Foreign Exchange 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
◦ These three components (profits, cash flow and market
value) are the key financial elements of how we view the
relative success or failure of a firm
◦ While finance theories tell us that cash flows matter and
accounting does not, we know that currency-related gains
and losses can have destructive impacts on reported
earnings – which are fundamental to the markets opinion
of that company

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Foreign Exchange Exposure
— 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 rate changes
◦ Operating Exposure – also called economic exposure,
measures the change in the present value of the firm
resulting from any change in expected future operating
cash flows caused by an unexpected change in exchange
rates

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Foreign Exchange Exposure
◦ Translation Exposure – also called accounting exposure,
is the potential for accounting derived changes in
owner’s equity to occur because of the need to
“translate” financial statements of foreign subsidiaries
into a single reporting currency for consolidated
financial statements
◦ Tax Exposure – the tax consequence of foreign
exchange exposure varies by country, however as a
general rule only realized foreign losses are deductible
for purposes of calculating income taxes

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Exhibit 9.1 Conceptual Comparison of Transaction,
Operating, and Translation Foreign Exchange Exposure

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Exhibit 9.3 The Life Span of a
Transaction Exposure

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Why Hedge?
— Hedging protects the owner of an asset (future
stream of cash flows) from loss
— However, it also eliminates any gain from an
increase in the value of the asset hedged against
— Since the value of a firm is the net present value
of all expected future cash flows, it is important to
realize that variances in these future cash flows
will affect the value of the firm and that at least
some components of risk (currency risk) can be
hedged against

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Why Hedge - the Pros & Cons
— Opponents of hedging give the following
reasons:
◦ Shareholders are more capable of diversifying risk than
the management of a firm; if stockholders do not wish
to accept the currency risk of any specific firm, they can
diversify their portfolios to manage that risk
◦ Currency risk management does not increase the
expected cash flows of a firm; currency risk management
normally consumes resources thus reducing cash flow
◦ Management often conducts hedging activities that
benefit management at the expense of shareholders

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Why Hedge - the Pros & Cons
— Opponents of hedging give the following
reasons (continued):
◦ Managers cannot outguess the market; if and when markets
are in equilibrium with respect to parity conditions, the
expected NPV of hedging is zero
◦ Management’s motivation to reduce variability is
sometimes driven by accounting reasons; management
may believe that it will be criticized more severely for
incurring foreign exchange losses in its statements than for
incurring similar or even higher cash cost in avoiding the
foreign exchange loss
◦ Efficient market theorists believe that investors can see
through the “accounting veil” and therefore have already
factored the foreign exchange effect into a firm’s market
valuation

9-8
Why Hedge - the Pros & Cons
— Proponents of hedging give the following
reasons:
◦ Reduction in risk in future cash flows improves the
planning capability of the firm
◦ Reduction of risk in future cash flows reduces the
likelihood that the firm’s cash flows will fall below a
necessary minimum
◦ Management has a comparative advantage over the
individual investor in knowing the actual currency risk of
the firm
◦ Markets are usually in disequilibirum because of
structural and institutional imperfections

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Exhibit 9.2 Impact of Hedging on the
Expected Cash Flows of the Firm

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Measurement of Transaction
Exposure
— Transaction exposure measures gains or losses
that arise from the settlement of existing financial
obligations, namely
◦ Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
◦ Borrowing or lending funds when repayment is to be
made in a foreign currency
◦ Being a party to an unperformed forward contract and
◦ Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies

9-11
Other Causes of Transaction
Exposure
— When a firm buys a forward exchange
contract, it deliberately creates transaction
exposure; this risk is incurred to hedge an
existing exposure
◦ Example: US firm wants to offset transaction
exposure of ¥100 million to pay for an import
from Japan in 90 days
◦ Firm can purchase ¥100 million in forward
market to cover payment in 90 days

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Contractual Hedges
— Transaction exposure can be managed by
contractual, operating, or financial hedges
— The main contractual hedges employ forward,
money, futures and options markets
— Operating and financial hedges use risk-sharing
agreements, leads and lags in payment terms, swaps,
and other strategies
— A natural hedge refers to an offsetting operating
cash flow, a payable arising from the conduct of
business
— A financial hedge refers to either an offsetting debt
obligation or some type of financial derivative such as
a swap

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Managing an Account Payable
— Just as Maria’s alternatives for managing the
receivable, the choices are the same for managing
a payable
◦ Assume that the £1,000,000 was an account payable in
90 days
— Remain unhedged – Trident could wait the 90 days
and at that time exchange dollars for pounds to
pay the obligation
◦ If the spot rate is $1.76/£ then Trident would pay
$1,760,000 but this amount is not certain

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Managing an Account Payable
— Use a forward market hedge – Trident could
purchase a forward contract locking in the
$1.754/£ rate ensuring that their obligation will
not be more than $1,754,000
— Use a money market hedge – this hedge is distinctly
different for a payable than a receivable
◦ Here Trident would exchange US dollars spot and invest
them for 90 days in pounds
◦ The pound obligation for Trident is now offset by a
pound asset for Trident with matching maturity

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 Managing an Account Payable
— Using a money market hedge –
◦ To ensure that exactly £1,000,000 will be
received in 90 days time, Maria discounts the
principal by 8% p.a.

This £980,392.16 would require $1,729,411.77 at the current

spot rate

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 Managing an Account Payable
— Using a money market hedge –
◦ Finally, carry the cost forward 90 days in order
to compare the payout from the money market
hedge

This is higher than the forward hedge of $1,754,000 thus

unattractive

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 Managing an Account Payable
— Using an option hedge – instead of
purchasing a put as with a receivable, Maria
would want to purchase a call option on
the payable
◦ The terms of an ATM call option with strike
price of $1,75/£ would be a 1.5% premium

Carried forward 90 days the premium amount is comes to

$27,254

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 Managing an Account Payable

— Using an option hedge –

◦ If the spot rate is less than $1.75/£ then the option would be
allowed to expire and the £1,000,000 would be purchased on
the spot market
◦ If the spot rate rises above $1.75/£ then the option would be
exercised and Trident would exchange the £1,000,000 at $1.75/£
less the option premium for the payable

Exercise call option (£1,000,000 ´ $1.75/£ $1,750,000

Call option premium (carried forward 90 days) $27,254
Total maximum expense of call option hedge $1,777,254

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Exhibit 9.6 Valuation of Hedging
Alternatives for an Account Payable

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Risk Management in Practice
— Which Goals?
◦ The treasury function of most firms is usual considered
a cost center; it is not expected to add to the bottom
line
◦ However, in practice some firms’ treasuries have
become aggressive in currency management and act as
profit centers
— Which Exposures?
◦ Transaction exposures exist before they are actually
booked yet some firms do not hedge this backlog
exposure
◦ However, some firms are selectively hedging these
backlog exposures and anticipated exposures

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Risk Management in Practice
— Which Contractual Hedges?
◦ Transaction exposure management programs
are generally divided along an “option-line;”
those which use options and those that do not
◦ Also, these programs vary in the amount of risk
covered; these proportional hedges are policies
that state which proportion and type of
exposure is to be hedged by the treasury

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9-23
Summary of Learning Objectives
— MNEs encounter three types of currency exposure: (1)
transaction; (2) operating; and (3) translation exposure
— Transaction exposure measures gains or losses that arise
from the settlement of financial obligations whose terms
are stated in a foreign currency
— Operating exposure measures the change in the present
value of the firm resulting from any change in future
operating cash flows caused by an unexpected change in
exchange rates
— Translation exposure is the potential for accounting-oriented
changes in owner’s equity when a firm translates foreign
subsidiaries’ financial statements to consolidated financial
statements

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Summary of Learning Objectives
— Transaction exposure arises from (1) purchasing
or selling on credit and prices are stated in
foreign currencies; (2) borrowing or lending funds
when repayment is to be made in a foreign
currency; (3) being party to an unperformed
forward contract; and (4) otherwise acquiring
assets or liabilities denominated in foreign
currencies
— Considerable theoretical debate exists as to
whether or not firms should hedge currency risk

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Summary of Learning Objectives
— Transaction exposure can be managed by
contractual techniques and certain operating
strategies. Contractual techniques include
forward contracts, money market and option
hedges
— The choice of which hedge to use depends on the
individual firm’s currency risk tolerance and its
expectations of the probable movement of
exchange rates over the transaction exposure
period

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Summary of Learning Objectives
— In general, if an exchange rate is expected to
move in a firm’s favor, the preferred contractual
hedges are those which allow the firm to
participate in some of the upside potential, but
protect it against adverse exchange rate
movements
— In general, if an exchange rate is expected to
move against the firm, the preferred contractual
hedge is one which locks-in an exchange rate

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Summary of Learning Objectives
— Risk management in practice requires a firm’s
treasury department to identify its goals. Is the
treasury a cost or a profit center?
— Treasury must also choose which contractual
hedges it wishes to use and what proportion of
the currency risk should be hedged. Additionally,
treasury must determine whether the firm should
buy and/or sell currency options, a strategy that
has historically been risky for some firms and
banks

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