Management of Transaction
Exposure
Three Types of Exposure
• It is conventional to classify foreign currency
exposures into three types:
1. Transaction exposure is the potential change in
the value of financial positions due to changes in the
exchange rate between the inception of a contract and
the settlement of the contract
2. Economic exposure is the possibility that cash
flows and the value of the firm may be affected by
unanticipated changes in the exchange rates
3. Translation exposure is the effect of an
unanticipated change in the exchange rates on the
consolidated financial reports of an MNC
8-2
Transaction exposure
• The firm is subject to transaction exposure when
it faces contractual cash flows that are fixed in
foreign currencies
• The home-currency cash flow is uncertain as it
depends on changes in exchange rates
• Hedging transaction exposure with financial
contracts:
▫ Forward market hedge
▫ Money market hedge
▫ Option market hedge
8-3
Importer (payable) vs.
Exporter (receivable)
IMPORTER (payable)
EXPORTER (receivable)
Cash flow
owes foreign currency
receives foreign currency
Risk
if the foreign currency
appreciates against the
domestic currency, the
domestic currency outflow will
be higher
if the foreign currency
depreciates against the
domestic currency, the domestic
currency receipt will be lower
Exposure
payable is like a short
position in the foreign
currency as the company
gains when the foreign currency
depreciates and loses when
appreciates
receivable is like a long
position in the foreign
currency as the company gains
when the foreign currency
appreciates and loses when
depreciates
8-4
Forward Market Hedge: Importer
• If you expect to owe foreign currency in the future, you can hedge by
agreeing today to buy the foreign currency in the future at a set
price by entering into a long position in a forward contract.
Importer
Forward
Contract
Counterparty
Foreign
Supplier
8-5
Forward Market Hedge: Exporter
• If you are going to receive foreign currency in the future, agree to
sell the foreign currency in the future at a set price by entering into
short position in a forward contract.
Exporter
Forward
Contract
Counterparty
Foreign
Customer
8-6
Importer’s Forward Market Hedge
A U.S.-based importer of Italian shoes has just ordered next year’s inventory. Payment
of €100,000 is due in one year. If the importer buys €100,000 at the forward exchange
rate of $1.50/€, the cash flows at maturity look like this:
U.S.
Importer
Forward
Contract
Counterparty
Italian
Supplier
8-7
Importer’s Forward Market Hedge
Suppose the
forward exchange
rate is $1.50/€.
$30k
If he does not
hedge the €100,000
payable, in one year $0
his gain (loss) on
the unhedged
position is shown in –$30k
green.
The importer will be better off
if the euro depreciates: he still
buys €100,000 but at an
exchange rate of only $1.20/€
he saves $30k relative to
$1.50/€
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
But he will be worse off if
the euro appreciates.
Unhedged
payable
8-8
Importer’s Forward Market Hedge
If he agrees to
buy €100,000
in one year at
$1.50/€ his
gain (loss) on
the forward are
shown in blue.
$30k
$0
If you agree to buy
€100,000 at a price of
$1.50/€, you will make
$30,000 if the price of the
euro reaches $1.80.
Long
forward
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
–$30k
If you agree to buy €100,000 at a price
of $1.50 per euro, you will lose
$30,000 if the price of the euro falls to
$1.20/€.
8-9
Importer’s Forward Market Hedge
The red line
shows the
gains/losses of
the hedged
$30 k
payable. Note
that gains on one
$0
position are
offset by losses
on the other
–$30 k
position.
Long
forward
Hedged payable
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
Unhedged
payable
8-10
Importer’s Forward Market Hedge
The red line
shows the payoff
of the hedged
payable.
$150 k
$0
Unhedged
payable
Hedged payable
Value of €1 in $
$1.20/€ $1.50/€ $1.80/€
in one year
8-11
Exporter’s Forward Market Hedge
A U.K.-based exporter sold a €100,000 order to an Italian
retailer. Payment is due in 1 year and the exporter used a
forward hedge.
S0(£/€) = £0.80/€,
i£ = 15½% i€ = 5%
F1(£/€) = £0.88/€
Forward
€100,000 Exporter
Goods
Contract
Customer
Counterparty
£88,000
€100,000
8-12
Currency Futures versus Forwards
• A firm could use a currency futures contract, rather
than a forward contract, for hedging purposes
• A futures contract is not as suitable as a forward
contract for hedging purposes for two reasons:
1. Unlike forward contracts that are tailor-made to the firm’s
specific needs, futures contracts are standardized
instruments in terms of contract size, delivery date, etc.

Thus, in most cases, the firm can only hedge approximately
2. Due to the marking-to-market property, there are interim
cash flows prior to the maturity date of the futures
contract that may have to be invested at uncertain interest
rates

Again, this makes exact hedging difficult
8-13
Exporter’s Futures Market Cross-Currency Hedge
Your firm is a U.K.-based exporter of bicycles. You have sold €750,000 worth of bicycles to an
Italian retailer.
Payment (in euros) is due in six months. Your firm wants to hedge the receivable into pounds.
Country
U.S. $ equiv.
Currency per U.S. $
Britain (£62,500)
$2.0000
£0.5000
1 Month Forward
$1.9900
£0.5025
3 Months Forward
$1.9800
£0.5051
6 Months Forward
$2.0000
£0.5000
12 Months Forward
$2.1000
£0.4762
Euro (€125,000)
$1.4700
€0.6803
1 Month Forward
$1.4800
€0.6757
3 Months Forward
$1.4900
€0.6711
6 Months Forward
$1.5000
€0.6667
12 Months Forward
$1.5100
€0.6623
Sizes of forwards on this exchange are £62,500 and €125,000.
8-14
Exporter’s Futures Market Cross-Currency Hedge
• The exporter has to convert the €750,000 receivable first into dollars
and then into pounds.
• If we sell the €750,000 receivable forward at the six-month forward rate
of $1.50/€, we can do this with a SHORT position in 6 six-month euro
futures contracts.
€750,000
6 contracts =
€125,000/contract
 Selling the €750,000 forward at the six-month forward rate of $1.50/€
generates $1,125,000:
$1.50
$1,125,000 = €750,000 ×

€1
At the six-month forward exchange rate of $2/£, $1,125,000 will buy
£562,500. We can secure this trade with a LONG position in 9 six-month
pound futures contracts:
£562,500
9 contracts =
£62,500/contract
8-15
Exporter’s Futures Market Cross-Currency
Hedge: Cash Flows at Maturity
Short position
in 6 six-month
euro futures on
€125,000
at $1.50/€1
€750,000
$1,125,000
Long position
$1,125,000
in 9 six-month
pound futures £562,500
on £62,500 at
$2.00/£1
Exporter
Bicycles
Customer
€750,000
8-16
Money Market Hedge
• This is the same idea as covered interest
arbitrage.
• A firm may borrow (lend) in foreign currency to
hedge its foreign currency receivables
(payables), thereby matching its assets and
liabilities in the same currency
8-17
Importer’s Money Market Hedge
• To hedge a foreign currency payable, buy the
present value of that foreign currency payable
today and put it in the bank at interest.
▫ Buy the present value of the foreign currency payable
today at the spot exchange rate.
▫ Invest that amount at the foreign rate.
▫ At maturity your investment will have grown enough
to cover your foreign currency payable.
8-18
Importer’s Money Market Hedge
A U.S.–based importer of Italian shoes owes €100,000
to an Italian supplier in one year.
▫ The spot exchange rate is $1.514 = €1.00.
▫ The one-year interest rate in Italy is i€ = 4%.
▫ The importer can hedge this payable by buying
€100,000
€96,153.85 =
1.04
and investing €96,153.85 at 4% in Italy for one year. At maturity, he
will have €100,000 = €96,153.85 × (1.04).
Dollar cost today = $145,631.1 = €96,153.85 ×
$1.514
€1.00
8-19
Importer’s Money Market Hedge
• With this money market hedge, we have redenominated
a one-year €100,000 payable into a $ 145,631.1 payable
due today.
• If the U.S. interest rate is i$ = 3%, we could borrow the
$145,631.1 today and owe $150,000 in one year.
$148,557.69 = $ 145,631.1 × (1.03)
€100,000
T
$150,000 = S($/€)×
×
(1+
i
)
$
(1+ i€)T
8-20
Importer’s Money Market Hedge: Cash Flows
Now and at Maturity
€96,153.85
Importer
$145,631.1
€96,153.85 Italian Bank
€100,000
$145,631.1
$150,000
Spot Foreign
Exchange
Market
deposit i€ = 4%
T= 1
cash
flows
Supplier
U.S Bank
8-21
Importer’s Money Market Hedge:
Step One
Suppose you want to hedge a payable in the amount
of €y with a maturity of T:
i. Borrow $x at t = 0 on a loan at a rate of i$ per year.
€y
$x = S($/€)× (1+ i )T
€
$x
0
Repay the loan in T years
–$x(1 + i$)T
T
8-22
Importer’s Money Market Hedge:
Step Two
ii. Exchange the borrowed $x for
at the prevailing spot rate.
€y
Invest
(1+ i€)T
€y
(1+ i€)T
at i€ for the maturity of the payable.
At maturity, you will owe a $x(1 + i$)T.
Your Euro investments will have grown to €y. This amount will
service your payable and you will have no exposure to the euro.
8-23
Importer’s Money Market CrossCurrency Hedge
Your firm is a U.K.-based importer of bicycles.
You have bought €750,000 worth of bicycles from
an Italian firm. Payment (in euros) is due in one
year. Your firm wants to hedge the payable into
pounds.
▫
▫
Spot exchange rates are $2/£ and $1.55/€
The interest rates are 3% in €, 6% in $ and 4% in £,
all quoted as an APR.
What should you do to redenominate this 1-year €denominated payable into a £-denominated
payable with a 1-year maturity?
8-24
Importer’s Money Market CrossCurrency Hedge
• Sell pounds for dollars at spot exchange rate, buy euro at
spot exchange rate with the dollars, invest in the euro zone
for one year at i€ = 3%, all such that the future value of the
investment equals €750,000. Using the numbers, we have:
▫ Step 1: Borrow £564,320.39 at i£ = 4%.
▫ Step 2: Sell pounds for dollars, receive $1,128,640.78.
▫ Step 3: Buy euro with the dollars, receive €728,155.34.
▫ Step 4: Invest in the euro zone for 12 months at 3% APR (the
future value of the investment equals €750,000).
▫ Step 5: Repay your borrowing with £586,893.20.
(see next slide for where the numbers come from)
8-25
Where Do the Numbers Come From?
€750,000
The present value of the euro payable =€728,155.34 =
(1.03)
The dollar cost of buying
the present value of the = $1,128,640.78 = €728,155.34 × $1.55
€1
euro payable today
Cost today in pounds of the
£1
present dollar value of the £564,320.39 = $1,128,640.78 × $2
euro payable
FV in pounds of the cost in
pounds of being able to pay £586,893.20 = £564,320.39 × (1.04)
the supplier €750,000
8-26
Importer’s Money Market Cross-Currency Hedge:
Cash Flows Now and at Maturity
Spot Foreign $1,128,640.77
€728,155.34
Exchange
Market
€728,155.34 Importer deposit i€ = 3% Italian Bank
£564,320.39
$1,128,640.77
£586,893.20
€750,000
£564,320.39
Spot Foreign
Exchange
Market
U.K Bank
T= 1
cash
flows
Supplier
8-27
Exporter’s Money Market Hedge
Borrow PV of €100,000 at i€ = 5%
Exporter €95,238.10
£76,190.48
€100,000
A British exporter has just
sold €100,000 worth of
bicycles to an Italian
customer.
Payment is due in one year.
Interest rates are 15.5% in
the U.K. and 5% in the euro
zone.
The spot exchange rate is
£0.80/€1.00.
£88,000
€95,238.10
£76,190.48
Spot Foreign
Exchange
Market
U.K Bank
Italian Bank
T= 1
cash
flows
Customer
8-28
Exporter’s Money Market Hedge
1. Borrow the present value of €y at i€
€y
(1+ i€)T
€y
2. Exchange £x = S(£/€)×
(1+ i€)T
€y
(1+ i€)T
for
3. Invest £x at i£ for T years.
4. Collect €y from your customer and use it to repay the € loan.
5. Receive the maturity value £x (1+i£)T which is the guaranteed £
proceeds from your sale
8-29
Money Market Hedge: a recap
• Generally speaking, the firm:
• may borrow in foreign currency to hedge its
foreign currency receivables
• may lend (i.e. invest) in foreign currency to
hedge its foreign currency payables
• Apart from transaction costs, the money market
hedge is fully self-financing
8-30
Options Market Hedge
• One possible shortcoming of both forward and money
market hedges is that these methods completely
eliminate exchange risk exposure
▫ Ideally, an exporter would like to protect itself only if the
foreign currency weakens, while retaining the opportunity to
benefit if the foreign currency strengthens
• Currency options provide a flexible “optional” hedge
against exchange exposure
▫ Firm may buy a foreign currency call (put) option to hedge its
foreign currency payables (receivables)
8-31
Using Options to Hedge: Exports
• A British exporter who is owed €100,000 in one period has many
choices:
▫ Buy call options on the pound with a strike in dollars while also
buying put options on the euro with a strike in dollars.
▫ Buy call options on the pound with a strike in euros.
▫ Buy put options on the euro with a strike in pounds.
▫ Spot rates are S0(£/€) = £0.80/€, i£ = 15½% and i€ = 5%.
▫ In the next year, suppose that there are two possibilities:
 S1(£/€) = £1.00/€ or
 S1(£/€) = £0.75/€
8-32
Exporter’s Options Market Hedge
• An option is written on €10,000.
• Strike price £0.80/€
A British exporter with a
€100,000 receivable
should buy 10 put options
on €10,000.
10 × p0 = £2,077.92
S1(£/€) = £1.00/€
or
S1(£/€) = £0.75/€
€10,000 = £8,000
p0 = £207.79
£10,000
up
p1 = £0
S1(£/€) = £1.00/€
£7,500
down
p1
= £500
S1(£/€) = £0.75/€
8-33
10 Puts on €10,000 (Strike £8,000)
Option
Dealer
Out-of-the-Money:
S1(£/€) = £1.00/€
K0(£/€) = £0.80/€
Put
Buying
Exporter
£100,000
T = 1 Spot Market
Sell €100,000
€100,000
S1(£/€) = £1.00/€.
customer
10×p0 = £2,077.92
£80,000
Put
S1(£/€) = £0.75/€
Buying
K0(£/€) = £0.80/€
Exporter
€100,000
Option
Dealer
The future value of the
receivable net of the cost of 10 options is either
£97,600 = £100,000 − £2,077.92 × 1.155
or £77,600 = £80,000 − £2,077.92 × 1.155
8-34
Options Market “Perfect” Hedge
• Suppose the exporter (importer) wants to
completely eliminate exchange risk exposure
using options
• How can this be achieved?
• Compute the hedge ratio and choose the number
of options to buy accordingly
• The hedge ratio tells how fast the option value
changes with changes in the value of the
underlying currency
8-35
Options Market “Perfect” Hedge
Consider a British exporter with a €100,000 receivable.
The hedge ratio of this option is − 1/5
£10,000
up
H=
p
up
1 –
down
1
p
S1up – S1down
€10,000 = £8,000
p0 = £207.79
–£500
£0 – £500
1
=
= − /5
=
£10,000 – £7,500 £2,500
p1 = £0
S1(£/€) = £1.00/€
£7,500
down
p1
= £500
S1(£/€) = £0.75/€
With a hedge ratio of –0.20 our exporter would actually achieve a
perfect hedge with a long position in 50 puts (written on €10,000). 8-36
Long 50 Puts = Perfect Hedge
50 × p0 = £10,389.61
Out-of-the-Money:
Put
S1(£/€) = £1.00/€
K0(£/€) = £0.80/€ Buying
£100,000
T = 1 Spot Market
Sell €100,000
€100,000
S1(£/€) = £1.00/€.
Option
Dealer
Exporter
T = 1 Spot Market
Buy €400,000
S1(£/€) = £0.75/€.
customer
Put
Buying
Exporter
In-the-Money Puts
S1(£/€) = £0.75/€
K0(£/€) = £0.80/€
£400,000
€500,000
The future value of the
receivable net of the cost of 50 puts is
£88,000 = £100,000 − £10,389.61 × 1.155 or
£88,000 = £400,000 − £10,389.61 × 1.155 − £300,000
Option
Dealer
8-37
Importer’s Options Market Hedge
Consider a British importer who owes €100,000 in one
year.
The importer can use call options on the euro
with a pound strike to hedge his € liability.
Buy 10 call, each written on
€10,000
£10,000
up
c1 = £2,000
£8,000
c0 = £900.43
£7,500
down
c1
= £0
8-38
Importer’s Option Market Hedge
Option
Dealer
Out-of-the-Money:
Call
S1(£/€) = £0.75/€
K0(£/€) = £0.80/€ Buying
Importer
£75,000
T = 1 Spot Market
Buy €100,000
€100,000
S1(£/€) = £0.75/€.
T = 1 Spot Market
Supplier
Call premium:
900.43*10*1.155=£10,400
S1(£/€) = £1.00/€.
Call
Buying
Importer
The future value of the
payable plus the cost of the call is
£85,400 = £75,000 + £10,400 or
£90,400 = £80,000 + £10,400
£80,000
€100,000
Option
Dealer
In-the-Money Calls:
S1(£/€) = £1.00/€
K0(£/€) = £0.80/€
8-39
Options Markets Hedge
With an exercise price denominated in domestic currency
IMPORTERS who OWE
foreign currency in the
future should BUY
CALL OPTIONS.
EXPORTERS with accounts
receivable denominated in
foreign currency should BUY
PUT OPTIONS.
▫ If the price of the currency
goes up, his call will lock in an
upper limit on the domestic
cost of his imports.
▫ If the price of the currency
goes down, he will have the
option to buy the foreign
currency at a lower price.
▫ If the price of the currency goes
down, puts will lock in a lower limit
on the domestic value of his exports.
▫ If the price of the currency goes up,
he will have the option to sell the
foreign currency at a higher price.
8-40
Summary of Hedging Strategies for
Transaction Exposure
Forward
Hedge
Foreign Currency
Receivable
Foreign Currency
Payable
Sell the foreign currency
receivable amount forward by
entering into a short position on
a forward contract.
Buy the foreign
currency payable
amount forward by
entering into a long
position on a forward
contract.
Borrow in foreign currency
against the foreign currency
Money Market receivable, buy domestic
Hedge
currency with the loan, and
invest in the domestic
market.
Borrow in domestic
currency, buy foreign
currency today with the
loan, and invest
abroad against the
foreign currency
payable.
Options
Hedge
Buy call options on the
foreign currency
payable.
Buy put options on the foreign
currency receivable.
8-4141
Cross-Hedging Minor Currency Exposure
• If a firm has positions in major currencies (e.g.,
British pound, euro, and Japanese yen), it can easily
use forward, money market, or options contracts to
manage its exchange risk exposure
• However, if the firm has positions in less liquid
currencies (e.g., Indonesian rupiah, Thai bhat, and
Czech koruna), it may be either very costly or
impossible to use financial contracts in these
currencies
▫ In this situation, firms may use cross-hedging, which
involves hedging a position in one asset by taking position in
another asset
8-42
Hedging Contingent Exposure
• Options contract can also provide an effective hedge
against what might be called contingent exposure
▫ Contingent exposure is the risk due to uncertain
situations in which a firm does not know if it will face
exchange risk exposure in the future
▫ Example: Suppose GE is bidding on a hydroelectric project in
Canada. If the bid is accepted, which will be known in three
months, GE is going to receive C$100m to initiate the project.
Since GE may or may not face exchange exposure, it faces a
typical contingent exposure situation
▫ Difficult to manage contingent exposure using traditional
hedging tools like forward contracts, but an alternative is for
GE to buy a put option on C$100m
8-43
Hedging Recurrent Exposure with
Swap Contracts
• Firms often must deal with a “sequence” of accounts
payable or receivable in terms of a foreign currency,
and these recurrent cash flows can be best hedged
using a currency swap contract
▫ Currency swap contracts are agreements to exchange one
currency for another at a predetermined exchange rate,
that is, the swap rate, on a sequence of future dates
▫ Similar to a portfolio of forward contracts with different
maturities
▫ Very flexible in terms of amount and maturity, with
maturity ranging from a few months to 20 years
8-44
Hedging through Invoice Currency
• Hedging through invoice currency is an operational
technique that allows the firm to shift, share, or
diversify exchange risk by appropriately choosing
the currency of invoice
▫ Example: If the U.K. exporter invoices £88k rather than
€100k for the sale of bicycles to the Italian customer, it
does not face exchange exposure anymore. Though the
exchange exposure has not disappeared, it has been shifted
to the importer.
▫ Another option would be for the U.K. exporter to invoice
half of the bill in pounds and the remaining half in foreign
currency, thereby sharing the exchange exposure
8-45
Hedging via Lead and Lag
• The lead/lag strategy reduces transaction exposure
by paying or collecting foreign financial obligations
early (lead) or late (lag) depending on whether the
currency is hard or soft
▫ To “lead” means to pay or collect early; to “lag” means to pay or
collect late
▫ If a currency is 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.
▫ If a currency is 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.
▫ Strategy can be employed more effectively to deal with intrafirm
payables and receivables among subsidiaries
8-46
Exposure Netting: Lufthansa
• “In 1984, Lufthansa, a German airline, signed a contract
to buy $3 billion worth of aircraft from Boeing and
entered into a forward contract to purchase $1.5 billion
forward for the purpose of hedging against the expected
appreciation of the dollar against the German mark. This
decision, however, suffered from a major flaw: A
significant portion of Lufthansa’s cash flows was also
dollar-denominated.”
▫ Lufthansa had a so-called “natural hedge”
▫ The following year, the dollar depreciated substantially
against the mark and Lufthansa experienced a major foreign
exchange loss from settling the forward contract
▫ The lesson here is that, when a firm has both receivables and
payables in a given foreign currency, it should consider hedging
only its net exposure
8-47
Exposure Netting
• Realistically, typical multinational corporations are
likely to have a portfolio of currency positions
▫ In this case, firms should hedge residual exposure rather than
hedge each currency position separately
• Exposure netting is hedging only the net exposure
by firms that have both payable and receivables in
foreign currencies
▫ For firms that would like to apply this approach aggressively,
it helps to centralize the firm’s exchange exposure
management function in one location
▫ Many MNCs are using a reinvoice center, a financial
subsidiary, as a mechanism for centralizing exposure
management functions
8-48
Should the Firm Hedge?
• Not everyone agrees that a firm should hedge.
▫ Hedging by the firm may not add to shareholder
wealth if the shareholders can manage exposure
themselves.
▫ Hedging may not reduce the non-diversifiable risk
of the firm. Therefore, shareholders who hold a
diversified portfolio are not benefitted when
management hedges.
8-49
LA METTE COME DOMANDA
Market imperfections and hedging
• 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.
• Taxes can be a large market imperfection:
▫ Corporations that face progressive tax rates may find that they
pay less in taxes if they can manage earnings by hedging than if
they have “boom and bust” cycles in their earnings stream.
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What Risk Management Products Do
Firms Use?
• Among U.S. corporations, based on a survey of
Fortune 500 firms, the most popular product was the
traditional forward contract
▫ Jesswein, Kwok, and Folks (1995) found 93% of
respondents reported using forward contracts
• Kim and Chance (2018) study:
▫ Examined actual currency risk management practices of 101
largest nonfinancial corporations in South Korea
▫ Authors document a great discrepancy between what firms
say they do versus what they actually do, attributing the
discord to attempts by companies to time their hedges
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Required reading
• Eun C.S. and Resnik B.G. (2021) “International
Financial Management”, Mc Graw Hill, ch. 8
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