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. Translation 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
Translation 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
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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
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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7. 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, or
hedge in the options market.
These choices apply to an account receivable and/or an account payable.
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8. 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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9. 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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10. 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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11. 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 $1.71/£
ATM put
option hedge
1.80
1.78
Money market hedge
1.76
1.74
Forward contract hedge
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
1.78
1.80
1.82
1.84
1.86
Ending spot exchange rate (US$/£)
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12. Exhibit 8.6 Valuation of Hedging Alternatives for an Account Payable
Cost in US dollars of
Dayton’s £1,000,000 A/P
Call option strike
price of $1.75/£
Uncovered costs
whatever the ending
spot rate is in 90 days
Forward rate
is $1.7540/£
1.84
1.82
1.80
Money market hedge
Locks in a cost of $1,781,294
1.78
1.76
Forward contract hedge
locks in a cost of $1,754,000
Call option hedge
1.74
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
1.78
1.80
1.82
1.84
1.86
Ending spot exchange rate (US$/£)
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13. 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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14. 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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15. 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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16. 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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17. 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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18. 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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19. 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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