Chapter 10

Transaction
Exposure
 Learning Objectives

• Distinguish between the three major foreign

exchange exposures experienced by firms
• Analyze the pros and cons of hedging foreign
exchange transaction exposure
• Examine the alternatives available to a firm for
managing a large and significant transaction
exposure
• Evaluate the institutional practices and concerns of
conducting foreign exchange risk management
• Explore advanced dimensions of foreign currency
hedging

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 Transaction 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.
• An important task of the financial manager is to
measure foreign exchange exposure and to manage
it so as to maximize the profitability, net cash flow,
and market value of the firm.
• Exhibit 10.1 shows schematically the three main
types of foreign exchange exposure: transaction,
translation, and operating.

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 Exhibit 10.1 The Foreign Exchange
Exposures of the Firm

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 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 rates change.
• Thus, this type of exposure deals with
changes in cash flows the result from
existing contractual obligations.

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 Types of Foreign
Exchange Exposure
• Operating exposure, also called economic
exposure, competitive exposure, or strategic
exposure, measures the change in the
present value of the firm resulting from any
change in future operating cash flows of the
firm caused by an unexpected change in
exchange rates.

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 Types of Foreign
Exchange Exposure
• Transaction exposure and operating
exposure exist because of unexpected
changes in future cash flows.
• The difference between the two is that
transaction exposure is concerned with
future cash flows already contracted for,
while operating exposure focuses on
expected (not yet contracted for) future
cash flows that might change because a
change in exchange rates has altered
international competitiveness.
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 Types of 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” foreign
currency financial statements of foreign
subsidiaries into a single reporting currency
to prepare worldwide consolidated financial
statements.

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 Why Hedge?

• MNEs possess a multitude of cash flows that

are sensitive to changes in exchange rates,
interest rates, and commodity prices.
• These three financial price risks are the
subject of the growing field of financial risk
management.
• Many firms attempt to manage their
currency exposures through hedging.

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 Why Hedge?

• Hedging is the taking of a position, acquiring

either a cash flow, an asset, or a contract
(including a forward contract) that will rise
(fall) in value and offset a fall (rise) in the
value of an existing position.
• While hedging can protect the owner of an
asset from a loss, it also eliminates any gain
from an increase in the value of the asset
hedged against.

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 Why Hedge?

• The value of a firm, according to financial theory, is

the net present value of all expected future cash
flows.
• Currency risk is defined roughly as the variance in
expected cash flows arising from unexpected
exchange rate changes.
• A firm that hedges these exposures reduces some
of the variance in the value of its future expected
cash flows.
• Exhibit 10.2 illustrates the distribution of expected
net cash flows of the individual firm.

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 Exhibit 10.2 Hedging’s Impact on
the Expected Cash Flows of the Firm

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 Why Hedge?

• Proponents of hedging cite:

– 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 (the point of financial distress)
– Management has a comparative advantage over the
individual shareholder in knowing the actual currency risk
of the firm
– Management is in better position to take advantage of
disequilibrium conditions in the market

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 Why Hedge?

• Opponents of hedging state:

– Shareholders are much more capable of diversifying
currency risk than the management of the firm
– Currency risk management does not increase the expected
cash flows of the firm
– Management often conducts hedging activities that benefit
management at the expense of the shareholders
– Managers cannot outguess the market
– Management’s motivation to reduce variability is
sometimes for accounting reasons.
– Hedging only adds costs from an efficient market
perspective.

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 Measurement
of Transaction Exposure
• Transaction exposure measures gains or
losses that arise from the settlement of
existing financial obligations whose terms
are stated in a foreign currency.
• The most common example of transaction
exposure arises when a firm has a
receivable or payable denominated in a
foreign currency. Exhibit 10.3 demonstrates
how this exposure comes about.

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 Exhibit 10.3 The Life Span of
Transaction Exposure

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 Measurement
of Transaction Exposure
• Foreign exchange transaction exposure can
be managed by contractual, operating, and
financial hedges.
• The main contractual hedges employ the
forward, money, futures, and options
markets.
• Operating and financial hedges employ the
use of risk-sharing agreements, leads and
lags in payment terms, swaps, and other
strategies.

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 Measurement
of Transaction Exposure
• The term natural hedge refers to an off-
setting operating cash flow, a payable
arising from the conduct of business.
• A financial hedge refers to either an off-
setting debt obligation (such as a loan) or
some type of financial derivative such as an
interest rate swap.
• Care should be taken to distinguish
operating hedges from financing hedges.

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 Ganado’s Transaction Exposure

• With reference to Ganado’s transaction

exposure, the CFO, Maria Gonzalez, has four
alternatives:
– remain unhedged;
– hedge in the forward market;
– hedge in the money market; or
– hedge in the options market.
• These choices apply to an account
receivable and/or an account payable.
• See Exhibit 10.4

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 Exhibit 10.4 Ganado’s Transaction
Exposure

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 Ganado’s Transaction Exposure

• A forward hedge involves a forward (or futures)

contract and a source of funds to fulfill the contract.
• In some situations, funds to fulfill the forward
exchange contract are not already available or due
to be received later, but must be purchased in the
spot market at some future date.
• This type of hedge is “open” or “uncovered” and
involves considerable risk because the hedge must
take a chance on the uncertain future spot rate to
fulfill the forward contract.
• The purchase of such funds at a later date is
referred to as covering.

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 Ganado’s Transaction Exposure

• A money market hedge also involves a contract and

a source of funds to fulfill that contract.
• The firm seeking the money market hedge borrows
in one currency and exchanges the proceeds for
another currency.
• Funds to fulfill the contract may be generated from
business operations, in which case the money
market hedge is covered.
• Alternatively, funds to repay the loan may be
purchased in the foreign exchange spot market
when the loan matures (uncovered or open money
market hedge).

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 Ganado’s Transaction Exposure

• Hedging with options allows for participation in any

upside potential associated with the position while
limiting downside risk.
• The choice of option strike prices is a very
important aspect of utilizing options as option
premiums, and payoff patterns will differ
accordingly.
• Exhibit 10.5 shows the value of Ganado’s
£1,000,000 account receivable over a range of
possible ending spot exchange rates and hedging
alternatives.
• Exhibit 10.6 shows alternatives for an A/P

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 Exhibit 10.5 Ganado’s A/R Transaction
Exposure Hedging Alternatives

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 Exhibit 10.6 Ganado’s A/P Transaction
Exposure Hedging Alternatives

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 Risk Management in Practice

• The treasury function of most private firms,

the group typically responsible for
transaction exposure management, is
usually considered a cost center.
• The treasury function is not expected to add
profit to the firm’s bottom line.
• Currency risk managers are expected to
earn on the conservative side when
managing the firm’s money.

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 Risk Management in Practice

• Firms must decide which exposures to hedge:

– Many firms do not allow the hedging of quotation exposure
or backlog exposure as a matter of policy
– Many firms feel that until the transaction exists on the
accounting books of the firm, the probability of the
exposure actually occurring is considered to be less than
100%
– An increasing number of firms, however, are actively
hedging not only backlog exposures, but also selectively
hedging quotation and anticipated exposures
– Anticipated exposures are transactions for which there are
no contracts or agreements between parties

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 Risk Management in Practice

• As might be expected, transaction exposure

management programs are generally
divided along an “option-line,” those that
use options and those that do not.
• Firms that do not use currency options rely
almost exclusively on forward contracts and
money market hedges.

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 Risk Management in Practice

• Many MNEs have established rather rigid

transaction exposure risk management
policies that mandate proportional hedging.
• These contracts generally require the use of
forward contract hedges on a percentage of
existing transaction exposures.
• The remaining portion of the exposure is
then selectively hedged on the basis of the
firm’s risk tolerance, view of exchange rate
movements, and confidence level.

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 Advanced Topics in Hedging

• There are other theoretical dimensions to

currency hedging that are not often
considered in actual industry practice:
– optimal hedge ratio;
– hedge symmetry;
– hedge effectiveness; and
– hedge timing.

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 Chapter 10
Appendix

Complex Option
Hedges
 Exhibit 10A.1 Ganado’s A/R
Exposure and Put Option Hedges

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 Exhibit 10A.2 Ganado’s Synthetic
Forward A/R Exposure Hedge

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 Exhibit 10A.3 Ganado’s Range
Forward A/R Exposure Hedge

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 Exhibit 10A.4 Ganado’s Participating
Forward A/R Exposure Hedge

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