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Management of Transaction Exposure - Coggle Diagram
Management of Transaction
Exposure
Three types of Exposure
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.
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.
Management of Transaction Expose
Operational techniques
Lead/lag strategy
Exposure netting
Choice of the invoice currency
Financial contracts
Swap market hedge
Money market hedge
Option market hedge
Forward market hedge
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.
To hedge the firm’s foreign currency payables
the firm may lend in foreign currency
To hedge the firm’s foreign currency receivables
the firm may borrow in foreign currency
Forward Market Hedge
The most direct and popular way of hedging transaction exposure is by currency forward contracts.
The firm is short the underlying
go long forward
The firm is long the underlying
go short forward
Gain = (F − ST) × the amount of hedging currency
Hedging Foreign Currency Payables
Hedging purpose: Boeing will have to try to minimize the dollar cost of paying off the payable.
In this section, we are going to discuss how to hedge foreign currency “payables.”
Option Market Hedge
Currency options provide such a flexible “optional” hedge against exchange exposure.
One possible shortcoming of both forward and money market hedges is that these methods completely eliminate exchange risk exposure.
Cross-hedging Minor Currency
Exposure
Contingent exposure
refers to a situation in which the firm may or may not be subject to
exchange exposure.
The above scenarios indicate that when the put option is purchased, each outcome is adequately covered;
the firm will not be left with an unhedged foreign currency position.
Hedging Contingent Exposure
Financial contracts in less liquid currencies, such as the Korean won, Thai bhat, and Czech koruna, may be prohibitively expensive or difficult to employ.
To handle its minimal currency exposure, the company can employ cross-hedging tactics. Hedging a holding in one asset with a position in another is referred to as cross-hedging.
Hedging recurrent with Swap
contract
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 forward.
Recall that swap contracts can be viewed as a portfolio of forward contracts.
The firm can shift, share, or diversify:
Share exchange rate risk
by pro-rating the currency of the invoice between foreign and home currencies.
Diversify exchange rate risk
by using a currency basket unit such as SDR.
Shift exchange rate risk
by forcing suppliers to invoice in buyer’s home currency
by invoicing foreign sales in home currency
Another operational technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments.
appreciating,
pay those bills denominated in that currency early; let
customers in that country pay late as long as they are paying in that currency.
depreciating,
give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.
Should the firm
Hedge?
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.
Information Asymmetry
The managers may have better information than the shareholders.
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.