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CHAPTER 8 : MANAGEMENT OF TRANSACTION EXPOSURE - Coggle Diagram
CHAPTER 8 : MANAGEMENT OF TRANSACTION EXPOSURE
1. Three types of Exposure
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
Exposure netting
: 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.
2. Forward Market Hedge
(1) 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
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
5. Hedging Foreign
Currency Payables
Forward Contracts
Money Market Instruments
Currency Options Contracts
4.Option Market Hedge
Currency options provide such a flexible “optional” hedge against exchange exposure.
the firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables)
Hedging Foreign Currency Receivables –Summary
6. Cross-hedging Minor
Currency Exposure
Situation : If the firm has positions in less liquid currencies such as the Korean won, Thai bhat, and Czech koruna, it may be either very costly or impossible to use financial contracts in these currencies.
Solution: 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.
7. Hedging Contingent Exposure
An alternative approach is to buy a three-month put option on C$100 million.
The bid is accepted and the spot exchange rate turns out to be less than the exercise rate
The bid is accepted and the spot exchange rate turns out to be greater than the exercise rate
The bid is rejected and the spot exchange rate turns out to be less than the exercise rate
The bid is rejected and the spot rate turns out to be greater than the exercise rate
Contingent exposure
refers to a situation in which the firm may or may not be subject to exchange exposure.
8. Hedging recurrent
with Swap contract
Hedging through Invoice Currency
Share exchange rate risk
Shift exchange rate risk
Diversify exchange rate risk
Hedging via Lead and Lag
''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.
9. 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.
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.