1. 13 Management of Transaction Exposure Chapter Objective:
This chapter discusses various methods available for the management of transaction exposure facing multinational firms.
This chapter ties together chapters 4, 5, and 6. 13
Chapter Thirteen
Management of Transaction Exposure
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2. Chapter Outline Forward (Futures) Market Hedge Money Market Hedge
Options Market Hedge
Cross-Hedging Minor Currency Exposure

3. Transaction Exposure: Definition
The potential change in the value of financial positions due to changes in the exchange rate between the inception of a contract and the settlement of the contract.
A special case of economic exposure.
But often explored and discussed as a type of exposure hedging.

4. Forward Market Hedge: Imports
If you expect to owe foreign currency in the future, you can hedge by agreeing today to buy the foreign currency in the future at a set price by entering into a long position in a forward contract.
Domestic Currency
Importer
Goods or Services
Foreign currency
Foreign currency
Foreign Supplier
Forward Contract Counterparty

5. Forward Market Hedge: Exports
If you are going to receive foreign currency in the future, you can hedge by agreeing today to sell the foreign currency in the future at a set price by entering into short position in a forward contract.
Exporter
Goods or Services
Foreign Currency
Domestic Currency
Foreign Currency
Foreign Customer
Forward Contract Counterparty

6. Forward Contract Counterparty
Importer’s Forward Market Hedge
A U.S.-based importer of Italian shoes has just ordered next year’s inventory. Payment of €1M is due in one year. If the importer buys €1M at the forward exchange rate of $1.50/€, the cash flows at maturity look like this:
U.S. Importer
$1,500,000
Shoes
€1,000,000
€1,000,000
Italian Supplier
Forward Contract Counterparty

7. Forward Market Hedge Suppose the forward exchange rate is $1.50/€.
The importer will be better off if the euro depreciates: he still buys €1m but at an exchange rate of only $1.20/€ he saves $0.3 million relative to $1.50/€
Suppose the forward exchange rate is $1.50/€.
If he does not hedge the €1m payable, in one year his gain (loss) on the unhedged position is shown in green.
$0.3m
$1.20/€ $0
$1.80/€
Value of €1 in $ in one year
$1.50/€
–$0.3m
But he will be worse off if the pound appreciates.
Unhedged payable 7
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8. Forward Market Hedge
If you agree to buy €1 million at a price of $1.50/€, you will make $0.3 million if the price of the euro reaches $1.80.
Long forward
If he agrees to buy €1m in one year at $1.50/€ his gain (loss) on the forward are shown in blue.
$0.3m
$1.80/€ $0
$1.20/€
Value of €1 in $ in one year
$1.50/€
–$0.3m
If you agree to buy €1 million at a price of $1.50 per pound, you will lose $0.3 million if the price of the euro falls to $1.20/€. 8
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9. Forward Market Hedge
Long forward
The red line shows the payoff of the hedged payable. Note that gains on one position are offset by losses on the other position.
$0.3 m
Hedged payable $0
Value of €1 in $ in one year
$1.20/€
$1.50/€
$1.80/€
–$0.3 m
Unhedged payable
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10. Exporter’s Futures Market Cross-Currency Hedge
Country
U.S. $ equiv.
Currency per U.S. $
Britain (£62,500)
$2.0000
£0.5000
1 Month Forward
$1.9900
£0.5025
3 Months Forward
$1.9800
£0.5051
6 Months Forward
12 Months Forward
$2.1000
£0.4762
Euro (€125,000)
$1.4700
€0.6803
$1.4800
€0.6757
$1.4900
€0.6711
$1.5000
€0.6667
$1.5100
€0.6623
Your firm is a U.K.-based exporter of bicycles.
You have sold €750,000 worth of bicycles to an Italian retailer.
Payment (in euros) is due in six months.
Your firm wants to hedge the receivable into pounds.
Sizes of forwards on this exchange are £62,500 and €125,000.

11. Exporter’s Futures Market Cross-Currency Hedge
The exporter has to convert the €750,000 receivable first into dollars and then into pounds.
If we sell the €750,000 receivable forward at the six-month forward rate of $1.50/€, we can do this with a SHORT position in 6 six-month euro futures contracts.
6 contracts =
€750,000
€125,000/contract
Selling the €750,000 forward at the six-month forward rate of $1.50/€ generates $1,125,000:
$1,125,000 = €750,000 × €1
$1.50
At the six-month forward exchange rate of $2/£, $1,125,000 will buy £562,500. We can secure this trade with a LONG position in 9 six-month pound futures contracts:
9 contracts =
£562,500
£62,500/contract

12. Exporter’s Futures Market Cross-Currency Hedge: Cash Flows at Maturity
Short position in 6 six-month euro futures on
€125,000
at $1.50/€1
€750,000
$1,125,000
Exporter
Bicycles
Customer
€750,000
Long position in 9 six-month pound futures on £62,500 at $2.00/£1
$1,125,000
£562,500

13. Importer’s Money Market Hedge
This is the same idea as covered interest arbitrage.
To hedge a foreign currency payable, buy the present value of that foreign currency payable today and put it in the bank at interest.
Buy the present value of the foreign currency payable today at the spot exchange rate.
Invest that amount at the foreign rate.
At maturity your investment will have grown enough to cover your foreign currency payable.

14. Importer’s Money Market Hedge
A U.S.–based importer of Italian bicycles owes €100,000 to an Italian supplier in one year.
The spot exchange rate is $1.50 = €1.00.
The one-year interest rate in Italy is i€ = 4%.
The importer can hedge this payable by buying
and investing €96, at 4% in Italy for one year. At maturity, he will have €100,000 = €96, × (1.04).
€100,000
1.04
€96, =
$1.50
€1.00
Dollar cost today = $144, = €96, ×

15. Importer’s Money Market Hedge
With this money market hedge, we have redenominated a one-year €100,000 payable into a $144, payable due today.
If the U.S. interest rate is i$ = 3%, we could borrow the $144, today and owe $148, in one year.
$148, = $144, × (1.03)
$148, =
€100,000
(1+ i€)T
(1+ i$)T ×
S($/€)×

16. Importer’s Money Market Hedge: Cash Flows Now and at Maturity
deposit i€ = 4%
Spot Foreign Exchange Market
€96,153.85
Importer
€96,153.85
Italia Bank
$144,230.77
€100,000
T= 1 cash flows
€100,000
$144,230.77
$148,557.69
bicycles
Supplier
U.S Bank

17. Exporter’s Money Market Hedge
Spot Foreign Exchange Market
€95,238.10
€95,238.10
Crédit
Agricole
Exporter
Borrow i€ = 5%
$119,047.62
€100,000
An American exporter has just sold €100,000 worth of shoes to a French customer.
Payment is due in one year.
Interest rates in dollars are 7.10 percent in the U.S. and 5 percent in the euro zone.
The spot exchange rate is $1.25/€1.00. Use a money market hedge to eliminate the exporter’s exchange rate risk.
T= 1 cash flows
€100,000
deposit i$ = 7.10%
$119,047.62
$127,500.00
shoes
Customer
U.S Bank

18. Importer’s Money Market Cross-Currency Hedge
Your firm is a U.K.-based importer of bicycles. You have bought €750,000 worth of bicycles from an Italian firm. Payment (in euros) is due in one year. Your firm wants to hedge the payable into pounds.
Spot exchange rates are $2/£ and $1.55/€
The interest rates are 3% in €, 6% in $ and 4% in £, all quoted as an APR.
What should you do to redenominate this 1-year €-denominated payable into a £-denominated payable with a 1-year maturity?

19. Importer’s Money Market Cross-Currency Hedge
Sell pounds for dollars at spot exchange rate, buy euro at spot exchange rate with the dollars, invest in the euro zone for one year at i€ = 3%, all such that the future value of the investment equals €750,000. Using the numbers we have:
Step 1: Borrow £564, at i£ = 4%.
Step 2: Sell pounds for dollars, receive $1,128,
Step 3: Buy euro with the dollars, receive €728,
Step 4: Invest in the euro zone for 12 months at 3% APR (the future value of the investment equals €750,000).
Step 5: Repay your borrowing with £586,
(see next slide for where the numbers come from)

20. Where Do the Numbers Come From?
€728, =
€750,000
(1.03)
The present value of the euro payable =
The dollar cost of buying the present value of the euro payable today
= $1,128, = €728, × €1
$1.55
Cost today in pounds of the present dollar value of the euro payable
£564, = $1,128, × $2 £1
FV in pounds of the cost in pounds of being able to pay the supplier €750,000
£586, = £564, × (1.04)

21. Importer’s Money Market Cross-Currency Hedge: Cash Flows Now and at Maturity
$1,128,640.77
Spot Foreign Exchange Market
€728, deposit i€ = 3%
€728,155.34
Importer
Italia Bank
€750,000
Spot Foreign Exchange Market
£564,320.39
T= 1 cash flows
$1,128,640.77
€750,000
£564,320.39
£586,893.20
bicycles
Supplier
U.K Bank

22. Options Market Hedge
Options provide a flexible hedge against the downside, while preserving the upside potential.
To hedge a foreign currency payable buy calls on the currency.
If the currency appreciates, your call option lets you buy the currency at the exercise price of the call.
To hedge a foreign currency receivable buy puts on the currency.
If the currency depreciates, your put option lets you sell the currency for the exercise price.
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23. Options Market Hedge
The importer will be better off if the euro depreciates: he still buys €100m but at an exchange rate of only $1.20/€ he saves $30 million relative to $1.50/€
Suppose the forward exchange rate is $1.50/€.
If an importer who owes €100m does not hedge the payable, in one year his gain (loss) on the unhedged position is shown in green.
$30m
$1.20/€ $0
$1.80/€
Value of €1 in $ in one year
$1.50/€
–$30m
But he will be worse off if the euro appreciates.
Unhedged payable
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24. Options Markets Hedge
Profit
Long call on €100m
Suppose our importer buys a call option on €100m with an exercise price of $1.50 per pound.
He pays $.05 per euro for the call.
–$5m
Value of €1 in $ in one year
$1.55/€
$1.50/€
loss
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25. Options Markets Hedge Profit Long call on €100m
The payoff of the portfolio of a call and a payable is shown in red.
He can still profit from decreases in the exchange rate below $1.45/€ but has a hedge against unfavorable increases in the exchange rate.
$25m
$1.20/€
–$5m
$1.45 /€
Value of €1 in $ in one year
$1.50/€
Unhedged payable
loss
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26. Options Markets Hedge Profit
If the exchange rate increases to $1.80/€ the importer makes $25 m on the call but loses $30 m on the payable for a maximum loss of $5 million.
This can be thought of as an insurance premium.
Long call on €100m
$25 m
–$5 m
$1.45/€
$1.80/€
Value of €1 in $ in one year
–$30 m
$1.50/€
Unhedged payable
loss
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27. Options Markets Hedge X
With an exercise price denominated in local currency
IMPORTERS who OWE foreign currency in the future should BUY CALL OPTIONS.
If the price of the currency goes up, his call will lock in an upper limit on the dollar cost of his imports.
If the price of the currency goes down, he will have the option to buy the foreign currency at a lower price.
EXPORTERS with accounts receivable denominated in foreign currency should BUY PUT OPTIONS.
If the price of the currency goes down, puts will lock in a lower limit on the dollar value of his exports.
If the price of the currency goes up, he will have the option to sell the foreign currency at a higher price.
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28. Hedging Exports with Put Options
Show the portfolio payoff of an exporter who is owed £1 million in one year.
The current one-year forward rate is £1 = $2.
Instead of entering into a short forward contract, he buys a put option written on £1 million with a maturity of one year and a strike price of £1 = $2.
The cost of this option is $0.05 per pound.
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29. Options Market Hedge:
–$50k
$2.05
Hedged receivable
Exporter buys a put option to protect the dollar value of his receivable.
Long put
$1,950,000
–$50k
S($/£)360 $2
Long receivable
–$2m 29
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30. has essentially purchased a call.
The exporter who buys a put option to protect the dollar value of his receivable
–$50k
$2.05
Hedged receivable
has essentially purchased a call.
S($/£)360 $2 30
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31. Hedging Imports with Call Options
Show the portfolio payoff of an importer who owes £1 million in one year.
The current one-year forward rate is £1 = $1.80; but instead of entering into a long forward contract,
He buys a call option written on £1 million with an expiry of one year and a strike of £1 = $1.80 The cost of this option is $0.08 per pound.
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32. Importer buys £1m forward.
Forward Market Hedge:
GAIN
(TOTAL)
Importer buys £1m forward.
Long currency forward
This forward hedge fixes the dollar value of the payable at $1.80m.
S($/£)360
$1.80
Accounts Payable = Short Currency position
LOSS
(TOTAL) 32
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33. Importer buys call option on £1m.
Options Market Hedge:
Importer buys call option on £1m.
$1.8m
$1,720,000
$1.72
Call
–$80k
$1.88
Call option limits the potential cost of servicing the payable.
S($/£)360
$1.80
Unhedged obligation 33
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34. He makes money if the pound falls in value. $1,720,000
Our importer who buys a call to protect himself from increases in the value of the pound creates a synthetic put option on the pound.
He makes money if the pound falls in value.
$1,720,000
$1.72
S($/£)360
–$80k
$1.80
The cost of this “insurance policy” is $80,000 34
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35. Taking it to the Next Level X
Suppose our importer can absorb “small” amounts of exchange rate risk, but his competitive position will suffer with big movements in the exchange rate.
Large dollar depreciations increase the cost of his imports
Large dollar appreciations increase the foreign currency cost of his competitors exports, costing him customers as his competitors renew their focus on the domestic market.
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36. Our Importer Buys a Second Call Option X
This position is called a straddle
$1,720,000
$1.72
2ndCall
$1.88
$1,640,000
$1.64
$1.96
S($/£)360
–$80k
Importers synthetic put
$1.80
–$160k 36
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37. X $2
buy a put $2 strike
Suppose instead that our importer is willing to risk large exchange rate changes but wants to profit from small changes in the exchange rate, he could lay on a butterfly spread.
$1,720,000
$1.72
Sell 2 puts $1.90 strike.
$1.90
butterfly spread
S($/£)360
–$80k
Importers synthetic put
$1.80
A butterfly spread is analogous to an interest rate collar; indeed it’s sometimes called a zero-cost collar. Selling the 2 puts comes close to offsetting the cost of buying the other 2 puts. 37
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38. Options
A motivated financial engineer can create almost any risk-return profile that a company might wish to consider.
Straddles and butterfly spreads are quite common.
Notice that the butterfly spread costs our importer quite a bit less than a naïve strategy of buying call options.
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