Transaction Exposure

1
 Types of forex exposure
Forex exposure
potential change in profitability, net cash flow, market value
due to change in forex rate.
Transaction Exposure
changes in value of outstanding financial obligations
incurred prior to change in forex, not due to settle until after
forex change.
Operating (Economic) Exposure
change in firm PV resulting from change in expected future
operating cash flows due to unexpected forex change
Translation (Accounting) Exposure
accounting-derived changes in owner equity due to
consolidation in single currency.
Tax Exposure
varies by country, general rule only realized foreign losses
are deductible for calculating income taxes

2
Why Hedge? Pros & Cons
Improves planning.
Reduces likelihood of bankruptcy.
Management better knows actual risks.
vs.
Currency risk management costly, may not
increase expected cash flows.
Shareholders more capable diversifying risk.
Investors already factored forex exposure into
valuation.
Conducts hedging to benefit management.
Managers cannot outguess efficient market .
Management criticized for forex losses but not
for cost in avoiding forex losses.

3
 Why Hedge?
Reduction of risk?
Hedged
Increase/decrease in expected
cash flow?
Increase in value?

Unhedged

NCF Net Cash Flow (NCF)

Expected Cash Flow

4
 What causes transaction
exposure?
Purchasing or selling on credit.

Borrowing or lending in foreign currency.

Being party to unperformed forward contract.

Acquiring assets/ incurring liabilities in

foreign currency.

5
 Open Account Purchasing/ Selling

t1 t2 t3 t4
Seller Buyer Seller ships Buyer
quotes places product settles A/R
price order

Quotation Backlog Exposure Billing Exposure

Exposure
Anticipa- Contract Signed. Time to get paid.
tion Time b/n quoting
Time to fill order.
Exposure price & reaching
sale.

6
 Borrowing &Lending
Grupo Embotellador de Mexico
(Gemex)

Dollar debt mid-December, 1994:

$ 264 m PS 3.45/$ = PS 910,800,000.
Dollar debt in mid-January, 1995:
$ 264 m PS 5.50/$ = PS 1,452,000,000
(59% up!)

7
How to manage transaction
exposure?
Contractual hedge
Operating hedges
Risk-sharing agreements.
Leads and lags in payment terms.
Swaps.
Natural hedge
Financial hedge
offsetting debt obligation.
financial derivative such as swap.

8
 Account Payable Hedge
Assume 1,000,000 A/P in 90 days
Unhedged position: expected pay $1,760,000.
Forward market hedge: purchase forward @
$1.754/, cost locked $1,754,000.
Money market hedge:
Offset obligation by asset w/ matching maturity.
Exchange US$ spot & invest for 90 days in .
1,000,000
980,392, 980,392 $1.764/ $1,729,412.
90
1 .08 x
360

Carry the cost forward 90 days

90
$1,729,412 x 1 0.12 x $1,781,294.
360

13
 Account Payable Hedge
Option hedge:
purchase call option on payable.
ATM call option w/ strike $1,75/ would be
1.5% premium.
If spot less $1.75/ option expire &
1,000,000 purchased on spot market.
If spot above $1.75/ option exercised:
exchange 1,000,000 @ $1.75/ less option
premium:
1,000,000 x 0.015 x $1.75/ $26,460
Carried forward 90 days @ 12% p.a.
premium $27,254.
Exercise call option (1,000,000 $1.75/ $1,750,000
Call premium (carried forward 90 days) $27,254
Total maximum expense of call option hedge$1,777,254
14
 A / P Hedges
US$ value of
1,000,000 A/R
Uncovered
1.84 Forward
$1.754/
1.82
Call strike Call option:
1.80 $1.75/
$1,777,254
1.78
Money market
1.76 $1,781,294

1.74 Forward contract

$1,754,000
1.72

1.70

1.68
1.68 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 1.86

Ending spot (US$/)

15
Forex Risk Management for
Real
Goals?
cost center vs. profit center.
Exposures?
backlog exposure?
selectively hedge backlog & anticipated
exposures?
Contractual Hedges?
Amount of risk covered, proportional
hedges?
Currency options?

16
 Things to remember
Types of forex exposures
Transaction
Operating
Translation
Tax
How to hedge A/R & A/P transaction
exposure?
Money market?
Forward market?
Option market?

17