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CHAPTER 8 Management of Transaction Exposure - Coggle Diagram
CHAPTER 8
Management of Transaction Exposure
Hedging Contingent Exposure
Contingent exposure refers to a situation in which the firm may or may not be subject to
exchange exposure.
Should the firm Hedge?
Information Asymmetry : The managers may have better information than the shareholders.
Differential Transactions Costs: The firm may be able to hedge at better prices than the
shareholders.
Progressive corporate taxes: Stable before-tax earnings lead to lower corporate taxes than volatile earnings with the same average value
Default Costs: Hedging may reduce the firms cost of capital if it reduces the probability of
default.
Option Market Hedge
Forward and money market hedges
Forgo the opportunity to benefit from favorable exchange rate changes.
Completely eliminate exchange risk exposure.
Currency options provide such a flexible “optional” hedge against exchange exposure.
.What risk management products
do firms use?
Options
Forward Contracts
Swaps
Futures Options
Futures Contracts
Money Market Hedge
Transaction exposure can also be hedged
by lending and borrowing in the domestic and foreign money markets.
To hedge the firm’s foreign currency receivables → the firm may borrow in foreign
currency
To hedge the firm’s foreign currency payables → the firm may lend in foreign currency
Hedging recurrent with Swap
contract
Hedging through Invoice Currency
Share exchange rate risk
Diversify exchange rate risk
Shift exchange rate risk
Hedging via Lead and Lag
“lead”: means to pay or collect early,
“lag”: means to pay or collect late.
Hedging recurrent with Swap
contract
It is also the case that swaps are available in longer-terms than futures and forwards.
Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along
Hedging Foreign Currency
Payables
Boeing imported a Rolls-Royce jet engine for £5 million payable in one year.
The U.S. interest rate: 6.00% per annum.
The U.K. interest rate: 6.50% per annum.
The spot exchange rate: $1.80/£.
The forward exchange rate: $1.75/£ (1-year maturity)
Boeing will have to try to minimize the dollar cost of paying off the payable.
Dollar Costs of Securing the Pound Payable: Alternative Hedging Strategies
Forward Market Hedge
Forward Market Hedge
The most direct and popular way of hedging transaction exposure is by currency forward contracts.
Gain = (F − ST) × the amount of hedging currency
Cross-hedging Minor Currency
Exposure
Situation
the firm has positions in less liquid currencies such as the Korean won, Thai bhat, and Czech koruna,
Maybe either very costly or impossible to use financial contracts in these
currencies.
Solution
May consider using cross-hedging techniques to manage its minor currency exposure.
Cross-hedging involves hedging a position in one asset by taking a position in another asset.
Three types of
Exposure
Three types of Exposure
.
Transaction exposure: the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes.
Economic exposure: the extent to which the value of the firm would be affected by
unanticipated changes in exchange rates.
Translation exposure: the potential that the firm’s consolidated financial statements can
be affected by changes in exchange rates.
Management of Transaction Expose
This chapter will thus focus on alternative ways of hedging transaction exposure using various financial contracts and operational techniques: Operational techniques and Financial contracts