1 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.

2 Life Span of a Transaction Exposure t1t1 t2t2 t3t3 t4t4 Seller quotes a price to buyer (in verbal or written form) Buyer places firm order with seller at price offered at time t 1 Seller ships product and bills buyer (becomes A/R) Buyer settles A/R with cash in amount of currency quoted at time t 1 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 Time and Events

3 Management of Transaction Exposure Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges. 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.

4 Management of Transaction Exposure Natural hedge refers to an off-setting operating cash flow, a payable arising from the conduct of business. 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.

5 Case Study – Dilly Automobiles Ltd.(DAL)

6 DAL’s Information DAL, a U.S. based manufacturer has just sold a machine to a firm based in U.K. for £ 1,000,000 The sale is made in the month of March and the payment is to be received in June. Spot Rate $1.7640/£3m forward Rate $1.7540/£ Cost of Capital 12% U.K. 3m interest rate 8%/10% OTC June Put(X=$1.75) at 1.5% Premium OTC June Put(X=$1.71) at 1.0% Premium U.S. 3m interest rate 6%/8% Spot Rate Forecast 3m $1.7600/£ Budget Rate $1.7000/£

7 Alternatives to DAL Remain unhedged Hedge in the forward market Hedge in the money market Hedge in the options market

8 Remain Unhedged Do nothing today Receive £ 1,000,000 at the end of 3 months and sell spot to receive $. If pound falls, there will be a considerable loss and vice versa, if it appreciates. As per the forecast, the value of receivable will be $ 1,760,000.

9 Forward Hedge A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract. Sometimes, 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. It is “open” or “uncovered” and involves considerable risk. The purchase of such funds at a later date is referred to as covering. DAL sells at 3 month forward rate i.e. $1.7540/£ and receives $ 1,754,000.

10 Money Market Hedge 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. Hedging firm 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).

11 Money Market Hedge InvestmentOptionsTerminal Value $1,720,9766%(Investment Rate)$1,746,791 $1,720,9768%(Borrowing rate)$1,755,396 $1,720,97612%(Cost of capital)$1,772,605 DAL borrows £975,610 and pays £975,610 + £24390 (interest) from the proceeds. DAL sells £975,610 at spot $1.7640/£ and receives $1,720,976.

12 Options Market Hedge 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.

13 Options Market Hedge Buy Put(at-the-money) to sell pounds at $1.75/£. Pay $26,460(+12%*3/12) i.e. $27,254 for put option. Deliver £ 1,000,000 against put or sell spot if the current spot rate > $1.75/£ Receive an unlimited maximum less $27,254 Receive expected $1,760,000 less $27,254 Receive a minimum of $1,750,000 less $27,254

14 Valuation of Cash Flows Under Hedging Alternatives for DAL 1.68 Value in US dollars of DAL’s £1,000,000 A/R Ending spot exchange rate (US$/£) Uncovered Forward contract hedge Money market hedge ATM put option hedge Put option strike price of $1.75/£ Put option strike price of $1.71/£ OTM put option hedge

15 Valuation of Hedging Alternatives for an Account Payable Cost in US dollars of DAL £1,000,000 A/P 1.68 Ending spot exchange rate (US$/£) Uncovered costs whatever the ending spot rate is in 90 days Forward contract hedge locks in a cost of $1,754,000 Money market hedge Locks in a cost of $1,781,294 Forward rate is $1.7540/£ Call option strike price of $1.75/£ Call option hedge

16 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.

17 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

18 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.

19 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.

20 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.

21 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.

22 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.