TRANSACTION EXPOSUREForeign Currency Exposure

TYPES OF EXPOSURE Transaction exposure Operating Exposure Translation exposure Tax Exposure

DEFINITION Transaction Exposure: Outstanding

financial obligation that may have to be settled at a different exchange rate at settlement time.

HEDGING Taking a position that will offset a

potential loss due to a change in exchange rate. Such a position will also wipe out a potential gain due to a favorable change in the exchange rate.

HEDGE OR NOT TO HEDGE Reasons for not hedging

It does not really improve cash flow. Management cannot predict the future

exchange rate. It is not consistent with value maximization Shareholders can diversify on their own.

Management need not try to hedge. They should focus on actual business

HEDGE OR NOT TO HEDGE Reasons to Hedge

Improves planning function. Liquidity management Management has better information than

Individual shareholders

MEASUREMENT OF TRANSACTION EXPOSURE

Results from outstanding financial obligations. Resulting from purchase or sale.

Exposure begins when a quote is made. Total exposure:

Quotes Transactions- Transactions resulting from due

course of business - borrowed or lending position to offset an

exposure Regular business bills.

MANAGING TRANSACTION EXPOSURE Shift Exposure- Get transaction denominated in

your currency. Choices for Managing Exposure:

Do nothing Hedge in the forward market Hedge in the money market

Full Hedge Partial hedge

Hedge in the options market Buy options Write options

Mixed options (Appendix)

MANAGING TRANSACTION EXPOSURE Example: (Receivable) You expect to

receive € 3,000,000 in 3 months. Suppose you do nothing. What is the dollar value of the at various exchange rates?

Exposure

MANAGING TRANSACTION EXPOSURE Example: (Receivable) You expect to

receive € 3,000,000 in 3 months. What is the dollar value of the exposure with a forward hedge? Current 3 month forward rate is €: $ 1.246

No hedge for Euro 3,000,000 (version 1).xlsx

MANAGING TRANSACTION EXPOSURE Example: (Receivable) You expect to

receive € 3,000,000 in 3 months. What is the dollar value of the exposure with a money market hedge? Current 3 month (annualized) rate in Europe is 3.5% and in the USA 4.25%. Current Spot Rate is €: $ 1.248.

FORMING MONEY MARKET HEDGE(FULL) 1. Borrow in Europe €3000000/(1+.035/4) =

€2,973,978. 2. Convert into $ at present spot:

€2,973,978*1.248 = 3,711,524 3. Invest in the USA for 3 months. You know

that you will have $3,711,524*(1+ .0425/4) = $3,750,959.

4. Your Euro loan matures in 3 months. Maturity value is €3000000. Use your expected inflow to pay off the loan

FORMING MONEY MARKET HEDGE(PARTIAL)

1. Borrow in Europe €3000000/(1+.035/4) = €2,973,978.

2. Convert into $ at present spot: €2,973,978*1.248 = 3,711,524

3. Invest in the USA for 3 months. You know that you will have $3,711,524*(1+ .0425/4) = $3,750,959. (This step is avoided)

4. Your Euro loan matures in 3 months. Maturity value is €3000000. Use your expected inflow to pay off the loan

MANAGING TRANSACTION EXPOSURE Example: (Receivable) You expect to

receive € 3,000,000 in 3 months. What is the dollar value of the exposure with a put option hedge? A June (3 months away) put option (on currency) with a strike of 12500 has a premium 1.45 cents per Euro.

MANAGING TRANSACTION EXPOSURE Example: (Receivable) You expect to

receive € 3,000,000 in 3 months. What is the dollar value of the exposure if you choose to write call options of equivalent amount? A June (3 months away) call option (on currency) with a strike of 12500 has a premium 1.85 cents per Euro. (Note: options will not be exercised unless price is higher than strike. So if price is lower, you will have to sell the euro in the open market)

MANAGING TRANSACTION EXPOSURE Shift Exposure- Get transaction denominated in

your currency. Options for Managing Exposure:

Do nothing Hedge in the forward market Hedge in the money market

Full Hedge Partial hedge

Hedge in the options market Buy options Write options

Mixed options (Appendix)

MANAGING TRANSACTION EXPOSURE Example: (Payable) You have a

payable of £1,800,000 in three months. Current spot rate is £: $ 1.5500. The forward rate for 3 months is £: $ 1.5600. What dollar cost can you lock in for the payable with a forward contract? What is the gain or loss from the hedge if the actual spot rate on payment date is ……?

MANAGING TRANSACTION EXPOSURE Example: (Payable) You have a

payable of £1,800,000 in three months. What is the dollar value of the exposure with a money market hedge? Current 3 month (annualized) rate in England is 3.0% and in the USA 4.25%. Current Spot Rate is £: $ 1.55.

MANAGING TRANSACTION EXPOSUREMM HEDGE (FULL HEDGE)

You need to buy at spot £1,800,000/(1+.03/4) = £1,786,600.

1. Borrow £1,786,600 *1.55 = $2,769,231 at 4.25 rate in the USA

3. Buy £1,786,600 at spot. Cost (now) $2,769,231. 4. Invest £1,786,600 in UK for 3 months. It will grow

to £1,800,000. When it matures, make the payment. 4. Your dollar loan of $2,769231 will mature to

$2,769231 *(1+.0425/4) = $2,798,654 in three months. Pay off this loan. This is the dollar cost you lock in for your Due Pound.

MANAGING TRANSACTION EXPOSUREMM HEDGE (PARTIAL HEDGE) You need to buy at spot £1,800,000/(1+.03/4) =

£1,786,600. 1. Borrow £1,786,600 *1.55 = $2,769,231 at 4.25 rate

in the USA. Instead of borrowing, you will use company’s own money.

3. Buy £1,786,600 at spot. Cost (now) $2,769,231. 4. Invest £1,786,600 in UK for 3 months. It will grow to

£1,800,000. When it matures, make the payment. 4. Your dollar loan of $2,769231 will mature to

$2,769231 *(1+.0425/4) = $2,798,654 in three months. Pay off this loan. This is the dollar cost you lock in for your Due Pound.

MANAGING TRANSACTION EXPOSURECALL OPTION HEDGE

Example: (Payable) You have a payable of £1,800,000 in three months. What is the dollar value of the exposure with a call option hedge? A June (3 months away) call option (on currency) with a strike of 1560 has a premium 1.25 cents per £.

hedging for payments tod.xlsx

MANAGING TRANSACTION EXPOSURECALL OPTION HEDGE

Example: (Payable) You have a payable of £1,800,000 in three months. What is the dollar value of the exposure if you choose to write put options (57 Philadelphia)? A March (3 months away) put option (on currency) with a strike of 1550 has a premium 0.75 cents per Pound. (Note: options will not be exercised unless price is lower than strike. So if price is higher, you will have to buy pound in the open market)