Chapter 8 – Transaction Exposure
Companies conducting international business might supply
or receive goods in months when exchange rates are
changing. How can the manufacturer guarantee they receive
or pay a set amount of the proceeds in the future? Similar to
a farmer with a wheat forward.
Transaction exposure arises from:
Purchasing or selling on credit goods or services
whose prices are stated in foreign currencies;
Borrowing or lending funds when repayment is to be
made in a foreign currency;
Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies.
Suppose a U.S. firm sells merchandise on open account to
Belgian buyer for:
Bf700,000, payment to be made in 60 days.
S0 = 35 Bf/$
The U.S. seller expects to exchange the Bf700,000
payment for $20,000 when payment is received.
Transaction exposure arises because of the risk that the
U.S. seller will receive something other than $20,000.
For example, if S60 = 38 Bf/$, U.S. seller receives only
$18,421 = (Bf700,000) * (1$/38 Bf)
On the other hand, if S60 = 33 Bf/$, U.S. seller receives
$21,212 = (Bf700,000) * (1$/33 Bf)
Thus, exposure is the chance of either a loss or a gain.
In 1971, Great Britain’s Beecham Group borrowed SF100
million (equivalent to £10.13 million).
When the loan came due five years later, the cost of
repayment of principal was £22.73 million – more than
double the amount borrowed!
We will discuss three ways to hedge transaction exposure.
1. A forward hedge
2. A money market hedge
3. An option hedge.
Forward Market Hedge – Exporter (Accounts Receivable).
An example: Suppose your company is Raleigh bicycle and
you sell 750,000 euros of bicycles to an Italian wholesaler,
Colnago, payable in six months.
UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€
How can you guarantee Raleigh will receive a set amount of
pounds in six months, and how much will Raleigh receive?
1. Sell forward 750,000€ in six months in exchange for
pounds. In six months your company will have to deliver
(pay) 750,000€ and will receive a set amount of pounds.
How many pounds will Raleigh receive?
2. Use the 750,000€ receivable from Colnago to fulfill the
750,000€ forward contract.
3. In the end Raleigh will take delivery of 535,725£ regardless
of the exchange rate.
Exporter -- Money Market Hedge
750,000 euro to be received in six months
UK interest rate 3%/6 mo.
Italian interest rate 5.985%/6mo.
Spot exchange rate 0.735 £/€
Forward exchange rate 0.7143 £/€
1. With a money market hedge, borrow an amount today in
the foreign currency that you can repay in the future with
the accounts receivable.
2. Convert the 707,647€ to £ at the spot rate.
3. Invest the converted amount at the UK interest rate.
4. Use the 750,000 euro from the receivable to repay the
Note: the forward hedge and money market hedge give the
same value. This is not coincidence, it is due to IRP.
For an importer, it is the opposite direction
If you expect to owe foreign currency in the future, you can
hedge by agreeing today to buy the foreign currency in the
future at a set price by entering into a long position in a
Importer’s Forward Market Hedge
E.G. Same info as before but now Colnogo must pay Raleigh
10,000£ for bike OEM parts in six months.
A Future Contract isn’t as Suitable for Hedging.
Futures contracts are standardized, not taylor made.
Issues with contract size, delivery, date, etc.
Mark-to-market means there are interim CFs prior to
maturity that may have to be invested/borrowed.
Importer’s Money Market Hedge
This is the same idea as covered interest arbitrage.
To hedge a foreign currency payable, buy the present
value of that foreign currency payable today and put it in
the bank at interest.
– Buy the present value of the foreign currency payable
today at the spot exchange rate.
– Invest that amount at the foreign rate.
– At maturity your investment will have grown enough
to cover your foreign currency payable.
A U.S.–based importer of Italian bicycles owes €100,000 to
an Italian supplier in one year.
– The spot exchange rate is $1.50 = €1.00.
– The one-year interest rate in Italy is i€ = 4%.
– The one-year interest rate in US is i$ = 3%.
1. How many dollars would the importer need today to meet
2. If the importer borrowed the $144,230.77, how much
would he need to repay the bank in one year?
Options – One shortcoming for forward and money market
hedges is that the firm has to forgo the opportunity to benefit
from favorable exchange rate changes. Not so with options.
Suppose Litespeed sells titanium bicycle frames to an
English firm and is due £10 million in one year. The
interest rate is 6.1%. The current spot price is $1.46/£ and
the put option premium is $0.02 per pound.
Litespeed could pay $200,000 ($0.02x10 million) for a
put option. This gives Litespeed the right to sell up to
£10 million for $1.46/£ regardless of the future spot
Suppose spot price changes to $1.30/£ in one year.
Litespeed would receive $13 M instead of $14.6 M.
However, Litespeed will make $0.16/option contract,
resulting in $1.6 in addl wealth, totaling $14.6M.
Since the option cost is $0.2122M ($200,000*1.061),
Litespeed is guaranteed $14.3878M.
If the spot price changes to $1.60/£ in one year, Litespeed
would receive $16 M instead of the $14.6 M. They would
let the option expire worthless for net proceeds of
$15.7878M ($16 - $0.2122M).
Summary -- Hedging Foreign Currency Payables
Suppose the following:
US interest rate 6%/year
UK interest rate 6.5%/year
Spot exchange rate $1.80/£
Forward exchange rate $1.75/£
Boeing decides to hedge a £5M payable due in 1 year.
Using a forward contract.
Using a Money Market Instrument.
Is the Forward or the MM Hedge preferable in this
For an option hedge assume X = $1.80/£ and the
premium is $0.018/£.
Cross-Hedging Minor Currency Exposure
The major world currencies are the U.S. dollar, Canadian
dollar, British pound, euro, Swiss franc, Mexican peso, and
Everything else is a minor currency (for example, the
It is difficult, expensive, and sometimes even impossible to
use financial contracts to hedge exposure to minor
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.
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 Recurrent Exposure with Swaps
Swap contracts are an agreement to exchange one
currency for another at a predetermined exchange rate on
a sequence of future dates. It is a portfolio of forward
contracts with agreed upon exchange rates.
Swaps are lower cost than hedging each exposure as
it comes along.
Swaps are available in longer-terms than futures and
E.G. Boeing is to receive £10 M from British Air for each of
the next five years in exchange for airplane parts. Boeing
finds a counterparty that agrees to a swap an exchange
rate of $1.50/£ for each of the next five years. Boeing is
then guaranteed $15 M /year for the next five years.
A multinational firm should not consider deals in isolation,
but should focus on hedging the firm as a portfolio of
Other Hedging Strategies
Hedging through invoice currency.
– The firm can shift, share, or diversify:
• Shift exchange rate risk by invoicing foreign sales
in home currency
• Share exchange rate risk by pro-rating the
currency of the invoice between foreign and
• Diversify exchange rate risk by using a market
Hedging via lead and lag.
– 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
– 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.
Should the Firm Hedge?
Not everyone agrees that a firm should hedge.
– Hedging by the firm may not add to shareholder
wealth if the shareholders can manage exposure
– Hedging may not reduce the non-diversifiable risk of
the firm. Therefore, shareholders who hold a
diversified portfolio are not benefitting when
What Risk Management Products do Firms Use?
Most U.S. firms use forward, swap, and options contracts.
The greater the degree of international involvement, the
greater the firm’s use of foreign exchange risk
Chapter 9 – Economic Exposure
Economic Exposure – How do exchange rates affect a
business’s competitiveness vis-à-vis their competition.
Changes in exchange rates can affect not only firms that
are directly engaged in international trade but also purely
If the domestic firm’s products compete with imported
goods, then their competitive position is affected by the
strength or weakness of the local currency.
Consider a U.S. bicycle manufacturer who sources,
produces, and sells only in the U.S.
Since the firm’s product competes against imported
bicycles, it is subject to foreign exchange exposure. Their
customers are comparing the cost and features of the
domestic bicycle against Japanese, British, and Italian
Economic exposure can be defined as the extent to which
the value of the firm would be affected by unanticipated
changes in exchange rates. Any anticipated changes in the
exchange rates would already have been discounted and
reflected in the firm’s value.
The home currency value of assets and liabilities (asset
The home currency value of a firm’s operating CFs due to
random changes in exchange rates (operating exposure)
Asset exposure -- a statistical measurement of sensitivity.
– Sensitivity of the future home currency values of the
firm’s assets and liabilities to random changes in
If a U.S. MNC were to run a regression on the dollar value
(P) of its British assets on the dollar-pound exchange rate,
S($/£), the regression would be of the form: P = a + b×S + e
Where a is the regression constant, e is the random error
term with mean zero. The regression coefficient b measures
the sensitivity of the dollar value of the assets (P) to the
exchange rate, S. The exposure coefficient, b, is defined as
The extent to which the firm’s operating cash flows or
competitive position are affected by random changes in
Competitive effect – A pound depreciation can affect
operating CFs in pounds by altering the firm’s
competitive position in the marketplace.
Conversion effect – A given operating CF in pounds
will be converted into a lower dollar amount after the
An Illustration of Operating Exposure
Case 1 – No variables change except the price of imported
– Increased costs of raw material
– Leads to decreased operating CF
– The degree to which the firm can pass the increased
costs along to customers depends on substitutes and
Case 2 – Selling price as well as the price of the imported
inputs changes, with no other changes.
– Since the firm can pass costs along to customers
(inelastic demand), this case shows that a pound
depreciation need not lead to a lower dollar
Case 3 – All variables change, selling price, sales volume,
prices of both locally sourced and imported inputs change
following depreciation in the pound.
– Assume elastic demand – then increases in prices lead
to fewer units sold and CFs are reduced.
Determinants of Operating Exposure
The firm’s operating exposure is determined by:
– How competitive or how monopolistic the market
structure of inputs and products is. If the firm can
adjust its markets, product mix, and sourcing it can
mitigate the effect of exchange rate changes.
– A firm is subject to a high degree of operating
exposure when either costs or price is sensitive to
exchange rate changes. When both cost and price
are sensitive or insensitive to exchange rate changes,
the firm has no major operating exposure.
– (E.G. Ford Mexicano). Inflation US = 4%; Inflation
Mexico = 15%; Dollar appreciates by 11%.
Suppose the Peso price of Ford cars appreciates by
15%, reflecting a 4% increase in the $ price of cars
and an 11% dollar appreciation. Since peso price of
both Ford and locally produced cars rises by the same
15%, the 11% appreciation of the dollar will not affect
the competitive position of Ford relative to local car
makers. Therefore, Ford does NOT have operating
– Generally, companies pass through some but not all
Managing Operating Exposure – Objective is to Stabilize CFs in
Face of Fluctuating Exchange Rates.
Selecting Low Cost Production Sites – Toyota
produces in US for US sales.
Flexible Sourcing Policy – Low cost material inputs.
Diversification of the Market – Sell in several markets and
if pricing becomes unfavorable in one market, hopefully it
will become more favorable in another market.
R&D and Product Differentiation – Limit chance of
substitutes and focus on cutting costs through R&D.
Successful product differentiation gives the firm less
elastic demand—which may translate into less exchange
Financial Hedging – An approximate solution.
Chapter 10 – Translation Exposure
This is frequently called accounting exposure as it refers to
the effect that an unanticipated change in exchange rates
will have on consolidated financial statements.
There are four methods of foreign currency translation
Current Rate Method
International Accounting Standards
IAS 21, The Effects of Changes in Foreign Exchange Rates is
the European standard for handling foreign currency
IAS 21 most closely resembles the monetary/nonmonetary
The underlying principle is that monetary accounts have a
similarity because their value represents a sum of money
whose value changes as the exchange rate changes.
All monetary balance sheet accounts (cash, marketable
securities, accounts receivable, etc.) of a foreign subsidiary
are translated at the current exchange rate.
All other (nonmonetary) balance sheet accounts (owners’
equity, land, etc.) are translated at the historical exchange
rate in effect when the account was first recorded.
All monetary balance sheet accounts are translated at the
current exchange rate. e.g. €2 = $1. All other balance
sheet accounts are translated at historical exchange rate in
effect when the account was first recorded. e.g. €3 = $1
Balance Sheet Local Monetary/
Cash € 2,100 $1,050
Inventory € 1,500 $500
Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,550
Current liabilities € 1,200 $600
Long-Term debt € 1,800 $900
Common stock € 2,700 $900
Retained earnings € 900 $0
CTA -------- --------
Total Liabilities € 6,600 $2,400
Translation Exposure versus Transaction Exposure
Translation exposure -- The effect that unanticipated
changes in exchange rates has on the firm’s consolidated
financial statements. An accounting issue.
Transaction exposure -- The effect that unanticipated
changes in exchange rates has on the firm’s cash flows.
It is generally not possible to eliminate both translation
exposure and transaction exposure.
If the managers of the firm wish to manage their
accounting numbers as well as their business, they have
two methods for dealing with translation exposure:
Balance sheet hedge -- Eliminates the mismatch
between net assets and net liabilities denominated in
the same currency. May create transaction exposure.
Derivatives hedge -- An example would be the use of a
forward contract with a maturity of the reporting period
to attempt to manage the accounting numbers.
Using a derivatives hedge to control translation
exposure involves speculation about foreign
exchange rate changes.
Translation Exposure versus Operating Exposure
The effect that unanticipated changes in exchange rates
has on the firm’s ongoing operations.
Operating exposure is a substantive issue with which the
management of the firm should concern itself with.