1. Chapter 14 Transaction Exposure to Currency Risk
14.1 An Example of Transaction Exposure to Currency Risk
14.2 Managing Transaction Exposure Internally
Multinational netting
Leading and lagging
14.3 Managing Transaction Exposure in the Financial Markets
Currency forwards
Currency futures
Money market hedges
Currency options
Currency swaps
14.4 Summary

2. Economic exposure to currency risk
Economic exposure Û change in firm value due to unexpected changes in exchange rates
Transaction exposure
change in the value of contractual cash flows
change in the value of monetary assets and liabilities
Operating exposure
change in the value of noncontractual cash flows
change in the value of real assets
Monetary
assets
Monetary
liabilities
Real
assets
Common
equity

3. A survey of corporate treasurers
Do you agree or disagree with the following statements?
Mean score
“Managing transaction exposure is important.” 1.4
“Managing economic exposure is important.” 1.8
“Managing translation exposure is important.” 2.4
Key: 1= strongly agree, ... 3=neutral, ... 5= strongly disagree
Source: Kurt Jesswein, Chuck C.Y. Kwok, William R. Folks, Jr., “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics,” Journal of Applied Corporate Finance, Fall 1995.
Transaction exposure is viewed as the most important currency risk exposure

4. Currency risk versus currency risk exposure
Rd/f
Currency risk exposure
sd/f
Currency risk
sd/f

5. Exposure to foreign exchange risk (contract price FF40,000)
+FF40,000 Û +$10,000 at $0.25/FF
Expected receipt in francs
at E[S1$/FF] = $0.25/FF
Actual exchange
S1$/FF = $0.20/FF
Net loss from
original position
Risk (or payoff) profile
of underlying exposure
+FF40,000 Û +$8,000 at $0.20/FF
-$2,000
DV$/FF
-$0.05/FF
DS$/FF
-$0.05/FF

6. Currency hedging with forwards (contract price FF40,000)
Buy $10,000 forward $10,000
at F1$/FF = $0.25/FF
Sell FF40,000 forward -FF40,000
Market exchange of FF $8,000
for $ at S1$/FF = $0.20/FF
-FF40,000
Net gain on forward $2,000
Risk (or payoff) profile
of forward contract
DV$/FF
+$0.05/FF
DS$/FF
-$0.05/FF

7. Net currency exposure short francs long francs Underlying position
Sell francs forward
(short francs and long dollars)
Net position
Net exposure
+FF40,000
+$10,000
-FF40,000
+$10,000
DV$/FF
short francs
long francs
DS$/FF

8. Managing transaction exposure
Managing transaction exposure internally
leading and lagging
currency diversification and multinational netting
Managing transaction exposure in financial markets
currency forwards
money market hedges
futures
options
swaps

9. Multinational netting

10. Cash flows before multinational netting

11. Cash flows after multinational netting

12. Leading and lagging
Timing of cash flows within the corporation to offset underlying currency exposures.
Leading - If a U.S. parent is short euros, the parent can accelerate euro repatriations from its European affiliates.
Lagging - If a U.S. parent is long euros, the parent can accelerate euro payments to its European affiliates.
Like multinational netting, leading and lagging works best when the currency needs of the individual units within the corporation offset one another.

13. Financial market instruments used to hedge currency risk
Currency forward contracts
Advantages
Currency forwards can provide a perfect hedge of transactions of known size and timing
Disadvantages
Bid-ask spreads can be large on long-dated contracts or infrequently traded currencies
A pure credit instrument, so currency forward contracts have credit risk

14. Financial market instruments used to hedge currency risk
Currency futures contracts
Advantages
Low cost if the currency and maturity match the underlying exposure
Low credit risk because of daily marking-to-market
Disadvantages
Exchange-traded futures come in limited currencies and maturities
Daily marking-to-market can cause a cash flow mismatch

15. Financial market instruments used to hedge currency risk
Money market hedges
Advantages
Forward positions can be built in currencies for which there are no forward currency markets
Disadvantages
Relatively expensive hedge
Might not be feasible if there are contraints on borrowing or lending

16. Financial market instruments used to hedge currency risk
Currency option contracts
Advantages
Disaster hedge insures against unfavorable currency movements
Disadvantages
Option premiums reflect option values, so option hedges can be expensive in volatile currencies and at distant expiration dates

17. Financial market instruments used to hedge currency risk
Currency swap contracts
Advantages
Quickly transforms liabilities into other currencies or payout structures (e.g., fixed vs. floating)
Low cost for plain vanilla swaps in actively traded currencies
Able to hedge long-term exposures
Disadvantages
Not the best choice for near-term exposures
Innovative or exotic swaps can be expensive

18. Corporate use of currency risk management products
Used Used Used once Never
Type of product often sometimes or twice heard of
Forward contracts 72.3% 17.9% 2.9% 0.0%
Foreign currency swaps
OTC currency options
Currency futures contracts
Exchange-traded
currency (spot) options
futures options
Foreign currency warrants
Cylinder options
Synthetic forwards
Source: Jesswein, Kwok, and Folks, “What New Currency Risk Products Are Companies Using and Why?” Journal of Applied Corporate Finance 8, Fall 1995, pages