1. Chapter 8
Transaction Exposure

2. Transaction Exposure
Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates.
An important task of the financial manager is to measure foreign exchange exposure and to manage it so as to maximize the profitability, net cash flow, and market value of the firm.
The effect on a firm when foreign exchange rates change can be measured in several ways.
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3. Accounting exposure Operating exposure Transaction exposure
Exhibit 8.1 Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure
Moment in time when
exchange rate changes
Accounting exposure
Operating exposure
Changes in reported owners’ equity
in consolidated financial statements
caused by a change in exchange rates
Change in expected future cash flows
arising from an unexpected change in
exchange rates
Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates
Time

4. Types of Foreign Exchange Exposure
Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change.
Thus, this type of exposure deals with changes in cash flows the result from existing contractual obligations.
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5. Types of Foreign Exchange Exposure
Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates.
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6. Types of Foreign Exchange Exposure
Transaction exposure and operating exposure exist because of unexpected changes in future cash flows.
The difference between the two is that transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because a change in exchange rates has altered international competitiveness.
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7. Types of Foreign Exchange Exposure
Accounting exposure, also called translation exposure, is the potential for accounting-derived changes in owner’s equity to occur because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.
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8. Types of Foreign Exchange Exposure
The tax consequence of foreign exchange exposure varies by country.
As a general rule, however, only realized foreign exchange losses are deductible for purposes of calculating income taxes.
Similarly, only realized gains create taxable income.
“Realized” means that the loss or gain involves cash flows.
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9. Why Hedge?
MNEs possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices.
These three financial price risks are the subject of the growing field of financial risk management.
Many firms attempt to manage their currency exposures through hedging.
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10. Why Hedge?
Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position.
While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against.
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11. Why Hedge?
The value of a firm, according to financial theory, is the net present value of all expected future cash flows.
The fact that these cash flows are expected emphasizes that nothing about the future is certain.
Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes.
A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
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12. Exhibit 8.2 Impact of Hedging on the Expected Cash Flows of the Firm
Hedged
Unhedged
NCF
Net Cash Flow (NCF)
Expected Value, E(V)
Hedging reduces the variability of expected cash flows about the mean of the distribution.
This reduction of distribution variance is a reduction of risk.

13. Why Hedge?
However, is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of hedging state (among other things):
Shareholders are much more capable of diversifying currency risk than the management of the firm
Currency risk management does not increase the expected cash flows of the firm
Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict)
Managers cannot outguess the market
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14. Why Hedge? Proponents of hedging cite:
Reduction in risk in future cash flows improves the planning capability of the firm
Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)
Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm
Management is in better position to take advantage of disequilibrium conditions in the market
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15. Measurement of Transaction Exposure
Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.
The most common example of transaction exposure arises when a firm has a receivable or payable denominated in a foreign currency.
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16. Exhibit 8.3 The Life Span of a Transaction Exposure
Time and Events t1 t2 t3 t4
Seller quotes
a price to buyer
(in verbal or
written form)
Buyer places
firm order with
seller at price
offered at time t1
Seller ships
product and
bills buyer
(becomes A/R)
Buyer settles A/R
with cash in
amount of currency
quoted at time t1
Quotation
Exposure
Backlog
Exposure
Billing
Exposure
Time between quoting
a price and reaching a
contractual sale
Time it takes to
fill the order after
contract is signed
Time it takes to
get paid in cash after
A/R is issued
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17. Measurement of Transaction Exposure
Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges.
The main contractual hedges employ the forward, money, futures, and options markets.
Operating and financial hedges employ the use of risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies.
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18. Measurement of Transaction Exposure
The term natural hedge refers to an off-setting operating cash flow, a payable arising from the conduct of business.
A financial hedge refers to either an off-setting debt obligation (such as a loan) or some type of financial derivative such as an interest rate swap.
Care should be taken to distinguish operating hedges from financing hedges.
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19. Dayton Manufacturing’s Transaction Exposure
With reference to Dayton Manufacturing’s Transaction Exposure, the CFO, Scout Finch, has four alternatives:
Remain unhedged
Hedge in the forward market
Hedge in the money market
Hedge in the options market
These choices apply to an account receivable and/or an account payable
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20. Dayton Manufacturing’s Transaction Exposure
A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract.
In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date.
This type of hedge is “open” or “uncovered” and involves considerable risk because the hedge must take a chance on the uncertain future spot rate to fulfill the forward contract.
The purchase of such funds at a later date is referred to as covering.
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21. Dayton Manufacturing’s Transaction Exposure
A money market hedge also involves a contract and a source of funds to fulfill that contract.
In this instance, the contract is a loan agreement.
The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency.
Funds to fulfill the contract – to repay the loan – may be generated from business operations, in which case the money market hedge is covered.
Alternatively, funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures (uncovered or open money market hedge).
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22. Dayton Manufacturing’s Transaction Exposure
Hedging with options allows for participation in any upside potential associated with the position while limiting downside risk.
The choice of option strike prices is a very important aspect of utilizing options as option premiums, and payoff patterns will differ accordingly.
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23. Forward contract hedge
Exhibit 8.5 Valuation of Cash Flows Under Hedging Alternatives for Dayton
Value in US dollars of
Dayton’s £1,000,000 A/R
Uncovered
Put option strike
price of $1.75/£
OTM put
option hedge
1.84
1.82
Put option strike
price of $1.71/£
ATM put
option hedge
1.80
1.78
Money market hedge
1.76
1.74
Forward contract hedge
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
1.78
1.80
1.82
1.84
1.86
Ending spot exchange rate (US$/£)

24. Forward contract hedge
Exhibit 8.6 Valuation of Hedging Alternatives for an Account Payable
1.68
1.70
1.74
1.76
1.72
1.82
1.80
1.78
1.86
1.84
Cost in US dollars of
Dayton’s £1,000,000 A/P
Ending spot exchange rate (US$/£)
Call option strike
price of $1.75/£
Uncovered costs
whatever the ending
spot rate is in 90 days
Forward rate
is $1.7540/£
Money market hedge
Locks in a cost of $1,781,294
Forward contract hedge
locks in a cost of $1,754,000
Call option hedge

25. Risk Management in Practice
The treasury function of most private firms, the group typically responsible for transaction exposure management, is usually considered a cost center.
The treasury function is not expected to add profit to the firm’s bottom line.
Currency risk managers are expected to err on the conservative side when managing the firm’s money.
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26. Risk Management in Practice
Firms must decide which exposures to hedge:
Many firms do not allow the hedging of quotation exposure or backlog exposure as a matter of policy
Many firms feel that until the transaction exists on the accounting books of the firm, the probability of the exposure actually occurring is considered to be less than 100%
An increasing number of firms, however, are actively hedging not only backlog exposures, but also selectively hedging quotation and anticipated exposures.
Anticipated exposures are transactions for which there are – at present – no contracts or agreements between parties
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27. Risk Management in Practice
As might be expected, transaction exposure management programs are generally divided along an “option-line”; those that use options and those that do not.
Firms that do not use currency options rely almost exclusively on forward contracts and money market hedges.
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28. Risk Management in Practice
Many MNEs have established rather rigid transaction exposure risk management policies that mandate proportional hedging.
These contracts generally require the use of forward contract hedges on a percentage of existing transaction exposures.
The remaining portion of the exposure is then selectively hedged on the basis of the firm’s risk tolerance, view of exchange rate movements, and confidence level.
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29. Risk Management in Practice
In addition to having required minimum forward-cover percentages, many firms also require full forward-cover when forward rates “pay them the points.”
The points on the forward rate is the forward rate’s premium or discount.
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30. Risk Management in Practice
A further distinction in practice can be made between those firms that buy currency options (buy a put or buy a call) and those that both buy and write currency options.
Those firms that do use currency options are generally more aggressive in their tolerance of currency risk.
However, in many cases firms that are extremely risk-intolerant will utilize options to hedge backlog and/or anticipated exposures.
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31. Risk Management in Practice
Since the writer of an option has a limited profit potential with unlimited loss potential, the risks associated with writing options can be substantial.
Firms that write options usually do so to finance the purchase of a second option.
The most frequently used complex options are range forwards, participating forwards, break forwards, and average rate options.
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