Managing Risk in an International Business (Transactions
Exchange rate fluctuations meant that international firms face
three distinct types of risk
Translation Exposure risk that financial statements will
change because of exchange rate fluctuations even though
nothing real has happened.
Economic Exposure risk that fluctuations in exchange rates
will have a real impact on the firm. Economic exposure is
further broken down into two categories.
• Operating Exposure: The risk that non-contractual cash
flows will change because of unexpected changes in
• Transactions Exposure: The risk that contractual cash
flows will change because of unexpected changes in
Unhedged Transactions Exposure: Example
• Suppose TI is expanding a computer chip manufacturing
facility in Italy at a cost of €100 million. It has secured a
construction loan from a European bank but intends to pay off
the loan in six months by borrowing dollars. Since it cannot
know exactly the $/€ exchange rate in six months this is an
uncertain contractual obligation.
•Unhedged Risk Profile (Centered on .90 future spot price)
Dollar Value of Contract
0.86 0.88 0.9 0.92 0.94
Transactions Exposure and Laker Airways
• After a six year court battle, Freddie Laker was granted permission to
operate the Skytrain service on both sides of the Atlantic using two DC-
• Skytrain was a no-reservation, low-cost air service that revolutionized the
• 1st flight was in September 1977, and by the end of the year had carried
over 50,000 passengers with each flight over 80% full
• Expanded from 1978-1981 to include London to Miami, Tampa, and
• During this time, the USD was weak against the GBP, and US trips were
relatively cheap for U.K. residents.
• Freddie purchased New DC-10s for the expansion, financing in USD
• Therefore, Skytrain’s debt payments were in USD and it’s revenues were
mostly in GBP
• In 1981, the USD started to gain against all European currencies
• Therefore, expenses increased
• Revenues decreased
• In February 1982, Laker Airways was forced to file for bankruptcy
• Skytrain’s foreign exchange losses were one of the main factors behind
Laker Airways’ bankruptcy.
Transactions Exposure and Siam City Cement
• On July 2, 1997, Thailand devalued the baht (THB) by 18%.
• Siam City Cement, Thailand’s second largest cement producer, lost THB
5,870 million (USD 146 million), giving a net deficit for the nine-month
period of 1997 of THB 5,380.
• During the first nine-months of 1996, Siam City Cement reported a net
profit of THB 817 million
• Industry analysts said the company was affected by foreign exchange
losses on USD 590 million foreign debt, reported as of June 30.
Tools for managing transactions exposure
• Financial Contracts
•Forward and/or futures contracts
•Money market hedges
•Contractual hedging/risk sharing
Forward and Futures Market Hedges
• We’ve already talked about forward and futures markets and so it
should be obvious a firm could use these tools to eliminate
transactions exposure. (For example if TI could enter into a
contract to buy euros in the forward market at .90 it would lock in
the exchange rate).
•Issue: What is the cost of a forward market hedge?
• The real cost is known only at the time the forward
transaction is completed
– Suppose in six months S=.9=F. The hedge was costless (except for
transactions costs) in the sense that TI would have paid $90,000,000
– Suppose in six months S=.88. The hedge ―cost‖ (.90-
.88)x100,000,000=$2,000,000 since if TI hadn’t hedged it would
have paid $88,000,000 instead of $90,000,000.
– Of course if in six months S=.92, the hedge was beneficial since
since without it, TI would have paid $92,000,000
– If forward parity hold (E(St)=Ft), then hedging is costless
Money Market Hedges (An Example)
•Suppose that your firm will receive R 2 million (Brazilian Real) in one
year. At present
•This would imply that F=S(1+rus)/(1+rbrazil)=.35x1.03/1.12=.321875
•If you hedged in the forward market you would have
•But suppose the forward market isn’t available (or you don’t like the
•Steps in money market hedge (let L be the amount that you expect to
•Go to Brazil and borrow L/(1+rus)=2/1.12 = R 1,785,714
•Convert the borrowings to dollars at
•Loan the dollars
•When it is time to pay back the Brazilian lender, you will owe
(1,785,714x1.12) =R 2 million,
(which is exactly what you will receive)
•When it is time to collect on the US loan you will have
(Which is what you would have made with the forward contract).
Hedging With Currency Options
Currency options can be used to protect against unfavorable
exchange rate movements, while allowing the firm to capture
the benefits of favorable movements
o Suppose Boeing expected to receive €10,000,000
o If Boeing bought €10,000,000 put options at .90, it
would be guaranteed at least $9,000,000-cost of the
option. If the rate goes up, the option is worthless, but
the euros it receives are worth more.
o But remember, this isn’t costless--the have to pay the
When the firm hedges by means of options, it is speculating in
Hedging with options and contingent claims (an example)
• Suppose Lufthansa agrees to purchase 10 airplanes from Boeing,
taking delivery in 2 years. In one year, the contract requires that
Lufthansa pay a $10 million deposit--if they don’t make the
deposit, they lose their delivery position.
• Lufthansa could certainly buy dollars in the forward market to
cover this transaction. But if they decided not to make the
payment (that is, give up their delivery position), they would
have to buy the dollars at the agreed forward rate and could lose
money if the spot rate has risen above the forward rate.
• Suppose F$/€=.90 and they sold €11,111,111 forward. If
S$/€=.92 in one year, they lose .02x11,111,111=$222,222 (the
forward contract requires them to sell euros for .90 when they
are in fact worth .92 on the spot market.)
• If they purchase a put options (the right to sell euros at the
exercise price), they know that the worse they can do is lose the
• Suppose the cost of a put option for euros with an exercise
price of .90 is .003 and Lufthansa buys the put option for
€11,111,111 at a cost of .003x11,111,111=$33,333. If the
euro falls below .90, and Lufthansa decides to go ahead with
the purchase, they put gives them the right to sell euros at .90
(they most they will have to pay is €11,111,111). If the euro is
above .90, but Lufthansa decides not to go ahead with the
purchase of the aircraft, the option expires and nothing else
happens. (If they decide not to buy the planes, the most they
can lose as a consequence of a currency appreciation is
Hedging With Currency Swaps
• Suppose Coca Cola has built a bottling plant in Japan and has
paid for the property and construction by borrowing from a
Japanese bank. The terms of the loan require it to make four
annual payments of ¥5 billion. Coke is subject to exchange rate
risk (for example if the spot rate goes from .01 to .012, their
payment goes from $50 million to $60 million)
• Suppose Honda has built an addition to a U.S. manufacturing
facility and has paid by borrowing from a U.S. bank. The terms of
the loan require them to make four annual payments of $50
million. Honda is subject to exchange rate risk (for example, if the
spot rate falls from .01 to .008, their payment goes from ¥5 billion
to ¥62.5 billion).
•If Honda and Coke were both interested in locking in an exchange
rate of .90, they could simply swap obligations—Honda would
agree to pay Coke’s Japanese band and Coke would agree to pay
Honda’s Japanese bank.
Managing Transactions Exposure Internally: Exposure Netting
• Simplest Case: Obligation in one currency canceling an
entitlement in the same currency
• Example: Boeing agrees to pay £80 million in 6 months for
several Rolls Royce aircraft engines. Coincidentaly, at the
same time British Air contracts to buy a 747, for which they
are obligated to make a payment in six months of
approximately $120 million. Both firms face a currency risk.
If the six month forward rate for the pound was 1.50 both
firms could eliminate the risk (Boeing could lock in a payment
amount of $120 million and BA could lock in a payment
amount of £80 million.) But notice that Boeing is in a position
to eliminate all the risk for both firms without using a forward
contract simply by letting BA make its payment in pounds
(perhaps even earning a small profit by doing so since it saves
both firms the cost of the forward contract).
•Exposure Netting: ―Correlated Currencies‖
• Exchange rates S$/€=1.2, S$/sfr=.8, S$/mxp=.10
euro 3.0 MXP 10
sfr 1.6 euro 8.0
• Correlations: C€:SFR=1, Csfr:mxp=-1
– that is, € and sfr move closely together, mxp and sfr move in
• First write out the T-Account In Dollar values at spot rates)
$3.6 (euro) $1.0 (Mexico)
$1.6 (Swiss) $9.6 (euro)
• Because the Swiss franc and the euro move together, treat them as the
same currency for purposes of evaluating risk (thus offset the combined
$5.2 asset against the $9.6 liability, leaving $.4 liability)
• Because the euro and the mxp are negatively correlated, use the $1.0
million mxp liabilty to offset some of the 4.4 euro liability.
• Net $3.4 short in euros (as if you had to hedge 3.4/1.2 = 2.833
• Important Note: The success of this exposure netting will depend on
whether the historical correlations maintain in the future.
Contractual Hedging of Transactions Exposure
•Remember, when we talk about ―transactions risk‖ we are talking
about hedging currency risk that results from contracted cash
•Thus, there is at least the possibility that the two parties might be
able to negotiate a way to share the risk that is in the best interest
of both parties.
Suppose a U.S. horse breeder has sold 5 foals to an
Australian at a price of $2 million for delivery and
payment in one year.
The Australian faces transactions exposure and might ask
the American to accept payment in A$’s, shifting the risk
to the American.
The American might be unwilling to accept all of the risk,
but might accept a share. Suppose they agreed that the
price of the horses would be adjusted by half of the
deviation between the spot rate at delivery and a spot rate
of S$/A$=.50. (i.e., the delivery price is 2(1 + (S$/A$-.50)/2)
o If the S=.50, the American gets $2 million and the
Australian pays A$4 million.
o If S=.40, the American gets $1.8 million and the
Australian pays A$ 4.5 million. (Without the deal,
the American would have gotten $2 million, but
the Australian would have paid A$5.0 M).
Issues in Hedging: Selective versus Complete Hedging
•Complete hedging: the attempt to completely eliminate the risk
that cash flows will vary with exchange rates.
•Selective hedging: the attempt to eliminate the risk that cash
flows will suffer from changes in exchange rates while still
benefiting from favorable changes in rates
•Selective hedging sounds good, but remember it effectively turns
the firm’s treasury into a profit center which is supposed to take
advantage of exchange rate changes. Currency trading is a tough
business and may actually be beyond to expertise of the firm.
Issues in Hedging: Should the Firm Hedge at All?
Argument Against Hedging: Hedging is costly and risk averse
shareholders can hedge their own positions by diversifying their
own portfolios. (A risk averse U.S. investor shouldn’t own only
Arguments for Hedging: Deal with specific circumstances
• Information asymmetry Stockholders may not be able to assess
the firm’s true exposure and so may not know how to hedge.
•Transactions cost advantages: Stockholders may not have access
to the same tools for hedging as does the firm.
•Default Risk. Excessive exposure to exchange rate risk might
drive a firm close to or even send it into bankruptcy. Thus hedging
can lower the risk of bankruptcy and so lower the cost of
•Progressive taxes. If the tax rates (not payments, but rates)
increase when income increases, hedging can smooth income and
so eliminate the need to make very large tax payments when
income is high (which may not be offset by lower taxes when
income is low.)
Progressive Taxes and Hedging (an example)
Imagine a U.S. firm that expects to earn €100 in one year, plans
to convert these into dollars and then distribute the after tax
income to shareholders.
Suppose (to make for a simple example), the tax schedule is
such that no taxes are paid on the first $100 and then taxes are paid
at a 50% rate for all income greater than $100.
Suppose (again, to make it easy to see) that the firm believes
next year’s spot rate will be either .90 or 1.10, with a 50%
probability of each.
If the firm did not hedge, it’s after-tax dollar earnings in the
event of a low exchange rate would be $90. If the exchange rate
was high, the firm would earn $105 after taxes. This means it has
expected earnings of $97.5.
If the firm’s expectations about future exchange rates are
consistent with the market’s expectations, the forward contract on
the euro should be 1.0 (the expected future spot rate). This means
that if the firm hedges, it locks in $100.