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CHAP 8: Management of Transaction Exposure - Coggle Diagram
CHAP 8
:
Management of Transaction 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
Some ways of hedging transaction exposure
Financial contracts
Forward market hedge
Money market hedge
Option market hedge
Swap market hedge
Operational techniques
Choice of the invoice currency
Lead/lag strategy
Exposure netting
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
Option market hedge
One possible shortcoming of both forward and money market hedges is that these methods completely eliminate exchange risk exposure.
Consequently, the firm has to forgo the opportunity to benefit from favorable exchange rate changes.
Hedging foreign currency payables
Cross- hedging minor currency exposure
The firm 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
Hedging recurrent with Swap contract
Swap contracts can be viewed as a portfolio of forward contracts.
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.
It is also the case that swaps are available in longer-terms than futures and
forwards.
Hedging through Invoice Currency
(1) Shift exchange rate risk
By invoicing foreign sales in home currency
By forcing suppliers to invoice in buyer’s home currency
(2) Share exchange rate risk:
by pro-rating the currency of the invoice between foreign and home currencies.
(3) Diversify exchange rate risk:
By using a currency basket unit such as SDR.
Hedging via Lead and Lag
Another operational technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments.
•
“lead”:
means to pay or collect early.
•
“lag
”: means to pay or collect late.
Exposure Netting:
A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.
Should the firm
Hedge?
In the presence of market imperfections, the firm should 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.
Default Costs:
Hedging may reduce the firms cost of capital if it reduces the probability of default.
Progressive corporate taxes
: Stable before-tax earnings lead to lower corporate taxes than volatile earnings with the same average value. This happens because under progressive tax rates, the firm pays more taxes in high-earning periods than it saves in low-earning periods.
What risk management products do firms use?
The survey suggests that many multinational firms use a combination of operational techniques and financial contracts to deal with transaction exposure.
The use of currency futures and options contracts is substantially more popular among Asian multinationals, especially among the Japanese and Singaporean firms, than among U.K. and U.S. multinationals
Forward Market Hedge
The most direct and popular way of hedging transaction exposure is by currency forward contracts
If The firm is going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract.
The firm is short the underlying → go long forward
(2) If The firm is going to receive foreign currency in the future, sell the foreign currency now by entering into short position in a forward contract.
The firm is long the underlying → go short forward
The gain/loss is computed as follows:
Gain = (F − ST) × the amount of hedging currency
3.
Money Market Hedge
This is the same idea as covered interest arbitrage. Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money markets
Solution
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 Contingent
Exposure**
Contingent exposure
refers to a situation in which the firm may or may not be subject to exchange exposure.
An alternative approach is to buy a three-month put option on C$100 million. In this case, there are four possible outcomes:
The bid is accepted and the spot exchange rate turns out to be less than the exercise rate
: In this case, the firm will simply exercise the put option and convert C$100 million at the exercise rate
The bid is accepted and the spot exchange rate turns out to be greater than the exercise rate
: In this case, the firm will let the put option expire and convert C$100 million at the spot rate
The bid is rejected and the spot exchange rate turns out to be less than the exercise rate
: In this case, although the firm does not have Canadian dollars, it will exercise the put option and make a profit
The bid is rejected and the spot rate turns out to be greater than the exercise rate
: In this case, the firm will simply let the put option expire
