the investment equals €750,000.)
Step 5: Repay your borrowing with £586,893.20
8-19
Money Market Cross-Currency Hedge

Where do the numbers come from?
€750,000
€728,155.34 =
(1.03)
$1.55
$1,128,640.77 = €728,155.34 ×
€1
£1
£564,320.39 = $1,128,640.77 ×
$2
£586,893.20 = £564,320.39 × (1.04)
8-20
Options Market Hedge


Options provide a flexible hedge against the
downside, while preserving the upside potential.
To hedge a foreign currency payable buy calls on
the currency.


To hedge a foreign currency receivable buy puts
on the currency.

8-21
If the currency appreciates, your call option lets you buy
the currency at the exercise price of the call.
If the currency depreciates, your put option lets you sell
the currency for the exercise price.
Options Market Hedge
Suppose the
forward exchange
rate is $1.50/€.
If an importer who $30m
owes €100m does
not hedge the
$0
payable, in one
year his gain (loss)
on the unhedged
position is shown –$30m
in green.
8-22
The importer will be better off if
the euro depreciates: he still buys
€100m but at an exchange rate of
only $1.20/€ he saves $30 million
relative to $1.50/€
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
But he will be worse off if
the euro appreciates.
Unhedged
payable
Options Markets Hedge
Profit
Suppose our
importer buys a
call option on
€100m with an
exercise price
of $1.50 per
–$5m
pound.
He pays $.05
per euro for the
loss
call.
8-23
Long call on
€100m
$1.55/€
$1.50/€
Value of €1 in $
in one year
Options Markets Hedge
Profit
The payoff of the
portfolio of a call
and a payable is
shown in red.
$25m
He can still profit
from decreases in
the exchange rate –$5m
below $1.45/€ but
has a hedge against
unfavorable
increases in the
loss
exchange rate.
8-24
Long call on
€100m
$1.20/€
$1.45 /€
$1.50/€
Value of €1 in $
in one year
Unhedged
payable
Options Markets Hedge
Profit
If the exchange
rate increases to
$1.80/€ the
importer makes
$25 m
$25 m on the call
but loses $30 m on
the payable for a
maximum loss of –$5 m
$5 million.
–$30 m
This can be
thought of as an
insurance
loss
premium.
8-25
Long call on
€100m
$1.45/€
$1.50/€
Value of €1 in $
$1.80/€
in one year
Unhedged
payable
Options Markets Hedge
With an exercise price denominated in local currency
IMPORTERS who OWE
foreign currency in the
future should BUY CALL
OPTIONS.


8-26
If the price of the currency goes
up, his call will lock in an upper
limit on the dollar cost of his
imports.
If the price of the currency goes
down, he will have the option to
buy the foreign currency at a
lower price.
EXPORTERS with accounts
receivable denominated in
foreign currency should BUY
PUT OPTIONS.


If the price of the currency goes down,
puts will lock in a lower limit on the
dollar value of his exports.
If the price of the currency goes up, he
will have the option to sell the foreign
currency at a higher price.
Hedging Exports with Put Options



Show the portfolio payoff of an exporter who
is owed £1 million in one year.
The current one-year forward rate is £1 = $2.
Instead of entering into a short forward
contract, he buys a put option written on £1
million with a maturity of one year and a
strike price of £1 = $2.

8-27
The cost of this option is $0.05 per pound.
Options Market Hedge:
Exporter buys a put option to protect the dollar
value of his receivable.
$1,950,000
S($/£)360
–$50k
Long put
$2 $2.05
–$2m
28
8-28
The exporter who buys a put option to protect
the dollar value of his receivable
has essentially purchased a call.
S($/£)360
–$50k
$2 $2.05
29
8-29
Hedging Imports with Call Options



8-30
Show the portfolio payoff of an importer who owes
£1 million in one year.
The current one-year forward rate is £1 = $1.80; but
instead of entering into a long forward contract,
He buys a call option written on £1 million with an
expiry of one year and a strike of £1 = $1.80 The
cost of this option is $0.08 per pound.
GAIN
(TOTAL)
Forward Market Hedge:
Importer buys £1m forward.
Long
currency
forward
This forward hedge
fixes the dollar value
of the payable at
$1.80m.
S($/£)360
$1.80
LOSS
8-31
(TOTAL)
Accounts Payable = Short
Currency position 31
$1.8m
$1,720,000
Options Market Hedge:
Importer buys call option on £1m.
Call
Call option limits
the potential cost of
servicing the payable.
S($/£)360
–$80k
$1.80
$1.72 $1.88
32
8-32
$1,720,000
Our importer who buys a call to protect himself
from increases in the value of the pound creates a
synthetic put option on the pound.
He makes money if the pound falls in value.
S($/£)360
–$80k
$1.80
$1.72
The cost of this “insurance policy” is $80,000
33
8-33
Taking it to the Next Level

Suppose our importer can absorb “small” amounts
of exchange rate risk, but his competitive position
will suffer with big movements in the exchange
rate.


8-34
Large dollar depreciations increase the cost of his
imports
Large dollar appreciations increase the foreign currency
cost of his competitors exports, costing him customers
as his competitors renew their focus on the domestic
market.
Our Importer Buys a Second Call Option
$1,720,000
This position is called a straddle
2nd
Call
$1,640,000
S($/£)360
–$80k
–$160k
$1.64 $1.80 $1.96
$1.72 $1.88
Importers synthetic put
35
8-35
$1,720,000
Suppose instead that our importer is willing to
risk large exchange rate changes but wants to
profit from small changes in the exchange rate,
he could lay on a butterfly spread.
Sell 2 puts $1.90 strike.
butterfly spread
S($/£)360
–$80k
$1.80 $1.90
$1.72
Importers synthetic put
$2 buy a put $2 strike
A butterfly spread is analogous to an interest rate collar; indeed it’s
sometimes called a zero-cost collar. Selling the 2 puts comes close
to offsetting the cost of buying the other 2 puts.
8-36
36
Options



A motivated financial engineer can create almost
any risk-return profile that a company might wish
to consider.
Straddles and butterfly spreads are quite common.
Notice that the butterfly spread costs our importer
quite a bit less than a naïve strategy of buying call
options.
37
8-37
Cross-Hedging
Minor Currency Exposure



8-38
The major currencies are the: U.S. dollar,
Canadian dollar, British pound, Euro, Swiss franc,
Mexican peso, and Japanese yen.
Everything else is a minor currency, like the Thai
bhat.
It is difficult, expensive, or impossible to use
financial contracts to hedge exposure to minor
currencies.
Cross-Hedging
Minor Currency Exposure


Cross-Hedging involves hedging a position in one
asset by taking a position in another asset.
The effectiveness of cross-hedging depends upon
how well the assets are correlated.

8-39
An example would be a U.S. importer with liabilities in
Swedish krona hedging with long or short forward
contracts on the euro. If the krona is expensive when the
euro is expensive, or even if the krona is cheap when the
euro is expensive it can be a good hedge. But they need
to co-vary in a predictable way.
Hedging Contingent Exposure


8-40
If only certain contingencies give rise to exposure,
then options can be effective insurance.
For example, if your firm is bidding on a
hydroelectric dam project in Canada, you will
need to hedge the Canadian-U.S. dollar exchange
rate only if your bid wins the contract. Your firm
can hedge this contingent risk with options.
Hedging Recurrent Exposure
with Swaps



8-41
Recall that swap contracts can be viewed as a
portfolio of forward contracts.
Firms that have recurrent exposure can very likely
hedge their exchange risk at a lower cost with
swaps than with a program of hedging each
exposure as it comes along.
It is also the case that swaps are available in
longer-terms than futures and forwards.
Hedging through
Invoice Currency

The firm can shift, share, or diversify:

shift exchange rate risk


share exchange rate risk


by pro-rating the currency of the invoice between foreign and
home currencies
diversify exchange rate risk

8-42
by invoicing foreign sales in home currency
by using a market basket index
Hedging via Lead and Lag


8-43
If a currency is appreciating, pay those bills
denominated in that currency early; let customers
in that country pay late as long as they are paying
in that currency.
If a currency is depreciating, give incentives to
customers who owe you in that currency to pay
early; pay your obligations denominated in that
currency as late as your contracts will allow.
Exposure Netting

A multinational firm should not consider deals in
isolation, but should focus on hedging the firm as
a portfolio of currency positions.


8-44
As an example, consider a U.S.-based multinational
with Korean won receivables and Japanese yen
payables. Since the won and the yen tend to move in
similar directions against the U.S. dollar, the firm can
just wait until these accounts come due and just buy yen
with won.
Even if it’s not a perfect hedge, it may be too expensive
or impractical to hedge each currency separately.
Exposure Netting



Many multinational firms use a reinvoice center.
Which is a financial subsidiary that nets out the
intrafirm transactions.
Once the residual exposure is determined, then the
firm implements hedging.
In the following slides, a firm faces the following
exchange rates:
£1.00 = $2.00
€1.00 = $1.50
SFr 1.00 = $0.90
8-45
Exposure Netting
SFr150
$150
SFr150
€150
£150
$150
€150
£150
8-46
$2.00
$0.90
$1.50
£150×
$300 SFr150× SFr1 = $135
€150× €1 = $225
Exposure
£1 = Netting
SFr150
$135
$150
SFr150
$135
$225
€150
$225
$300
£150
$150
$225
€150
£150
$300
$300
8-47
Exposure Netting
$135
$135
$150
$225
$75
$300
$165
$150
$225
$75
$300
8-48
$15
8-49
$165
$180 = $165 +$180
$15
$75
Exposure Netting
$15
$75
Exposure Netting: an Example
Consider a U.S. MNC with three subsidiaries and
the following foreign exchange transactions:
$20
$30
$40
$10
$10 $35
$30 $40
$25
$20
$30
$60
50
8-50
Exposure Netting: an Example
Bilateral Netting would reduce the number of
foreign exchange transactions by half:
$20
$10
$30
$10$25$35
$40
$20
$15 $10
$25
$20
$10
$30
$30$10$40
$60
51
8-51
Multilateral Netting: an Example
Consider simplifying the bilateral netting with multilateral
netting:
$10
$15$25
$15
$10
$20
$30
$40
$40
$15
$15
$10
$10
8-52
$10
Should the Firm Hedge?

Not everyone agrees that a firm should hedge:


8-53
Hedging by the firm may not add to shareholder wealth
if the shareholders can manage exposure themselves.
Hedging may not reduce the non-diversifiable risk of
the firm. Therefore shareholders who hold a diversified
portfolio are not helped when management hedges.
Should the Firm Hedge?

In the presence of market imperfections, the firm
should hedge.

Information Asymmetry


Differential Transactions Costs


The firm may be able to hedge at better prices than the
shareholders.
Default Costs

8-54
The managers may have better information than the
shareholders.
Hedging may reduce the firms cost of capital if it reduces the
probability of default.
Should the Firm Hedge?

Taxes can be a large market imperfection.

8-55
Corporations that face progressive tax rates may find
that they pay less in taxes if they can manage earnings
by hedging than if they have “boom and bust” cycles in
their earnings stream.
What Risk Management Products do
Firms Use?


8-56
Most U.S. firms meet their exchange risk
management needs with forward, swap, and
options contracts.
The greater the degree of international
involvement, the greater the firm’s use of foreign
exchange risk management.
Exercises
EOC Problems 3, 4, 8
Mini Case: Airbus (p. 213)
Case Application (pp. 213-7)
End Chapter Eight
8-58